Chapter 3 Cost, Revenue, and Income Behavior

The Contribution Format Used primarily for external reporting. Used primarily by management.

Contribution Margin Practice (d) (e) (f) Per Unit Var. Cost Total Total Total Operating Selling Per Units CM Fixed Income Price Unit Sold Costs $30 120,000 $720,000 $640,000 $ 10 $6 100,000 $320,000 $9 80,000 $ 160,000 $120,000

Contribution Margin Method to Determine Break-even Fixed expenses Unit contribution margin = Break-even point in units sold Break-even point in total sales dollars Fixed expenses CM ratio =

CVP Graph Total Sales Total Expenses Dollars Fixed expenses Units

CVP Graph Profit Area Dollars Break-even point Loss Area Units

Profit-Volume Graph Profit area Loss area Break-even point Profit 1 3 4 5 2 6 7 8 Profit Revenues (000s), Units sold (00s) Profit area Loss area Break-even point

Target Operating Profit - CM Approach Original contribution margin formula: Break Even Point in Units = Fixed Expenses Contribution Margin per Unit Target operating profit modification: Units Sold to Earn Target Profit = Fixed Expenses +Target Op. Profit Unit Contribution Margin

After-Tax Profit Targets Net income = Operating profit – Income taxes = Operating profit – (Tax rate x Operating profit) = Operating profit (1 – Tax rate) Or Operating profit = Net income (1 – Tax rate)

After-Tax Profit Targets Fisher Company has a selling price of $40 for its only product. Variable cost per unit is $24, and fixed costs are $800,000 for the year. The Company wants to achieve an annual net income (after taxes) of $487,500. How many units must it sell if its income tax rate is 35 percent.

The Margin of Safety Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred. Margin of safety = Total sales - Break-even sales

Cost Structure and Profitability Alpha Beta Gamma Amount % Sales $800,000 100% Variable Expenses 400,000 50% 300,000 37.5% 200,000 25% Contribution Margin 500,000 62.5% 600,000 75% Fixed Expenses Op. Income $ 100,000

Effect on Profit of 10% Increase in Sales Revenue Contribution Margin Ratio Increase in Op.Income Alpha $80,000 X 50% = $40,000 +40% Beta 62.5% = $50,000 +50% Gamma 75% = $60,000 +60%

Break-Even Points Fixed Expenses $300,000 / $400,000 / $500,000 / $300,000 / $400,000 / $500,000 / Contribution Margin Ratio 50% = 62.5% = 75% = Break-Even Sales Revenue $600,000 $640,000 $666,667 Alpha Beta Gamma

Break-Even Sales Revenue Margin of Safety Actual Sales Revenue Break-Even Sales Revenue Margin of Safety Alpha Beta Gamma $800,000 - 800,000 - 800,000 - $600,000 = 640,000 = 666,667 = $200,000 160,000 133,333

Definition of Operating Leverage The relative mix of a firm’s fixed and variable costs determines its operating leverage. At a given level of sales: Degree of operating = Contribution Margin leverage Operating Income The higher a firm’s fixed cost as compared to its variable cost, the greater its operating leverage. Operating leverage acts like a multiplier. The greater the operating leverage, the greater the change in operating income for a given change in sales. Let’s calculate the operating leverage for each firm.

Application of Operating Leverage At a given level of sales, the operating leverage is a measure of how a given percentage change in sales will affect operating profits. In fact, the operating profit will increase by the operating leverage times the percentage change in sales. For a 10% increase in sales , Firm Alpha’s operating income increased 40% (4 times 10%). For a 10% increase in sales , Firm Beta’s operating income increased 50% (5 times 10%). For a 10% increase in sales , Firm Gamma’s operating income increased 60% (6 times 10%).

Break-even Analysis (in Units) with Multiple Products Curl Company provides us with the following information: Fixed cost is $120,000. What is the break-even point in units? What are the sales of Surfboards and Sailboards at the break-even point?

Break-even Analysis (in Sales Dollars) with Multiple Products Curl’s Contribution Margin income statement is shown below: $150,000 $450,000 = 33.3% What is the break-even point in Sales? What are the sales of Surfboards and Sailboards at the break-even point?