© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.1 Finance for Non-Financial Managers Fifth Edition Slides prepared by Pierre G. Bergeron University of Ottawa

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.2 Profit Planning and Decision-Making 1.Explain various cost concepts related to break-even analysis such as fixed and variable costs, the relationship between sales revenue and costs, the contribution margin, the relevant range and relevant costs. 2.Draw the break-even chart and calculate the break-even point, the cash break-even point, and the profit break-even point, and how they can be applied in different organizations. 3.Differentiate between different types of cost concepts such as committed and discretionary costs, controllable and non- controllable costs, and direct and indirect costs. Chapter Reference Chapter 9: Profit Planning and Decision-Making Chapter Objectives

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.3 Relevance of Break-Even Analysis Break-even analysis helps to: 1.Price existing or new products and services. 2.Decide whether to introduce a new product or service, open a new plant, hire a sales representative, open a new sales office, launch an advertising program. 3.Modernize or automate an existing plant. 4.Expand an existing plant. 5.Change the cost structure (fixed versus variable).

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Fixed and Variable Costs Fixed costs Period costs Constant costs Standby costs Characteristic Element of fixedness and must be paid with passage of time. Variable costs Direct costs Out-of-pocket costs Volume costs Characteristic Vary almost automatically with volume. Sales commission, direct labour, packing material, electricity, overtime premiums, equipment rental, truck expenses Rent, interest, insurance, property taxes, office salaries, amortization, telephone

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.5 Connection Between Revenue and Costs Factors that affect profit: 1.Volume of production 2.Prices 3.Costs (fixed and variable) 4.Changes in product mix Cost per Unit (in $) AB C D E G F H % of Capacity

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.6 The Contribution Margin PV Ratio $250,000 $1,000, Sales revenue Less variable costs: Direct material Direct labour Total variable costs Contribution margin Less fixed costs: Manufacturing Administration Total fixed costs Operating profit $ 500, , ,000 50,000 $ 1,000, , , ,000 $ 50,000 PV ratio

© 2008 by Nelson, a division of Thomson Canada Limited Transparency J. Smith’s Break-Even (Taxi Driver) $ Trips 6,000 Costs/Revenue Variable costs $2.00 Fixed costs Insurance Car payment (principal or amortization) Interest Dispatcher fees Variable costs Gas Maintenance & repairs Fixed costs $15,000 $$$$$$ Revenue Variable costs Contribution margin $$$$ = 15, ,875 trips Revenue $10.00 Total costs = $$$$ 45, ,625 trips Break-even point

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.8 J. Smith’s Break-Even (Taxi Driver) No salary With salary 1,875 $ 18,750 $ 3,750 $ 15, ,625 $ 56,250 $ 11,250 $ 45,000 $ 15,000 $ 30, ,000 $ 60,000 $ 12,000 $ 48,000 $ 15,000 $ 30,000 $ 3, No. of trips Sales revenue ($10.00) Variable costs ($2.00) Contribution margin Fixed costs Salary Profit P.V. Ratio

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.9 Finding the Break-Even Point Using the Formula Unit selling price$ (P) Fixed costs$200,000 (F) Unit variable costs$ (V) Break-even calculation Step 2:$200,000 ÷ $5.00 = 40,000 units (volume) Step 3:40,000 units X $15.00 = $600,000 (sales revenue) Step 1:Contribution margin Selling price$15.00 Variable costs$10.00 Contribution margin$ 5.00

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.10 Break-Even Point Calculation Fixed costs Price per unit sold – Variable cost per unit or unit contribution $200,000 $ $10.00 B.E.P.= In Units In revenue B.E.P.= = 40,000 units Step 2:Find the sales revenue break-even point B.E.P. = == $600,000 Step 1:Find the PV ratio PV = ==.333 Fixed costs PV $200, Unit contribution Unit selling price $5.00 $15.00 X $15.00 $ 600,000

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.11 Break-Even Point By Using the PV Ratio Step 2:Find the sales revenue break-even point B.E.P. = == $600,000 Step 1:Find the PV ratio PV = ==.333 Fixed costs PV $200, Contribution Sales revenue $200,000 $600,000 Finding the break-even point when units are not known, you need to re-structure the P&L statement $$$$$$$$$$ Sales revenue600,000 Variable costs 400,000 Contribution margin 200,000 Fixed costs 200,000 Profit/loss 0

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.12 Break-Even Point (Retail Store) Suits Jackets Shirts Ties Socks Overcoats Total No. of units , Unit selling price $300$150$50$50 $8$300 Sales revenue$500,000 Variable costs $275,000 25,000 Total variable costs$300,000 Contribution margin$200,000 Fixed costs $100,000 Profit$100,000 Contribution margin$200,000 Sales revenue$500,000 Fixed costs$100,000 PV ratio.40 = =.40 or $0.40 = = $250,000 Purchases Sales commission (rent, telephone, salaries, security system) 50% of objective OK!!!

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.13 Cash Break-Even Point Fixed costs - Amortization Price per unit sold – Variable cost per unit $200,000 - $50,000$150,000 $ $10.00$5.00 = In Units In revenue == = 30,000 units = = = $450,000 Fixed costs - Amortization PV $150,

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.14 Profit Break-Even Fixed costs + Profit objective Price per unit sold – Variable cost per unit $200,000 + $20,000$220,000 $ $10.00$5.00 = In Units In revenue == = 44,000 units = = = $660,000 Fixed costs + Profit objective PV $220,

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.15 Sensitivity Analysis Base case Break-even Break-even in units in revenue 40,000 $600,000 Selling price (increased by $0.50 to $15.50) 36,364 $563,642 Change in Fixed costs (increased by $50,000 to $250,000) 50,000 $750,000 Variable costs (decreased by $0.75 to $9.25) 34,782 $521,730

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.16 Company ACompany B Company DCompany C Revenue Fixed costs PV =.40 Total costs Revenue Fixed costs PV =.30 Total costs Revenue Fixed costs PV =.30 Total costs Revenue Fixed costs PV =.40 Total costs Break-Even Wedges

© 2008 by Nelson, a division of Thomson Canada Limited Transparency 9.17 Where Break-Even Analysis Can be Used Company-wide Trucking operation Plant Direct mail advertising District or sales territory Taxi business Retail store Movie theatre Production centre Advertising program Department store Travel agency Product/division Hotel business Service centre Restaurant business Machine operation Book publishing Airline business

© 2008 by Nelson, a division of Thomson Canada Limited Transparency Other Cost Concepts Committed costs: Costs that must be incurred in order to operate a business. Discretionary fixed costs: Costs that can be controlled by managers. Controllable costs: Costs that operating managers are accountable for. Non-controllable costs: Costs that are not under the direct control of managers. Direct costs: Materials and labour expenses that are directly incurred when making a product or providing a service. Indirect costs: Costs that are necessary in the production cycle but that cannot be clearly allocated to specific products or services.