3 C Profitability Analysis and Planning hapter Prepared by Douglas Cloud Pepperdine University 1 1 1 1

After studying this chapter, you should be able to: Objectives 1. Discuss the uses and limitations of traditional cost-volume-profit analysis. 2. Prepare and contrast contribution and functional income statements. 3. Use cost-volume-profit analysis to find a break-even point and for preliminary profit planning without and with income taxes. After studying this chapter, you should be able to: Continued 2 2 4 2

Objectives 4. Analyze the profitability of a multiple product firm with a constant sales mix. 5. Use operating leverage to analyze profit opportunities and the risk of loss. 6. Analyze the profitability of organizations that operate with unit and nonunit cost drivers.

Profitability Analysis with Unit Cost Drivers Unit-level approach based on the assumption that units sold or sales dollars is the only activity cost driver. A cost hierarchy approach that incorporates nonunit as well as unit-level activity cost drivers.

CVP Assumptions 1. All costs are classified as fixed or variable with unit level activity cost drivers. 2. The total cost function is linear within the relevant range. 3. The total revenue function is liner within the relevant range. 4. The analysis is for a single product, or the sales mix of multiple products is constant. 5. There is only one activity cost driver: unit or dollar sales volume.

The Profit Formula  = R - Y  = Profit R = Total revenues Where:  = Profit R = Total revenues Y = Total costs

The Profit Formula R = pX Y = a + bX p = Unit selling price Where: p = Unit selling price a = Fixed costs b = Unit variable costs X = Unit sales

Summary of Profit Formula  = pX - (a + bX)

Benchmark Paper Company’s only product is a high-quality photocopy paper that it manufactures and sells to wholesale distributors at $8.00 per carton.

Benchmark’s variable and fixed expenses are detailed as follows: Direct materials refers to the cost of the primary raw materials converted into finished goods. Direct materials represent a variable cost. Direct labor represents wages earned by production employees for the time they spend working on the conversion of raw materials into finished goods. Direct labor is a variable cost. Variable manufacturing overhead includes all other variable costs associated with converting raw materials into finished goods.

4. Variable selling and administrative costs include all variable costs other than those directly associated with converting raw materials into finished goods. 5. Fixed manufacturing overhead includes all fixed costs associated with converting raw materials into finished goods. 6. Fixed selling and administrative costs include all fixed costs other than those directly associated with converting raw materials into finished goods.

Variable Costs per Carton Benchmark Costs Variable Costs per Carton Manufacturing: Direct materials $1.00 Direct labor 0.25 Manufacturing overhead 1.25 $2.50 Selling and administrative 0.50 Total $3.00 Fixed Costs per Month Manufacturing overhead $ 5,000 Selling and administrative 10,000 Total $15,000

Contribution Income Statement Benchmark Paper Company Contribution Income Statement For a Monthly Volume of 5,400 Cartons Sales (5,400 x $8) $43,200 Less variable costs: Direct materials (5,400 x $1.00) $ 5,400 Direct labor (5,400 x $0.25) 1,350 Manufacturing overhead (5,400 x $1.25) 6,750 Selling and administrative (5,400 x $0.50) 2,700 (16,200 ) Contribution margin $27,000 Less fixed costs: Manufacturing $ 5,000 Selling and administrative 10,000 (15,000 ) Profit $12,000

Functional Income Statement Benchmark Paper Company Functional Income Statement For a Monthly Volume of 5,400 Cartons Sales (5,400 x $8) $43,200 Less cost of goods sold: Direct materials (5,400 x $1.00) $ 5,400 Direct labor (5,400 x $0.25) 1,350 Variable Mfg. overhead (5,400 x $1.25) 6,750 Fixed manufacturing overhead 5,000 (18,500 ) Gross margin $24,700 Less other expenses: Variable selling and admin. (5,400 x $0.50) $ 2,700 Fixed selling and administrative 10,000 (12,700 ) Profit $12,000

Sensitivity Analysis Ratio to Total Per Unit Sales Sales (5,400 units) $43,200 Variable costs (16,200 ) Contribution margin $27,000 Fixed costs (15,000 ) Profit $12,000 $8 1.000 (3 ) (0.375 ) $5 0.625 If sales increase by 100 cartons per month, what will be the increase in net income? 100 x $5 = $500

Contribution Margin Ratio Sales CMR = $27,000 $43,200 = = 0.625

Break-Even Point Selling price - Variable costs per unit per unit Break-even unit sales volume = Fixed costs Unit contribution margin Break-even unit sales volume = Fixed costs $5 Break-even unit sales volume = $15,000 = 3,000 units per month

Profit Planning Assume Benchmark’s management desires to know the unit sales volume required to achieve a monthly profit of $18,000. Unit contribution margin Break-even unit sales volume = Fixed costs + Desired Profit $5 Break-even unit sales volume = $15,000 + $18,000 = 6,600 units

Cost-Volume-Profit Chart $60,000 - $50,000 - $40,000 - $30,000 - $20,000 - $10,000 - $0 - Profit area Total revenues $8 per unit Break-even point 3,000 units Loss area Total Revenues and Total Costs Fixed costs $15,000 Variable costs $3X | | | | 0 2000 4000 6000 8000 Unit Sales

Profit-Volume Graph Total profit or loss $20,000 - $15,000 - $5,000 - $20,000 - $15,000 - $5,000 - $0 - ($5,000) - ($10,000) - ($15,000) - Break-even point $24,000 Profit area Total Profit or (Loss) | | | Loss area 20,000 40,000 60,000 Total Revenues

Impact of Income Taxes - Before-tax profit After-tax profit = 1 - Tax rate Before-tax profit = After-tax profit 1 - Tax rate

Impact of Income Taxes Steps in Determining the Unit Sales Volume Required to Earn a Desired After-Tax Profit: 1. Determine the required before-tax profit. 2. Substitute the required before-tax profit into the profit formula. 3. Solve for the required unit sales volume.

Impact of Income Taxes Benchmark is subject to a 40 percent tax rate and that management desires to earn a November 2001 after-tax profit of $18,000. Benchmark’s present sales are 6,600. To earn an after-tax profit of $18,000, what would be the required sales volume in units?

Fixed costs + (Desired after- tax profit /[1 - Tax rate]) Impact of Income Taxes Fixed costs + (Desired after- tax profit /[1 - Tax rate]) Contribution margin $15,000 + $18,000/(0.60) $5 = 9,000 Units

Contribution Income Statement With Income Taxes Benchmark Paper Company Contribution Income Statement Planned for the Month of November 2004 Sales (9,000 x $8) $72,000 Less variable costs: Direct materials (9,000 x $1.00) $ 9,000 Direct labor (9,000 x $0.25) 2,250 Manufacturing overhead (9,000 x $1.25) 11,250 Selling and administrative (9,000 x $0.50) 4,500 (27,000 ) Contribution margin $45,000 Less fixed costs: Manufacturing $ 5,000 Selling and administrative 10,000 (15,000 ) Before-tax profit $30,000 Income taxes ($30,000 x 0.40) (12,000 ) After-tax profit $18,000 100% 40% 60%

Dollar Break-Even Point Benchmark’s contribution margin ratio is 62.5 percent ([$8 - $3/$8]) Dollar break-even point = Fixed costs Contribution margin ratio Dollar break-even point = $15,000 0.625 Dollar break-even point = $24,000

Target Dollar Sales Volume Benchmark’s desires a profit of $12,000. Target dollar sales volume = Fixed costs + Desired profit Contribution margin ratio Target dollar sales volume = $15,000 + $12,000 0.625 Target dollar sales volume = $43,200

Degree of operating leverage = Contribution margin Income before taxes Operating leverage refers to the extent that an organization’s costs are fixed.

Degree of operating leverage = Contribution margin Income before taxes Operating Leverage High Low Profit opportunity with sales increase Risk of loss with sales decrease

To Avoid Financial Crisis, Lower Operating Leverage or Debt Benchmark Paper Company competes with High-Fixed Paper Company. Both companies operate at a monthly level of 4,000 units.

Unit variable costs (3.00 ) (1.50 ) Benchmark High-Fixed Unit selling price $ 8.00 $ 8.00 Unit variable costs (3.00 ) (1.50 ) Unit contribution margin $ 5.00 $ 6.50 Unit sales x 4,000 x 4,000 Contribution margin $20,000 $26,000 Fixed cost (15,000 ) (21,000 ) Before-tax profit $ 5,000 $ 5,000 Contribution margin $20,000 $26,000 Before-tax profit ÷ 5,000 ÷ 5,000 Degree of operating leverage 4.0 5.2

Degree of operating leverage Benchmark Degree of operating leverage = Contribution margin Income before taxes 4 = $20,000 $5,000 Current = If Benchmark’s sales increase 12.5 percent, how much should profits increase?

Operating Leverage Benchmark Increase in sales 0.125 Degree of operating leverage x 4.0 Increase in profits 0.50 Current profit $5,000 Increase in profits ($5,000 x 0.50) 2,500 New profit $7,500

Degree of operating leverage High Fixed Degree of operating leverage = Contribution margin Income before taxes 5.2 = $26,000 $5,000 Current = If High Fixed’s sales are increased 12.5 percent, how much should profits increase?

Operating Leverage High Fixed Increase in sales 0.125 Degree of operating leverage x 5.2 Increase in profits 0.65 Current profit $5,000 Increase in profits ($5,000 x 0.65) 3,250 New profit $8,250

Multi-Level Contribution Income Statement With Income Taxes General Distribution Multi-Level Contribution Income Statement For the Year 2004 Sales $3,000,000 Less unit level costs: Cost of goods sold ($5,000,000 x 0.80) (2,400,00 ) Unit level contribution margin $ 600,000 Cost of processing order (3,200 orders x $20) (64,000 ) Order level contribution margin $ 536,000 Less customer level costs: Mail, phone, sales visits, recordkeeping, and so forth (400 customers x $200) (80,000 Customer level contribution margin $ 456,000 Continued

Customer level contribution margin $456,000 Less facility level costs: Depreciation, manager salaries, insurance, and so forth -120,000 Before-tax profit $336,000 Income taxes ($336,000 x 0.40) 134,400 After-tax profit $201,600

Multi-Level Break-Even Current Current order- + customer- + Facility level level level costs costs costs Unit level break-even point in dollars with no changes in other costs = Contribution margin ratio = ($64,000 + $80,000 + $120,000)/(1 - 0.80) = $1,320,000

C 3 hapter The End