1. Analyzing Cost, Volume, and Pricing to Increase Profitability Chapter 3

2. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-2 Operating Leverage How a small percentage increase in sales volume can produce a significantly higher percentage increase in profitability.

3. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-3 Determining the Contribution Margin Per Unit Contribution margin (CM) is the difference between the sales revenue and the variable costs.

4. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-4 CM is a measure of the amount available to cover fixed costs and profits for an enterprise. Determining the Contribution Margin Per Unit

5. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-5 For each additional K6 unit Jeff sells, $200 more in contribution margin will help to cover fixed expenses and profit. Determining the Contribution Margin Per Unit

6. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-6 Determining the Contribution Margin Per Unit Each month Jeff must generate at least $80,000 in CM to break even.

7. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-7 Determining the Contribution Margin Per Unit If Jeff sells 400 units in a month, it will be operating at the break-even point.

8. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-8 Determining the Contribution Margin Per Unit If Jeff sells one additional unit above the break-even point, net income increases by the amount of the contribution margin.

9. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-9 Determining the Break-Even Point The break-even point is where total revenue is equal total costs.

10. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-10 Determining the Break-Even Point The break-even point in units can be determined using the following equation: Break-Even Volume in Units = Fixed Costs Contribution Margin Per Unit

11. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-11 Determining the Break-Even Point The break-even point in units can be determined using the following equation: Break-Even Volume in Units = Fixed Costs Contribution Margin Per Unit For Jeff’s K6 model computer the break- even volume in units is: $80,000 $200 = 400 computers

12. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-12 Estimating the Sales Volume Necessary to Attain a Target Profit At the break-even point profits equal zero. Sales Volume in Units = Fixed Costs + Desired Profit Contribution Margin Per Unit

13. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-13 Estimating the Sales Volume Necessary to Attain a Target Profit Jeff wants to know how many K6 computers must be sold to earn a profit of $100,000.

14. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-14 Estimating the Sales Volume Necessary to Attain a Target Profit Calculate volume in units: Sales Volume in Units = Fixed Costs + Desired Profit Contribution Margin Per Unit Sales Volume in Units = $80,000 + $100,000 $200 Sales Volume in Units = 900 units

15. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-15 Estimating the Sales Volume Necessary to Attain a Target Profit Here’s the proof:

16. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-16 Estimating the Effects of Changes in Sales Price Competition is forcing Jeff to consider a drop in selling price of the K6 model. What is the impact on break-even of a drop in selling price from $500 to $460 per unit?

17. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-17 Estimating the Effects of Changes in Sales Price The new contribution per unit would be $160 ($460 - $300). Break-Even Volume in Units = Fixed Costs Contribution Margin Per Unit Break-Even Volume in Units = $80,000 $160 Break-Even Volume in Units = 500 units

18. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-18 Estimating the Effects of Changes in Sales Price Here is the proof...

19. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-19 Changes in Fixed Costs and Sales Volume Jeff is currently selling 500 K6 computers per month. The sales manager believes that an increase of $10,000 in the monthly advertising budget would increase sales to 540 units. Should Jeff authorize the requested increase in the advertising budget?

20. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-20 Changes in Fixed Costs and Sales Volume. Sales increased by $20,000, but net income decreased by $2,000. $80,000 + $10,000 advertising = $90,000

21. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-21 Changes in Fixed Costs and Sales Volume The Shortcut Solution

22. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-22 Cost-Volume-Profit Graph Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way. Consider the following information for Jeff:

23. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-23 Cost-Volume-Profit Graph Fixed expenses Units Dollars Total Expenses Total Sales

24. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-24 Dollars Cost-Volume-Profit Graph Break-even point Units Profit Area Loss Area

25. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-25 The Margin of Safety The number of units (or sales dollars) by which actual sales can fall below budgeted sales before a loss is incurred. Margin of safety = Let’s calculate the margin of safety for Jeff’s K6 model. Budgeted Sales - Break-even sales Budgeted Sales

26. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-26 The Margin of Safety Jeff has a break-even point of $200,000. If budgeted sales are $250,000, the margin of safety is $50,000 or 100 units.

27. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-27 The Margin of Safety The margin of safety can be expressed as 20 percent of sales. Margin of safety = Budgeted Sales - Break-even sales Budgeted Sales Margin of safety = $250,000 - $200,000 $250,000 Margin of safety =20%

28. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-28 Using Contribution to Assess the Effect of Simultaneous Changes in CVP Variables Jeff believes that by cutting the price of the K6 model by $25, sales will increase to 550 units.

29. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-29 Using Contribution to Assess the Effect of Simultaneous Changes in CVP Variables Jeff believes that by cutting the price of the K6 model by $25, sales will increase to 550 units. Profits will be reduced from $20,000 to $16,250. Profits will be reduced from $20,000 to $16,250.

30. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-30 CVP Analysis Using the Contribution Margin Ratio The contribution margin is expressed as a percentage of sales price.

31. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-31 CVP Analysis Using the Contribution Margin Ratio We can calculate the break-even point in total sales dollars as follows: Fixed expenses Fixed expenses CM ratio CM ratio = Break-even point in total sales dollars $80,000 $80,000 40% 40% = $200,000 Break-even point in total sales dollars =

32. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-32 CVP Analysis Using the Equation Method Selling Price Per Unit × Number of Units Sold Variable Cost Per Unit × Number of Units Sold + Fixed Cost= If we let X equal the number of units, we can express Jeff’s break-even equation as: $500X = $300X + $80,000

33. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-33 CVP Limitations  Selling price is constant throughout the entire relevant range.  Costs are linear throughout the entire relevant range.  In multi-product companies, the sales mix is constant.  In manufacturing companies, inventories do not change (units produced = units sold).

34. Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 3-34 End of Chapter 3 We made it!