1. Financial and Cost-Volume-Profit Models
Chapter 12

2. Financial Modeling
Quantitative simulation of relations among various factors
Allows the organization to assess “what if” scenarios to support
Decision making
Forecasting

3. Cost-Volume-Profit Models
Illustrates the relationship between sales volume, costs and revenues
Based on variable (direct) costing
Sales – variable costs = contribution margin
Each additional unit sold “contributes” that amount to the bottom line
Breakeven point is reached when total contribution equals total fixed costs

4. Cost-Volume-Profit Models
Basic formula
Unit sales =
Breakeven point occurs at a profit of zero
Fixed cost + desired profit
Contribution margin per unit

5. Cost-Volume-Profit Models
Example
Sales price = $100
Variable cost per unit = $40
Total fixed cost = $36,000

6. Profit
Breakeven
point
Variable cost
Loss

7. Cost-Volume-Profit Models
Income tax effect
“Desired profit” in basic model assumes no income taxes
Obviously, more units must be sold if taxes must be paid on the profits
Adjustment to basic model
Unit sales =
Fixed cost + Profit / (1 – tax rate)
Contribution margin per unit

8. Cost-Volume-Profit Models
Same example
Desired profit = $24,000
Basic model
If tax rate is 20%

9. Cost-Volume-Profit Models
Contribution margin can be used to make scarce resource allocation decisions
Goal is to maximize the amount of income that can be generated
How to best use the scarce resource?
Determine the contribution per unit of the scarce resource
Can only consider one resource at a time

11. Cost-Volume-Profit Models
Multiple product situations
Basic model assumes only one product
Multiple product situation replaces the contribution margin per unit with the weighted average contribution margin
Based on the normal relative sales volumes of the products
Resulting “units to sell” is then divided among the products in their original proportions

12. Cost-Volume-Profit Models
Example

13. Cost-Volume-Profit Models

14. Cost-Volume-Profit Models
Operating leverage
Companies with relatively low variable costs per unit, but high fixed costs, experience greater swings in profitability with volume changes than do companies with high variable costs and low fixed costs
Operating leverage is a multiplier
%∆ in sales * operating leverage = %∆ in income

15. Cost-Volume-Profit Models
Contribution margin
Operating income
Operating leverage =

16. Cost-Volume-Profit Models
A 10% increase in sales will result in a 70% increase in Company A’s income, but only a 40% increase in Company B’s

17. Multiple Driver Models
CVP model assumes all costs are either variable and driven by sales, or fixed
In reality, costs and revenues have many different drivers
ABC-based model should be more accurate
Considers the major drivers of costs

18. Sensitivity Analysis
Model inputs are estimates, actual results may vary considerably
Sensitivity analysis plays “what if” with the inputs
Changes in volume of cost and revenue drivers
How much will the income be affected by other scenarios?

19. Theory of Constraints Identification and best use of bottlenecks
Bottleneck is anything that prevents the company from producing and selling more
Process: machine capacity, available labor
Policy: no weekend or overtime work
Resource: shortage of materials
Market: not enough demand for product

20. Theory of Constraints

21. Theory of Constraints Step 1: Identify appropriate value measure
Usually throughput
Step 2: Identify bottlenecks
Work piling up, unused capacity, etc.
Step 3: Optimize the bottleneck
What will produce the greatest value?

22. Theory of Constraints Step 4: Adjust process to bottleneck’s needs
Produce only what is needed by the bottleneck
Step 5: Alleviate the bottleneck
Add capacity, demand, etc.
Step 6: Repeat steps 1-5
Eliminating one bottleneck creates another