1. 2-1 Profit Planning Prepared by Douglas Cloud Pepperdine University Prepared by Douglas Cloud Pepperdine University 2

2. 2-2  Describe and apply the concepts of fixed and variable costs.  Describe and apply the concept of contribution margin.  Prepare contribution margin format income statements.  Describe and discuss the significance of the relevant range.  Construct and interpret a cost-volume-profit graph. ObjectivesObjectives After reading this chapter, you should be able to:

3. 2-3  Determine the sales volume or selling price needed to achieve a target profit.  Describe and illustrate target costing.  Describe and discuss the importance of cost structure.  Discuss the assumptions that underlie cost- volume-profit analysis. ObjectivesObjectives

4. 2-4 Cost Behavior Variable costs change, in total, in direct proportion to changes in volume. Selling price of backpack$20.00 Cost of backpack from manufacturer$10.00 Variable cost to pack and ship1.00 Sales commission (5%) 1.00 Total variable cost$12.00 Total monthly fixed costs (rent, salaries, depreciation, etc.)$40,000

5. 2-5 5,000 units6,000 units7,000 units Sales ($20 per unit)$100,000$120,000$140,000 Variable costs ($12 per unit) 60,000 72,000 84,000 Contribution margin$ 40,000$ 48,000$ 56,000 Fixed costs 40,000 40,000 40,000 Profit$0$8,000$16,000 Variable Costs Example Exeter Company

6. 2-6 Important Rule As sales change, income changes by unit contribution margin multiplied by the change in sales. The unit contribution margin per backpack is $8. 6,000 Backpacks Contribution margin for 6,000 backpacks$48,000 Less fixed costs 40,000 Net income$ 8,000

7. 2-7 Income Statement Formats— Financial Accounting Format Income Statement Formats— Financial Accounting Format Sales, 6,000 x $20$120,000 Cost of sales, 6,000 x $10 60,000 Gross profit$ 60,000 Operating expenses: Packaging and shipping$ 6,000 Commissions6,000 Rent, salaries, depreciation, etc. 40,000 Total operating expenses$ 52,000 Income$ 8,000 (Functional)

8. 2-8 Income Statement Formats— Contribution Margin Format Income Statement Formats— Contribution Margin Format Sales, 6,000 x $20$120,000 Variable costs: Cost of sales$ 60,000 Packing and shipping6,000 Commissions 6,000 Total variable costs$ 72,000 Contribution margin$ 48,000 Fixed costs 40,000 Income$ 8,000 (Behavioral)

9. 2-9 Operating Leverage 6,000 Backpacks Contribution margin for 6,000 backpacks$48,000 Less fixed costs 40,000 Net income$ 8,000 $48,000 $8,000 = 6

10. 2-10 Relevant Range Relevant range is the range of volume over which it can reasonably expect selling price, per- unit variable cost, and total fixed costs to be constant.

11. 2-11 Definitions Cost-volume-profit (CVP) analysis is a method for analyzing the relationships among costs, volume, and profits. Contribution margin is the difference between selling price per unit and variable cost per unit.

12. 2-12 Contribution margin percentage is per-unit contribution margin divided by selling price, or total contribution margin divided by total sales dollars. Variable cost percentage is per-unit variable cost divided by selling price, or total variable costs divided by total sales dollars. Definitions

13. 2-13 Cost-Volume-Profit Graph $160,000 $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 2,000 4,000 6,000 8,000 10,000 Unit Sales Dollar s Break-even point, 5,000 units, $100,000 Total Cost Total Revenues Loss Area Profit Area Fixed cost line

14. 2-14 Break-Even Point Break-even point is the point at which profits are zero because total revenues equal total costs. Profit = total sales dollars – total variable costs – total fixed costs

15. 2-15ProfitProfit Using Q to denote the quantity of units sold, we can restate the formula as-- Profit = per-unit selling price – per –unit variable costs – total fixed costs x Q

16. 2-16ProfitProfit Combining the two components, we get-- Profit = – Contribution margin per unit total fixed costs x Q

17. 2-17 Break-Even Point Q (break-even sales in units) Total fixed costs Contribution margin per unit = $40,000 $20 - $12 = 5,000 backpacks In units

18. 2-18 Contribution Margin Percentage B/E in $ Total fixed costs Contribution margin ratio per unit = Contribution margin Sales Contribution margin Sales $8 ÷ $20 = 40%

19. 2-19 Break-Even Point S (break-even sales in dollars) Total fixed costs Contribution margin ratio = $40,000.40 = $100,000 In dollars

20. 2-20 Target Return on Sales Exeter wishes to earn a 15 percent return on sales. Desired sales (in dollars) = fixed costs contribution margin percentage – target ROS Desired sales (in dollars) = $40,000 40% - 15% Desired sales (in dollars) = $160,000

21. 2-21 Exeter’s Income Statement Dollars Percentages Sales$160,000100% Variable costs 96,000 60% Contribution margin$ 64,00040% Fixed costs 40,000 25% Income $ 24,00015%

22. 2-22 Additional Sales Required Suppose the company’s marketing manager has proposed an advertising campaign that will cost $10,000. How many additional units need to be sold to recover the additional costs? $10,000 / $8 = 1,250 units

23. 2-23 Target Selling Prices The company’s target profit is $10,000 per month and it expects to sell 6,000 units per month. What should be the selling price? Profit=sales – variable costs – fixed costs $10,000 =S – [(6,000 x $11) + 5%S] –$40,000 $122,105 = S Selling price= sales / units Selling price =$122,105/ 6,000 Selling price=$20.35/unit (rounded)

24. 2-24 Target Costing Target costing is the process of determining how much the company can spend to manufacture and market a product, given a target profit. Example:Managers agree on a target profit of $300,000 and that unit volume of 100,000 is achievable at a $20 price. The target cost is: Revenue (100,000 x $20)$2,000,000 Target cost 1,700,000 Target profit$ 300,000

25. 2-25 Cost Structure and Managerial Attitudes Caldwell Company’s managers decide to introduce a new product. They expect to sell 20,000 units at $10. They can make the product in either of two manufacturing processes. Process A uses a great deal of labor and has variable costs of $7 per unit and annual fixed costs of $40,000. Process B uses more machinery, with unit variable costs of $4 and annual fixed costs of $95,000.

26. 2-26 Cost Structure and Managerial Attitudes Process A Process B Sales (20,000 x $10)$200,000$200,000 Variable costs at $7 and $4 140,000 80,000 Contribution margin at $3 and $6$ 60,000$120,000 Fixed costs 40,000 95,000 Profit$ 20,000$ 25,000

27. 2-27 Cost Structure and Managerial Attitudes Break-even Process A:B/E units = $40,000 $3 = 13,333 units Process B:B/E units = $95,000 $6 = 15,833 units

28. 2-28 Margin of Safety The difference in volume from the expected level of sales to the break-even point is called the margin of safety (MOS). If expected sales are 20,000 units, the margin of safety is 6,667 units (20,000 - 13,333). If expected sales are $200,000, the margin of safety is $66,670 ($200,000 - $133,330).

29. 2-29 Indifference Point The indifference point is the level of volume at which total costs, and hence profits, are the same under both cost structures. Example:Total cost of A = $40,000 + $7Q Total cost of B = $95,000 + $4Q $40,000 + $7Q = $95,000 + $4Q Q = 18,333 units (rounded)

30. 2-30 Assumptions and Limitations of CVP Analysis Selling price, per-unit variable cost, and total fixed costs must be constant throughout the relevant range. The company sells only one product, or the sales of each product in a multiproduct company are a constant percentage of sales. Production equals sales in units.

31. 2-31 The End Chapter 2

32. 2-32