1. Decision Making and CVP
6-1
Decision Making and CVP
EMBA 5412
Fall 2007

2. Decision-Making Process
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Decision-Making Process
Set goals and objectives
Gather information
Evaluate alternatives
Plan and implement
Get feedback and revise
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3. Strategic Decision Making
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Strategic Decision Making
Strategic Planning
Company policies and plans to reflect how to reach the company goals.
Answers the following two major questions:
What are the ways of achieving?
What to we want to accomplish?
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4. Managerial Accounting
Process of
Identifying
Measuring
Analyzing
Interpreting
Communicating information in pursuit of a company’s goals
Managerial accountants – business partners/consultants in companies
Provides information to managers
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5. Cost Management Perspective
Provide highest quality service/goods with lowest possible cost
Objectives:
Determine cost of resources consumed in company’s activities
Eliminate non-value added activities as much as possible
Determine efficiency and effectiveness of all major activities
Identify and evaluate new activities that can improve the performance of the company
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6. Strategic Cost Management
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Strategic Cost Management
Value chain
Get raw materials and other resources
Research and development – including quality assessment
Product design
Production
Marketing
Distribution
Customer service
Should understand the value chain
Cost drivers in activities
Managing the cost relationships to a company’s advantage – strategic cost management
Where should the company focus?
To be successful should perform the activities in the value chain at the same quality as the competitors at a lower price or higher quality at the same price
What factors affect the cost of activities = cost drivers
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7. The Value Chain Primary processes Design Supply Production Marketing
6-7
Exh.
1.2
The Value Chain
R & D
Design
Supply
Production
Marketing
Distri-
bution
Customer
service
Value of
products
and
services
Support services
Accounting
Human resources
Legal services
Information systems
Telecommunications
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Primary processes

8. Strategic Position of a Company and its missions
6-8
Exh.
1.1
Strategic Position of a Company and its missions
New market potential
Be early entrant
Achieve growth
Capture market share
Build
High
Continuing market
Maintain growth
Be a major player
Protect market share
Hold
Continuing market
Maintain cash flow
Maintain volume
Cut costs
Medium
Return
Harvest
Declining market
Exit at lowest cost
Minimize losses
Find a buyer quickly
Divest
Low
Risk
Low
Medium
High
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9. Types of Costs
The opportunity cost is the monetary amount associated with the next best use of the resource.
differential costs- (benefits) – costs or benefits that change between/among alternatives
Irrelevant costs -Costs that don’t change are irrelevant to the decision
Choose the alternatives where differential benefits exceed differential costs
Opportunity costs
Sunk costs
Controllable /avoidable costs/discretionary costs
Costs that have already been incurred and cannot be changed no matter what action is taken in the future.
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10. Cost Definitions
Fixed Costs: Costs incurred when there is no production.
Marginal cost: cost of producing (and selling) one more unit = variable costs after the initial production stage
Average cost: Total costs divided by number of units produced
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11. Cost Definitions TC = FC + (VC Q) for Q in relevant range
Total costs (TC) are a linear function of quantity (Q) produced over a relevant range.
Variable Cost (VC): Cost to produce one more unit. Variable cost is a linear approximation of marginal opportunity costs.
Fixed Cost (FC): Predicted total costs with no production (Q=0).
Relevant Range: Range of production quantity (Q) where a constant variable cost is a reasonable approximation of opportunity cost.
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12. Cost Curve Y X Total Cost –Mixed Cost
Variable Cost per unit or marginal cost
Total Cost
Average Cost
Fixed Cost
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13. Cost Drivers
Cost driver: units of physical activity most highly associated with total costs in an activity center
Examples of cost drivers:
Quantity produced
Direct labor hours
Number of set-ups
Number of orders processed
Different activity drivers might be used for different decisions
Costs could be fixed, variable, or mixed in different situations
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14. Cost Estimation Example
In each month, Exclusive Billiards produces between 4 to 10 pool tables. The plant operates on 40-hr shift to produce up to seven tables. Producing more than seven tables requires the craftsmen to work overtime. Overtime work is paid at a higher hourly wage. The plant can add overtime hours and produce up to 10 tables per month. The following table contains the total cost of producing between 4 and 10 pool tables.
Required: a. compute average cost per pool table for 4 to 10 tables
Estimate fixed costs per month.
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15. Format of Income Statement
Financial Accounting (traditional – required for financial statements and tax )
Sales Revenue
- Cost of goods sold (product costs)
= Gross profit
- General, selling, administrative, and taxes (period costs)
= Net income
Decision Making( useful for managers – internal oriented)
Revenue
- Variable costs (product and selling and administration)
= Contribution margin
- Fixed costs and taxes( product and selling and administration)
= Net income
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16. Income Statement Example
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17. Income Statement Example
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18. CVP definitions
Cost-Volume-Profit (C-V-P) analysis is very useful for production and marketing decisions.
Contribution margin equals price per unit minus variable cost per unit: CM = (P – VC).
Total contribution margin equals total revenue minus total variable costs: (CM Q) = (P - VC) Q.
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19. COST VOLUME PROFIT ANALYSIS
HELPFUL TO UNDERSTAND THE RELATIONSHIP AMONG VARIABLE COSTS, FIXED COSTS AND PROFIT
BASIC ASSUMPTIONS:
SELLING PRICE IS CONSTANT
COSTS ARE LINEAR AND CAN BE DIVIDED INTO FIXED AND VARIABLE
FIXED ELEMENT CONSTANT OVER THE RELEVANT RANGE
UNIT VARIABLE COST CONSTANT OVER THE RELEVANT RANGE
SALES MIX IS CONSTANT
INVENTORIES STAY AT THE SAME LEVEL
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20. Basics of Cost-Volume-Profit Analysis
6-20
Basics of Cost-Volume-Profit Analysis
CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income.
Contribution margin is used first to cover fixed expenses. Any remaining contribution margin contributes to net operating income.
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21. The Contribution Approach
6-21
The Contribution Approach
Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. If FM sells an additional gadget, TL 175 additional CM will be generated to cover fixed expenses and profit.
Sales, variable expenses, and contribution margin can also be expressed on a per unit basis..
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22. The Contribution Approach
6-22
The Contribution Approach
Each month FM must generate at least TL in total CM to break even.
Each month FM must generate at least TL in total contribution margin to break-even (which is the level of sales at which profit is zero).
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23. The Contribution Approach
6-23
The Contribution Approach
If FM sells 3800 units in a quarter, it will be operating at the break-even point.
Therefore, iIf FM sells 3800 units a quarter, it will be operating at the break-even point. If FM sells one more gadget (3801 gadgets), net operating income will increase by 175 TL.
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24. The Contribution Approach
6-24
The Contribution Approach
If FM sells one more gadget (3801 gadgets), net
operating income will increase by TL 175.
You can see that the sale of one unit above the break-even point yields net income of 175 TL for FM.
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25. The Contribution Approach
6-25
The Contribution Approach
We do not need to prepare an income statement to estimate profits at a particular sales volume. Simply multiply the number of units sold above break-even by the contribution margin per unit.
If FM sells 4000 gadgets, its net income will be TL.
If we develop equations to calculate break-even and net income, we will not have to prepare an income statement to determine what net income will be at any level of sales. For example, we know that if FM sells four thousand gadgets, net income will be TL. The company will sell 200 above the break-even unit sales and the contribution margin is 175 TL per gadget. So, we multiply 200 gadgets times 175 TL per gadget and get net income of TL.
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26. Break-even analysis can be approached in two ways:
6-26
Break-Even Analysis
Break-even analysis can be approached in two ways:
Equation method
Contribution margin method
We can accomplish break-even analysis in one of two ways. We can use the equation method or the contribution margin method. We get the same results regardless of the method selected. You may prefer one method over the other. It’s a personal choice, but be aware there are some problems associated with either method. Some are easier to solve using the equation method, while others can be quickly solved using the contribution margin method.
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27. EQUATION METHOD-1 q= FC ÷ (p - vcu) OR q=FC ÷ cmu
SALES= VARIABLE COSTS+FIXED COSTS + PROFIT
p*q= vcu *q + FC + ¶
p= price;
q=quantity sold (in terms of units)
vcu=variable cost per unit = VC/ q;(includes both manufacturing and selling and administrative)
FC= total fixed costs;
¶= profit
AT BREAKEVEN PROFIT = 0
p*q=vcu *q +FC
q * (p-vcu) = FC
BREAKEVEN in units sold: (q)
q= FC ÷ (p - vcu) OR q=FC ÷ cmu
Breakeven Sales amount = selling price x breakeven quantity
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28. EQUATION METHOD-2 Therefore
Sales = (Variable Cost Ratio x Sales) + Fixed Costs + Profit
VCR = Variable Cost Ratio
FC = total fixed costs (both manufacturing, and selling and administrative)
AT BREAKEVEN PROFIT = 0
Sales = (Sales x VCR) + FC + 0
Therefore
Sales amount (monetary terms) at breakeven point is
Sales (breakeven)= FC ÷ (1-VCR)
BREAKEVEN in units sold= Sales (breakeven) ÷ selling price
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29. Sensitivity Analysis EFFECT OF CHANGE IN FIXED COSTS?
EFFECT OF CHANGE IN VARIABLE COSTS?
EFFECT OF CHANGE IN SELLING PRICE?
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30. Here is the information from FM Company:
6-30
Break-Even Analysis
Here is the information from FM Company:
Here is some information provided by FM Company that we will use to solve some problems. We have the contribution margin income statement, the selling price and variable expenses per unit, and the contribution margin ratio.
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31. We can calculate the break-even point as follows:
6-31
Equation Method-1
We can calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits
360q = 185q
Where:
q = Number of gadgets sold
TL 360 = Unit selling price
TL 185 = Unit variable expense
TL = Total fixed expense
The break-even point in units is determined by creating the equation as shown We need to solve for Q.
Breakeven units = q= 3800 gadgets
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32. Equation Method-2 X = 0,5139X + 665.000 + 0 Where:
6-32
Equation Method-2
The equation can be modified to calculate the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits
X = 0,5139X Where:
X = Total sales amount
0, = Variable expenses as a % of sales
TL = Total fixed expenses
The equation can be modified as shown to calculate the break-even point in sales amount. We need to solve for X.
Breakeven Sales amount = Sales (BE) = TL *
*rounding error might occur
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33. Reconciliation of the Equation Method 1 and 2
From equation method 1:
Breakeven units:
3800 gadgets x price 360= TL = sales amount at breakeven
From equation 2:
Breakeven sales amount:
÷ TL 360 per unit= 3800 gadgets = breakeven units
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34. CONTRIBUTION MARGIN RATIO
CMR= CONTRIBUTION MARGIN RATIO
= CM / SALES OR cmu/p
VCR = VARIABLE COST RATIO
= VC/SALES OR vcu/p
CM= SALES - TOTAL VC
VC= SALES – CM (variable costs include both manufacturing and selling and administrative variable costs)
cmu =CONTRIBUTION MARGIN PER UNIT= p - vcu=CM/q
CM = total contribution margin
vcu= variable cost (manufacturing and selling and administrative per unit)
p= selling price
cmu = contribution margin per unit
CMR +VCR= 1
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35. Contribution Margin Method
6-35
Contribution Margin Method
The contribution margin method has two key equations.
Fixed expenses
Unit contribution margin =
Break-even point
in units sold
The contribution margin method has two key equations: Break-even point in units sold equals Fixed expenses divided by CM per unit, and
Break-even point in sales dollars equals Fixed expenses divided by CM ratio.
Fixed expenses
CM ratio =
Break-even point in
total sales dollars
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36. Contribution Margin Method
6-36
Contribution Margin Method
Let’s use the contribution margin method to calculate the breakeven sales amount at FM Company.
Fixed expenses
CM ratio =
Break-even point in
total sales dollars TL
48,61%
= TL break-even sales
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37. PROFIT ANALYSIS AT BREAKEVEN PROFIT = 0
BEFORE BREAKEVEN LOSS; AFTER BREAKEVEN PROFIT
CM COVERS FIXED COST UPTO BREAKEVEN POINT
AFTER BREAKEVEN POINT INCREASE IN CM WILL INCREASE NET INCOME
CM = FC + INCOME BEFORE TAX
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38. Basic Analysis using CVP
EFFECT OF CHANGE IN FIXED COSTS?
EFFECT OF CHANGE IN VARIABLE COSTS?
EFFECT OF CHANGE IN SELLING PRICE?
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39. Target Profit Analysis
6-39
Target Profit Analysis
The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit.
Suppose FM Company wants to know how many gadgets must be sold to earn a before tax profit of TL100,000.
We can use either method to determine the revenue or units needed to achieve a target level of profits.
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40. The CVP Equation Method
6-40
The CVP Equation Method
Sales = Variable expenses + Fixed expenses + Profits
360q = 185q
Where:
q = Number of gadgets sold
TL 360 = Unit selling price
TL 185 = Unit variable expense
TL = Total fixed expense
TL = profit BEFORE tax
Target income units = q= 4372*gadgets
*rounded up
Instead of setting profit to zero like we do in a break-even analysis, we set the profit level to one hundred thousand TL.
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41. The Contribution Margin Approach
6-41
The Contribution Margin Approach
Fixed expenses + Target profit
Unit contribution margin =
Unit sales to attain
the target profit
TL TL100,000
TL175 per gadget
= gadgets Or
TL ÷ TL 175 = 572 more units after the breakeven point need to be sold
= 4372 gadgets
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42. Target Income –after tax profit
Assume that FM Company’s tax rate is 20%; and the company wants an after-tax income of TL How many units must it sell?
After tax TL ÷0.8 (after tax percent of net income) = Before Tax income of TL
Then the company needs to sell after breakeven
TL ÷ TL 175 = 715*(rounded up) more units
3800(breakeven )+715(units after breakeven) =
4515 gadgets
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43. 6-43
The Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales over the break-even amount of sales.
The margin of safety can also be expressed as
% of sales
Units
Margin of safety = Total sales - Break-even sales
MoS TL = ACTUAL OR BUDGETED SALES - BREAKEVEN SALES $
MoS % = MoS TL / ACTUAL OR BUDGETED SALES
MoS units = MoS TL / selling price
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44. The Margin of Safety FM Company
6-44
The Margin of Safety FM Company
Margin of safety = = TL
MoS % =
÷ = 24%
MoS units =
÷ 360 = 1200 gadgets
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45. Cost Structure and Profit Stability
6-45
Cost Structure and Profit Stability
Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization’s cost structure.
A company’s cost structure refers to the relative proportion of fixed and variable expenses. Some companies have high fixed expenses relative to variable expenses. Do you remember our discussion of utility companies? Because of the heavy investment in property, plant and equipment, many utility companies have a high proportion of fixed costs.
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46. Operating Leverage The effect of cost structure on operating income
6-46
Operating Leverage
The effect of cost structure on operating income
Higher operating leverage – very sensitive to changes in sales volume
Contribution margin
Operating income
Degree of
operating leverage =
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47. Operating Leverage At FM, the degree of operating leverage is.
6-47
Operating Leverage
At FM, the degree of operating leverage is. TL TL
=4,17
If sales increase by 10% income is going increase by 41,67%
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48. Cost Structure and Profitability
High variable costs lead to lower CM and less vulnerable in crisis time
High fixed costs cause higher breakeven point; after the breakeven point profits increase faster than the high variable cost company
Degree of operating leverage effects:
For a given % change in sales, income will increase by (% increase in sales *degree of operating leverage)
Degree of operating leverage decreases as the sales move away from the breakeven point
If variable costs are high degree of operating leverage low; and vice versa
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49. Structuring Sales Commissions
6-49
Structuring Sales Commissions
Companies generally compensate salespeople by paying them either a commission based on sales or a salary plus a sales commission. Commissions based on sales dollars can lead to lower profits in a company. Let’s look at an example.
You have probably heard that salespersons can be compensated on a commission basis. The commission is usually based on sales revenue generated. Some salespersons work on a salary plus commission. When salespersons are paid a commission based on sales amount generated, the income statement impact may not be fully understood. Let’s look at an example.
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50. Structuring Sales Commissions
6-50
Structuring Sales Commissions
Pipeline Unlimited produces two types of surfboards, the XR7 and the Turbo. The XR7 sells for $100 and generates a contribution margin per unit of $25. The Turbo sells for $150 and earns a contribution margin per unit of $18. The sales force at Pipeline Unlimited is compensated based on sales commissions.
This company produces two surfboards. The XR7 model sells for one hundred dollars and has a contribution margin per unit of twenty-five dollars. The second surfboard, the Turbo model, sells for one hundred fifty dollars and has a contribution margin of eighteen dollars per unit sold. The sales force at Pipeline is paid on sales commissions.
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51. Structuring Sales Commissions
6-51
Structuring Sales Commissions
If you were on the sales force at Pipeline, you would push hard to sell the Turbo even though the XR7 earns a higher contribution margin per unit. To eliminate this type of conflict, commissions can be based on contribution margin rather than on selling price alone.
If you were on the sales force, you would try to sell all the Turbo models you could because it has a higher selling price per unit. The problem is that the XR7 model produces a higher contribution margin to the company. It might be a good idea for Pipeline to base its sales commissions on contribution margin rather than selling price alone.
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52. The Concept of Sales Mix
6-52
The Concept of Sales Mix
Sales mix is the relative proportion in which a company’s products are sold.
Different products have different selling prices, cost structures, and contribution margins.
When a company sells more than one product, break-even analyses become more complex because of the relative mix of the products sold. Different products will have different selling prices, cost structures and contribution margins. Let’s expand the product line at Racing Bicycle and see what impact this has on break-even. We are going to assume that the sales mix between the products remains the same in our example.
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53. Multiple Products Example
6-53
Multiple Products Example
Let’s assume Han sells synthetic fiber filled and dawn feather sleeping bags. Then we’ll calculate a break-even point that encompasses both products and their cost-price parameters.
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54. Multiple Products Example
6-54
Multiple Products Example
Cost other related information
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55. Multiple Products Example
Breakeven Sales Amount =
TL ÷ 48.18% = TL
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56. Multiple Products Example
Or we can use the following method
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57. Multiple Products Example
6-57
Multiple Products Example
Weighted-average unit contribution margin
TL 200 × 62.5%
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58. Multiple Products Example
6-58
Multiple Products Example
The break-even point is 514 combined units. We can use the sales mix to find the number of units of each product that must be sold to break even.
Break-even
point
Fixed expenses
Weighted-average unit contribution margin =
Break-even
point
170,000
331.25 =
Break-even
point =
514 combined units
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59. Multiple Products Example
6-59
Multiple Products Example
The break-even point of 514 units is valid only for the sales mix of 62.5% and 37.5%.
Sales amount to break even:
There is a slight difference between the results of the approaches due to rounding.
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60. In Class – Multiple Customers
Cali sells PROD 1.0 which is a top electronic spreadsheet product. Now, the company is coming up with the new version –PROD 2.0. The company offers the new version at substantially lower prices to customers who has PROD 1.0 (upgrade customers).
Cali plans to sell units of PROD 2.0 and wants to have a net income of TL after tax. Current tax rate is 20%.
The expected sales mix in units is 60% new customers; and 40% upgrade customers.
Cali management wants to know:
What the expected breakeven in units and TLs for PROD 2.0 at 60/40 sales mix.
Whether they will be able to attain its target income with the expected sales level and sales mix.
What the optimal sales mix is.
Relevant information appear in the following slide.
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61. In Class – Multiple Customers
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62. Solution to CALI

63. Modeling Multiple Cost Drivers
6-63
Modeling Multiple Cost Drivers
Some costs treated as fixed (when sales volume is the only activity) may now be considered variable.
An insight from activity-based costing: costs may be a function of multiple activities, not merely sales volume.
Total Cost =
(Unit variable cost × Sales units)
+ (Batch cost × Batch activity)
+ (Product cost × Product activity)
+ (Customer cost × Customer activity)
+ (Facility cost × Facility activity)
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64. Multiple Cost Drivers
Variable costs may arise from multiple cost drivers or activities. A separate variable cost needs to be calculated for each driver. Examples include:
Customer or patient count
Passenger miles
Patient days
Student credit-hours
Set-up Costs – number of setups
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65. Multiple Cost Drivers
EMBA Company produces a single product with the following costs:
Selling price: TL 200
Variable production costs per product TL 120
Variable gift wrapping costs TL 10 per customer
Fixed costs TL 4500
Determine the breakeven sales.
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66. Multiple Cost Drivers If EMBA sells 150 products to 100 customers?
Operating Income = Sales
– (Variable production cost x number of units sold)
- ( Variable gift wrapping cost x number of customers)
- Fixed Costs
If EMBA sells 150 products to 100 customers?
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67. Multiple Cost Drivers
Number of units sold is NOT the only determinant of operating income; there are two cost drivers
– the number of units sold; and – the number of customers
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68. Multiple Cost Drivers
There is no unique breakeven point
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69. In Class – CVP multiple cost drivers
Sade Comp is a distributor of special dolls. For 2008, Seyda, the manager, plans to purchase the dolls for TL 30 each and sell them for TL 45 each. Sade’s fixed costs are expected to be TL Seyda’s only other costs will be variable costs of TL 60 per shipment for each customer regardless of the number of dolls in the order.
Seyda wants to know:
How much operating income will be if she sell 40,000 dolls in shipments? 800 shipments?
She estimates that she can make 500 shipments in She wants to know how many dolls she needs to sell to breakeven.
Is this the only breakeven point? Can she have other breakeven points if she can make more or less shipments?
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70. Solution to Sade Company

71. USING CVP with Absorption Costing
Poli Company produces and sells coffee mugs. Cost and revenue related information is provided below.
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72. USING CVP with Absorption Costing
Determine the break-even point under contribution approach.
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73. USING CVP with Absorption Costing
If the company uses absorption costing and wants to determine the breakeven point, three cases arise.
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74. USING CVP with Absorption Costing
Let’s prove: at 20,000 units – sales=production
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75. USING CVP with Absorption Costing
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76. USING CVP with Absorption Costing
Amount of fixed manufacturing costs absorbed in the increase in ending inventory
Amount of fixed manufacturing costs absorbed in the units sold
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77. USING CVP with Absorption Costing
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78. USING CVP with Absorption Costing
Amount of fixed manufacturing costs absorbed in the increase in ending inventory
Amount of fixed manufacturing costs absorbed in the units sold
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79. With fixed selling and admin costs
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80. With fixed selling and admin costs
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81. With fixed selling and admin costs
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