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

2. 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

3. 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.

4. 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.

5. 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.

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

7. 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

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

9. 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.

10. 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.

11. 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.

12. 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

13. 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

14. 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

15. 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 $
(3 ) (0.375 ) $
If sales increase by 100 cartons per month, what will be the increase in net income?
100 x $5 = $500

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

17. 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

18. 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

19. 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
| | | |
Unit Sales

20. 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
Total Revenues

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

22. 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.

23. 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?

24. 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

25. 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%

26. 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

27. 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

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

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

30. 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.

31. Unit variable costs (3.00 ) (1.50 )
Benchmark High-Fixed
Unit selling price $ $
Unit variable costs (3.00 ) (1.50 )
Unit contribution margin $ $
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

32. 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?

33. 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

34. 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?

35. 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

36. 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

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

38. 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)/( )
= $1,320,000

39. C 3
hapter
The End