Cost-Volume-Profit Relationships

1. Cost-Volume-Profit Relationships Chapter 03

2. Quick Check  Racing Bicycle Company • Selling price per unit: $500 • Variable costs per unit: $300 • Fixed costs per month: $80,000 What is the company’s net operating income if the production and selling is 500 units in January 2014?

3. Contribution Margin Approach What is the implication of Contribution margin per unit?

4. CVP Graph

5. Sales Total costs Fixed costs CVP Graph $ units

6. Contribution Margin Ratio (CM Ratio) What is the implication of Contribution margin ratio?

7. CM per unit SP per unit CM Ratio = $200 $500 = 40% Contribution Margin Ratio (CM Ratio) The contribution margin ratio at Racing Bicycle is: =

8. Quick Check  Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the CM Ratio for Coffee Klatch? a. 1.319 b. 0.758 c. 0.242 d. 4.139

9. Changes in Fixed Costs and Sales Volume Wind is currently selling 500 bikes per month. The company’s sales manager believes that an increase of $10,000 in the monthly advertising budget would increase bike sales to 540 units. • Should we authorize the requested increase in the advertising budget?

10. $80,000 + $10,000 advertising = $90,000 Changes in Fixed Costs and Sales Volume Sales increased by $20,000, but net operating income decreased by $2,000.

11. Changes in Fixed Costs and Sales Volume The Shortcut Solution

12. Break-Even Analysis Break-even analysis can be approached in three ways: • Graphical analysis. • Equation method. • Contribution margin method.

13. Equation Method Profits = Sales – (Variable expenses + Fixed expenses) OR Sales = Variable expenses + Fixed expenses + Profits At the break-even point profits equal zero.

14. Break-Even Analysis Here is the information from Racing Bicycle Co.:

15. Equation Method • We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 +$0 Where: Q = Number of bikes sold $500 = Unit selling price $300 = Unit variable expense $80,000 = Total fixed expense

16. Equation Method • We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = $80,000 ÷ $200 per bike Q = 400 bikes

17. Equation Method • We can also use the following equation to compute the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + $80,000 + $0 Where: X = Total sales dollars 0.60 = Variable expenses as a % of sales $80,000 = Total fixed expenses

18. Equation Method • We can also use the following equation to compute the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $80,000 ÷ 0.40 X = $200,000

19. Break-even point in units sold Fixed expenses Unit contribution margin = Contribution Margin Method The contribution margin method is a variation of the equation method. Break-even point in total sales dollars Fixed expenses CM ratio =

20. Quick Check  Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in units? a. 872 cups b. 3,611 cups c. 1,200 cups d. 1,150 cups

21. Quick Check  Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in dollars? a. $1,300 b. $1,715 c. $1,788 d. $3,129

22. Target Profit Analysis Suppose Racing Bicycle wants to know how many bikes must be sold to earn a profit of $100,000. We can use our CVP formula to determine the sales volume needed to achieve a target net profit figure.

23. The CVP Equation Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 +$100,000 $200Q = $180,000 Q =900 bikes

24. Unit sales to attain the target profit Fixed expenses + Target profit Unit contribution margin = $80,000 + $100,000 $200 per bike = 900 bikes The Contribution Margin Approach We can determine the number of bikes that must be sold to earn a profit of $100,000 using the contribution margin approach.

25. Quick Check  Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. How many cups of coffee would have to be sold to attain target profits of $2,500 per month? a. 3,363 cups b. 2,212 cups c. 1,150 cups d. 4,200 cups

26. The Margin of Safety Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred. Margin of safety = Total sales - Break-even sales

27. The Margin of Safety Racing Bicycle has a break-even point of $200,000. If actual sales are $250,000, the margin of safety is $50,000 or 100 bikes.

28. The Margin of Safety The margin of safety can be expressed as 20%of sales.($50,000 ÷ $250,000)

29. Quick Check  Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the margin of safety? a. 3,250 cups b. 950 cups c. 1,150 cups d. 2,100 cups

30. Example – SAA • School of Accounting & Auditing launches monthly tax accounting courses (10 sessions, 2 hours each). There are three alternatives for tuition fees: tuition fee No. of learners VND 600,000 25 500,000 32 400,000 42 • Each course incurs: • Instructor expense: VND500,000/session; • Classroom rent expense: VND100,000/session; • Advertising & administrative expense: VND3,000,000đ/course • Learning materials & certification preparation: VND100,000/learner • How many leaners should each course have to breakeven? • What alternative the School should choose?

31. Example - SAA

32. Cost structure Cost structure refers to the types and relative proportions of variable and fixed costs that a business incurs. Which cost structure is better? More fixed or more variable?

33. Cost structure

34. Cost structure What is an increase in net operating income if each company’s sales increaseby20%?

35. Ford Increase in Operating income: Vinaxuki Increase in Operating income: Cost structure

36. Cost structure What is an increase in net operating income if each company’s sales decreaseby20%?

37. Vinaxuki Decrease in Operating income: Ford Decrease in Operating income: Cost structure

38. Degree of operating leverage Contribution margin Net operating income = Degree of operating leverage (DOL) ∆%Net operating income = ∆% Sales Operating Leverage • A measure of how sensitive net operating income is to percentage changes in sales. • With high leverage, a small percentage increase in sales can produce a much larger percentage increase in net operating income.

39. Operating leverage • Ford: DOL = 500/200 = 2,5 • Vinaxuki: DOL = 400/200 =2,0

40. Operating levegare ∆%Net operating income = DOL x ∆% Sales • Ford • Increase in Net operating income (%) = 2,5 x 20% = 50% • Increase in Net operating income ($) = 50% x 200 = 100 • Vinaxuki • Increase in Net operating income (%)= 2,0 x 20% = 40% • Increase in Net operating income ($) = 40% x 200 = 80

41. Quick Check  Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the operating leverage? a. 2.21 b. 0.45 c. 0.34 d. 2.92

42. Quick Check  At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, and the average fixed expense per month is $1,300. 2,100 cups are sold each month on average. If sales increase by 20%, by how much should net operating income increase? a. 30.0% b. 20.0% c. 22.1% d. 44.2%

43. The Concept of Sales Mix • Sales mix is the relative proportions in which a company’s products are sold. • In units • In dollars • Average contribution margin per unit = ∑ UCMi X unit sales mixi • Average contribution margin rate = ∑ CM ratei X $ sales mixi

44. 30% 7up UCM: VND600 per litre 70% Pepsi UCM: VND500 per litre Average contribution margin per unit 500 x 70% + 600 x 30% = 530 6000x 30% = 1800 litres 6000 x 70% = 4200 litres Breakeven point 3.180.000/530 = 6000 litres Breakeven analysis with sales mix Fixed costs VND318,000,000

45. Tỷ lệ lợi nhuận góp bình quân 30% x 70% + 40% x 30% = 33% 10,000 x 70% = VND 7,000mil. 10,000x 30% = VND 3,000 mil. Breakeven point 3.300/33% = VND 10,000 mil. Breakeven analysis with sales mix 30% Internet services CM rate 40% 70% Telephone services CM rate 30% Fixed costs VND3,300 mil.

46. Example 2 Nhu Ngoc is a Mooncake producer. The information for the performance in Jan. and Feb. 2014 as below. Calculate net operating income for each month and explain for the difference.

49. Key Assumptions of CVP Analysis • Selling price is constant. • Costs are linear and can be accurately divided into variable (constant per unit) and fixed (constant in total) elements. • In multiproduct companies, the sales mix is constant. • In manufacturing companies, inventories do not change (units produced = units sold).

50. End of Chapter 03