April 19, 2010 • A deeper look at Contribution Analysis • Break even • Cost-Volume-Profit • Variable Costing and Decision Making
Contribution Analysis • Below is a Contribution Income Statement for the Go Fast Car Company • The Contribution Margin is $52 million, $4,727 per unit, or 39% • With this analysis in place, we can test different volume scenarios
Calculating Break Even • Under a Contribution Analysis framework, calculating break-even becomes very straight forward • Break Even Volume = Fixed Costs / Unit Contribution Margin • Break Even Sales = Break Even Volume * Unit Sales Price • At sales volume of $96.5 million, Go Fast Car Co will make $0 • For every additional sale, the company will add $4.7k to its operating income
Total CM Total sales CM Ratio = Contribution Margin Ratio • The Contribution margin ration is: • For Go Fast Car Co • 52,000,000 / 132,000,000 = 39% • For every additional $1 sold, the company will see 39 cents go to Operating Income
Multiple Volume Scenarios & Cost Volume Profit • The Variable Cost Model allows us to easily test a multitude of volume scenarios and assess the impact on income • What would Operating Income be at unit sales of 20,000? • Graph the company’s CVP (X axis -$s; Y axis – units)
Assumptions and Shortcomings • The Contribution Model can be very helpful, but it does make a number of simplifying assumptions • Selling price is constant • Costs are linear • Sales/product mix is constant • Inventories do not change (production = sales) • Ultimately, reliable models will be much more detailed • Nonetheless, and certainly within certain bounds, these concepts are most helpful
Decision Making • The VP Sales wants to undertake a $3 million promotional campaign • How many more cars would Go Fast have to sell to justify that level of expenditure?
Decision Making • Analysis of how many cars would need to be sold to justify a $3 million promotional expenditure • In this case, if the VP Sales signed up to selling more than 635 incremental cars, the company should proceed • The VP Sales compensation should be driven by the success of this • Of course, the company would only do this for substantially more than break even
Decision Making • An economist reported that demand for Go Fast’s cars is highly elastic • A decrease in price of 2% would increase unit sales volume by 10% • Would Go Fast Car Co be better off by doing this?
Decision Making • Analysis of a 2% decrease in price resulting in 10% increase in unit sales • Results in a decrease in Contribution per car, but an increase in operating income
Multi-Product Companies and Sales Mix • Analysis of a multi-product company • What is break-even? • Which product would the company rather sell and why?
Multi-Product Companies and Sales Mix • Break even sales = Fixed Costs/Contribution Ratio • $53 million / .36 = $147 million • The company would rather sell a car as they contribute more in absolute dollars and profitability
Review • A deeper look at Contribution Analysis • Break even • Cost-Volume-Profit • Variable Costing and Decision Making