CostVolumeProfit Relationships EMBA 5403 Fall 2010 Cost Estimation

Cost-Volume-Profit Relationships EMBA 5403 Fall 2010

Cost Estimation 1 Constant Std Err of Y Est R squared No. of Observations Degrees of Freedom X Coefficient(s) Std Err of Coef. Fall 2010 EMBA 5403 250 299. 304749934466 0. 944300518134715 5 3 6. 75 0. 9464847243 2

Estimation (continued) The results gives rise to the following equation: Utility Costs = £ 250 + (£ 6. 75 x # of units produced) R 2 =. 944, or 94. 4 percent of the variation in setup costs is explained by the number of setup hours variable. Fall 2010 EMBA 5403 3

Estimation (continued) Given: *T-value for sample size of 5 at 95% confidence level is 3. 182 (two-tale test and 3 degrees of freedom) *Standard error of estimate for this sample at the 95% confidence level is 598. 6 The confidence interval for 300 units is: TC = £ 250 + 6. 75 (300) + (3. 182 x £ 598. 6) = £ 2275 + £ 1911 Fall 2010 EMBA 5403 4

Cost Estimation Example 2 o 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 o Estimate fixed costs per month. Fall 2010 EMBA 5403 5

Cost-Volume-Profit Analysis o o Examines the behavior of total revenues, total costs, and operating income as changes occur in the output level, selling price, variable costs or fixed costs helpful to understand the relationship among variable costs, fixed costs and profit Assumptions of CVP Analysis 1. revenues change in relation to production and sales 2. costs can be divided in variable and fixed categories and fixed element constant over the relevant range 3. 4. 5. 6. 7. revenues and costs behave in a linear fashion costs and prices are known if more than one product exists, the sales mix is constant inventories stay at the same level we can ignore the time value of money Fall 2010 EMBA 5403 6 Page 67

Contribution Margin o Contribution margin is equal to the difference between total revenue and total variable costs Contribution margin per unit = Selling price - Variable cost per unit Contribution margin percentage = Contribution margin per unit / selling price per unit Per Unit Revenue Variable costs Contribution margin Fall 2010 EMBA 5403 $200 120 $80 Total for 2 units $400 240 $160 % 100% 60% 40% 7 Pages 68 - 69

Contribution Margin Income Statement o Income statement that groups line items by cost behaviour to highlight the contribution margin 0 Revenue 1 Packages Sold 2 25 40 $0 $200 $400 $5, 000 Variable costs Contribution margin 0 0 $8, 000 120 240 3, 0004, 800 80 160 2, 0003, 200 Fixed costs 2, 0002, 000 Operating income$(2, 000) $0 $1, 200 Fall 2010 EMBA 5403 $(1, 920) $(1, 840) 8 Page 69

Breakeven Point o o Quantity of output where total revenues equal total costs Point where operating income equals zero Breakeven point in units = Fixed costs / Contribution margin per unit = $2, 000 / $80 = 25 units Breakeven point in dollars = Fixed costs / contribution margin % = $2, 000 / 40% = $5, 000 Fall 2010 EMBA 5403 9 Page 71

Cost-Volume-Profit Graph Total revenues line Breakeven Point 25 units $10, 000 $8, 000 Total costs line $6, 000 Operating income $4, 000 $2, 000 Operating loss $0 0 10 20 30 40 50 Units Sold Fall 2010 EMBA 5403 10 Page 72

Target Operating Income o o For most firms in the private sector, the main objective is not to breakeven Convert after-tax desired net income to its before-tax equivalent operating income Target operating income = Target net income / (1 - tax rate) Target Unit Sales = (Fixed costs + Target operating income) / Contribution margin per unit Target Dollar Sales = (Fixed costs + Target operating income) / Contribution margin % Fall 2010 EMBA 5403 11 Pages 73 - 75

Sensitivity Analysis o o sensitivity analysis is a “what-if” technique that examines how a result will change if the original predicted data are not achieved or if an underlying assumption changes What will happen to operating income if volume declines by 5%? What will happen to operating income if variable costs increase by 10% per unit? sensitivity analysis broadens management’s perspectives about possible outcomes Fall 2010 EMBA 5403 12 Pages 76 - 77

Alternative Cost Structures o CVP helps managers assess the risks and potential benefits of adopting alternative cost structures Example: Alternative rental arrangements Option 2 $1, 400 Fixed Fee + 5% Commission Option 1 $2, 000 Fixed Fee Rev $ Cost Units Breakeven = 25 units Fall 2010 EMBA 5403 Option 3 20% Commission Rev $ Cost Units Breakeven = 20 units Breakeven = 0 units 13 Pages 77 - 78

Basics of Cost-Volume-Profit Analysis Fall 2010 EMBA 5403 CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income. 14

The Contribution Approach Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. If Racing sells an additional bicycle, $200 additional CM will be generated to cover fixed expenses and profit. Fall 2010 EMBA 5403 15

The Contribution Approach Each month Racing must generate at least $80, 000 in total CM to break even. Fall 2010 EMBA 5403 16

The Contribution Approach If Racing sells 400 units in a month, it will be operating at the break-even point. Fall 2010 EMBA 5403 17

The Contribution Approach If Racing sells one more bike (401 bikes), bikes net operating income will increase by $200. Fall 2010 EMBA 5403 18

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 Racing sells 430 bikes, its net income will be $6, 000. Fall 2010 EMBA 5403 19

CVP Relationships in Graphic Form The relationship among revenue, cost, profit and volume can be expressed graphically by preparing a CVP graph. Racing developed contribution margin income statements at 300, 400, and 500 units sold. We will use this information to prepare the CVP graph. Fall 2010 EMBA 5403 20

Dollars CVP Graph In a CVP graph, unit volume is usually represented on the horizontal (X) axis and dollars on the vertical (Y) axis. Units Fall 2010 EMBA 5403 21

Dollars CVP Graph Fixed Expenses Units Fall 2010 EMBA 5403 22

Dollars CVP Graph Total Expenses Fixed Expenses Units Fall 2010 EMBA 5403 23

CVP Graph Dollars Total Sales Total Expenses Fixed Expenses Units Fall 2010 EMBA 5403 24

CVP Graph Break-even point (400 units or $200, 000 in sales) t Dollars fi o r P s s o L a e r A Units Fall 2010 EMBA 5403 25

Contribution Margin Ratio The contribution margin ratio is: CM Ratio = Total CM Total sales For Racing Bicycle Company the ratio is: $80, 000 = 40% $200, 000 Each $1. 00 increase in sales results in a total contribution margin increase of 40¢. Fall 2010 EMBA 5403 26

Contribution Margin Ratio Or, in terms of units, the contribution margin ratio is: CM Ratio = Unit CM Unit selling price For Racing Bicycle Company the ratio is: $200 = 40% $500 Fall 2010 EMBA 5403 27

Contribution Margin Ratio A $50, 000 increase in sales revenue results in a $20, 000 increase in CM. ($50, 000 × 40% = $20, 000) Fall 2010 EMBA 5403 28

CONTRIBUTION MARGIN RATIO CMR= CONTRIBUTION MARGIN RATIO = CM / SALES OR cmu/p VCR = VARIABLE COST RATIO = VC/SALES OR vcu/p CMR +VCR= 1 EFFECT OF CHANGE IN FIXED COSTS? EFFECT OF CHANGE IN VARIABLE COSTS? EFFECT OF CHANGE IN SELLING PRICE? Fall 2010 EMBA 5403 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 CM Ratio for Coffee Klatch? a. 1. 319 b. 0. 758 c. 0. 242 d. 4. 139 Fall 2010 EMBA 5403 30

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 Unit contribution margin CM Ratio = Unit selling price c. 0. 242 d. 4. 139 ($1. 49 -$0. 36) = = Fall 2010 EMBA 5403 $1. 49 $1. 13 = 0. 758 $1. 49 31

Changes in Fixed Costs and Sales Volume What is the profit impact if Racing can increase unit sales from 500 to 540 by increasing the monthly advertising budget by $10, 000? Fall 2010 EMBA 5403 32

Changes in Fixed Costs and Sales $80, 000 + $10, 000 advertising = $90, 000 Volume Sales increased by $20, 000, but net operating Fall 2010 income decreased by $2, 000. EMBA 5403 33

Changes in Fixed Costs and Sales Volume The Shortcut Solution Fall 2010 EMBA 5403 34

Change in Variable Costs and Sales Volume What is the profit impact if Racing can use higher quality raw materials, thus increasing variable costs per unit by $10, to generate an increase in unit sales from 500 to 580? Fall 2010 EMBA 5403 35

Change in Variable Costs and Sales Volume 580 units × $310 variable cost/unit = $179, 800 Sales increase by $40, 000, and net operating income Fall 2010 36 increases by $10, 200. EMBA 5403

Change in Fixed Cost, Sales Price and Volume What is the profit impact if Racing (1) cuts its selling price $20 per unit, (2) increases its advertising budget by $15, 000 per month, and (3) increases unit sales from 500 to 650 units per month? Fall 2010 EMBA 5403 37

Change in Fixed Cost, Sales Price and Volume Sales increase by $62, 000, fixed costs increase by $15, 000, and net operating income increases by $2, 00038. Fall 2010 EMBA 5403

Change in Variable Cost, Fixed Cost and Sales Volume What is the profit impact if Racing (1) pays a $15 sales commission per bike sold instead of paying salespersons flat salaries that currently total $6, 000 per month, and (2) increases unit sales from 500 to 575 bikes? Fall 2010 EMBA 5403 39

Change in Variable Cost, Fixed Cost and Sales Volume Sales increase by $37, 500, variable costs increase by $31, 125, but fixed expenses decrease by $6, 000. 40 Fall 2010 EMBA 5403

Change in Regular Sales Price If Racing has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers or fixed expenses, what price would it quote to the wholesaler if it wants to increase monthly profits by $3, 000? Fall 2010 EMBA 5403 41

Change in Regular Sales Price Fall 2010 EMBA 5403 42

Break-Even Analysis 1. 2. Fall 2010 EMBA 5403 Break-even analysis can be approached in two ways: Equation method Contribution margin method 43

Equation Method Profits = (Sales – Variable expenses) – Fixed expenses OR Sales = Variable expenses + Fixed expenses + Profits At the break-even point profits equal zero Fall 2010 EMBA 5403 44

Break-Even Analysis Here is the information from Racing Bicycle Company: Fall 2010 EMBA 5403 45

Equation Method We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500 Q = $300 Q + $80, 000 + $0 Where: Q = Number of bikes sold $500 = Unit selling price $300 = Unit variable expense $80, 000 = Total fixed expense Fall 2010 EMBA 5403 46

Equation Method We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500 Q = $300 Q + $80, 000 + $0 $200 Q = $80, 000 ÷ $200 per bike Q = 400 bikes Fall 2010 EMBA 5403 47

Equation Method The equation can be modified to calculate the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0. 60 X + $80, 000 + $0 Where: X = Total sales dollars 0. 60 = Variable expenses as a % of sales $80, 000 = Total fixed expenses Fall 2010 EMBA 5403 48

Equation Method The equation can be modified to calculate the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0. 60 X + $80, 000 + $0 0. 40 X = $80, 000 ÷ 0. 40 X = $200, 000 Fall 2010 EMBA 5403 49

Contribution Margin Method The contribution margin method has two key equations. Break-even point = in units sold Break-even point in total sales dollars = Fall 2010 EMBA 5403 Fixed expenses Unit contribution margin Fixed expenses CM ratio 50

Contribution Margin Method Let’s use the contribution margin method to calculate the break-even point in total sales dollars at Racing. Break-even point in total sales dollars = Fixed expenses CM ratio $80, 000 = $200, 000 break-even sales 40% Fall 2010 EMBA 5403 51

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 Fall 2010 52 EMBA 5403

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 Fixed expenses Break-even Unit CM units? = $1, 300 a. 872 cups = $1. 49/cup - $0. 36/cup b. 3, 611 cups $1, 300 = $1. 13/cup c. 1, 200 cups = 1, 150 cups d. 1, 150 cups Fall 2010 53 EMBA 5403

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 Fall 2010 54 EMBA 5403

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? Fixed expenses Break-even = a. $1, 300 CM Ratio sales $1, 300 b. $1, 715 = 0. 758 c. $1, 788 = $1, 715 d. $3, 129 Fall 2010 55 EMBA 5403

DERIVATION OF EQUATIONS SALES= VARIABLE COSTS+FIXED COSTS + PROFIT p*q= vcu *q + FC + ¶ AT BREAKEVEN PROFIT = 0 p*q=vcu *q +FC q * (p-vcu) = FC q= FC / (p - vcu) OR q=FC/ cmu CM= SALES - TOTAL VC VC= SALES - CM= INCLUDE VARIABLE PRODUCTION AND SELLING EXPENSES cmu=CONTRIBUTION MARGIN PER UNIT= p - vcu=CM/q vcu= VARIABLE COST PER UNIT= VC/ q q number of units Fall 2010 EMBA 5403 56

PROFIT ANALYSIS o o o 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 Fall 2010 EMBA 5403 57

Target Profit Analysis The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit. Suppose Racing Bicycle Company wants to know how many bikes must be sold to earn a profit of $100, 000. Fall 2010 EMBA 5403 58

The CVP Equation Method Sales = Variable expenses + Fixed expenses + Profits $500 Q = $300 Q + $80, 000 + $100, 000 $200 Q = $180, 000 Q = 900 bikes Fall 2010 EMBA 5403 59

The Contribution Margin Approach The contribution margin method can be used to determine that 900 bikes must be sold to earn the target profit of $100, 000. Unit sales to attain = the target profit Fixed expenses + Target profit Unit contribution margin $80, 000 + $100, 000 = 900 bikes $200/bike Fall 2010 EMBA 5403 60

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 Fall 2010 61 EMBA 5403

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 Fall 2010 62 EMBA 5403

Unit breakeven Unit sales Fixed expenses + Target profit to attain = Unit CM target profit $1, 300 + $2, 500 = $1. 49 - $0. 36 = $3, 800 $1. 13 = 3, 363 cups Fall 2010 EMBA 5403 63

The Margin of Safety The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. Margin of safety = Total sales - Break-even sales Let’s look at Racing Bicycle Company and determine the margin of safety. Fall 2010 EMBA 5403 64

The Margin of Safety If we assume that Racing Bicycle Company has actual sales of $250, 000, given that we have already determined the break-even sales to be $200, 000, the margin of safety is $50, 000 as shown Fall 2010 EMBA 5403 65

The Margin of Safety The margin of safety can be expressed as 20% of sales. ($50, 000 ÷ $250, 000) Fall 2010 EMBA 5403 66

The Margin of Safety The margin of safety can be expressed in terms of the number of units sold. The margin of safety at Racing is $50, 000, and each bike sells for $500. Margin of $50, 000 = = 100 bikes Safety in units $500 Fall 2010 EMBA 5403 67

MARGIN OF SAFETY EXCESS OF SALES (EITHER ACTUAL OR FORECASTED ) OVER THE BREAKEVEN SALES I. E. , THE BUFFER AMOUNT Mo. S $= ACTUAL OR BUDGETED SALES - BREAKEVEN SALES $ Mo. S % = Mo. S $ / ACTUAL OR BUDGETED SALES BREAKEVEN SALES IN SINGLE PRODUCT SETTING SALES $ = VC$ + FC$ WHERE VCR= x% *SALES THEN 1 -x% = CMR SALES $ = x% *SALES +FC (1 -x)* SALES $ = FC THAT IS CMR*SALES = FC SALES $ AT BREAKEVEN = FC/ CMR Fall 2010 EMBA 5403 68

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 Fall 2010 EMBA 5403 69

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 Fall 2010 EMBA 5403 70

Margin of Safety Margin of safety = Total sales – Break-even sales = 2, 100 cups – 1, 150 cups = 950 cups or 950 cups Margin of safety = 2, 100 cups = 45% percentage Fall 2010 EMBA 5403 71

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. Fall 2010 EMBA 5403 72

Cost Structure and Profit Stability There advantages and disadvantages to high fixed cost (or low variable cost) and low fixed cost (or high variable cost) structures. An advantage of a high fixed cost structure is that income will be higher in good years compared to companies A disadvantage of a high fixed with lower proportion of cost structure is that income fixed costs. will be lower in bad years compared to companies with lower proportion of Fall 2010 73 fixed costs. EMBA 5403

Operating Leverage o A measure of how sensitive net operating income is to percentage changes in sales. Degree of Contribution margin = operating leverage Net operating income Fall 2010 EMBA 5403 74

Operating Leverage At Racing, the degree of operating leverage is 5. Fall 2010 EMBA 5403 $100, 000 = 5 $20, 000 75

Operating Leverage With an operating leverage of 5, if Racing increases its sales by 10%, net operating income would increase by 50%. Here’s the verification! Fall 2010 EMBA 5403 76

Operating Leverage 10% increase in sales from $250, 000 to $275, 000. . . Fall 2010 EMBA 5403 . . . results in a 50% increase in 77 income from $20, 000 to $30, 000.

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 Fall 2010 EMBA 5403 78

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 Operating Contribution margin c. 0. 34 leverage = Net operating income d. 2. 92 $2, 373 = $1, 073 = 2. 21 Fall 2010 EMBA 5403 79

Con’t Fall 2010 EMBA 5403 80

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% Fall 2010 EMBA 5403 81

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% Fall 2010 EMBA 5403 82

Cost Structure and Operating Leverage Operating leverage is greatest in companies that have a high proportion of fixed costs in relation to variable costs. Fall 2010 EMBA 5403 83

Operating Leverage Factor q A measure of how a percentage change in sales will affect profits. Operating leverage factor q = Contribution margin Net income The greater the operating leverage, the greater the sensitivity of its profit to changes in volume. Fall 2010 EMBA 5403 84

Operating Leverage Factor If Company A and B increases its sales by 10%, which company will have the greatest change in net income and why? Fall 2010 EMBA 5403 85

COST STRUCTURE AND PROFITABILITY o o o 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: CONTRIBUTION MARGIN / NET INCOME 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 Fall 2010 EMBA 5403 86

Verify Increase in Profit Fall 2010 EMBA 5403 87

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. Fall 2010 EMBA 5403 88

Structuring Sales Commissions Pipeline Unlimited produces two types of surfboards, the XR 7 and the Turbo. The XR 7 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. Fall 2010 EMBA 5403 89

Structuring Sales Commissions If you were on the sales force at Pipeline, you would push hard to sell the Turbo even though the XR 7 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. Fall 2010 EMBA 5403 90

The Concept of Sales Mix o o 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. Let’s assume Racing Bicycle Company sells bikes and carts and that the sales mix between the two products remains the same. Fall 2010 EMBA 5403 91

Revenue Mix o Revenue mix (or sales mix) is the relative combination of quantities of products or services that make up total revenue Fall 2010 EMBA 5403 92 Pages 73 - 75

Multi-product break-even analysis Racing Bicycle Co. provides the following information: Fall 2010 EMBA 5403 $265, 000 93 = 48. 2% (rounded) $550, 000

Multi-product break-even Break-even Fixed expenses = analysis sales CM Ratio $170, 000 = 48. 2% = $352, 697 Fall 2010 EMBA 5403 94

SALES MIX= % OF TOTAL SALES FOR EVERY PRODUCT THREE PRODUCTS A , B, C % SALES OF a, b , c where a= sales of product a / total sales etc. CMa = CM OF PRODUCT A, B OR C WEIGHTED CMR= a * CMR of product A + b * CMR of product B + c * CMR of product C BREAKEVEN IN MULTIPLE PRODUCT S= FC/ WEIGHTED CMR • TO FIND HOW MANY UNITS MUST BE SOLD AT BREAKEVEN (OR FOR TARGET INCOME): 1. FIND BREAKEVEN IN MULTIPLE PRODUCTS 2. COMPUTE EACH PRODUCTS SALES AMOUNT BY MULTIPLYING THE SALES RATIO * BREAKEVEN SALES 3. FIND THE BREAKEVEN SALE SHARE OF EACH PRODUCT; 4. DIVIDE EACH PRODUCTS SHARE OF BREAKEVEN SALES BY THE UNIT PRICE OF EACH PRODUCT TO GET THE NUMBER OF UNITS TO BE SOLD OF EACH PRODUCT IN ORDER TO BREAKEVEN OR FOR TARGET INCOME Fall 2010 EMBA 5403 95

Key Assumptions of CVP Analysis Selling price is constant. Costs are linear. In multi-product companies, the sales mix is constant. In manufacturing companies, inventories do not change (units produced = units sold). Fall 2010 EMBA 5403 96

Multiple Cost Drivers o In many cases there may be multiple cost drivers Do-All Software Example Variable costs: $40 per software package sold $15 per invoice issued Operating income = Revenue – ($40 x packages sold) – ($15 x invoices issued) – Fixed costs o In cases where there are multiple cost drivers there are multiple breakeven points Fall 2010 EMBA 5403 97

Examples o Please do the exercises before the next session. Fall 2010 EMBA 5403 98

Contribution Margin & Gross Margin Merchandising Sector Gross Margin Format Contribution Margin Format Revenues Variable costs: Cost of goods sold Other variable Contribution margin Fixed costs: Cost of goods sold $200 $120 43 5 163 37 Other fixed 19 24 Operating income $13 Fall 2010 EMBA 5403 Revenues $200 Cost of goods sold (120+5) 125 Gross margin 75 Operating costs (43+19) 62 Operating income $13 99 Pages 82 - 83

Example 1: equation approach • • • Movie theater: $48, 000 monthly fixed costs $8 ticket price. $2 variable cost per ticket. $6 contribution margin per ticket; 75% cont. margin ratio Give breakeven units and revenue BEunits = $48, 000/($8 - $2) BEunits = 8, 000 tickets. BErevenue = $64, 000 Fall 2010 EMBA 5403 100

Fall 2010 EMBA 5403 101

Example 1 Cont’d • Suppose practical capacity per month is 12, 000 tickets and that the movie theater has operated at 60% capacity during December. It is now December 30. • Has theater made money in December? • If they could capture 1, 000 customers by lowering the ticket price to $7 for New Year’s Eve, should they do it? Fall 2010 EMBA 5403 102

Example 1 con’t Fall 2010 EMBA 5403 103

Example 2 Data: The Doral Company manufactures and sells pens. Present sales output is 5, 000 per year at a selling price of $. 50 per unit. Fixed costs are $900, 000 per year. Variable costs are $. 30 per unit. o What is the current yearly operating income? o What is the current breakeven point in sales dollars? Fall 2010 EMBA 5403 104

Example 2 Cont’d –answer part 1 Fall 2010 EMBA 5403 105

Example 2 Cont’d – question part 2 Compute the new operating income if. . . 1. A $. 04 per-unit increase in variable costs. 2. A 20% decrease in fixed costs, a 20% decrease in selling price, a 10% decrease in variable costs, and a 40% increase in units sold. Fall 2010 EMBA 5403 106

Example 2 Cont’d –answer part 2 Fall 2010 EMBA 5403 107

Example 2 Cont’d-questions part 3 Compute the new breakeven point in units for each of the following changes. o A 10% increase in fixed costs: o A 10% increase in selling price and a $20, 000 increase in fixed costs. Fall 2010 EMBA 5403 108

Example 2 Cont’d –answer part 3 Fall 2010 EMBA 5403 109

Example 3 The Rapid Meal has two restaurants that are open 24 hours per day. Fixed costs for the two restaurants together total $450, 000 per year. Service varies from a cup of coffee to full meals. The average sales check for each customer is $8. 00. The average cost of food and other variable costs for each customer is $3. 20. The income tax rate is 30%. Target net income is $105, 000. Fall 2010 EMBA 5403 110

Example 3 Cont’d Compute the total dollar sales needed to obtain the target net income. How many sales checks are needed to break even? Compute net income if the number of sales checks is 150, 000 Fall 2010 EMBA 5403 111

Example 3 - answers Fall 2010 EMBA 5403 112

Example 3 - answers Fall 2010 EMBA 5403 113

Multiple-Product Example Assume the following: Units sold Sales price per unit Sales Less: Variable expenses Contribution margin Less: Fixed expenses Net income Regular Deluxe Total Percent 400 $ 500 $200, 000 120, 000 $ 80, 000 200 $750 $150, 000 60, 000 $ 90, 000 600 ---$350, 000 180, 000 $170, 000 130, 000 $ 40, 000 ======= ------100. 0% 51. 4 48. 6% 1. What is the break even point? 2. How much sales revenue of each product must be generated to earn a before tax profit $50, 000? Fall 2010 EMBA 5403 114

Multi product example -answer Fall 2010 EMBA 5403 115

Multiple product - verify Fall 2010 EMBA 5403 116

Example 4 o o o A financial analyst is studying the feasibility of two alternative assembly methods, manual and automated. The automated method has variable costs of TL 2. 10 per unit and annual committed costs of TL 130. 000; in contrast, the manual method has variable costs of TL 4. 20 per unit and committed costs of TL 60. 000. The company sells its products for TL 23 per unit. What is break-even of each method? Above what volume level will management prefer the automated method to the manual method? Fall 2010 EMBA 5403 117

Example 4 Answer Fall 2010 EMBA 5403 118

Example 4 answer Fall 2010 EMBA 5403 119