CostVolumeProfit Relationships Mc GrawHill Irwin Copyright 2008 by

May 19, 2009 n A deeper look at Contribution Analysis n Break even n Cost-Volume-Profit n Variable Costing and Decision Making Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Contribution Analysis n Below is a Contribution Income Statement for the Go Fast Car Company n The Contribution Margin is $52 million, $4, 727 per unit, or 39% n With this analysis in place, we can test different volume scenarios Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Calculating Break Even n Under a Contribution Analysis framework, calculating break-even becomes very straight forward n Break Even Volume = Fixed Costs / Unit Contribution Margin n Break Even Sales = Break Even Volume * Unit Sales Price n At sales volume of $96. 5 million, Go Fast Car Co will make $0 n For every additional sale, the company will add $4. 7 k to its operating income Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Contribution Margin Ratio n The Contribution margin ration is: CM Ratio = Total CM Total sales n For Go Fast Car Co n 52, 000 / 132, 000 = 39% n For every additional $1 sold, the company will see 39 cents go to Operating Income Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Multiple Volume Scenarios & Cost Volume Profit n The Variable Cost Model allows us to easily test a multitude of volume scenarios and assess the impact on income n What would Operating Income be at unit sales of 20, 000? n Graph the company’s CVP (X axis -$s; Y axis – units) Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Assumptions and Shortcomings n The Contribution Model can be very helpful, but it does make a number of simplifying assumptions n Selling price is constant n Costs are linear n Sales/product mix is constant n Inventories do not change (production = sales) n Ultimately, reliable models will be much more detailed n Nonetheless, and certainly within certain bounds, these concepts are most helpful Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Decision Making n The VP Sales wants to undertake a $3 million promotional campaign n How many more cars would Go Fast have to sell to justify that level of expenditure? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Decision Making n Analysis of how many cars would need to be sold to justify a $3 million promotional expenditure n In this case, if the VP Sales signed up to selling more than 635 incremental cars, the company should proceed n The VP Sales compensation should be driven by the success of this n Of course, the company would only do this for substantially more than break even Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Decision Making n An economist reported that demand for Go Fast’s cars is highly elastic n A decrease in price of 2% would increase unit sales volume by 10% n Would Go Fast Car Co be better off by doing this? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Decision Making n Analysis of a 2% decrease in price resulting in 10% increase in unit sales n Results in a decrease in Contribution per car, but an increase in operating income Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Multi-Product Companies and Sales Mix n Analysis of a multi-product company n What is break-even? n Which product would the company rather sell and why? Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Multi-Product Companies and Sales Mix n Break even sales = Fixed Costs/Contribution Ratio n $53 million /. 36 = $147 million n The company would rather sell a car as they contribute more in absolute dollars and profitability Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Review n A deeper look at Contribution Analysis n Break even n Cost-Volume-Profit n Variable Costing and Decision Making Mc. Graw-Hill /Irwin Copyright © 2008 by The Mc. Graw-Hill Companies, Inc. All rights reserved.