CVP Analysis Cost Volume Profit What is CVP

CVP Analysis Cost, Volume, Profit

What is CVP? • Uses a specific cost-profit-volume formula to study the relationship of the costs, price, sales volume and profit. • Profit = (price – vcost/unit)*Volume – Total Fixed Costs. • Price and vcost are per unit.

Developing the formula • Profit = (price – vcost/unit)*Volume – Total Fixed Costs. • price and vcost are per unit. • P = (p – c)V – F (Basic Formula) • P = profit • p = price (per unit) • c = Variable cost/unit • F = total Fixed Costs • V = Sales Volume (units sold)

Example Using Basic Formula • • • P = (p – c)V – F price (p) = $300/unit vcost (c) = $100/unit Total Fixed Costs = $50, 000 If you sell 1, 500 units, what is the profit? P = (300 – 100)1500 – 50000 = (200)1500 – 50000 = 300000 – 50000 = $250, 000

Using CVP • Breakeven analysis • Profit, price, Volume analysis

Using CVP for Breakeven is the situation where no profit or loss is generated. • Income = Costs • In the Basic Formula, Profit = 0 Two ways to use: • Breakeven Volume: VBE • Breakeven price: p. BE

Calculating Breakeven Volume • Breakeven Volume is the quantity that will generate Profit = 0 for given costs and price. • Using the formula, we need to determine what V is when P = 0. • P = (p – c)V – F • 0 = (p – c) VBE – F • F = (p – c) VBE • F/(p – c) = VBE • VBE is being use to denote specifically the Breakeven Volume.

Contribution Margin • VBE = F/(p – c) • The breakeven volume is calculated by Total Fixed costs divided by price minus variable costs. • (p – c) is often called the Contribution Margin (per unit) or Unit Contribution Margin. • Another way of looking at breakeven is it is the sales volume where Income = Costs.

Breakeven: Income = Costs • • • Income = Costs P = (p – c)V – F 0 = (p – c) VBE – F 0 = p VBE – c VBE – F p VBE = c VBE + F p VBE is the income and c VBE + F are the total costs, Variable Costs + Fixed Costs.

Example of Breakeven Calculations • • VBE = F/(p – c) price (p) = $300/unit vcost (c) = $100/unit Total Fixed Costs = $50, 000 What the Breakeven volume? VBE = 50000/(300 – 100) VBE = 50000/200 VBE = 250 units

Check & Validate… • • • Check: Income = Total Costs p VBE = c VBE + F ? ? 300(250) = 100(250) + 50000 75000 = 25000 + 50000 75000 = 75000

Breakeven Graph INCOME = p. V Breakeven: Income = Total Costs FIXED COSTS + VARIABLE COSTS FIXED COSTS VBE

Breakeven Price • Let’s say you know the volume and you want to know the price that will generate a breakeven situation: i. e. P = 0 • 0 = p. BE V – c V – F • p. BE V = c V + F • p. BE = (c V + F)/V • Breakeven price is calculated by dividing the Total Costs by the Volume.

Example Breakeven price • • • p. BE = (c V + F)/V or c + F/V c = 100 (per unit) F = 50000 V = 1500 units p. BE = [100(1500) + 50000]/1500 = [150000 + 50000]/1500 = [200000]/1500 = $133. 33/unit If you price the item at $133. 33 then if you sell, 1500 units, you will Breakeven.

Example Breakeven price • • • p. BE = (c V + F)/V or c + F/V c = 100 (per unit) F = 50000 V = 1500 units p. BE = $133. 33 If you price it higher than $133. 33, and you sell 1500 units, you will make a profit.

Using X 5 from Tablet Sim • • • Default Values: p = $265 (you can change this after SLP 1) c = $120 (does not change in the simulation) Unit Contr. Margin = $145 From Default Run Year 2012: R&D costs = 7, 260, 000 – (33% of 22, 000 budget, you decide allocation %) • Other Fixed Costs = 72, 000 (does not change) • Total Fixed Costs = 79, 260, 000 (R&D + Other Fixed) • 2012 unit sales volume: 1, 859, 856

Using X 5 from Tablet Sim • Let’s validate the results in the Sim and calculate Profit • P = (p – c)V – F • P = (265 – 145) 1, 859, 856 – 79, 260, 000 • = (120) 1, 859, 856 – 79, 260, 000 • = 223, 182, 720 - 79, 260, 000 • = 143, 922, 720 • Profit from Default Sim for X 5 in 2012 = 143, 922, 720

Using X 5 from Tablet Sim • Let’s estimate what will happen in 2013 if we lower R&D and we lower the price. • R&D% = 10% (of 20, 000) • R&D = 2, 000 • Price p = $225 (down from $250 by 15%) • Sales Volume V = 1, 427, 666 (from 2013 default run) • Profit = (225 – 145) 1, 427, 666 – 74, 000 • = (80) 1, 427, 666 – 74, 000 • = 114, 213, 280 – 74, 000 • = 40, 213, 280 • Profit = 92, 059, 892 from 2013, default run

Using X 5 from PDA Sim • So if you lower your price to $225 and decrease R&D and the volume does not change from the default volume, you will earn less profit in 2013 that you did in the default run. • BUT, if you lower the price will that help to increase the volume? • Maybe, but what does the volume need to be to obtain the same profit that was earned in 2013, default run (92, 059, 892)

Using X 5 from Tablet Sim • • Profit, P = 92, 059, 892 Volume = ? P = (p – c)V – F (P + F)/(p – c) = V (92, 059, 892 + 74, 000)/(85) = V 166, 059, 892/ 80 = 2, 075, 748. 65 V = 2, 075, 749 units to achieve the same profit If you lower the price to $225 and reduce the R&D to 10%, does the reduced price cause an increase in Volume so that the profit is the same?

Determining Strategy: X 5 Example • • Default run 2013 p = 265 c = 145 Unit Contr. Margin = 120 R&D (33%) = 7, 260, 000 Other Fixed = 72, 000 Profit = 92, 059, 892 Volume = 1, 427, 666 • • Possible strategy 2013 p = 225 c = 145 ucm = 80 R&D (10%) = 2, 000 Other Fixed = 70, 000 Profit = 81, 690, 327 Volume = 2, 075, 749 If you lower price from $250 to $225 in 2007, will volume go up to or higher than 81, 690, 327

Breakeven Formulas • P = (p – c)V – F • For Breakeven, set P = 0 Breakeven Volume • VBE = F/(p – c) Breakeven Price • p. BE = (c V + F)/V or • p. BE = c + F/V • REMEMBER: in the Tablet Sim, you need to consider that R&D is part of Fixed Costs, so here F = Fo + R

Other CVP Formulas Use F = Fo + R (sim fixed costs) • Price, for a given Profit, Volume and Costs • p* = (P + Fo + R + c. V) / V • Volume, for a given price, Profit and Costs • V* = (P + Fo + R) / (p – c)

Application of CVP in the PDA Sim • When should you use Breakeven? • How do you deal with multiple years? • How do you deal with multiple products? • Give these questions some thought. • Experiment with CVP.

USING THE CVP CALCULATOR An Example for X 5 in the Tablet SIM

Default X 5 2012 Price: $265 R&D%: 33% This Year Last Year % Change 1, 859, 856 1, 535, 407 21% 492, 861, 819 406, 882, 843 21% 269, 679, 108 222, 634, 008 21% Fixed Costs 72, 000, 000 0% R & D Costs 7, 260, 000 0% 348, 939, 108 301, 894, 008 16% Total Profit 143, 922, 711 104, 988, 835 42% Total Profitability 29% 23% 17% X 5 Financials for 2012 Revenue Sales Volume Revenue Volume Cost Variable Costs Total Costs Profit

Default X 5 Market Report for the year 2012 This Year Last Year % Change Installed Base 3, 246, 936 1, 875, 622 69% Remaining Customers Market Saturation 2, 779, 064 4, 149, 378 -31% 54% 31% 69% First-Time Customers Repeat Sales 1, 575, 220 1, 369, 625 15% 284, 636 165, 782 72% Total Sales 1, 859, 856 1, 535, 407 21% Customer Base Sales Volume

USING CVP Calculator: Variable cost/unit: $145 R&D Total Budget Price $ 22, 000 R&D% Allocation 33% R&D Costs $ Fixed Costs $ 72, 000 Total Fixed Costs $ 79, 260, 000 Target Profit Variable Cost/Unit 7, 260, 000 $143, 992, 711 $ 145. 00 Volume $ 265. 00 1, 859, 856 $ 492, 861, 820 Sales Revenue ROS 29. 20% Note that the results from the CVP Calculator are nearly the same as you get in the SIM. The only difference is because the SIM must be using 33. 3333% for the R&D Allocation and the CVP Calculator is using 33%. So we will ignore the difference.

Now let’s develop a Revised Strategy Now, let’s try to develop a different price and R&D allocation for 2012 for our Revised Strategy using the • CVP Calculator. Should we lower R&D or increase it? Should we lower the price or increase it? How much profit do we want? How much will we sell? • Let’s lower the R&D%, say down to 15% - why? I will leave that up to you decide why we might want to do this. • Let’s leave the price the same for this first estimate: $265. • And let’s shoot for the same profit: $143, 922, 711 • If you put these into the CVP Calculator, this says you need less volume: 1, 826, 856 units.

Price: $265 R&D: 15% Volume: 1, 826, 856 R&D Total Budget $ 22, 000 R&D% Allocation 15% R&D Costs $ Fixed Costs $ 75, 300, 000 Total Fixed Costs $ 75, 000 Target Profit Variable Cost/Unit 3, 300, 000 $143, 922, 711 $ 145. 00 Price Volume Sales Revenue ROS $ 265. 00 1, 826, 856 $ 484, 116, 820. 00 29. 73%

What price if Volume does not change? • Price = ? • Same volume as default run • Same profit as default run • R&D%: 15% Volume 1, 859, 856 Price $ Sales Revenue $ 488, 901, 831. 00 ROS Price = $262. 87 29. 44%

What happens in SIM? • Let’s run the sim with our revised strategy for X 5 for 2012. • Price: $263 • R&D%: 15% This Year Revenue Sales Volume Last Year % Change 1, 928, 810 1, 535, 407 26% 507, 277, 039 406, 882, 843 25% Cost Variable Costs 279, 677, 455 222, 634, 008 26% Revenue Volume Fixed Costs 72, 000, 000 0% R & D Costs 3, 300, 000 7, 260, 000 -55% 354, 977, 455 301, 894, 008 19% 152, 299, 584 104, 988, 835 45% 30% 23% 15% Total Costs Profit Total Profitability

Results do not match!! • Volume sold: 1, 928, 810 • Profit earned: 152, 299, 584 • We don’t get the same results that were predicted by the CVP!! In the CVP we used a Volume of: 1, 859, 856 But in the SIM, when we lowered the price just a bit down to $263, we got a volume of: 1, 928, 810. We will get this same result in the CVP calculator if we put in the actual profit earned in the SIM

CVP Calculator with Revised Strategy Results R&D Total Budget R&D% Allocation R&D Costs Fixed Costs Total Fixed Costs $ 22, 000 Price 15% $ 3, 000 Volume $ 70, 000 $ 73, 000 Target Profit Variable Cost/Unit $152, 299, 584 $ $ 263 0 1, 928, 81 $ Sales Revenue 507, 277, 038. 92 145. 00 ROS 30. 63%

Why does the SIM not match your predictions with the CVP Calculator? • The SIM gives you the results based on your inputs of price and R&D% • It will determine how much you sell based on the price – usually a lower price will generate a higher sales volume and vice versa, depending on the price elasticity. • The CVP calculator does not know the price: demand curve – it is simply telling you how much you need to sell for a given Price and a Target Profit.

Some final thoughts • So what is missing is the relationship between price and demand. • Demand is based on based price and the performance (how much is being spent on R&D). • You need to use CVP to help you determine or predict a price in your revised strategy. • Then based on the results you get, you can begin to understand the price: demand relationship. • That is why you get to run the SIM several times as you learn more about price: demand. • And of course demand is related to how much you spend on R&D. • And each product is more or less sensitive to price and product development efforts.