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Profit Profit PlanningPlanning

Prepared by Douglas Cloud

Pepperdine University

22

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Describe and apply the concepts of fixed and variable costs.

Describe and apply the concept of contribution margin.

Prepare contribution margin format income statements.

Describe and discuss the significance of the relevant range.

Construct and interpret a cost-volume-profit graph.

ObjectivesObjectives

After reading this After reading this chapter, you should chapter, you should

be able to:be able to:

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Determine the sales volume or selling price needed to achieve a target profit.

Describe and illustrate target costing. Describe and discuss the importance of cost

structure. Discuss the assumptions that underlie cost-

volume-profit analysis.

ObjectivesObjectives

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Cost BehaviorCost Behavior

Variable costs change, in total, in direct proportion to changes in volume.

Selling price of backpack $20.00Cost of backpack from

manufacturer $10.00Variable cost to pack and ship 1.00Sales commission (5%) 1.00Total variable cost $12.00

Total monthly fixed costs (rent,salaries, depreciation, etc.) $40,000

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5,000 units 6,000 units7,000 unitsSales ($20 per unit) $100,000$120,000$140,000Variable costs ($12 per unit) 60,000 72,000 84,000Contribution margin $ 40,000$ 48,000$ 56,000Fixed costs 40,000 40,000 40,000Profit $0$8,000$16,000

Variable Costs Variable Costs ExampleExample

Exeter Company

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Important RuleImportant Rule

As sales change, income changes by unit contribution

margin multiplied by the change in sales.

The unit The unit contribution contribution margin per margin per

backpack is $8.backpack is $8.

6,000 BackpacksContribution margin

for 6,000 backpacks $48,000

Less fixed costs 40,000

Net income $ 8,000

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Income Statement Formats—Financial Accounting Format

Sales, 6,000 x $20 $120,000Cost of sales, 6,000 x $10 60,000Gross profit $ 60,000Operating expenses:

Packaging and shipping $ 6,000Commissions 6,000Rent, salaries, depreciation, etc. 40,000

Total operating expenses $ 52,000Income $ 8,000

(Functional)

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Income Statement Formats—Contribution Margin Format

Sales, 6,000 x $20 $120,000Variable costs:

Cost of sales $ 60,000Packing and shipping 6,000Commissions 6,000

Total variable costs $ 72,000Contribution margin $ 48,000Fixed costs 40,000Income $ 8,000

(Behavioral)

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Operating LeverageOperating Leverage

6,000 BackpacksContribution margin

for 6,000 backpacks $48,000

Less fixed costs 40,000

Net income $ 8,000

$48,000$8,000

= 6

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Relevant RangeRelevant Range

Relevant range is the range of volume

over which it can reasonably expect selling price, per-unit variable cost,

and total fixed costs to be constant.

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Definitions

Cost-volume-profit (CVP) analysis is a method for analyzing the relationships among costs, volume, and profits.

Contribution margin is the difference between selling price per unit and variable cost per unit.

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Contribution margin percentage is per-unit contribution margin divided by selling price, or total contribution margin divided by total sales dollars.

Variable cost percentage is per-unit variable cost divided by selling price, or total variable costs divided by total sales dollars.

Definitions

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Cost-Volume-Profit GraphCost-Volume-Profit Graph

$160,000

$140,000

$120,000

$100,000

$80,000

$60,000

$40,000

$20,000

$0

2,000 4,000 6,000 8,000 10,000

Unit Sales

Dollars

Break-even point,5,000 units, $100,000

TotalCost

TotalRevenues

LossArea

Profit Area

Fixed cost line

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Break-Even PointBreak-Even Point

Break-even point is the point at which profits are zero because total revenues equal total costs.

Profit =total sales

dollars–

total variable

costs–

total fixed costs

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ProfitProfit

Using Q to denote the quantity of units sold, we can restate the formula as--

Profit =per-unit selling price

–per –unit variable

costs–

total fixed costs

x Q x Q

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ProfitProfit

Combining the two components, we get--

Profit = –Contribution margin per

unit

total fixed costs

x Q

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Break-Even PointBreak-Even Point

Q (break-even sales in units)Total fixed costs

Contribution margin per unit

=

$40,000

$20 - $12= 5,000 backpacks

In units

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Contribution Margin Contribution Margin PercentagePercentage

B/E in $Total fixed costs + target profit

Contribution margin ratio per unit=

Contribution marginSales

$8 ÷ $20 = 40%

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Break-Even PointBreak-Even Point

Q (break-even sales in dollars)Total fixed costs

Contribution margin ratio

=

$40,000

.40= $100,000

In dollars

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Target Return on SalesTarget Return on SalesExeter wishes to earn a 15 percent return on sales.

Desired sales (in dollars)

=fixed costs

contribution margin percentage – target ROS

Desired sales (in dollars)

=$40,000

40% - 15%

Desired sales (in dollars)

= $160,000

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Exeter’s Income Statement

Dollars Percentages

Sales $160,000 100%Variable costs 96,000 60%Contribution margin $ 64,000 40%Fixed costs 40,000 25%Income $ 24,000 15%

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Additional Sales RequiredAdditional Sales Required

Suppose the company’s marketing manager has proposed an advertising campaign that will cost $10,000. How many additional units need to be sold?

$10,000 / $8 = 1,250 units

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Target Selling PricesTarget Selling Prices

The company’s target profit is $10,000 per month and it expects to sell 6,000 units per month. What should be the selling price? Profit = sales – variable costs – fixed costs$10,000 = S – [(6,000 x $11) + 5%S] – $40,000$122,105 = S

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Target CostingTarget Costing

Target costing is the process of determining how much the company can spend to manufacture and market a product, given a target profit.

Example: Managers agree on a target profit of $300,000 and that unit volume of 100,000 is achievable at a $20 price. The target cost is:

Revenue (100,000 x $20)$2,000,000

Target cost 1,700,000Target profit $ 300,000

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Cost Structure and Cost Structure and Managerial AttitudesManagerial Attitudes

Caldwell Company’s managers decide to introduce a new product. They expect to sell 20,000 units at $10. They can make the product in either of two manufacturing processes. Process A uses a great deal of labor and has variable costs of $7 per unit and annual fixed costs of $40,000. Process B uses more machinery, with unit variable costs of $4 and

annual fixed costs of $95,000.

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Cost Structure and Cost Structure and Managerial AttitudesManagerial Attitudes

Process A Process BSales (20,000 x $10) $200,000 $200,000Variable costs at $7 and $4 140,000 80,000Contribution margin at $3

and $6 $ 60,000 $120,000Fixed costs 40,000 95,000Profit $ 20,000 $ 25,000

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Cost Structure and Cost Structure and Managerial AttitudesManagerial Attitudes

Break-even

Process A: B/Eunits

= $40,000$3

= 13,333 units

Process B: B/Eunits

= $95,000$6

= 15,833 units

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Margin of SafetyMargin of Safety

The difference in volume from the expected level of sales to the break-even point is called the margin of safety (MOS).

If actual sales are 6,000 units, the margin of safety is 1,000 units (6,000 - 5,000).If actual sales are $120,000, the margin of safety is $20,000 ($120,000 - $100,000).

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Indifference PointIndifference Point

The indifference point is the level of volume at which total costs, and hence profits, are the same under both cost structures.

Example: Total cost of A = $40,000 + $7XTotal cost of B = $95,000 + $4X

$40,000 + $7X = $95,000 + $4XX = 18,333 units (rounded)

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Assumptions and Limitations Assumptions and Limitations of CVP Analysisof CVP Analysis

Selling price, per-unit variable cost, and total fixed costs must be constant throughout the relevant range.

The company sells only one product, or the sales of each product in a multiproduct company are a constant percentage of sales.

Production equals sales in units.

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The End

Chapter 2Chapter 2

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