# COST-VOLUME-PROFIT ANALYSIS

```COST-VOLUME-PROFIT ANALYSIS
AND PRICING DECISIONS
MARKETING WANTS ANOTHER \$50,000
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What will they do with it?
How will it affect sales volume?
What is the impact on our bottom line?
&copy; Tomwang112 / iStockphoto
BREAKEVEN ANALYSIS
Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4
31
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WHAT DOES IT MEAN TO “BREAK EVEN”
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3
Total revenues = total expenses
Profit = \$0
There is one sales volume at which this
relationship is true
This is called the “breakeven point”
TO CALCULATE THE BREAKEVEN POINT
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Use the equation approach
Sales Revenue – Variable expenses – Fixed expenses = Operating income
(SP&times;units sold) – (VC&times;units sold) – FC = \$0
[(SP – VC)&times;(units sold)] – FC = \$0
(CM/unit&times;units sold) – FC = \$0
• Solve for units sold, which equals the breakeven point
• Why is profit set to \$0?
3
BREAKEVEN
BREAKEVENPOINT
POINTFOR
FORUNIVERSAL
UNIVERSALSPORTS
SPORTSEXCHANGE
EXCHANGE
\$20x - \$16x - \$168,000 = \$0
\$4x - \$168,000 = \$0
x = 42,000 jerseys
SHORTCUTS…
FC
= Breakeven in units
CM/Unit
\$168,000
= 42,000 jerseys
\$4
3
SHORTCUTS…
FC
CMR
= Breakeven in sales \$
\$168,000
= \$840,000
0.2
3
LET’S
EVENGRAPHICALLY
GRAPHICALLY
LET’SLOOK
LOOKAT
AT BREAK
BREAKEVEN
\$168,000
MARGIN OF SAFETY
Current sales – Breakeven sales
52,500 – 42,000 = 10,500 jerseys
\$1,050,000 – \$840,000 = \$210,000
What does this mean?
3
PRACTICE BREAKING EVEN
Exercise 3-2
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EXERCISE 3-2 SOLUTION
a. \$.80 - \$.45 = \$.35
\$.35
= .4375
b. Contribution margin ratio =
\$.80
c. \$.80x – \$.45x – \$175,000 = \$0
\$.35x = \$175,000
x = 500,000 bars to breakeven
500,000 bars  \$.80 per bar = \$400,000 to breakeven
d. The breakeven point will increase to:
\$175,000
= 700,000 bars &times; \$0.80 = \$560,000
\$0.25
3
&copy; Tomwang112 / iStockphoto
C-V-P ANALYSIS
Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4
3.2
LET’S REVIEW THE PROFIT EQUATION
SP&times;(units sold) – VC&times;(units sold) – FC = OI
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HOW MUCH DO I HAVE TO SELL TO MAKE \$X?
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This is called the “target income” question
Use the profit equation
(SP&times;units sold) – (VC&times;units sold) – FC = \$X
Use the breakeven formula and treat your target
pretax income as additional fixed costs
FC + Target Income
= required sales volume
CM / unit
To find the sales dollars required to attain the target
income, use the CMR rather than the CM / unit.
WHAT ABOUT TARGET NET INCOME?
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You must adjust net income to pretax income
Divide target net income by (1 - tax rate)
Solve as before
Total FC +
Target net income
1 – tax rate
= required sales volume
CM / unit
3
TARGET PRACTICE
(EXERCISE 3-10)
Wimpee’s Hamburger Stand sells one burger, the
Super Tuesday Burger, for \$3.00. If total variable
expenses are \$1.75 per hamburger and total
monthly fixed expenses are \$25,000, how many
burgers would Wimpee have to sell each month:
To break even?
►To earn a pretax operating income of \$6,000?
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WHAT IF…
Suppose Wimpee has never sold more than
21,000 Super Tuesday Burgers in a single month.
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How likely is it that he will achieve the desired
\$6,000 target operating income?
What can he do to improve his chances of
reaching his \$6,000 target operating income?
CVP ANALYSIS
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Stands for cost-volume-profit
A tool to determine the impact of changes in sales
volume, costs, or sales mix on net income
Useful for evaluating decision alternatives
THREE APPROACHES TO CVP
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Prepare a contribution format income statement
before and after implementing the changes
Prepare a partial contribution format income
statement that includes only those items that
change (called the “incremental approach”)
Compare the current total contribution margin with
the proposed total contribution margin, then adjust
for changes in fixed expenses
CVP AND THE SUPPLY CHAIN
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How do the CVP decisions of supply chain
partners affect each other?
For example, consider the jerseys that Universal
Sports Exchange purchases from C&amp;C Sports.
• What happens if C&amp;C Sports increases the selling
price?
• What happens if Universal Sports Exchange decides
to use a cheaper supplier?
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OPERATING LEVERAGE
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Firms sometimes have the option to trade fixed
costs for variable costs
Higher levels of fixed costs introduce higher levels
of risk
Measures the magnitude of change in operating
income for a given percentage change in sales
revenue
Degree of operating leverage =
3
Contribution margin
Net operating income
WHYDO
DO WE
WE CARE
WHY
OPERATINGLEVERAGE?
LEVERAGE
DO THE CVP
Exercise 3-6
3
EXERCISE 3-6 SOLUTION
\$390,000
a. Contribution margin ratio =
= .65
\$600,000
Variable cost ratio = 1 - .65 = .35
b. Margin of safety = Current sales – Breakeven sales
\$292,500
Breakeven sales =
.65
= \$450,000
Margin of safety = \$600,000 – \$450,000
= \$150,000
c. Net operating income would increase by the change in
contribution margin: \$100,000  .65 = \$65,000
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EXERCISE 3-6 SOLUTION (CONT.)
\$17.50  1.16
\$20.30
\$50  1.1
\$55
\$600,000
current unit sales =
= 12,000
50
d. new variable cost =
=
new price =
=
new unit sales = 12,000  .98 = 11,760
operating income = [(\$55.00 – \$20.30)  11,760] – \$292,500
= \$115,572
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&copy; Tomwang112 / iStockphoto
MULTIPRODUCT C-V-P
ANALYSIS
Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4
3.3
MULTIPRODUCT CVP
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Rarely does a company produce a single product
Since not every product will have the same
contribution margin, we have a problem when
more than one product is produced
WHAT IS “SALES MIX”?
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The “bag” or “package” of goods sold
For example:
• For every dining room table sold, the company also
sells 4 chairs
• For every computer sold, the company also sells a
monitor and a printer
• For every pair of athletic shoes sold, Landon Sports
sells 4 baseball jerseys
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USE THE PROFIT EQUATION…WITH ADJUSTMENTS
Product
Price
Variable
Cost
Contribution
Margin
Jerseys
\$20
\$16.00
\$4.00
Shoes
\$45
\$38.70
\$6.30
CM(jerseys) + CM(shoes) – FC = OI
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DETERMINE THE SALES MIX
Product
Contribution
Margin
Sales Mix
Contribution Margin
Jerseys
\$4.00
4x
\$16.00x
Shoes
\$6.30
1x
\$ 6.30x
\$4.00(4x) + \$6.30(x) – FC = OI
\$16x + \$6.30x – FC = OI
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CALCULATING THE BREAKEVEN POINT
Product
Contribution
Margin
Sales Mix
Contribution Margin
Jerseys
\$4.00
4x
\$16.00x
Shoes
\$6.30
1x
\$ 6.30x
3
\$16x + \$6.30x – \$178,400 = \$0
\$22.30x = \$178,400
x = 8,000 shoes
4x = 4(8,000) = 32,000 jerseys
LIMITING ASSUMPTIONS OF CVP ANALYSIS
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All costs can be divided into fixed and variable
components
All cost and profit functions are linear throughout
the relevant range
Sales mix will remain constant
CHANGES EXAMINED USING CVP
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Change in sales price
Change in sales volume
Change in variable costs per unit
Change in fixed costs
Change in sales mix
Any combination of the above
Remember to always use “constant” forms – SP/unit,
VC/unit, Total FC – when doing CVP analysis
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TIME TO MIX IT UP
Exercise 3-14
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EXERCISE 3-14 SOLUTION
a. Kitchenware’s sales mix is 14,000 plastic pitchers and
42,000 glass pitchers, or a sales mix of 1 to 3.
(\$30 – \$15)x + (\$45 – \$24)3x – \$982,800 = 0
\$15x + \$63x = \$982,800
x = 12,600
plastic pitchers = x = 12,600; glass pitchers = 3x = 37,800
b. (\$30 – \$13)x + (\$45 – \$24)3x – \$982,800 = 0
\$17x + \$63x = \$982,800
x = 12,285
plastic pitchers = x = 12,285; glass pitchers = 3x = 36,855
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&copy; Tomwang112 / iStockphoto
PRICING DECISIONS
Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4
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ECONOMICS OF PRICE
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COST-PLUS PRICING
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Start with the cost to produce the product
Add a markup to the cost to arrive at price
Be clear about what cost you use in the markup
calculation
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=
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Product Cost
Markup
Sales Price
CALCULATING MARKUP PERCENTAGE
Sales price – Cost
= Markup %
Cost
\$20.00 - \$14.80
\$14.80
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= 35%
CALCULATING PRICE USING MARKUP %
Cost + (Cost &times; Markup %) = Price
\$36.00 + (\$36.00 &times; 35%) = Price
\$36.00 + \$12.60 = \$48.60
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ISSUES WITH COST-PLUS PRICING
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What if customers are willing to pay more than the
calculated price?
Cost-plus pricing does not recognize the value
provided to the customer; it recognizes a return to
the seller
The costs of the seller’s inefficiencies are borne by
the customers
TARGET COSTING
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Start with an estimate of the price customers will
pay
• Subtract the desired markup
• The result is the target, or maximum, product cost
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This is calculated before the product is designed
and manufactured
If you can produce the product for the target cost,
go forward
LET’S PRICE
Exercise 3-18
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EXERCISE 3-18 SOLUTION
a. cost of original pet bed = \$45 – \$15 = \$30
\$15
= 50% markup on COGS
markup percentage =
\$30
price of high-end bed = \$58 &times; 1.5 = \$87
\$15
= 1/3; COGS = 2/3
b. current gross margin =
\$45
high-end bed target cost of goods sold = 2/3 &times; \$78 = \$52
c. Pet Designs could
•redesign the high-end bed to reduce the cost to produce the bed;
•accept a lower gross margin percentage; or,
•not make the bed
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&copy; Beverley Vycital/iStockphoto
ONE FINAL REVIEW
Problem 3-20
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PROBLEM 3-20(A) SOLUTION
\$600,000
current sales volume:
= 50,000 units
\$12
new sales volume: 50,000 &times; .95 = 47,500 units
new sales price: \$12.00 &times; 1.10 = \$13.20
Sales
Less variable expenses
Contribution margin
Less fixed expenses
Operating income
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Total
\$627,000
332,500
294,500
175,000
\$119,500
Per unit
\$13.20
7.00
\$ 6.20
PROBLEM 3-20(B) SOLUTION
new sales price: \$12.00 &times; 1.10 = \$13.20
new variable cost per unit: \$7.00 &times; 1.05 = \$7.35
Sales
Less variable expenses
Contribution margin
Less fixed expenses
Operating income
3
Total
\$660,000
367,500
292,500
175,000
\$117,500
Per unit
\$13.20
7.35
\$ 5.85
PROBLEM 3-20(C) SOLUTION
new sales price: \$12.00 &times; .90 = \$10.80
new sales volume: 50,000&times; 1.20 = 60,000 units
Sales
Less variable expenses
Contribution margin
Less fixed expenses
Operating income
3
Total
\$648,000
420,000
228,000
175,000
\$ 53,500
Per unit
\$10.80
7.00
\$ 3.80
PROBLEM 3-20(D) SOLUTION
new fixed expenses: \$175,000 + \$20,000 = \$195,000
Sales
Less variable expenses
Contribution margin
Less fixed expenses
Operating income
3
Total
\$648,000
420,000
228,000
175,000
\$ 53,500
Per unit
\$10.80
7.00
\$ 3.80
PROBLEM 3-20(E) SOLUTION
new sales price: \$12.00 &times; 1.10 = \$13.20
new variable cost per unit: \$7.00 &times; 1.10 = \$7.70
new fixed expenses: \$175,000 + \$25,000 = \$200,000
new sales volume: 50,000 &times; .90 = 45,000 units
Sales
Less variable expenses
Contribution margin
Less fixed expenses
Operating income
3
Total
\$594,000
346,500
247,500
200,000
\$ 47,500
Per unit
\$13.20
7.70
\$ 5.50
```