Financial and
Cost-Volume-Profit Models
Chapter 12
Financial Modeling
Quantitative simulation of relations among
various factors
Allows the organization to assess “what if”
scenarios to support
Decision making
Forecasting
Cost-Volume-Profit Models
Illustrates the relationship between sales
volume, costs and revenues
Based on variable (direct) costing
Sales – variable costs = contribution margin
Each additional unit sold “contributes” that amount
to the bottom line
Breakeven point is reached when total
contribution equals total fixed costs
Cost-Volume-Profit Models
Basic formula
Fixed cost + desired profit
Unit sales =
Contribution margin per unit
Breakeven point occurs at a profit of zero
Cost-Volume-Profit Models
Example
Sales price = $100
Variable cost per unit = $40
Total fixed cost = $36,000
$36,000 + 0
= 600 units
$60/unit
$160,000
$140,000
$120,000
Breakeven
point
$100,000
$80,000
$60,000
Variable cost
$40,000
$20,000
Unit sales
Fixed cost
Total cost
Revenue
00
1,6
00
1,5
00
1,4
00
1,3
0
80
00
0
70
1,2
0
60
00
0
50
1,1
0
40
0
00
0
30
1,0
0
20
90
0
10
$0
0
Revenue and costs
$180,000
Cost-Volume-Profit Models
Income tax effect
“Desired profit” in basic model assumes no
income taxes
Obviously, more units must be sold if taxes must
be paid on the profits
Adjustment to basic model
Fixed cost + Profit / (1 – tax rate)
Unit sales =
Contribution margin per unit
Cost-Volume-Profit Models
Same example
Desired profit = $24,000
Basic model
$36,000 + 24,000
= 1,000 units
$60/unit
If tax rate is 20%
$36,000 + 24,000/(1 - .20)
$60/unit
= 1,100 units
Cost-Volume-Profit Models
Contribution margin can be used to make
scarce resource allocation decisions
Goal is to maximize the amount of income
that can be generated
How to best use the scarce resource?
Determine the contribution per unit of the
scarce resource
Can only consider one resource at a time
Sales price
Variable cost/unit
Contribution margin
Units of scarce
resources required for
each unit of product
Contribution margin per
unit of scarce resource
Product A Product B Product C Product D
$
100 $
210 $
380 $
450
72
90
200
210
$
28 $
120 $
180 $
240
2
$
14
5
$
24
6
$
What is the best use of 300 units of the resource?
30
12
$
20
Cost-Volume-Profit Models
Multiple product situations
Basic model assumes only one product
Multiple product situation replaces the
contribution margin per unit with the weighted
average contribution margin
Based on the normal relative sales volumes of the
products
Resulting “units to sell” is then divided among
the products in their original proportions
Cost-Volume-Profit Models
Example
Selling
Product
price
Folders
$ 1.00
Binders
5.00
Portfolios
20.00
Var.cost
per unit
$ 0.40
2.20
12.00
CM per
unit
$ 0.60
2.80
8.00
Relative Weighted
sales
CM per unit
60% $
0.36
30%
0.84
10%
0.80
$
2.00
Fixed cost
$ 100,000
Desired profit
$
10,000
Cost-Volume-Profit Models
$100,000 + 10,000
= 55,000 units
$2.00/unit
Product
Folders
Binders
Portfolios
Relative
sales
60%
30%
10%
Total
sales
55,000
55,000
55,000
Units of
product
33,000
16,500
5,500
CM per
unit
$ 0.60
2.80
8.00
Total CM
$ 19,800
46,200
44,000
$ 110,000
Cost-Volume-Profit Models
Operating leverage
Companies with relatively low variable costs
per unit, but high fixed costs, experience
greater swings in profitability with volume
changes than do companies with high
variable costs and low fixed costs
Operating leverage is a multiplier
%∆ in sales * operating leverage = %∆ in income
Cost-Volume-Profit Models
Contribution margin
Operating leverage = Operating income
Sales
Variable costs
Contribution margin
Fixed costs
Operating income
Company A
$ 1,000,000
300,000
$
700,000
600,000
$
100,000
Company B
$ 1,000,000
600,000
$
400,000
300,000
$
100,000
Operating leverage
7.00
4.00
Cost-Volume-Profit Models
A 10% increase in sales will result in a
70% increase in Company A’s income, but
only a 40% increase in Company B’s
Sales
Variable costs
Contribution margin
Fixed costs
Operating income
New operating leverage
Company A
$ 1,100,000
330,000
$
770,000
600,000
$
170,000
Company B
$ 1,100,000
660,000
$
440,000
300,000
$
140,000
4.53
3.14
Multiple Driver Models
CVP model assumes all costs are either
variable and driven by sales, or fixed
In reality, costs and revenues have many
different drivers
ABC-based model should be more
accurate
Considers the major drivers of costs
Sensitivity Analysis
Model inputs are estimates, actual results
may vary considerably
Sensitivity analysis plays “what if” with the
inputs
Changes in volume of cost and revenue
drivers
How much will the income be affected by
other scenarios?
Theory of Constraints
Identification and best use of bottlenecks
Bottleneck is anything that prevents the
company from producing and selling more
Process: machine capacity, available labor
Policy: no weekend or overtime work
Resource: shortage of materials
Market: not enough demand for product
Theory of Constraints
Product A
Product B
Product C
Process 1
Capacity:
12/hour
Process 2
Capacity:
4/hour
Process 3
Capacity:
6/hour
Process 4
Capacity:
5/hour
Theory of Constraints
Step 1: Identify appropriate value measure
Usually throughput
Step 2: Identify bottlenecks
Work piling up, unused capacity, etc.
Step 3: Optimize the bottleneck
What will produce the greatest value?
Theory of Constraints
Step 4: Adjust process to bottleneck’s needs
Produce only what is needed by the bottleneck
Step 5: Alleviate the bottleneck
Add capacity, demand, etc.
Step 6: Repeat steps 1-5
Eliminating one bottleneck creates another
Product A Product B Product C
Throughput
per unit
Daily demand
Minutes req'd
per unit
Process 1
Process 2
Process 3
Process 4
Throughput
per minute of
Process 2
Produce
Process 2
minutes used
$
28
14
$
5
10
3
7
$
2.80
6
60
$
120
10
$
180
15
8
15
6
8
15
18
5
9
8.00
10
$ 10.00
15
150
270
Total minutes
required
375
560
177
313
Total used
480