2-1
Profit
Planning
Prepared by
Douglas Cloud
Pepperdine University
2-2
Objectives
 Describe and apply the concepts of fixed and
After reading this
variable costs.
chapter, you should
 Describe and apply the concept of
be able to:
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.
2-3
Objectives
 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 costvolume-profit analysis.
2-4
Cost Behavior
Variable costs change, in total, in direct
proportion to changes in volume.
Selling price of backpack
Cost of backpack from
manufacturer
Variable cost to pack and ship
Sales commission (5%)
Total variable cost
Total monthly fixed costs (rent,
salaries, depreciation, etc.)
$20.00
$10.00
1.00
1.00
$12.00
$40,000
2-5
Variable Costs
Example
Exeter Company
5,000 units 6,000 units 7,000 units
Sales ($20 per unit)
$100,000 $120,000 $140,000
Variable costs ($12 per unit)
60,000
72,000
84,000
Contribution margin
$ 40,000 $ 48,000 $ 56,000
Fixed costs
40,000
40,000
40,000
Profit
$0
$8,000
$16,000
2-6
Important Rule
As sales change,
income changes by
unit contribution
margin multiplied by
the change in sales.
6,000 Backpacks
Contribution margin
for 6,000 backpacks
Less fixed costs
Net income
The unit
contribution
margin per
backpack is $8.
$48,000
40,000
$ 8,000
2-7
Income Statement Formats—
Financial Accounting Format
(Functional)
Sales, 6,000 x $20
Cost of sales, 6,000 x $10
Gross profit
Operating expenses:
Packaging and shipping
Commissions
Rent, salaries, depreciation, etc.
Total operating expenses
Income
$120,000
60,000
$ 60,000
$
6,000
6,000
40,000
$ 52,000
$ 8,000
2-8
Income Statement Formats—
Contribution Margin Format
(Behavioral)
Sales, 6,000 x $20
Variable costs:
Cost of sales
Packing and shipping
Commissions
Total variable costs
Contribution margin
Fixed costs
Income
$120,000
$ 60,000
6,000
6,000
$ 72,000
$ 48,000
40,000
$ 8,000
2-9
Operating Leverage
6,000 Backpacks
Contribution margin
for 6,000 backpacks
Less fixed costs
Net income
$48,000
$48,000
40,000
$8,000
$ 8,000
=6
2-10
Relevant Range
Relevant range is
the range of volume
over which it can
reasonably expect
selling price, perunit variable cost,
and total fixed costs
to be constant.
2-11
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.
2-12
Definitions
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.
2-13
Cost-Volume-Profit Graph
Dollar
s $160,000
Total
Revenues
$140,000
$120,000
Profit
Area
$100,000
$80,000
Total
Cost
Loss
Area
Break-even point,
5,000 units, $100,000
$60,000
$40,000
Fixed cost line
$20,000
$0
2,000
4,000
6,000
Unit Sales
8,000
10,000
2-14
Break-Even Point
Break-even point is the point at which profits
are zero because total revenues equal total
costs.
total
Profit = sales
dollars
total
– variable –
costs
total
fixed
costs
2-15
Profit
Using Q to denote the quantity of units sold,
we can restate the formula as--
Profit =
per-unit
selling x Q
price
–
per –unit
variable x Q
costs
total
– fixed
costs
2-16
Profit
Combining the two components, we get--
Profit =
Contribution
margin per x Q
unit
–
total
fixed
costs
2-17
Break-Even Point
In units
Total fixed costs
Q (break-even sales in units) =
Contribution margin
per unit
$40,000
$20 - $12
= 5,000 backpacks
2-18
Contribution Margin
Percentage
Total fixed costs
B/E in $ =
Contribution margin ratio per unit
Contribution margin
Sales
$8 ÷ $20 = 40%
2-19
Break-Even Point
In dollars
Total fixed costs
S (break-even sales in dollars) =
Contribution margin
ratio
$40,000
.40
= $100,000
2-20
Target Return on Sales
Exeter wishes to earn a 15 percent return on
sales.
Desired
fixed costs
sales (in =
contribution margin
dollars)
percentage – target ROS
Desired
$40,000
sales (in =
40% - 15%
dollars)
Desired
sales (in = $160,000
dollars)
2-21
Exeter’s Income Statement
Sales
Variable costs
Contribution margin
Fixed costs
Income
Dollars
$160,000
96,000
$ 64,000
40,000
$ 24,000
Percentages
100%
60%
40%
25%
15%
2-22
Additional 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 to recover the additional
costs?
$10,000 / $8 = 1,250 units
2-23
Target 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
$10,000
$122,105
=
=
=
Selling price =
Selling price =
Selling price =
sales – variable costs
–
S
– [(6,000 x $11) + 5%S] –
S
sales / units
$122,105/ 6,000
$20.35/unit (rounded)
fixed costs
$40,000
2-24
Target 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
1,700,000
Target profit
$ 300,000
2-25
Cost Structure and
Managerial 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.
2-26
Cost Structure and
Managerial Attitudes
Process A
$200,000
Process B
$200,000
Variable costs at $7 and $4
140,000
80,000
Contribution margin at $3
and $6
$ 60,000
$120,000
40,000
95,000
$ 20,000
$ 25,000
Sales (20,000 x $10)
Fixed costs
Profit
2-27
Cost Structure and
Managerial Attitudes
Break-even
Process A: B/E
units
Process B: B/E
units
=
$40,000
$3
=
$95,000
$6
= 13,333 units
= 15,833 units
2-28
Margin 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 expected sales are 20,000 units, the margin of
safety is 6,667 units (20,000 - 13,333).
If expected sales are $200,000, the margin of
safety is $66,670 ($200,000 - $133,330).
2-29
Indifference 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 + $7Q
Total cost of B = $95,000 + $4Q
$40,000 + $7Q = $95,000 + $4Q
Q = 18,333 units (rounded)
2-30
Assumptions and Limitations
of 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.
2-31
Chapter 2
The End
2-32