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3 CHAPTER COST-VOLUME-PROFIT ANALYSIS AND PRICING DECISIONS photo: © Tischenko Irina/Shutterstock

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3 MARKETING WANTS ANOTHER $50,000 What will they do with it? How will it affect sales volume? What is the impact on our bottom line?

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© Tomwang112 / iStockphoto BREAKEVEN ANALYSIS Unit 3.1 31. Unit 3.2Unit 3.3Unit 3.4

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3 WHAT DOES IT MEAN TO BREAK EVEN Total revenues = total expenses Profit = $0 There is one sales volume at which this relationship is true This is called the breakeven point

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3 TO CALCULATE THE BREAKEVEN POINT Use the equation approach Solve for units sold, which equals the breakeven point Why is profit set to $0? Sales Revenue– Variable expenses– Fixed expenses= Operating income (SP×units sold) – (VC×units sold) – FC = $0 [(SP – VC)×(units sold)] – FC = $0 (CM/unit×units sold) – FC = $0

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$20x - $16x - $168,000 = $0 x = 42,000 jerseys BREAKEVEN POINT FOR UNIVERSAL SPORTS EXCHANGE $4x - $168,000 = $0 BREAKEVEN POINT FOR UNIVERSAL SPORTS EXCHANGE

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3 FC CM/Unit = Breakeven in units SHORTCUTS… $168,000 $4 = 42,000 jerseys

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3 SHORTCUTS… FC CMR = Breakeven in sales $ $168,000 0.2 = $840,000

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LETS LOOK AT BREAK EVEN GRAPHICALLY $168,000 LETS LOOK AT BREAKEVEN GRAPHICALLY

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3 Current sales – Breakeven sales MARGIN OF SAFETY What does this mean? $1,050,000 – $840,000 = $210,000 52,500 – 42,000 = 10,500 jerseys

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© Tomwang112 / iStockphoto C-V-P ANALYSIS Unit 3.1 32. Unit 3.2 Unit 3.3Unit 3.4

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3 LETS REVIEW THE PROFIT EQUATION – VC×(units sold)SP×(units sold)– FC= OI

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3 HOW MUCH DO I HAVE TO SELL TO MAKE $X? This is called the target income question Use the profit equation Use the breakeven formula and treat your target pretax income as additional fixed costs FC + Target Income CM / unit = required sales volume To find the sales dollars required to attain the target income, use the CMR rather than the CM / unit. (SP×units sold) – (VC×units sold) – FC = $X

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3 WHAT ABOUT TARGET NET INCOME? You must adjust net income to pretax income Divide target net income by (1 - tax rate) Solve as before Total FC + = required sales volume CM / unit Target net income 1 – tax rate

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3 CVP ANALYSIS 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

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3 THREE APPROACHES TO CVP 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

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3 CVP AND THE SUPPLY CHAIN How do the CVP decisions of supply chain partners affect each other? For example, consider the jerseys that Universal Sports Exchange purchases from C&C Sports. What happens if C&C Sports increases the selling price? What happens if Universal Sports Exchange decides to use a cheaper supplier?

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3 OPERATING LEVERAGE 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 = Contribution margin Net operating income

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WHY DO WE CARE ABOUT OPERATING LEVERAGE? WHY DO WE CARE ABOUT OPERATING LEVERAGE

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© Tomwang112 / iStockphoto MULTIPRODUCT C-V-P ANALYSIS Unit 3.1 33. Unit 3.2 Unit 3.3 Unit 3.4

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3 MULTIPRODUCT CVP 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

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3 WHAT IS SALES MIX? 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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3 USE THE PROFIT EQUATION…WITH ADJUSTMENTS CM(jerseys) + CM(shoes) – FC = OI ProductPrice Variable Cost Contribution Margin Jerseys$20$16.00$4.00 Shoes$45$38.70$6.30

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3 DETERMINE THE SALES MIX $4.00(4x) + $6.30(x) – FC = OI Product Contribution MarginSales Mix Adjusted Contribution Margin Jerseys$4.004x4x$16.00x Shoes$6.301x1x$ 6.30x $16x + $6.30x – FC = OI Jerseys Shoes 4 1 :

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3 $22.30x = $178,400 $16x + $6.30x – $178,400 = $0 CALCULATING THE BREAKEVEN POINT Product Contribution MarginSales Mix Adjusted Contribution Margin Jerseys$4.004x4x$16.00x Shoes$6.301x1x$ 6.30x x = 8,000 shoes 4x = 4(8,000) = 32,000 jerseys

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3 LIMITING ASSUMPTIONS OF CVP ANALYSIS 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

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3 CHANGES EXAMINED USING CVP 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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© Tomwang112 / iStockphoto PRICING DECISIONS Unit 3.1 34. Unit 3.2Unit 3.3 Unit 3.4

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3 ECONOMICS OF PRICE Market equilibrium

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3 COST-PLUS PRICING 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 Product Cost + Markup = Sales Price

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3 CALCULATING MARKUP PERCENTAGE Sales price – Cost Cost = Markup % $20.00 - $14.80 $14.80 = 35%

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3 $36.00 + $12.60 = $48.60 CALCULATING PRICE USING MARKUP % Cost $36.00 + ($36.00 × 35%) = Price Markup amount + (Cost × Markup %)= Price

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3 ISSUES WITH COST-PLUS PRICING 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 sellers inefficiencies are borne by the customers

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3 TARGET COSTING Start with an estimate of the price customers will pay Subtract the desired markup The result is the target, or maximum, product cost This is calculated before the product is designed and manufactured If you can produce the product for the target cost, go forward

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