1. Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition PowerPoint Slides to accompany Prepared by Pierre Bergeron, University of Ottawa

2. Copyright © 2011 Nelson Education Limited Finance for Non-Financial Managers, 6 th edition CHAPTER 5 PROFIT PLANNING AND DECISION-MAKING

3. Copyright © 2011 Nelson Education Limited Profit Planning and Decision-Making 1.Explain various cost concepts related to break-even analysis such as fixed and variable costs, the relationship between revenue and costs, the contribution margin, the relevant range and relevant costs. 1.Draw the break-even chart and calculate the break-even point, the cash break-even point and the profit break-even point and how they can be applied in different organizations. 1.Differentiate between different types of cost concepts such as committed and discretionary costs, controllable and non- controllable costs, and direct and indirect costs. Chapter Reference Chapter 5: Profit Planning and Decision-Making Chapter Objectives

4. Copyright © 2011 Nelson Education Limited Relevance of Break-Even Analysis Break-even analysis helps to: 1.Price existing or new products and services. 2.Decide whether to introduce a new product or service, open a new plant, hire a sales representative, open a new sales office, launch an advertising program. 3.Modernize or automate an existing plant. 4.Expand an existing plant. 5.Change the cost structure (fixed versus variable).

5. Copyright © 2011 Nelson Education Limited 1. Fixed and Variable Costs Fixed costs Period costs Constant costs Standby costs Characteristic Element of fixedness and must be paid with passage of time. Variable costs Direct costs Out-of-pocket costs Volume costs Characteristic Vary almost automatically with volume. Sales commission, direct labour, packing material, electricity, overtime premiums, equipment rental, truck expenses Rent, interest, insurance, property taxes, office salaries, depreciation, telephone

6. Copyright © 2011 Nelson Education Limited Connection Between Revenue and Costs Factors that affect profit: 1.Volume of production 2.Prices 3.Costs (fixed and variable) 4.Changes in product mix Cost per Unit (in $) 16 14 12 10 40 60 80 100 AB C D E G F H % of Capacity

7. Copyright © 2011 Nelson Education Limited The Contribution Margin PV Ratio $250,000 $1,000,000.25 Revenue Less variable costs: Direct material Direct labour Total variable costs Contribution margin Less fixed costs: Manufacturing Administration Total fixed costs Operating profit ($ 500,000) (250,000) (150,000) (50,000) $ 1,000,000 (750,000) 250,000 (200,000) $ 50,000 PV ratio

8. Copyright © 2011 Nelson Education Limited 2. J. Smith’s Break-Even (Taxi Driver) $ Trips 6,000 Costs/Revenue Variable costs $2.00 Fixed costs Insurance Car payment (principal or depreciation) Interest Dispatcher fees Variable costs Gas Maintenance & repairs Fixed costs $15,000 $$$$$$ Revenue Variable costs Contribution margin 10.00 2.00 8.00 $$$$ = 15,000 8.00 1,875 trips Revenue $10.00 Total costs = $$$$ 45,000 8.00 5,625 trips Break-even point

9. Copyright © 2011 Nelson Education Limited J. Smith’s Break-Even (Taxi Driver) No salary With salary 1,875 $ 18,750 ($ 3,750) $ 15,000 ($ 15,000) 0.80 5,625 $ 56,250 ($ 11,250) $ 45,000 ($ 15,000) ($ 30,000) 0.80 6,000 $ 60,000 ($ 12,000) $ 48,000 ($ 15,000) ($ 30,000) $ 3,000.80 No. of trips Revenue ($10.00) Variable costs ($2.00) Contribution margin Fixed costs Salary Profit P.V. Ratio

10. Copyright © 2011 Nelson Education Limited Finding the Break-Even Point Using the Formula Unit selling price$ 15.00 (P) Fixed costs$200,000 (F) Unit variable costs$ 10.00 (V) Break-even calculation Step 2:$200,000 ÷ $5.00 = 40,000 units (volume) Step 3:40,000 units X $15.00 = $600,000 (sales revenue) Step 1:Contribution margin Selling price$15.00 Variable costs$10.00 Contribution margin$ 5.00

11. Copyright © 2011 Nelson Education Limited Break-Even Point Calculation Fixed costs Price per unit sold – Variable cost per unit or unit contribution $200,000 $15.00 - $10.00 B.E.P.= In Units In revenue B.E.P.= = 40,000 units Step 2:Find the revenue break-even point B.E.P. = == $600,000 Step 1:Find the PV ratio PV = ==.333 Fixed costs PV $200,000.333 Unit contribution Unit selling price $5.00 $15.00 X $15.00 $ 600,000

12. Copyright © 2011 Nelson Education Limited Break-Even Point By Using the PV Ratio Step 2: Find the revenue break-even point B.E.P. = == $600,000 Step 1:Find the PV ratio PV = ==.333 Fixed costs PV $200,000.333 Contribution Revenue $200,000 $600,000 Finding the break-even point when units are not known, you need to re-structure the statement of income $$$$$$$$$$ Revenue600,000 Variable costs 400,000 Contribution margin 200,000 Fixed costs 200,000 Profit/loss 0

13. Copyright © 2011 Nelson Education Limited Break-Even Point (Retail Store) Suits Jackets Shirts Ties Socks Overcoats Total No. of units 800 2007005002,500 500 Unit selling price $300$150$50$50 $8$300 Revenue$500,000 Variable costs ($275,000) (25,000) Total variable costs($300,000) Contribution margin$200,000 Fixed costs ($100,000) Profit$100,000 Contribution margin $200,000 Revenue $500,000 Fixed costs$100,000 PV ratio.40 = =.40 or $0.40 = = $250,000 Purchases Sales commission (rent, telephone, salaries, security system) 50% of objective OK!!!

14. Copyright © 2011 Nelson Education Limited Cash Break-Even Point Fixed costs - Depreciation Price per unit sold – Variable cost per unit $ 200,000 - $50,000 $150,000 $15.00 - $10.00$5.00 In Units In revenue = = 30,000 units = = $450,000 Fixed costs - Depreciation PV $150,000.333

15. Copyright © 2011 Nelson Education Limited Profit Break-Even Fixed costs + Profit objective Price per unit sold – Variable cost per unit $200,000 + $20,000 $220,000 $15.00 - $10.00 $5.00 In Units In revenue = = 44,000 units = = $660,000 Fixed costs + Profit objective PV $220,000.333

16. Copyright © 2011 Nelson Education Limited Sensitivity Analysis Base case Break-even Break-even in units in revenue 40,000 $600,000 Selling price (increased by $0.50 to $15.50) 36,364 $563,642 Change in Fixed costs (increased by $50,000 to $250,000) 50,000 $750,000 Variable costs (decreased by $0.75 to $9.25) 34,782 $521,730

17. Copyright © 2011 Nelson Education Limited Company ACompany B Company DCompany C Revenue Fixed costs PV =.40 Total costs Revenue Fixed costs PV =.30 Total costs Revenue Fixed costs PV =.30 Total costs Revenue Fixed costs PV =.40 Total costs Break-Even Wedges

18. Copyright © 2011 Nelson Education Limited Where Break-Even Analysis Can be Used Company-wide Trucking operation Plant Direct mail advertising District or sales territory Taxi business Retail store Movie theatre Production centre Advertising program Department store Travel agency Product/division Hotel business Service centre Restaurant business Machine operation Book publishing Airline business

19. Copyright © 2011 Nelson Education Limited 3. Other Cost Concepts Committed costs: Costs that must be incurred in order to operate a business. Discretionary fixed costs: Costs that can be controlled by managers. Controllable costs: Costs that operating managers are accountable for. Non-controllable costs: Costs that are not under the direct control of managers. Direct costs: Materials and labour expenses that are directly incurred when making a product or providing a service. Indirect costs: Costs that are necessary in the production cycle but that cannot be clearly allocated to specific products or services.