FINANCIAL AND COST VOLUME PROFIT MODELS © 2012 Pearson Prentice Hall. All rights reserved.

Class Announcements  No office hours today (Monday September 16 th )  See SCC for information on information sessions  Next class: Cloudwalkers (available on-line)  Assignment #1 due September 19 th (journal entries are for bonus marks!)  Business Society Golf Tournament (Daily Schwartz on Facebook)  Date: Saturday Sept 21 st ( Colin MacInnis, at x2010qbn)  Time: tee off times begin at 12:00pm  Location: Antigonish Golf & Country Club (87 Cloverville road)  Team size: 4  Fee: $50/team member  Invest-X Initial Meeting on Monday September 16 th in SCHW 152

© 2012 Pearson Prentice Hall. All rights reserved. Class Objectives 1. Understanding the impact of financial modeling 2. Cost Volume Profit analysis as a simplistic but powerful form of financial modeling 3. Incorporating target income, taxes, margin of safety, operating leverage, multiple products/services, etc.

© 2012 Pearson Prentice Hall. All rights reserved. Financial Models  Financial Models (definition):  Accurate, reliable simulations of relations among relevant costs, benefits, value and risk that are useful for supporting business decisions.  Financial Models (objectives):  To improve the quality of decisions  To allow flexible and responsive analyses  To simulate the reality of the relevant factors and relationships

© 2012 Pearson Prentice Hall. All rights reserved. Financial Models: CVP Analysis  Cost-Volume-Profit (CVP) analysis is the study of the effect of output volume on revenue, expense and net income  Managers use CVP analysis to try and obtain the most profitable combination of variable and fixed costs  Computers allow the manager to use a CVP modeling program to extensively and at minimal cost analyze relationships and to remove simplistic assumptions

© 2012 Pearson Prentice Hall. All rights reserved. CVP: Key Assumptions  Selling price (per unit), variable costs (per unit) and fixed costs (total) are constant;  Revenue and costs are linear;  Costs are separable into variable and fixed costs;  In multi-product companies, the sales mix is constant; and  In manufacturing companies, inventories do not change (units produced = units sold).

© 2012 Pearson Prentice Hall. All rights reserved. CVP: Break-Even  Breakeven analysis is the primary analysis of CVP analysis  1) Contribution-Margin Technique B/E in units = Fixed expense Contribution margin per unit B/E in sales = Fixed expenses Contribution margin ratio  2) Equation Technique sales-variable expenses-fixed expenses = 0  3) Graphical Technique Selling Price Sales Quantity * () - () * Unit Variable Costs Sales Quantity - Fixed Costs = Operating Income

© 2012 Pearson Prentice Hall. All rights reserved. CVP: Graphically

© 2012 Pearson Prentice Hall. All rights reserved. CVP: Weighted Contribution Margin  When the sales mix changes, the break-even point and the expected net income at various sales levels are altered  B/E in units = Fixed expense Weighted CM per unit  Sales mix is the relative proportions or combinations of quantities of products that comprise total sales  Weighted average contribution margin is:  WCM = (Sales Mix) x (CM per Product Type)

© 2012 Pearson Prentice Hall. All rights reserved. CVP: Profit Planning (Targeted Income)  The breakeven point formula can be modified to become a profit planning tool.  Profit is now reinstated to the BE formula, changing it to a simple sales volume equation.  Quantity of Units = (Fixed Costs + Operating Income) Required to Be Sold Contribution Margin per Unit

© 2012 Pearson Prentice Hall. All rights reserved. Breakeven Point: Profit Planning (p.24)

© 2012 Pearson Prentice Hall. All rights reserved. CVP: Income Taxes  After-tax profit can be calculated by:  Net Income = Operating Income * (1-Tax Rate)  Net income can be converted to operating income for use in CVP equation  Operating Income = I I Net Income I (1-Tax Rate)

© 2012 Pearson Prentice Hall. All rights reserved. CVP: Margin of Safety  One indicator of risk, the margin of safety (MOS), measures the distance between budgeted sales and breakeven sales:  MOS = Budgeted Sales – BE Sales  The MOS ratio removes the firm’s size from the output, and expresses itself in the form of a percentage:  MOS Ratio = MOS ÷ Budgeted Sales

© 2012 Pearson Prentice Hall. All rights reserved. CVP: Operating Leverage  Operating leverage is a measure, at a particular level of sales, of the % impact on net income of a given % change in sales  In highly leveraged companies (high fixed costs and low variable costs) a small change in sales volume results in a large change in net income (i.e. riskier)  Operating leverage (OL) is the effect that fixed costs have on changes in operating income as changes occur in units sold, expressed as changes in contribution margin.  OL = Contribution Margin Operating Income

© 2012 Pearson Prentice Hall. All rights reserved. Class Objectives - Revisited 1. Understanding the impact of financial modeling 2. Cost Volume Profit analysis as a simplistic but powerful form of financial modeling 3. Incorporating target income, taxes, margin of safety, operating leverage, multiple products/services, etc.