The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin CHAPTER 3 Analysis of Cost, Volume, and Pricing to Increase Profitability

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-2 Learning Objective LO1 To use the contribution margin per unit approach to calculate the sales volume required to break even or earn a target profit

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-3 Determining the Contribution Margin per Unit Bright Day produces one product called Delatine. Delatine is a nonprescription herb mixture. The contribution margin per bottle of Delatine is:

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-4 Determining the Break-even Point Bright Day uses a cost-plus-pricing strategy; it sets prices at cost plus a markup of 50% of cost. Delatine costs $24 per bottle to manufacture, so a bottle sells for $36 ($24 + [50% × $24]). The company’s first concern is if it can sell enough bottles of Delatine to cover its fixed costs and make a profit!

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-5 Determining the Break-even Point total revenue equals total costs The break-even point is the point where total revenue equals total costs (both variable and fixed). For Bright Day, the cost of advertising is estimated to be $60,000. Advertising costs are the fixed costs of the company. We use the following formula to determine the break-even point in units. Break-even volume in units = Fixed costs Contribution margin per unit = $60,000 $12 5,000 units = 5,000 units

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-6 Determining the Break-even Point For Delatine, the break-even point in sales dollars is $180,000 (5,000 bottles × $36 selling price).

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-7 Determining the Break-even Point $12 per unit contribution margin. Once all fixed costs have been covered (5,000 bottles sold), net income will increase by $12 per unit contribution margin. What will be the increase in net income if units sold increase from 5,000 units to 5,600 units? $12

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-8 Determining the Break-even Point What will be the increase in net income if units sold increase from 5,000 units to 5,600 units?

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-9 Reaching a Target Profit Bright Day’s president wants the advertising campaign to produce profits of $40,000 to the company. Break-even volume in units = Fixed costs + Desired profit Contribution margin per unit = $60,000 + $40,000 $12 8, units = 8, units which rounds to 8,334 whole units

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-10 Reaching a Target Profit Level At $36 per unit selling price, the sales dollars are equal to $300,000, as shown below:

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-11 Check Yourself Matrix, Inc. manufactures one model of lawnmower that sells for $175 each. Variable expenses to produce the lawnmower are $100 per unit. Total fixed costs are $225,000 per month, and management wants to earn a profit in the coming month of $37,500. Matrix must sell the following number of lawnmowers: Matrix, Inc. manufactures one model of lawnmower that sells for $175 each. Variable expenses to produce the lawnmower are $100 per unit. Total fixed costs are $225,000 per month, and management wants to earn a profit in the coming month of $37,500. Matrix must sell the following number of lawnmowers: 1.3, , , ,500. Matrix, Inc. manufactures one model of lawnmower that sells for $175 each. Variable expenses to produce the lawnmower are $100 per unit. Total fixed costs are $225,000 per month, and management wants to earn a profit in the coming month of $37,500. Matrix must sell the following number of lawnmowers: Matrix, Inc. manufactures one model of lawnmower that sells for $175 each. Variable expenses to produce the lawnmower are $100 per unit. Total fixed costs are $225,000 per month, and management wants to earn a profit in the coming month of $37,500. Matrix must sell the following number of lawnmowers: 1.3, , , ,500. $225,000 + $37,500 $75 = 3,500

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-12 Learning Objective LO2 To set selling prices by using cost-plus, prestige, and target profit

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-13 Assessing the Pricing Strategy Cost-Plus Pricing Prestige Pricing Target Pricing Price products at variable cost plus some percentage of the variable, normally 50%. Price products with a premium because the product is new or has a prestigious name brand. Price products at the market price and then control costs to be profitable at the market price.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-14 Assessing the Pricing Strategy The Marketing Department at Bright Day suggests that a price drop from $36 per bottle to $28 per bottle will make Delatine a more attractive product to sell. The president wants to know what effect such a price drop would have on the company’s stated goal of producing a $40,000 profit. You have been asked to determine the number of bottles that must be sold to earn the $40,000 profit at the new $28 selling price per bottle. See if you can provide an answer to the president before going to the next screen!

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-15 Effects of Changes in Sales Price Step 1 Break-even volume in units = Fixed costs + Desired profit Contribution margin per unit Step 2 = $60,000 + $40,000 $4 25,000 units = 25,000 units Step3

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-16 Effects of Changes in Sales Price The required sales volume in dollars is $700,000 (25,000 units × $28 per bottle) as shown below:

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-17 Learning Objective LO3 To use the contribution margin per unit to conduct cost-volume-profit analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-18 Assessing the Effects of Changes in Variable Costs Bright Day is considering an alternative mixture for Delatine along with new packaging. This new product would sell for $28 per bottle and have a variable cost per bottle of $12. The president is not in favor of the new product but wants to know how many units must be sold to produce the desired profit of $40,000. You have been asked to determine the units that must be sold and the total sales revenue that will be produced!

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-19 Assessing the Effects of Changes in Variable Costs Step 1 Break-even volume in units = Fixed costs + Desired profit Contribution margin per unit Step 2 = $60,000 + $40,000 $16 6,250 units = 6,250 units Step3

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-20 Assessing the Effects of Changes in Variable Costs At $28 per unit selling price, the sales dollars are equal to $175,000 as shown below:

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-21 Assessing the Effects of Changes in Fixed Costs Bright Day’s president has asked you to determine the required sales volume if advertising costs were reduced to $30,000, from the planned level of $60,000. = $30,000 $30,000 + $40,000 $16 4,375 units = 4,375 units Break-even volume (units)

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-22 Learning Objective LO4 To draw and interpret a cost- volume-profit graph

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-23 Cost-Volume-Profit Graph Information to prepare a break-even Excel graph. We have developed income statements for zero sales, break-even sales, and ten thousand units.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-24 Cost-Volume-Profit Graph $180,000 5,000 units

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-25 Cost-Volume-Profit Graph

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-26 Learning Objective LO5 To calculate margin of safety

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-27 Calculating the Margin of Safety The margin of safety measures the cushion between budgeted sales and the break-even point. It quantifies the amount by which actual sales can fall short of expectations before the company will begin to incur losses. With a selling price of $28 per unit and variable costs of $12 per unit, and a desired profit of $40,000, budgeted sales were: = $30,000 $30,000 + $40,000 $16 4,375 units = 4,375 units Break-even volume (units) Break-even unit sales assuming no profit would be: = 1,875 units = 1,875 units $30,000 $30,000 $16 Break-even volume (units)

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-28 Calculating the Margin of Safety Margin of safety = Budgeted sales – Break-even sales Budgeted sales Margin of safety = $122,500 – $52,500 $122, % = 57.14%

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-29 Management considers a new product, Delatine that has a sales price of $36 and variable costs of $24 per bottle. Fixed costs are $60,000. Break- even is 5,000 units. Management wants to earn a $40,000 profit on Delatine. The sales volume to achieve this profit level is 8,334 bottles sold. Marketing advocates a target price of $28 per bottle. The sales volume required to earn a $40,000 profit increases to 25,000 bottles.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-30 Target costing is employed to reengineer the product and reduces variable cost per unit to $12. To earn the desired profit of $40,000, sales volume decreases to 6,250 units. Target costing is applied and fixed costs are reduced to $30,000. The sales volume to earn the desired $40,000 profit is 4,375 units. In view of the 57.14% margin of safety, management decides to add Delatine to its product line.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-31 Learning Objective LO6 To conduct sensitivity analysis for cost-volume- profit relationships

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-32 Performing Sensitivity Analysis Using Spreadsheet Software After reviewing the spreadsheet analysis, Bright Day’s management team is convinced it should undertake radio advertising for Delatine.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-33 Learning Objective LO3 To use the contribution margin per unit to conduct cost-volume-profit analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-34 Decrease in Sales Price with an Increase in Sales Volume The marketing manager believes reducing the sales price per bottle to $25 will increase sales volume by 625 units. Previous sales volume was: = $30,000 $30,000 + $40,000 $16 4,375 units = 4,375 units Break-even volume (units) Anticipated changes:

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-35 Decrease in Sales Price with an Increase in Sales Volume Current Situation Proposed Situation Because budgeted income will fall by $5,000, the proposal should be rejected!

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-36 Increase in Fixed Costs and Increase in Sales Volume After the previous project was rejected, the advertising manager believes that buying an additional $12,000 in advertising can increase sales volume to 6,000 units. The contribution margin will remain at $16. Should the company buy the additional advertising? Current Situation Proposed Situation Profit = Contribution margin – Fixed cost Profit = (6,000 × $16) – $42,000 =$54,000 Profit = (6,000 × $16) – $42,000 = $54,000

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-37 Change in Several Variables Management has been able to reduce variable costs to $8 per bottle and decides to reduce the selling price per bottle to $25 (so the contribution margin is now $17). Further, management believes that if advertising is cut to $22,000, the company can still expect sales volume to be 4,200 units. Should management adopt this plan? Management has been able to reduce variable costs to $8 per bottle and decides to reduce the selling price per bottle to $25 (so the contribution margin is now $17). Further, management believes that if advertising is cut to $22,000, the company can still expect sales volume to be 4,200 units. Should management adopt this plan?

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-38 Change in Several Variables Profit = Contribution margin – Fixed cost Profit = (4,200 × $17) – $22,000 =$49,400 Profit = (4,200 × $17) – $22,000 = $49,400 Current Situation Proposed Situation

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-39 Learning Objective LO7 To use the contribution margin ratio and the equation method to conduct cost-volume- profit analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-40 Contribution Margin Ratio The contribution margin ratio is the contribution margin divided by sales, computed using either total figures or per unit figures. Here is the total dollar, per unit and contribution margin (CM) ratio for Bright Day when sales volume is 5,000 bottles.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-41 Contribution Margin Ratio Bright Day is considering the introduction of a new product called Multi Minerals. Here is some per unit information about Multi Minerals: Bright Day expects to incur $24,000 in fixed marketing costs in connection with Multi Minerals. Let’s look at the calculation of the break-even point in units and dollars.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-42 Contribution Margin Ratio Break-even in Units Fixed costs CM per unit $24,000 $8 3,000 units = 3,000 units Break-even in Dollars Fixed costs CM ratio $24,000 40% $60,000 = $60,000

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-43 Contribution Margin Ratio Break-even in Units Fixed costs + Desired profit CM per unit Break-even in Dollars Fixed costs + Desired profit CM ratio Bright Day desires to earn a profit of $8,000 on the sale of Multi Minerals 4,000 units = 4,000 units $24,000 + $8,000 $8 $24,000 + $8,000 40% $80,000 = $80,000

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-44 The Equation Method At the break-even point: Sales = Variable cost + Fixed cost At the break-even point: Sales = Variable cost + Fixed cost We can look at the above equation like this:

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-45 The Equation Method Let’s use our information from Multi Minerals to solve the equation for the number of units sold. If we want to consider the desired profit of $8,000 the solution would be:

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-46 Check Yourself Matrix, Inc. manufactures one model of lawnmower that sells for $175 each. Variable expenses to produce the lawnmower are $100 per unit. Total fixed costs are $225,000 per month, and management wants to earn a profit in the coming month of $37,500. Use the equation method to determine how many lawnmowers Matrix must sell next month: Matrix, Inc. manufactures one model of lawnmower that sells for $175 each. Variable expenses to produce the lawnmower are $100 per unit. Total fixed costs are $225,000 per month, and management wants to earn a profit in the coming month of $37,500. Use the equation method to determine how many lawnmowers Matrix must sell next month: 1.3, , , ,500. Matrix, Inc. manufactures one model of lawnmower that sells for $175 each. Variable expenses to produce the lawnmower are $100 per unit. Total fixed costs are $225,000 per month, and management wants to earn a profit in the coming month of $37,500. Use the equation method to determine how many lawnmowers Matrix must sell next month: Matrix, Inc. manufactures one model of lawnmower that sells for $175 each. Variable expenses to produce the lawnmower are $100 per unit. Total fixed costs are $225,000 per month, and management wants to earn a profit in the coming month of $37,500. Use the equation method to determine how many lawnmowers Matrix must sell next month: 1.3, , , ,500.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 3-47 End of Chapter 3