ACTG 3020 Chapter 6 - Cost-Volume-Profit Relationships

Contribution Margin Sales - Variable Costs Per unit –Sales Price per unit - var. costs per unit –Tells us how much in $ is contributed to firm Ratio –CM per unit/Sales price per unit –Tells us what % of each dollar is contributed to the firm

Example of Contribution Margin Racer Rick’s Bicycles (Sales of 200 bikes) Sales Revenues $100,000 Var. Costs 40,000 Contr. Margin 60,000 Less Fixed costs 30,000 Net Income $30,000

Contribution Margin CM in total = $60,000 CM per unit = –$100,000/200 bikes = $500 sales price per bike –$ 40,000/200 bikes = $200 var.costs per bike –$ 60,000/200 bikes = $300 CM per bike CM Ratio = –$300/$500 = 60% OR –$60,000/$100,000 = 60%

Net Income if 1 more bike sold Sale of 201 bikes Sales Revenues$100,500 (201 x $500) Var. Costs 40,200 (201 x $200) Contribution Margin 60,300 Less fixed costs 30,000 Net income $30,300 Sales of one more unit = $300 increase in Net Income (due to contribution margin)

How Changes Affect CM Changes in sales price –Increase, CM increases –Decrease, CM decreases Changes in variable costs –Increase, CM decreases –Decrease, CM increases Changes in fixed costs –Increase or decrease, no change in CM

Break-Even Analysis Break-even (Point where Net Income = 0) Sales = Variable costs + Fixed costs How many bikes do we need to sell in order to break-even? 2 methods –Equation method –Contribution margin method

Break-even Analysis Equation Method Sales = Var. Costs + Fixed Costs $500x = $200x + $30,000 $300x = $30,000 x = 100 bikes Check Sales $50,000 (100 x $500) Var. Costs 20,000 (100 x $200) CM $30,000 - Fixed 30,000 Net Income -0-

Break-even Analysis Contribution Margin Method 1) Determine the CM per unit $500 - $200 = $300 2) Calculate how many units must be sold to break even by the following formula: Fixed costs $30,000 = 100 bikes CM per unit $300

Break-even Analysis In Sales Dollars B.E. in units x Sales price per unit 100 units X $500 = $50,000 OR Fixed Costs CM ratio = $30,000/60% = $50,000

How Changes Affect Break-even Point Changes in sales price –Increase, BEP decreases –Decrease, BEP increases Changes in variable costs –Increase, BEP increases –Decrease, BEP decreases Changes in fixed costs –Increase, BEP increases –Decrease, BEP decreases

Who wants to break even? Target Profit Analysis Add Profit to previous equations Profit is treated just like a fixed cost

Target Profit Analysis Add desired profit to fixed costs Equation Method $500x = $200x + $30,000 fixed + $60,000 Desired profit $300x = $90,000 x = 300 bikes Contribution Margin Approach $30,000 + $60,000 $300 = $90,000/300 = 300 bikes

Margin of Safety Current sales - Break-even sales = Margin of safety Tells you how far sales can drop before you have no net income. Indicates a safety cushion.

Cost Structure- what portions of costs are fixed or variable Company 1 - Pizza Pizza Sales$200,000 -Var. costs 150,000 CM 50,000 -Fixed costs 20,000 Net income 30,000 Company 2 - Pizza oven manufacturers Sales$200,000 -Var. costs 50,000 CM 150,000 -Fix. costs 120,000 Net income 30,000

Cost Structure What is CM ratio for each company? Company 1 = 50,000/200,000 Company 2 = 150,000/200,000 Which company is riskier? Operating Leverage = Contribution Margin Net Income Higher operating leverage, more risky company

Sales Mix –Sell more than one product –Compute contribution ratio for entire company –Break-even analysis is then computed using the regular equations –If actual sales mix is different than predicted, break-even analysis and profit calculations will be different than predicted.