# COST-VOLUME-PROFIT ANALYSIS AND PRICING DECISIONS

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

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?

3 1 . BREAKEVEN ANALYSIS Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4
© Tomwang112 / iStockphoto 3 1 . BREAKEVEN ANALYSIS Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4

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”

TO CALCULATE THE BREAKEVEN POINT
Use the equation approach 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 Solve for units sold, which equals the breakeven point Why is profit set to \$0?

BREAKEVEN POINT FOR UNIVERSAL SPORTS EXCHANGE
Exhibit 3-1 \$20x - \$16x - \$168,000 = \$0 \$4x - \$168,000 = \$0 x = 42,000 jerseys

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

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

LET’S LOOK AT BREAK EVEN GRAPHICALLY
Exhibit 3-2 \$168,000

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

3 2 . C-V-P ANALYSIS Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4
© Tomwang112 / iStockphoto 3 2 . C-V-P ANALYSIS Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4

LET’S REVIEW THE PROFIT EQUATION
SP×(units sold) – VC×(units sold) – FC = OI

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 (SP×units sold) – (VC×units sold) – FC = \$X 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.

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

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

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

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?

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

WHY DO WE CARE ABOUT OPERATING LEVERAGE?
Exhibit 3-4

MULTIPRODUCT C-V-P ANALYSIS
© Tomwang112 / iStockphoto 3 . MULTIPRODUCT C-V-P ANALYSIS Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4

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

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

Product Price Variable Cost Contribution Margin Jerseys \$20 \$16.00 \$4.00 Shoes \$45 \$38.70 \$6.30 CM(jerseys) + CM(shoes) – FC = OI

DETERMINE THE SALES MIX
Product Contribution Margin Sales Mix Adjusted Contribution Margin Jerseys \$4.00 4x \$16.00x Shoes \$6.30 1x \$ 6.30x Jerseys Shoes 4 1 : \$4.00(4x) + \$6.30(x) – FC = OI \$16x + \$6.30x – FC = OI

CALCULATING THE BREAKEVEN POINT
Product Contribution Margin Sales Mix Adjusted Contribution Margin Jerseys \$4.00 4x \$16.00x Shoes \$6.30 1x \$ 6.30x \$16x + \$6.30x – \$178,400 = \$0 \$22.30x = \$178,400 x = 8,000 shoes 4x = 4(8,000) = 32,000 jerseys

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

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

3 4 . PRICING DECISIONS Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4
© Tomwang112 / iStockphoto 3 4 . PRICING DECISIONS Unit 3.1 Unit 3.2 Unit 3.3 Unit 3.4

ECONOMICS OF PRICE Market equilibrium

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

CALCULATING MARKUP PERCENTAGE
Sales price – Cost Cost = Markup % \$ \$14.80 \$14.80 = 35%

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

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 seller’s inefficiencies are borne by the customers

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