1. Chapter 7: Cost-Volume-Profit (Part 1 of 3) Sections 1 and 2 Feb 4, 2013 Professor: Khim Kelly Office: HH386B Office Hours: Mon/Wed 11:30am – 12:30pm and Appointment Email: kokelly@uwaterloo.cakokelly@uwaterloo.ca TA: Kun Huo Email: khuo@uwaterloo.ca

2. 4 Feb 2013 Overview Last lecture – Completed Chapter 6 (Cost Behavior) Today’s lecture … – Basics of Chapter 7 – CM Ratio – Break even Analysis 2

3. Cost-Volume-Profit Uses … – Breakeven analysis – Scenario analysis (i.e. change in inputs) – Cost structure planning and leverage – Indifference calculations CVP considers how income is affected by: – Prices of products (i.e. sales price) – Variable costs per unit – Total fixed cost – Volume or level of activity (‘X’) – Mix of products sold

4. Contribution Margin CM is used to cover fixed costs, THEN anything left is profit Profit = Sales – Variable Costs – Fixed Costs CM

5. Contribution Margin Sales price per unit: $100 Variable cost per unit: $50 Fixed costs: $500,000 What would the operating income (loss) be if: – 0 units produced? Operating loss = CM – FC = Sales – VC – FC = $0 – $0 - $500,000 = ($500,000) – 1 unit produced? Operating loss = CM – FC = Sales – VC – FC = $100 – $50 - $500,000 = ($499,950) – 10,000 units produced? Operating loss = ????

6. Break-even Point Break-even point is … – The level of sales at which profit = 0 – Also known as the point where total sales = total expenses or where total contribution margin = fixed expenses Break-even point: Profit = Sales – Variable Costs – Fixed Costs = $0 CM – Fixed Cost = $0

7. Total Expenses … Activity $ Fixed Expenses Variable Expenses Total Expenses

8. CVP Relationships in Graphical Form Activity $ Total Expenses Total Sales Revenue As long as Contribution Margin > 0

9. CVP Relationships in Graphical Form Activity $ Total Expenses Total Sales Revenue

10. Contribution Margin Ratio CM ratio … – Contribution margin (Sales less Variable Expenses) as a percentage of total sales (say 40%) – For every $1 of sales increase, CM will increase by $0.40 – The effect on operating income of any dollar change in total sales can be computed by applying the CM ratio to the dollar change CM Ratio = Total CM per unit Total Sales per unit Total CM Total Sales = Change in op income = Change in sales x CM Ratio

11. It is Clicker Time!! Feel Free to Work Together on Clicker Questions

12. Clicker Question #1 Q: Dillon’s (Khim’s son) garage band – Tone Death – sold out 40 concerts in Khim’s basement, had total revenue of $3000, variable expenses of $2400, and total fixed expenses of $450. What is the band’s contribution margin ratio? A.25% B.$600 C.20% D.$150 E.Ozzy Osbourne

13. Clicker Question #2 Q: Dillon’s garage band – Tone Death – sold out 40 concerts, had total revenue of $3,000, variable expenses of $2,400, and total fixed expenses of $450. Estimate the change in the band’s income if total sales increased by $1,500 to a total of $4,500 (i.e., Khim forced all her AFM102 students to buy tickets)? A.($150) B.$300 C.($5,012.62) D.$150 E.$450

14. Clicker Question #3 Q: Acoustic is selling 400 speakers per month @ $250 per speaker for total monthly sales of $100,000. Current variable costs are $60,000 and current fixed costs are $35,000. Financially speaking, should they increase sales by $30,000 by increasing fixed costs (advertising) by $10,000? A.Yes B.No

15. Example: Application of CVP Solution 1: CM Ratio [(100k – 60k)/100k]40% Expected CM with new advertising$52K (130K*40%) Current CM (100K*40%)$40K Incremental CM$12K Change in Fixed Costs ($10K) Change in Operating Income $2K

16. Example: Application of CVP Solution 2 (incremental approach): Incremental CM (30K*40%)$12K Change in Fixed Costs ($10K) Change in Operating Income $2K Incremental analysis focuses only on the items that will change as a result of a decision. In general, if a change result in Increase in CM > Increase in fixed costs [or Decrease in CM < Decrease in fixed costs], then the change should be made

17. Change VC + Target Profit (P7-27) You manufacture skateboards that sell for $37.50. Rely on direct labour workers and variable costs are $22.50 per board. In the last year you sold 40,000 boards: Q. Increase of $3 in labour per board expected. How many boards do you need to make to earn the same Op. Income? Income Statement Sales1,500,000 VC 900,000 CM $600,000 FC 480,000 Op. Income $120,000 17 Before: Old Unit CM = $37.50 – $22.50 = $15 $15*40,000 - $480,000 = $120,000 Now (Increase in VC):

18. Change VC + Target Profit (P7-27) Alternatively: FC is not a differential cost (see pg. 47). Therefore, the simplest way is to make the CM of both options equal. Income Statement Sales1,500,000 VC 900,000 CM $600,000 FC 480,000 Op. Income $120,000 18 Before: Old CM = $15*40,000 Now (Increase in VC): New CM = $12*X CM equivalence:

19. Change VC + CM Ratio (P7-27) You manufacture skateboards that sell for $37.50. Rely on direct labour workers and variable costs are $22.50 per board. In the last year you sold 40,000 boards: Q. Increase of $3 in labour per board expected. What is the sales price for the same CM Ratio? Income Statement Sales1,500,000 VC 900,000 CM $600,000 FC 480,000 Op. Inc. $120,000 19 Before: CM Ratio = $600,000/$1,500,000 = 40% Now (Increase in VC):

20. Shift to FC from VC (P7-27) You manufacture skateboards that sell for $37.50. Rely on direct labour workers and variable costs are $22.50 per board. In the last year you sold 40,000 boards: Q. Should you automate your manufacturing? This results in VC to decrease 40% and FC to increase 90%. How many units (X) do we need to earn the same Op. Income? 20 Income Statement Sales1,500,000 VC 900,000 CM $600,000 FC 480,000 Op. Inc. $120,000 Income Statement Sales$37.50X VC ($22.5*0.6)X CM$24.00X FC $480,000 * 1.9 Op. Inc. $120,000

21. Shift to FC from VC (P7-27) Op. Inc = CM – FC 21 Income Statement Sales1,500,000 VC 900,000 CM $600,000 FC 480,000 Op. Inc. $120,000 Income Statement Sales$37.50X VC $13.50X CM$24.00X FC $912,000 Op. Inc. $120,000

22. Important points Use the formula flexibly – Income = Sales – VC – FC – Income = Units sold * price – units sold * VC per unit – FC – Income = Units sold * (price – VC per unit) – FC We test you by changing any of the variables but the concept remains the same! Make sure you identify the variable of interest first Buy Dillion’s concert tickets, circa 2025, spaces are limited!

23. Summary Today’s lecture … – Basics of CVP – Contribution Margin ratio – Break even analysis Next lecture … – More break even analysis – Margin of safety analysis – Target operating profit analysis