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Profit Planning

2. Profit Planning. Prepared by Douglas Cloud Pepperdine University. Objectives. Describe and apply the concepts of fixed and variable costs. Describe and apply the concept of contribution margin. Prepare contribution margin format income statements.

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Profit Planning

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  1. 2 Profit Planning Prepared by Douglas Cloud Pepperdine University

  2. Objectives • Describe and apply the concepts of fixed and variable costs. • Describe and apply the concept of contribution margin. • Prepare contribution margin format income statements. • Describe and discuss the significance of the relevant range. • Construct and interpret a cost-volume-profit graph. After reading this chapter, you should be able to:

  3. Objectives • Determine the sales volume or selling price needed to achieve a target profit. • Describe and illustrate target costing. • Describe and discuss the importance of cost structure. • Discuss the assumptions that underlie cost-volume-profit analysis.

  4. Selling price of backpack $20.00 Cost Behavior Variable costs change, in total, in direct proportion to changes in volume. Cost of backpack from manufacturer $10.00 Variable cost to pack and ship 1.00 Sales commission (5%) 1.00 Total variable cost $12.00 Total monthly fixed costs (rent, salaries, depreciation, etc.) $40,000

  5. Variable Costs Example 5,000 units6,000 units7,000 units Sales ($20 per unit) $100,000 $120,000 $140,000 Variable costs ($12 per unit) 60,000 72,000 84,000 Contribution margin $ 40,000 $ 48,000 $ 56,000 Fixed costs 40,000 40,000 40,000 Profit $0 $8,000 $16,000 Exeter Company

  6. 6,000 Backpacks Contribution margin for 6,000 backpacks $48,000 Less fixed costs 40,000 Net income $ 8,000 Important Rule As sales change, income changes by unit contribution margin multiplied by the change in sales. The unit contribution margin per backpack is $8.

  7. Income Statement Formats— Financial Accounting Format (Functional) Sales, 6,000 x $20 $120,000 Cost of sales, 6,000 x $10 60,000 Gross profit $ 60,000 Operating expenses: Packaging and shipping $ 6,000 Commissions 6,000 Rent, salaries, depreciation, etc. 40,000 Total operating expenses $ 52,000 Income $ 8,000

  8. Income Statement Formats— Contribution Margin Format (Behavioral) Sales, 6,000 x $20 $120,000 Variable costs: Cost of sales $ 60,000 Packing and shipping 6,000 Commissions 6,000 Total variable costs $ 72,000 Contribution margin $ 48,000 Fixed costs 40,000 Income $ 8,000

  9. 6,000 Backpacks Contribution margin for 6,000 backpacks $48,000 Less fixed costs 40,000 Net income $ 8,000 $48,000 $8,000 Operating Leverage = 6

  10. Relevant Range Relevant rangeis the range of volume over which it can reasonably expect selling price, per-unit variable cost, and total fixed costs to be constant.

  11. Definitions Cost-volume-profit (CVP) analysis is a method for analyzing the relationships among costs, volume, and profits. Contribution margin is the difference between selling price per unit and variable cost per unit.

  12. Definitions Contribution margin percentage is per-unit contribution margin divided by selling price, or total contribution margin divided by total sales dollars. Variable cost percentage is per-unit variable cost divided by selling price, or total variable costs divided by total sales dollars.

  13. Cost-Volume-Profit Graph Dollars Total Revenues $160,000 $140,000 $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 Total Cost Profit Area Loss Area Break-even point, 5,000 units, $100,000 Fixed cost line 2,000 4,000 6,000 8,000 10,000 Unit Sales

  14. total sales dollars total variable costs total fixed costs Profit = – – Break-Even Point Break-even point is the point at which profits are zero because total revenues equal total costs.

  15. per-unit selling price per –unit variable costs total fixed costs Profit = x Q x Q – – Profit Using Q to denote the quantity of units sold, we can restate the formula as--

  16. Contribution margin per unit total fixed costs x Q – Profit = Profit Combining the two components, we get--

  17. Total fixed costs Contribution margin per unit $40,000 $20 - $12 Break-Even Point In units Q (break-even sales in units) = = 5,000 backpacks

  18. Contribution margin Sales Contribution Margin Percentage Total fixed costs Contribution margin ratio per unit B/E in $ = $8 ÷ $20 = 40%

  19. Total fixed costs Contribution margin ratio $40,000 .40 = $100,000 Break-Even Point In dollars S (break-even sales in dollars) =

  20. Desired sales (in dollars) Desired sales (in dollars) fixed costs contribution margin percentage – target ROS $40,000 40% - 15% = = Desired sales (in dollars) $160,000 = Target Return on Sales Exeter wishes to earn a 15 percent return on sales.

  21. Exeter’s Income Statement DollarsPercentages Sales $160,000 100% Variable costs 96,000 60% Contribution margin $ 64,000 40% Fixed costs 40,000 25% Income $ 24,000 15%

  22. Additional Sales Required Suppose the company’s marketing manager has proposed an advertising campaign that will cost $10,000. How many additional units need to be sold to recover the additional costs? $10,000 / $8 = 1,250 units

  23. Target Selling Prices The company’s target profit is $10,000 per month and it expects to sell 6,000 units per month. What should be the selling price? Profit = sales – variable costs – fixed costs $10,000 = S – [(6,000 x $11) + 5%S] – $40,000 $122,105 = S Selling price = sales / units Selling price = $122,105/ 6,000 Selling price = $20.35/unit (rounded)

  24. Target Costing Target costing is the process of determining how much the company can spend to manufacture and market a product, given a target profit. Example: Managers agree on a target profit of $300,000 and that unit volume of 100,000 is achievable at a $20 price. The target cost is: Revenue (100,000 x $20) $2,000,000 Target cost 1,700,000 Target profit $ 300,000

  25. Cost Structure and Managerial Attitudes Caldwell Company’s managers decide to introduce a new product. They expect to sell 20,000 units at $10. They can make the product in either of two manufacturing processes. Process A uses a great deal of labor and has variable costs of $7 per unit and annual fixed costs of $40,000. Process B uses more machinery, with unit variable costs of $4 and annual fixed costs of $95,000.

  26. Cost Structure and Managerial Attitudes Process AProcess B Sales (20,000 x $10) $200,000 $200,000 Variable costs at $7 and $4 140,000 80,000 Contribution margin at $3 and $6 $ 60,000 $120,000 Fixed costs 40,000 95,000 Profit $ 20,000 $ 25,000

  27. $40,000 $3 $95,000 $6 B/E B/E Process A: Process B: = = units units Cost Structure and Managerial Attitudes Break-even = 13,333 units = 15,833 units

  28. Margin of Safety The difference in volume from the expected level of sales to the break-even point is called themargin of safety (MOS). If expected sales are 20,000 units, the margin of safety is 6,667 units (20,000 - 13,333). If expected sales are $200,000, the margin of safety is $66,670 ($200,000 - $133,330).

  29. Indifference Point The indifference pointis the level of volume at which total costs, and hence profits, are the same under both cost structures. Example:Total cost of A = $40,000 + $7QTotal cost of B = $95,000 + $4Q $40,000 + $7Q = $95,000 + $4Q Q = 18,333 units (rounded)

  30. Assumptions and Limitations of CVP Analysis • Selling price, per-unit variable cost, and total fixed costs must be constant throughout the relevant range. • The company sells only one product, or the sales of each product in a multiproduct company are a constant percentage of sales. • Production equals sales in units.

  31. Chapter 2 The End

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