Cost-Volume-Profit Relations

The Basics of Cost-VolumeProfit (CVP) Analysis

WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (500 bikes) $ 250,000 $ 500 Less: variable expenses 150,000 300 Contribution margin 100,000 $ 200 Less: fixed expenses 80,000 Net operating income $ 20,000

Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted.

The Basics of Cost-VolumeProfit (CVP) Analysis

WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (500 bikes) $ 250,000 $ 500 Less: variable expenses 150,000 300 Contribution margin 100,000 $ 200 Less: fixed expenses 80,000 Net operating income $ 20,000

SQ -VQ (S-V)Q -F OI

An identity:I
True by definitiondentity
(true by definition)

SQ -VQ (S-V)Q -F OI

A model: implicit assumptions about the Behavior of costs and revenues

Identity: Model:

SQ VQ F = OI OI = SQ VQ -F

Breakeven chart: OI = SQ VQ - F; = 500Q-300Q-80,000

450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 100 200 300 400 500 600 700 800

Total Sales

Total Expenses
Fixed expenses

Profit-volume chart OI = (S-V)Q -F

OI

Total Profit or Loss

Slope = 200 Q=400 80,000 Fixed expenses

Q
OI = 200Q 80,000

Contribution Margin Ratio

The contribution margin ratio is: Total contribution margin /Total sales For Wind Bicycle Co. the ratio is:
$100,000 $250,000 = 40%

Contribution Margin Ratio

Or, in terms of units, the contribution margin ratio is:
Unit CM CM Ratio = Unit selling price

For Wind Bicycle Co. the ratio is:

$200 = 40% $500

Profit-volume chart OI = (S-V)Q -F

OI

Total Profit or Loss

Slope = 40% SQ=200,000 80,000 Fixed expenses

SQ

OI = 40%xSQ 80,000

Applications of profit-volume analysis:

1. Breakeven point, units of output; sales dollars 2. Target profits, before tax 3. Target profits, after tax 4. Target return on sales (ROS%) 5. Margin of safety 6. Operating leverage 7. Comparisons of cost structures 8. Absorption costing profits 9. Breakeven with absorption costing 10 CPV with multiple products 11 Opportunity costs of scarce resources

1. The Breakeven Point

The Breakeven Point

The breakeven point may be computed in terms of either units sold or sales dollars.
Break-even point = in units sold Fixed expenses Unit contribution margin

The Breakeven Point

The breakeven point may be computed in terms of either units sold or sales dollars.
Break-even point = in units sold Fixed expenses Unit contribution margin

Q = $80,000 / $200; Q = 400 units

The Breakeven Point

The breakeven point may be computed in terms of either units sold or sales dollars.
Break-even point = in units sold Fixed expenses Unit contribution margin

Q = $80,000 / $200; Q = 400 units

Break-even point in total sales dollars

Fixed expenses CM ratio

The Breakeven Point

The breakeven point may be computed in terms of either units sold or sales dollars.
Break-even point = in units sold Fixed expenses Unit contribution margin

Q = $80,000 / $200; Q = 400 units

Break-even point in total sales dollars

Fixed expenses CM ratio

SQ = $80,000 / .40; SQ = $200,000

2. Target Profits Before Tax

Target Profit Analysis, before tax

Suppose Wind Co. wants to know how many bikes must be sold to earn a pretax profit of $100,000. We can use our CVP formula to determine the sales volume needed to achieve a target profit figure.
OI = 200Q - $80,000 Q = ($80,000 + OI) / $200 Q = ($80,000 + $100,000) / $200; Q = 900u

3. Target Profits After Tax

Target Profit Analysis, after tax

Suppose Wind Co. wants to know how many bikes must be sold to earn an after-tax profit of $90,000. The income tax rate is 40%.

Target Profit Analysis, after tax

Suppose Wind Co. wants to know how many bikes must be sold to earn an after-tax profit of $90,000. The income tax rate is 40%. We must first convert the after tax profit to before tax profit, as follows: OI(AT) = OI(BT) x (1-T)
OI(BT) = OI(AT) / (1 T)

Target Profit Analysis, after tax

Suppose Wind Co. wants to know how many bikes must be sold to earn an after-tax profit of $90,000. The income tax rate is 40%. We must first convert the after tax profit to before tax profit, as follows: OI(AT) = OI(BT) x (1-T)
OI(BT) = OI(AT) / (1 T) = $90,000 / (1 - .4) = $150,000

Target Profit Analysis, after tax

OI(BT) = OI(AT) / (1 T) = $90,000 / (1 - .4) = $150,000
OI = 200Q - $80,000 Q = ($80,000 + OI) / $200 Q = ($80,000 + $150,000) / $200; Q = 1,150u

4. Target Return on Sales

Target Return on Sales (ROS) %

Suppose Wind Co. wants to know the sales level at which profits will equal fifteen percent of sales.
OI = CM%(SQ) F ===

Target Return on Sales (ROS) %

Suppose Wind Co. wants to know the sales level at which profits will equal fifteen percent of sales. OI = CM%(SQ) F
ROS%(SQ) = CM%(SQ) F ===

Target Return on Sales (ROS) %

Suppose Wind Co. wants to know the sales level at which profits will equal fifteen percent of sales. OI = CM%(SQ) F
ROS%(SQ) = CM%(SQ) F SQ = F / (CM% - ROS%)

===

Target Return on Sales (ROS) %

Suppose Wind Co. wants to know the sales level at which profits will equal fifteen percent of sales. OI = CM%(SQ) F
ROS%(SQ) = CM%(SQ) F SQ = F / (CM% - ROS%)

= $80,000 / (.40 - .15)

===

Target Return on Sales (ROS) %

Suppose Wind Co. wants to know the sales level at which profits will equal fifteen percent of sales. OI = CM%(SQ) F
ROS%(SQ) = CM%(SQ) F SQ = F / (CM% - ROS%)

= $80,000 / (.40 - .15)

= $320,000 (or 640 units)

5. Margin of Safety

The Margin of Safety

The percentage by which sales can drop before losses begin to be incurred.
Margin of safety = Total sales - Break-even sales Total sales
Break-even sales 400 units Sales $ 200,000 Less: variable expenses 120,000 Contribution margin 80,000 Less: fixed expenses 80,000 Net operating income $ -

Actual sales 500 units $ 250,000 150,000 100,000 80,000 $ 20,000

The margin of safety can be expressed as 20% of sales. ($250,000 - $200,000) / $250,000

6. Operating Leverage

Operating Leverage
A measure of how sensitive net operating income is to percentage changes in sales. With high leverage, a small percentage increase in sales can produce a much larger percentage increase in net operating income.
Degree of operating leverage = Contribution margin Net operating income

Operating Leverage
Actual sales 500 Bikes Sales $ 250,000 Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Net income $ 20,000

$100,000 = 5 $20,000

Operating Leverage
With a operating leverage of 5, if Wind increases its sales by 10%, net operating income would increase by 50%.
Percent increase in sales Degree of operating leverage Percent increase in profits
10% 5 50%

Heres the verification!

Operating Leverage
Actual sales (500) Sales $ 250,000 Less variable expenses 150,000 Contribution margin 100,000 Less fixed expenses 80,000 Net operating income $ 20,000 Increased sales (550) $ 275,000 165,000 110,000 80,000 $ 30,000

10% increase in sales from $250,000 to $275,000 . . . . . . results in a 50% increase in income from $20,000 to $30,000.

Note that operating leverage is not a constant for a given firm. The degree of operating leverage depends upon the level of output. To illustrate this point, re-compute Wind Companys operating leverage at a sales level of 550 units.

7. Comparison of Cost Structures

Comparisons of alternative cost structures

Assume that Wind Company may replace its existing equipment with a more capital intense technology. The new equipment would result in a reduction of variable costs per unit from $300 to $250, and would increase annual fixed costs from $80,000 to $120,000. Question: At what level of output would the new technology result In higher profits for Wind?

Comparisons of alternative cost structures

Assume that Wind Company may replace its existing equipment with a more capital intense technology. The new equipment would result in a reduction of variable costs per unit from $300 to $250, and would increase annual fixed costs from $80,000 to $120,000. Question: At what level of output would the new technology result In higher profits for Wind?
Current cost structure: TC = $80,000 + $300Q Alternative cost structure: TC = $120,000 + $250Q

Difference in costs: $40,000 - $50Q

Output level with equal total costs: 800 units

Comparisons of alternative cost structures

Assume that Wind Company may replace its existing equipment with a more capital intense technology. The new equipment would result in a reduction of variable costs per unit from $300 to $250, and would increase annual fixed costs from $80,000 to $120,000. Question: At what level of output would the new technology result In equal profits for Wind?
Question: At that level of output, what amount of profit would be earned? Question: At 800 units, which cost structure has the higher operating leverage? Which has the higher breakeven point?

8. CPV with Absorption Costing

CPV Analysis with Absorption Costing QM = units produced QS = units sold FM/QM = fixed manufacturing cost per unit FS=fixed selling and administrative costs OI = (S V FM/QM) QS - FS

CPV Analysis with Absorption Costing OI = (S V FM/QM) QS - FS

OI = (S V) QS FM (QS/QM) FS Note: If QM = QS, then OI is the same using either variable or absorption costs.

Consider the original data for the Wind Company. Using variable costing, the firms breakeven point is 400 units. Assume instead that the firm uses absorption costing in measuring operating income. The firm intends to manufacture 500 units in the coming period. In addition, assume that Winds total fixed costs of $80,000 consists of $50,000 fixed manufacturing costs, and $30,000 fixed selling and administrative costs. Question: What is the firms absorption cost profit equation?

Consider the original data for the Wind Company. Using variable costing, the firms breakeven point is 400 units. Assume instead that the firm uses absorption costing in measuring operating income. The firm intends to manufacture 500 units in the coming period. In addition, assume that Winds total fixed costs of $80,000 consists of $50,000 fixed manufacturing costs, and $30,000 fixed selling and administrative costs. Question: What is the firms absorption cost profit equation? OI = (S V FM/QM) QS - FS = (500-300-50,000/500)QS 30,000 = (500-300-100)QS 30,000

9. Breakeven Point with Absorption Costing

Question: If the firm produces 500 units and sells 400 units, what will be the resulting operating income?

Question: If the firm produces 500 units and sells 400 units, what will be the resulting operating income? OI = (S V FM/QM) QS - FS

Question: If the firm produces 500 units and sells 400 units, what will be the resulting operating income? OI = (S V FM/QM) QS - FS
= (500-300-50,000/500)QS 30,000 = (500-300-50,000/500)400 30,000 = $10,000

Question: If the firm produces 500 units, what will be the breakeven point using absorption costing? OI = (S V FM/QM) QS - FS O = (500-300-50,000/500)QS 30,000 QS = 30,000 / (500-300-100) QS = 300 units

Assumptions of CVP Analysis

Selling price is constant. Costs are linear. In multi-product companies, the sales mix is constant. In manufacturing companies, inventories do not change (units produced = units sold). Otherwise, the equations must incorporate the impact of absorption costing.

10.CPV for Multi-Product Firms

The Concept of Sales Mix

Sales mix is the relative proportions in which a companys products are sold. Different products have different selling prices, cost structures, and contribution margins. Lets assume Wind sells bikes and carts and see how we deal with break-even analysis.

Multi-product break-even analysis

Wind Bicycle Co. provides the following information:
Sales $ Var. exp. Contrib. margin $ Fixed exp. Net operating income Sales mix $ Bikes 250,000 100% 150,000 60% 100,000 40% Carts $ 300,000 135,000 $ 165,000 100% 45% 55% Total $ 550,000 285,000 265,000 80,000 $ 185,000 $ 550,000 100.0% 51.8% 48.2%

250,000

45%

300,000

55%

100.0%

$265,000 = 48.2% (rounded) $550,000

Note: (45%x40%) + (55%x55%) = 48.2%

Multi-product break-even analysis

Fixed expenses Break-even sales = CM Ratio $80,000 = 0.482 = $165,975

Note that the dollar amount of sales must maintain the existing sales mix proportions (45% bikes and 55% carts). At any other sales mix, the breakeven sales amount would differ.

CPV Graph, Multi-Product Firm

CM% =.55
CM%=.40

11. Opportunity Cost of Scarce Resources

Extending CVP Analysis

Multi-product firms must make product mix decisions that earn the best total contribution margin for the firm. To accomplish this objective, we need to focus on the contribution margin earned by each unit of scarce input.

Decisions Involving Limited Resources

Firms often face the problem of deciding how limited resources are going to be used. Fixed costs are not affected by this decision, so management can focus on maximizing total contribution margin. Lets look at an example.

Limited Resources
Martin, Inc. produces two products and selected data is shown below:
Products Selling price per unit Less: variable expenses per unit Contribution margin per unit Contribution margin ratio Processing time required on the lathe per unit Bins $ 60 36 $ 24 40% 1.00 min. Tins $ 50 35 $ 15 30% 0.50 min.

Limited Resources
Products Selling price per unit Less: variable expenses per unit Contribution margin per unit Contribution margin ratio Processing time required on the lathe per unit Bins $ 60 36 $ 24 40% 1.00 min. Tins $ 50 35 $ 15 30% 0.50 min.

Questions: Assume that total fixed costs are $48,000. What is Martins profit-volume equation?

Limited Resources
Products Selling price per unit Less: variable expenses per unit Contribution margin per unit Contribution margin ratio Processing time required on the lathe per unit Bins $ 60 36 $ 24 40% 1.00 min. Tins $ 50 35 $ 15 30% 0.50 min.

Questions: Assume that total fixed costs are $48,000. What is Martins profit-volume equation?

What is Martins breakeven point if only Bins are produced?

What is Martins breakeven point if only Tins are produced?

Limited Resources Products

Selling price per unit Less: variable expenses per unit Contribution margin per unit Contribution margin ratio Processing time required on the lathe per unit Bins $ 60 36 $ 24 40% 1.00 min. Tins $ 50 35 $ 15 30% 0.50 min.

Questions: Assume that total fixed costs are $48,000. What is Martins profit-volume equation? What is Martins breakeven point if only Bins are produced?

What is Martins breakeven point if only Tins are produced?

Solve the profit-volume equation for Bins and prepare a graph to show all possible break-even product combinations.

Limited Resources
Assume that the lathe is being used at 100% of its capacity.The lathe capacity is 2,400 minutes per week. Write an equation to express the lathe constraint as a linear inequality. Solve this expression for Bins, and show the equation on the graph prepared earlier.

Should Martin focus its efforts on Bins or Tins?

Lets calculate the contribution margin per unit of the scarce resource, the lathe.
Products Contribution margin per unit Time required to produce one unit Contribution margin per minute Bins $ 24 Tins $ 15

Limited Resources

1.00 min. 0.50 min. $ 24 min. $ 30 min.

Tins should be produced. It is the more valuable use of the scarce resource the lathe, yielding a contribution margin of $30 per minute as opposed to $24 per minute for the Bins.

Limited Resources Bins

Contribution margin per unit Time required to produce one unit Contribution margin per minute $ 24

Products Tins $ 15

1.00 min. 0.50 min. $ 24 min. $ 30 min.

If there are no other considerations, the best plan would be to produce to meet current demand for Tins. If demand is sufficient, Martin would produce a total of 4,800 Tins, and earn a total contribution margin of $72,000 (4,800 x $15).

What would be the value to Martin of an additional 90 minutes of lathe time?

Bins Limited Resources Contribution margin per unit Time required to produce one unit Contribution margin per minute $ 24

Products Tins $ 15

1.00 min. 0.50 min. $ 24 min. $ 30 min.

At what sales price for Bins would both products be equally attractive?

Bins Limited Resources Contribution margin per unit Time required to produce one unit Contribution margin per minute $ 24

Products Tins $ 15

1.00 min. 0.50 min. $ 24 min. $ 30 min.

At what sales price for Bins would both products be equally attractive? Bins would need to provide a contribution margin per minute of $30. A sales price of $66 would be required to cover the variable unit cost of $36 and a contribution of $30. per minute. Required sales price equals variable unit cost plus the opportunity cost of the lathe minutes. Assume that the sales price of Bins has been increased to $66, and show the impact on your earlier graph of the breakeven combinations of Bits and Tins.

Extending CVP Analysis

Multi-product profit-volume analysis with changes in product mix is an application of Linear Programming. This decision tool begins with the profit volume equation, and deals with capacity limitations. This extension will be addressed in our subsequent discussion of Chapter 4.

Handouts will be discussed in the following order: Handout 3(c) Handout 3(a) Handout 3(d)

Handout 3(c) Comprehensive CVP Analysis

Handout 3(c) Cost-volume profit relations; operating leverage

Strictly Linear, Inc. provides the following information regarding operating costs and revenues for its single product, Product A: Sales price per unit: Variable cost per unit: Total fixed costs: Note: CM per unit = $8.00; CM% = 20% $ 40 $ 32 $ 66,000

Sales price per unit: Variable cost per unit: Total fixed costs:

$ 40 $ 32 $ 66,000

Based on this information, determine the following: (a) Breakeven point, in units Q = $66,000 / ($40 32) = 8,250 (b) Operating leverage at an output level of 12,000 units OpLev = TCM / OI = ($8 x 12,000) / ($8 x 12,000 - $66,000) = 3.2 (c) Total revenue needed to realize a return on sales of ten percent TR = F / (CM% - ROS%) = $66,000 / .10 = $660,000

___8,250_units

___3.2_____

$__$660,000__

Sales price per unit: Variable cost per unit: Total fixed costs:

$ 40 $ 32 $ 66,000

(d) Assume that the firm uses absorption costing, and has no beginning inventory. The fixed costs consist of $45,000 factory costs, and $21,000 SGA costs. If the firm intends to produce 10,000 units next period, what will be the absorption cost breakeven point, in units?_6,000 units__.

GM per unit = ($40 - $32 - $45,000 / 10,000u) = $3.50 Q = $21,000 / $3.50 = 6,000 units

Sales price per unit: Variable cost per unit: Total fixed costs:

$ 40 $ 32 $ 66,000

(e) Given the assumptions in (d) above, if the firm sells the breakeven number of units, what will be the absorption cost of the ending inventory? What portion of this amount is fixed manufacturing cost? The ending inventory consists of 4,000 units (10,000 6,000 = 4,000), with variable unit costs of $32 and unit fixed costs of $4.50. The total cost of the ending inventory is $146,000 (4,000 units x $36.50). Of this amount, $18,000 (4,000 x $4.50) represents fixed manufacturing costs.

(f) Management is considering an alternative method of production, which would incur total fixed costs of $ 90,000 and variable costs per unit of $ 27. At what output level would the existing and the alternative production methods result in the same profit for the company? __4,800__units

Total fixed costs are higher by $24,000 and unit variable costs are lower by $5.00. The increased fixed costs are exactly offset by the lower variable costs at an output of 4,800 units ($24,000 / $5.00)

(g) Assume that the company will introduce a second product, Product B, with a sales price of $60 and variable unit costs of $48. Total fixed costs are expected to remain the same. If the two products are sold in equal amounts (i.e, the same number of units for each product), at what sales level (in dollars) would the company break even? _

(g) Assume that the company will introduce a second product, Product B, with a sales price of $60 and variable unit costs of $48. Total fixed costs are expected to remain the same. If the two products are sold in equal amounts (i.e, the same number of units for each product), at what sales level (in dollars) would the company break even? $___330,000____ Combined sales price = $60 + $40 = $100 Combined variable cost = $32 + $48 = $80 Combined contribution margin = $100 - $80 = $20 Combined contribution margin percentage = 20% Breakeven sales level (in dollars) = $66,000 / .20 = $330,000 Note that the sales revenues differ for the two products. Sales of A are $132,000 (40% x $330,000, or 3,300 units at $40 per unit) and sales of B are $198,000 (60% x $330,000, or 3,300 units at $60 per unit).

(h) If the company expects to produce and sell only 2,000 units of Product B, what amount of Product A must be sold in order to break even? OI = $8 x A + $12 x B - $66,000 A = $66,000 / $8 - $12 / $8 x B = 8,250 1.5 x B When B = 2,000 then A = 5,250 __5,250_units of A

Handout 3(a) Alternative Cost Structures and CVP Analysis

Jennifers Flowers plans to open a retail outlet at the newly refurbished Hampshire Mall. The mall offers three alternative lease arrangements, as described below. Jennifers variable costs average 40 percent of sales, before considering variable occupancy expenses. Available lease arrangements: Option A: Five-year lease term at a fixed annual rental of $135,000; lease is renewable after the initial term, at a rate determined by future local market prices. Option B: Ten-year lease term at an annual rental of $45,000 plus 20 percent of Jennifers gross sales receipts; lease is renewable on the same terms as Option A. Option C: Three-year lease term at an annual rental of 40 percent of Jennifers gross sales receipts; lease is renewable at the end of each three-year term at the same rental percentage of revenues.

Option A: Five-year lease term at a fixed annual rental of $135,000; lease is renewable after the initial term, at a rate determined by future local market prices. Option B: Ten-year lease term at an annual rental of $45,000 plus 20 percent of Jennifers gross sales receipts; lease is renewable on the same terms as Option A. Option C: Three-year lease term at an annual rental of 40 percent of Jennifers gross sales receipts; lease is renewable at the end of each three-year term at the same rental percentage of revenues.

Before addressing the questions below, write out Jennifers total cost equation and profit (C-P-V) equation for each of the leasing alternatives: Total Cost Equation: Profit Equation: TC(A) = $135,000 + .4 (TR) OI(A) = .6 (TR) - $135,000 TC(B) = OI(B) = TC(C) = OI(C) =

Option A: Five-year lease term at a fixed annual rental of $135,000; lease is renewable after the initial term, at a rate determined by future local market prices. Option B: Ten-year lease term at an annual rental of $45,000 plus 20 percent of Jennifers gross sales receipts; lease is renewable on the same terms as Option A. Option C: Three-year lease term at an annual rental of 40 percent of Jennifers gross sales receipts; lease is renewable at the end of each three-year term at the same rental percentage of revenues.

Before addressing the questions below, write out Jennifers total cost equation and profit (C-P-V) equation for each of the leasing alternatives: Total Cost Equation: Profit Equation: TC(A) = $135,000 + .4 (TR) OI(A) = .6 (TR) - $135,000 TC(B) = $ 45,000 + .6 (TR) OI(B) = .4 (TR) - $ 45,000 TC(C) = .8 (TR) OI(C) = .2 (TR)

Total Cost Equation: TC(A) = $135,000 + .4 (TRev) TC(B) = $ 45,000 + .6 (TRev) TC(C) = .8 (TRev)

Profit Equation: OI(A) = .6 (TR) - $135,000 OI(B) = .4 (TR) - $ 45,000 OI(C) = .2 (TR)

Required: (a) Determine Jennifers breakeven point in terms of total revenues, for Options A, B, and C.

Total Cost Equation: TC(A) = $135,000 + .4 (TRev) TC(B) = $ 45,000 + .6 (TRev) TC(C) = .8 (TRev)

Profit Equation: OI(A) = .6 (TR) - $135,000 OI(B) = .4 (TR) - $ 45,000 OI(C) = .2 (TR)

Required: (a) Determine Jennifers breakeven point in terms of total revenues, for Options A, B, and C.

In each case, the breakeven point is total fixed cost divided by the contribution margin percentage (see the profit equations above): B/E (A) = $135,000 / .6; = $225,000 B/E (B) = $45,000 / .4; B/E (C) = $-0- / .2; = $112,500 = $-0-

Total Cost Equation: TC(A) = $135,000 + .4 (TRev) TC(B) = $ 45,000 + .6 (TRev) TC(C) = .8 (TRev)

Profit Equation: OI(A) = .6 (TR) - $135,000 OI(B) = .4 (TR) - $ 45,000 OI(C) = .2 (TR)

(b) Determine the point at which Jennifers operating income would be the same under (1) Options A and B; (2) Options B and C; and (3) Options A and C.

Total Cost Equation: TC(A) = $135,000 + .4 (TRev) TC(B) = $ 45,000 + .6 (TRev) TC(C) = .8 (TRev)

Profit Equation: OI(A) = .6 (TR) - $135,000 OI(B) = .4 (TR) - $ 45,000 OI(C) = .2 (TR)

(b) Determine the point at which Jennifers operating income would be the same under (1) Options A and B; (2) Options B and C; and (3) Options A and C. In each comparison, set the profit equations equal, and solve for total revenues: (Note that the same solution would be obtained using the equations for leasing costs or for total costs.) OI(A) = OI(B) .6 (TR) - $135,000 = .4 (TR) - $ 45,000 TR = $450,000 OI(A) = OI(C) .6 (TR) - $135,000 = .2 (TR) TR = $337,500 OI(B) = OI(C) .4 (TR) - $45,000 = .2 (TR) TR = $225,000

For purposes of comparison, the three alternative operating income equations may be drawn on a single profit-volume graph:
Total Cost Equation: TC(A) = $135,000 + .4 (TRev) TC(B) = $ 45,000 + .6 (TRev) TC(C) = .8 (TRev) Profit Equation: OI(A) = .6 (TR) - $135,000 OI(B) = .4 (TR) - $ 45,000 OI(C) = .2 (TR)

OI

OI(A) OI(B)

$450,000 A=B
$225,000 B=C

OI(C)

TRev

(a) Assume that Jennifers budgeted sales for the coming year are $480,000. Which of the three leasing options is most beneficial to Jennifer? At any level of total revenue above $450,000, leasing option A provides a higher operating income.

(d) At the budgeted sales level, determine the margin of safety and degree of operating leverage for each of the three leasing options. The margin of safety is the amount by which revenues exceed the breakeven point, scaled by revenues. Operating leverage is the reciprocal of the margin of safety. The breakeven points for each option are computed above. Option: A B C Margin of Safety ($480,000 - $225,000) / $480,000 = 53% ($480,000 - $112,500) / $480,000 = 77% ($480,000 - $-0-) / $480,000 = 100% Operating leverage 1 /.53 = 1.88 1 / .77 = 1.31 1 / 1.00 = 1.00

(e) Suppose that the budgeted revenues may vary from actual revenues by plus or minus 10 percent. Based upon the degrees of operating leverage determined above, what is the possible percentage impact on the budgeted profits for each of the three leasing options? What is the upper and lower limit to the range of possible profits for each leasing option? To obtain the percentage impact of a 10% change in revenues, simply multiply 10% by the operating leverage shown above. For example, for leasing option A the impact would be plus or minus 18.8% (10% x 1.88 = 18.8%).

(f) Other than total first-year operating income, are there other factors that might affect your choice among the three available leasing options? Discuss. Other pertinent factors include differences in risk among the options, proximity to the breakeven points, total revenues expected in future years (given the long-term nature of the leases), and flexibility (given that the duration of the lease differs among the options).

Handout 3(d) Cost-Volume-Profit

Multiple Choice Questions

1. Hopi Corporation expects the following operating results for next year:

What is Hopi expecting total fixed expenses to be next year? A. $75,000 B. $100,000 C. $200,000 D. $225,000

1. Hopi Corporation expects the following operating results for next year:

What is Hopi expecting total fixed expenses to be next year? A. $75,000 Total contribution margin is $ $300,000 B. $100,000 and operating leverage is 4, so operating C. $200,000 income is $75,000 and fixed expenses D. $225,000 are $225,000 ($300,000 - $75,000).

2. Holt Company's variable expenses are 70% of sales. At a $300,000 sales level, the degree of operating leverage is 10. If sales increase by $60,000, the degree of operating leverage will be: A. 12 B. 10 C. 6 D. 4

2. Holt Company's variable expenses are 70% of sales. At a $300,000 sales level, the degree of operating leverage is 10. If sales increase by $60,000, the degree of operating leverage will be: A. 12 B. 10 Total contribution margin is $90,000 (30% of sales) C. 6 and operating leverage is 10, so operating income is D. 4 $9,000 and fixed costs are $81,000. If sales increase
by $60,000 the contribution margin will increase to $108,000 ($90,000 + $18,000) and operating income will increase to $27,000 ($9,000 + $18,000). Operating leverage will decrease to 4 ($108,000 / $27,000).

3. Jilk Inc.'s contribution margin ratio is 58% and its fixed monthly expenses are $36,000. Assuming that the fixed monthly expenses do not change, what is the best estimate of the company's net operating income in a month when sales are $103,000? A. $23,740 B. $59,740 C. $67,000 D. $7,260

3. Jilk Inc.'s contribution margin ratio is 58% and its fixed monthly expenses are $36,000. Assuming that the fixed monthly expenses do not change, what is the best estimate of the company's net operating income in a month when sales are $103,000? A. $23,740 When sales are $103,000 the B. $59,740 contribution margin is $59,740 (58%) C. $67,000 and operating income is $23,740 D. $7,260
(59,740 - $36,000 fixed costs).

4. Wilson Company prepared the following preliminary budget assuming no advertising expenditures:

Based on a market study, the company estimated that it could increase the unit selling price by 15% and increase the unit sales volume by 10% if $100,000 were spent on advertising. Assuming that these changes are incorporated in its budget, what should be the budgeted net operating income? A. $175,000 B. $190,000 C. $205,000 D. $365,000

4. Wilson Company prepared the following preliminary budget assuming no advertising expenditures:

Based on a market study, the company estimated that it could increase the unit selling price by 15% and increase the unit sales volume by 10% if $100,000 were spent on advertising. Assuming that these changes are incorporated in its budget, what should be the budgeted net operating income? A. $175,000 Sales will increase to $ $1,265,000 (100,000u x B. $190,000 $10 x 1.15 x 1.10). Variable costs will increase C. $205,000 to $660,000 ($600,000 x 1.10). Fixed expenses D. $365,000

will increase to $400,000. Operating income will be $ $205,000 ($1,265,000 660,000

5. Ostler Company's net operating income last year was $10,000 and its contribution margin was $50,000. Using the operating leverage concept, if the company's sales increase next year by 8 percent, net operating income can be expected to increase by: A. 20% B. 16% C. 160% D. 40%

5. Ostler Company's net operating income last year was $10,000 and its contribution margin was $50,000. Using the operating leverage concept, if the company's sales increase next year by 8 percent, net operating income can be expected to increase by: A. 20% B. 16% Operating leverage is 5.0 ($50,000 / C. 160% $10,000). Operating income will D. 40% increase by 40% (5.0 x 8%).