2-1

Profit
Planning
Prepared
Preparedby
by

Douglas
DouglasCloud
Cloud

Pepperdine
PepperdineUniversity
University

2-2

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

2-3

Objectives
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 costvolume-profit analysis.

2-4

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

$20.00
$10.00
1.00
1.00
$12.00
$40,000

2-5

Variable
Variable Costs
Costs
Example
Example
Exeter Company
5,000 units 6,000 units 7,000 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

2-6

Important
Important Rule
Rule
As sales change,
income changes by
unit contribution
margin multiplied by
the change in sales.
The unit
contribution
margin per
backpack is $8.

6,000 Backpacks
Contribution margin
for 6,000 backpacks
Less fixed costs
Net income

$48,000
40,000
$ 8,000

2-7

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

$120,000
60,000
$ 60,000
$ 6,000
6,000
40,000
$ 52,000
$ 8,000

2-8

Income
Income Statement
Statement Formats
Formats
Contribution
Contribution Margin
Margin Format
Format
(Behavioral)
Sales, 6,000 x $20
Variable costs:
Cost of sales
Packing and shipping
Commissions
Total variable costs
Contribution margin
Fixed costs
Income

$120,000
$ 60,000
6,000
6,000
$ 72,000
$ 48,000
40,000
$ 8,000

2-9

Operating
Operating Leverage
Leverage
6,000 Backpacks
Contribution margin
for 6,000 backpacks
Less fixed costs
Net income

$48,000
40,000

$48,000
$8,000

$ 8,000

=6

2-10

Relevant
Relevant Range
Range
Relevant range is
the range of volume
over which it can
reasonably expect
selling price, perunit variable cost,
and total fixed costs
to be constant.

2-11

Definitions
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.

2-12

Definitions
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.

2-13

Cost-Volume-Profit
Cost-Volume-Profit Graph
Graph
Dollar
s $160,000

Total
Revenues

$140,000
$120,000

Profit
Area

$100,000
$80,000

Total
Cost

Loss
Area

Break-even point,
5,000 units, $100,000

$60,000
$40,000

Fixed cost line

$20,000
$0
2,000

4,000

6,000

Unit Sales

8,000

10,000

2-14

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

total
variable
costs

total
fixed
costs

2-15

Profit
Profit
Using Q to denote the quantity of units sold,
we can restate the formula as--

Profit =

per-unit
selling x Q
price

per unit
variable x Q
costs

total
fixed
costs

2-16

Profit
Profit
Combining the two components, we get--

Profit =

total
fixed
costs

Contribution
margin per x Q
unit

2-17

Break-Even
Break-Even Point
Point
In units
Total fixed costs
Q (break-even sales in units) =

$40,000
$20 - $12

Contribution margin
per unit
= 5,000 backpacks

2-18

Contribution
Contribution Margin
Margin
Percentage
Percentage
B/E in $ =

Total fixed costs + target profit

Contribution margin ratio per unit

Contribution
Contribution margin
margin
Sales
Sales
$8 $20 = 40%

2-19

Break-Even
Break-Even Point
Point
In dollars
Total fixed costs
Q (break-even sales in dollars) =

$40,000
.40

Contribution margin
ratio
= $100,000

2-20

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

2-21

Exeters
Exeters Income
Income Statement
Statement

Sales
Variable costs
Contribution margin
Fixed costs
Income

Dollars Percentages
$160,000
100%
96,000
60%
$ 64,000
40%
40,000
25%
$ 24,000
15%

2-22

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

2-23

Target
Target Selling
Selling Prices
Prices
The companys 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

$10,000 = S
[(6,000 x $11) + 5%S]
$122,105 = S

fixed costs
$40,000

2-24

Target
Target Costing
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

2-25

Cost
Cost Structure
Structure and
and
Managerial
Managerial Attitudes
Attitudes
Caldwell Companys 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.

2-26

Cost
Cost Structure
Structure and
and
Managerial
Managerial Attitudes
Attitudes
Process A
$200,000

Process B
$200,000

Variable costs at $7 and $4

140,000

80,000

Contribution margin at $3
and $6

$ 60,000

$120,000

40,000

95,000

$ 20,000

$ 25,000

Sales (20,000 x $10)

Fixed costs
Profit

2-27

Cost
Cost Structure
Structure and
and
Managerial
Managerial Attitudes
Attitudes
Break-even
Process A: B/E

units

Process B: B/E

units

=
=

$40,000
$3
$95,000
$6

= 13,333 units
= 15,833 units

2-28

Margin
Margin of
of Safety
Safety
The difference in volume from the expected
level of sales to the break-even point is called
the margin of safety (MOS).
If actual sales are 6,000 units, the margin of
safety is 1,000 units (6,000 - 5,000).
If actual sales are $120,000, the margin of safety
is $20,000 ($120,000 - $100,000).

2-29

Indifference
Indifference Point
Point
The indifference point is 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 + $7X
Total cost of B = $95,000 + $4X
$40,000 + $7X = $95,000 + $4X
X = 18,333 units (rounded)

Assumptions
Assumptions and
and Limitations
Limitations
of
of CVP
CVP Analysis
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.

2-30

2-31

Chapter 2
The
The End
End

2-32