Finance for Non-Financial Managers, 6th edition

PowerPoint Slides
to accompany

Prepared by
Pierre Bergeron, University of Ottawa

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Finance for Non-Financial Managers, 6th edition

CHAPTER 5

PROFIT PLANNING AND

DECISION-MAKING

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 Profit Planning and Decision-Making
Chapter Objectives
1. Explain various cost concepts related to break-even analysis
such as fixed and variable costs, the relationship between
revenue and costs, the contribution margin, the relevant
range and relevant costs.

1. Draw the break-even chart and calculate the break-even

point, the cash break-even point and the profit break-even
point and how they can be applied in different organizations.

1. Differentiate between different types of cost concepts such

as committed and discretionary costs, controllable and non-
controllable costs, and direct and indirect costs.

Chapter Reference
Chapter 5: Profit Planning and Decision-Making

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 Relevance of Break-Even Analysis

Break-even analysis helps to:

1. Price existing or new products and services.

2. Decide whether to introduce a new product or service,

open a new plant, hire a sales representative, open a new

sales office, launch an advertising program.

3. Modernize or automate an existing plant.

4. Expand an existing plant.

5. Change the cost structure (fixed versus variable).

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 1. Fixed and Variable Costs
Fixed costs Variable costs
Period costs Direct costs
Constant costs Out-of-pocket costs
Standby costs Volume costs

Characteristic Characteristic
Element of fixedness and must be paid Vary almost automatically with volume.
with passage of time.

Rent, interest, insurance, property Sales commission, direct labour,

taxes, office salaries, depreciation, packing material, electricity, overtime
telephone premiums, equipment rental, truck
expenses

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Connection Between Revenue and Costs
Factors that affect profit:
1. Volume of production
2. Prices
3. Costs (fixed and variable)
4. Changes in product mix

Cost per Unit

(in $)

G
16 H

E
14 F

12 C
D

10
A B

40 60 80 100
% of Capacity

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 The Contribution Margin
Revenue $ 1,000,000

Less variable costs:

Direct material ($ 500,000)
Direct labour (250,000) PV Ratio
Total variable costs (750,000)

$250,000
Contribution margin 250,000
$1,000,000

Less fixed costs:

Manufacturing (150,000)
Administration (50,000) .25
Total fixed costs (200,000)

Operating profit $ 50,000

PV ratio

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 2. J. Smith’s Break-Even (Taxi Driver)
$ Revenue $ 10.00
Fixed costs
Variable costs $ 2.00
Insurance Revenue
Contribution margin $ 8.00 $10.00

Costs/Revenue
Car payment
(principal or depreciation) $ 15,000 1,875 trips
=
$ 8.00
Interest

Dispatcher fees Break-even

point

Variable Total
costs costs
Variable costs
$2.00
Gas
$15,000
Maintenance &
repairs Fixed
$ 45,000 5,625 trips
= costs
$ 8.00

6,000
Trips

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 J. Smith’s Break-Even (Taxi Driver)
No salary With salary With salary
No. of trips 1,875 5,625 6,000

Revenue ($10.00) $ 18,750 $ 56,250 $ 60,000

Variable costs ($2.00) ($ 3,750) ($ 11,250) ($ 12,000)

Contribution margin $ 15,000 $ 45,000 $ 48,000

Fixed costs ($ 15,000) ($ 15,000) ($ 15,000)

Salary 0 ($ 30,000) ($ 30,000)

Profit 0 0 $ 3,000

P.V. Ratio .80 .80 .80

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Finding the Break-Even Point Using the Formula
Unit selling price $ 15.00 (P)

Fixed costs $200,000 (F)

Unit variable costs $ 10.00 (V)

Break-even calculation

Step 1: Contribution margin

Selling price $15.00

Variable costs $10.00
Contribution margin $ 5.00

Step 2: $200,000 ÷ $5.00 = 40,000 units (volume)

Step 3: 40,000 units X $15.00 = $600,000 (sales revenue)

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 Break-Even Point Calculation
In
Units Fixed costs
B.E.P. =
Price per unit sold – Variable cost per unit
or unit contribution
$200,000
B.E.P. = = 40,000 units
$15.00 - $10.00
X $15.00
$ 600,000

In
revenue
Step 1: Find the PV ratio

PV = Unit contribution = $5.00 = .333

Unit selling price $15.00
Step 2: Find the revenue break-even point

Fixed costs $200,000

B.E.P. = = = $600,000
PV .333

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 Break-Even Point By Using the PV Ratio
Finding the break-even point Revenue $ 600,000
when units are not known, Variable costs $ 400,000
you need to re-structure the Contribution margin $ 200,000
statement of income
Fixed costs $ 200,000
Profit/loss $ 0

Step 1: Find the PV ratio

PV = Contribution = $200,000 = .333

Revenue $600,000
Step 2: Find the revenue break-even point

Fixed costs $200,000

B.E.P. = = = $600,000
PV .333

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 Break-Even Point (Retail Store)
Suits Jackets Shirts Ties Socks Overcoats Total
No. of units 800 200 700 500 2,500 500
Unit selling price $300 $150 $50 $50 $8 $300
Revenue $500,000
Variable costs
Purchases ($275,000)
Sales commission (25,000)
Total variable costs ($300,000)

Contribution margin $200,000

Fixed costs (rent, telephone, salaries, security system) ($100,000)

Profit $100,000

Contribution margin = $200,000= .40 or $0.40 50%

Revenue $500,000
of objective
Fixed costs = $100,000= $250,000 OK!!!
PV ratio .40
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 Cash Break-Even Point
In
Units Fixed costs - Depreciation
Price per unit sold – Variable cost per unit

$ 200,000 - $50,000 = $150,000 = 30,000 units

$15.00 - $10.00 $5.00

In
revenue

Fixed costs - Depreciation = $150,000 = $450,000

PV .333

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 Profit Break-Even
In
Units Fixed costs + Profit objective
Price per unit sold – Variable cost per unit

$200,000 + $20,000 $220,000

= = 44,000 units
$15.00 - $10.00 $5.00

In
revenue

Fixed costs + Profit objective $220,000

= = $660,000
PV .333

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 Sensitivity Analysis
Base case Break-even Break-even
in units in revenue
40,000 $600,000

Change in
Fixed costs
(increased by $50,000 to $250,000) 50,000 $750,000

Selling price
(increased by $0.50 to $15.50) 36,364 $563,642

Variable costs
(decreased by $0.75 to $9.25) 34,782 $521,730

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 Break-Even Wedges
Company A Company B

Revenue Revenue

Total costs
PV = .40 Total costs
PV = .30

Fixed costs
Fixed costs

Company C Company D

Revenue Revenue

Total costs Total costs

PV = .30
PV = .40
Fixed costs
Fixed costs

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Where Break-Even Analysis Can be Used
• Company-wide
• Trucking operation
• Plant
• Direct mail advertising
• District or sales territory
• Taxi business
• Retail store
• Movie theatre
• Production centre
• Advertising program
• Department store
• Travel agency
• Product/division
• Hotel business
• Service centre
• Restaurant business
• Machine operation
• Book publishing
• Airline business

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 3. Other Cost Concepts

Committed costs: Costs that must be incurred in order to operate a

business.
Discretionary fixed costs: Costs that can be controlled by managers.

Controllable costs: Costs that operating managers are accountable for.

Non-controllable costs: Costs that are not under the direct control of
managers.

Direct costs: Materials and labour expenses that are directly incurred when
making a product or providing a service.
Indirect costs: Costs that are necessary in the production cycle but that
cannot be clearly allocated to specific products or services.

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