2-1

Profit
Planning
Prepared by
Douglas Cloud
Pepperdine University
 2-2

Objectives
Describe and apply the concepts of fixed and
After reading this
variable costs.
chapter, you should
Describe and apply the concept of
be able to:
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.
 2-3

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.
 2-4

Cost Behavior
Variable costs change, in total, in direct
proportion to changes in volume.
Selling price of backpack $20.00
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
 2-5

Variable Costs
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 Rule
As sales change,
income changes by 6,000 Backpacks
Contribution margin
unit contribution
for 6,000 backpacks $48,000
margin multiplied by
Less fixed costs 40,000
the change in sales.
Net income $ 8,000
The unit
contribution
margin per
backpack is $8.
 2-7

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
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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
 2-9

Operating Leverage

6,000 Backpacks
Contribution margin
for 6,000 backpacks $48,000 $48,000
Less fixed costs 40,000 $8,000
Net income $ 8,000 =6
 2-10

Relevant Range

Relevant range is
the range of volume
over which it can
reasonably expect
selling price, per-
unit variable cost,
and total fixed costs
to be constant.
 2-11

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.
 2-12

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.
 2-13

Cost-Volume-Profit Graph
Dollar
s $160,000 Total Total
Revenues Cost
$140,000

$120,000 Profit
$100,000 Area
Loss Break-even point,
$80,000
Area 5,000 units, $100,000
$60,000

$40,000
Fixed cost line
$20,000

$0

2,000 4,000 6,000 8,000 10,000

Unit Sales
 2-14

Break-Even Point

Break-even point is the point at which profits

are zero because total revenues equal total
costs.
total total total
Profit = sales variable fixed
dollars costs costs
 2-15

Profit

Using Q to denote the quantity of units sold,

we can restate the formula as--

per-unit per unit total

Profit = selling x Q variable x Q fixed
price costs costs
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Profit

Combining the two components, we get--

Contribution total
Profit = margin per x Q fixed
unit costs
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Break-Even Point
In units
Total fixed costs
Q (break-even sales in units) =
Contribution margin
per unit

$40,000
= 5,000 backpacks
$20 - $12
 2-18

Contribution Margin
Percentage
Total fixed costs
B/E in $ =
Contribution margin ratio per unit

Contribution margin
Sales

$8 $20 = 40%
 2-19

Break-Even Point
In dollars
Total fixed costs
S (break-even sales in dollars) =
Contribution margin
ratio

$40,000
= $100,000
.40
 2-20

Target Return on Sales

Exeter wishes to earn a 15 percent return on
sales.
Desired
fixed costs
sales (in =
dollars) contribution margin
percentage target ROS
Desired
$40,000
sales (in =
dollars) 40% - 15%
Desired
sales (in = $160,000
dollars)
 2-21

Exeters Income Statement

Dollars Percentages
Sales $160,000 100%
Variable costs 96,000 60%
Contribution margin $ 64,000 40%
Fixed costs 40,000 25%
Income $ 24,000 15%
 2-22

Additional Sales Required

Suppose the companys 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

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Target Selling 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 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)
 2-24

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
 2-25

Cost Structure and

Managerial 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.
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Cost Structure and

Managerial Attitudes
Process A Process 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
 2-27

Cost Structure and

Managerial Attitudes
Break-even

$40,000
Process A: B/E = = 13,333 units
units
$3
$95,000
Process B: B/E = = 15,833 units
units
$6
 2-28

Margin of Safety
The difference in volume from the expected
level of sales to the break-even point is called
the margin 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).
 2-29

Indifference 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 + $7Q

Total cost of B = $95,000 + $4Q

$40,000 + $7Q = $95,000 + $4Q

Q = 18,333 units (rounded)
 2-30

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.
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Chapter 2

The End
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