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CMA Part 2 Financial Decision Making: Study Unit 8 - CVP Analysis and Marginal Analysis
CMA Part 2 Financial Decision Making: Study Unit 8 - CVP Analysis and Marginal Analysis
Scatter Diagrams
Draw a line through the plotted data points so that about equal
numbers of points fall above and below the line.
20
* ** *
1,000’s of Dollars
* *
Total Cost in
**
10 * *
Estimated fixed cost = 10,000
0
0 1 2 3 4 5 6
Activity, 1,000’s of Units Produced
P1
Scatter Diagrams
Δ in cost
Unit Variable Cost = Slope =
Δ in units
20
* ** * Vertical
1,000’s of Dollars
* * distance is
Total Cost in
** the change
10 * * in cost.
Revenue $100,000
Var. Cost $ 80,000
Gross Margin $ 20,000
Fixed Cost $ 20,000
Oper. Income $ 0
SU- 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Other terms and def.
– Margin of safety = excess of “budgeted” sales over BE Sales
– Mixed costs – (See slide 11) Costs that have both a fixed and variable
component. For example, the cost of operating an automobile includes some
fixed costs that do not change with the number of miles driven (e.g., operating
license, insurance, parking, some of the depreciation, etc.) Other costs vary
with the number of miles driven (e.g., gasoline, oil changes, tire wear, etc.).
– Sensitivity analysis – (See slide 12) Examines the effect on the outcome of not
achieving the original forecast or of changing an assumption. Since many
decisions must be made due to uncertainty, probabilities can be assigned to
different outcomes (“what-if”).
C1 SU- 8.1 – Cost-Volume-Profit (CVP) Analysis – Theory
Mixed Costs
Mixed costs contain a fixed portion that is incurred even when the
facility is unused, and a variable portion that increases with
usage. Utilities typically behave in this manner.
Total Utility Cost
Variable
Cost per KW
Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
SU- 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
SU- 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Unit Contribution Margin (UCM) is an important term used with break-even point
or break-even analysis is contribution margin. In equation format it is defined as
follows:
• The contribution margin for one unit of product or one unit of service is defined
as:
Contribution Margin per Unit = Revenues per Unit (Sales price) – Variable
Expenses per Unit
Slope of total cost curve plotted so that volume is on the x-axis and dollar value is
on the y-axis
SU- 8.1 – Cost-Volume-Profit (CVP) Analysis -
Theory
• Break-even point in units
Fixed costs
UCM
Fixed costs
CMR
A1
Incorrect Answers:
A: The gross margin equals sales price minus cost of goods sold, including fixed
cost.
C: All fixed costs have been covered at the breakeven point.
D: Operating income will increase by the unit contribution margin, not the unit
variable cost.
SU- 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory - Question 2
Question 2 - CMA2 Study Unit 8: CVP
Analysis and Marginal Analysis
One of the major assumptions limiting
the reliability of breakeven analysis is
that
Incorrect Answers:
Incorrect Answers:
A: The contribution margin rate is computed by dividing contribution
margin by sales. The contribution margin equals sales minus total variable
costs.
B: The margin of safety is expressed in revenue or units, not contribution
margin.
D: Cash flow is not relevant.
SU- 8.1 – Cost-Volume-Profit (CVP) Analysis –
Theory - Question 4
Incorrect Answers:
B: A decrease in costs will cause the unit contribution margin to increase, lowering
the breakeven point.
C: An increase in the selling price will increase the unit contribution margin,
resulting in a lower breakeven point.
D: Both a cost decrease and a sales price increase will increase the unit
contribution margin, resulting in a lower breakeven point.
Remember
Computing the Break-Even Point
We have just seen one of the basic CVP relationships
– the break-even computation.
Fixed costs
Break-even point in units =
Contribution margin per unit
Fixed costs
Break-even point in dollars =
Contribution margin ratio
• CVP Applications
– Target Operating Income
– Multiple products
– Choice of products
• Problems
– 8, 9, 10, 12 & 13 starting on page 330
SU 8.2 – Practice Question 1
Which of the following would decrease unit a contribution margin the most?
= $100 – $50
= $50
= $85 – $50
= $35
= $100 – $57.50
= $42.50
Since $35 < $42.50, the lower selling price has
the greater effect.
SU 8.2 – Practice Question 2
The breakeven point in units sold for Tierson Corporation is
44,000. If fixed costs for Tierson are equal to $880,000 annually
and variable costs are $10 per unit, what is the contribution
margin per unit for Tierson Corporation?
A. $0.05
B. $20.00
C. $44.00
D. $88.00
SU 8.2 – Practice Question 2 Answer
Correct Answer: B
Continued
SU 8.2 – Practice Question 3 Answer
The new level is:
A. 65,000 units.
B. 36,562 units.
C. 90,000 units.
D. 25,000 units.
SU 8.3 – Practice Question 1 Answer
Correct Answer: C
6.5X = $585,000
X = 90,000 units
SU 8.3 – Practice Question 2
The data below pertain to the forecasts of XYZ Company for the upcoming year.
Total Cost Unit Cost
Assuming that XYZ Company sells 80,000 units, what is the maximum that can be paid
for an advertising campaign while still breaking even?
A. $135,000
B. $1,015,000
C. $535,000
D. $695,000
SU 8.3 – Practice Question 2 Answer
Correct Answer: A
The company will break even when net income equals zero. Net income is equal to
revenue minus variable expenses and fixed expenses, including advertising. Thus, if X
equals advertising cost, the equation is
How many units will Buona Fortuna have to sell to earn a pre-tax
income of $90,000 per year?
A. 65,000 units.
B. 75,000 units.
C. 77,250 units.
D. 97,500 units.
SU 8.3 – Practice Question 3 Answer
Correct Answer: D
Buona Fortuna’s unit contribution margin is $4 ($10 unit price – $6 unit variable cost).
By treating desired profit as an additional fixed cost, the target unit sales can be
calculated as follows:
Target unit sales = (Fixed costs + Target operating income)
÷ UCM
= ($300,000 + $90,000) ÷ $4
= 97,500
Computing a Multiproduct
Break-Even Point
The CVP formulas can be modified for use
when a company sells more than one product.
– The unit contribution margin is replaced with the
contribution margin for a composite unit.
– A composite unit is composed of specific numbers
of each product in proportion to the product sales
mix.
– Sales mix is the ratio of the volumes of the various
products.
SU – 8.4 CVP Analysis – Multiproduct
Calculations
• Multiple Products (or Services)
S = FC + VC = Calculated Weighted Average Contribution Margin
The machine hours are a scarce resource that must be allocated to the product(s) in a proportion that
maximizes the total CM. Given that potential additional sales of either product are in excess of production
capacity, only the product with the greater CM per unit of scarce resource should be produced. XY-7 requires
.75 hours; BD-4 requires .2 hours of machine time (given fixed manufacturing cost applied at $1 per machine
hour of $.75 for XY-7 and $.20 for BD-4). XY-7 has a CM of $1.33 per machine hour ($1 UCM ÷ .75 hours), and
BD-4 has a CM of $2.50 per machine hour ($.50 ÷ .2 hours). Thus, only BD-4 should be produced, yielding a
CM of $250,000 (100,000 × $2.50). The key to the analysis is CM per unit of scarce resource.
Incorrect Answers:
A: Product XY-7 actually has a CM of $133,333, which is lower than the $250,000 CM for product BD-4.
A. $375,000
B. $444,444
C. $500,000
D. $545,455
SU- 8.4 CVP Analysis – Multiproduct Calculations
– Answer to Question 2
Correct Answer: B
A. $100
B. $145
C. $179
D. $202
SU- 8.4 CVP Analysis – Multiproduct Calculations
– Answer to Question 3
Correct Answer: D
Contribution margin
equals selling price
minus variable costs.
A. $300,000
B. $750,000
C. $857,142
D. $942,857
SU- 8.4 CVP Analysis – Multiproduct Calculations
– Answer to Question 4
Correct Answer: D
A helpful approach in a multiproduct situation is to make calculations based on the
composite unit, i.e., 2 units of Product X and 3 units of Product Y (a 66% ratio). The
selling price of this composite unit is $110 [(2 × $10) + (3 × $30)]. The UCM of the
composite unit is $35 {[2 × ($10 – $6)] + [3 × ($30 – $21)]}. Consequently, the
breakeven point in composite units is 8,571.43 ($300,000 FC ÷ $35 UCM), and the
breakeven point in sales dollars is $942,857 (8,571.43 × $110).
Incorrect Answers:
A: This amount equals the fixed costs.
B: This amount assumes a 40% contribution margin ratio.
C: This amount assumes a 35% contribution margin ratio.
SU 8.5 – Marginal Analysis
• Accounting Costs vs. Economic Costs
– Accounting Costs = The total amount of money or goods expended in an endeavor. It is money
paid out at some time in the past and recorded in journal entries and ledgers.
• Economic Costs = The economic cost of a decision depends on both the cost of the
alternative chosen and the benefit that the best alternative would have provided if
chosen. Economic cost differs from accounting cost because it includes
opportunity cost.
As an example, consider the economic cost of attending college. The accounting cost of attending college
includes tuition, room and board, books, food, and other incidental expenditures while there. The
opportunity cost of college also includes the salary or wage that otherwise could be earning during the
period. So for the two to four years an individual spends in school, the opportunity cost includes the money
that one could have been making at the best possible job. The economic cost of college is the accounting
cost plus the opportunity cost.
Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost wages from
not working during that period equals $25,000 dollars a year, then the total economic cost of going to
college would be $180,000 dollars ($20,000 x 4 years + the interest of $20,000 for 4 years + $25,000 x 4
years).
SU 8.5 – Marginal Analysis
• Explicit vs. Implicit Costs
– Implicit Costs = implicit cost, also called an
imputed cost, implied cost, or notional cost, is
the opportunity cost equal to what a firm must
give up in order to use factors which it neither
purchases nor hires.
– Explicit Costs = An explicit cost is a direct payment
made to others in the course of running a
business, such as wage, rent and materials.
SU 8.5 – Marginal Analysis
• Accounting vs. Economic Profit
– See Utorial at http://www.khanacademy.org/economics-finance-domain/microeconomics/firm-
economic-profit/economic-profit-tutorial/v/economic-profit-vs-accounting-profit
– Disinvestments
– Sell-or-Process further
SU 8.6 Short-run Profit Maximization
• Pure Competition - A market structure in which a
very large number of firms sell a standardized
product into which entry is very easy in which the
individual seller has no control over the product
price and in which there is no nonprice competition;
a market characterized by a very large number of
buyers and sellers.
Examples / Importance
1. Public utilities: gas, electric, water, cable TV, and local telephone service
companies, are often pure monopolies.
2. First Data Resources (Western Union), Wham-O (Frisbees), and the DeBeers
diamond syndicate are examples of "near" monopolies. (See Last Word.)
3. Manufacturing monopolies are virtually nonexistent in nationwide U.S.
manufacturing industries.
4. Professional sports leagues grant team monopolies to cities.
5. Monopolies may be geographic. A small town may have only one airline, bank,
etc.
SU 8.6 Short-run Profit Maximization
• Monopolistic Competition - A market
structure in which many firms sell a
differentiated product into which entry is
relatively easy in which the firm has some
control over its product price and in which
there is considerable non-price competition.
– Price elasticity of demand is calculated as the percentage change in quantity demanded divided by
the percentage change in price.
– There are a number of factors that can determine the price elasticity of demand for a good or
service.
For example, the demand for luxury items tend to be more elastic than the demand for necessities.
For items that are essential, you tend to be less responsive to changes in price. An example of this
would be the demand for diamonds tends to be more price elastic than the demand for electricity.
Price elasticity of demand is also affected how large a percentage of your total income an item is. We
tend to be more elastic in regards to price changes for items that make up a larger percentage of our
incomes. For example, if the price of a pack of gum goes up by 10%, I probably wouldn't even notice.
On the other hand, if the price of a car I'm considering purchasing goes up by 10%, I would definitely
notice and I would probably reconsider the purchase.
A third factor that influences the price elasticity of demand is the time frame allowed for response.
We tend to be more responsive to changes in price in the long run than in the short run. For
example, if the price of gas were to go up overnight to $10/gallon I would still have to put gas in my
car tomorrow morning because I have to go to work and I have to go to school. But if the price of gas
were to stay at $10/gallon for a year, then I have more options. I could move closer to work, start
carpooling, or trade in my car for a hybrid with better gas mileage so that I don't have to buy as much
gas. So in the long run, demand tends to be more elastic than in the short run.
SU 8.6 Short-run Profit Maximization
Price elasticity example
Antoinette has a beauty salon. She services 100
customers per day. Her usual fee is $50. She
wants to expand her business. If she lowers her
price (gives everyone a coupon for $10 off), she
expects to get an extra 10 customers per day.
Calculate the price elasticity of demand. Did she
make the correct decision?
SU 8.6 Short-run Profit Maximization
Price elasticity example
• A) Percentage change in quantity demanded = 10% (100 customers
increased to 110 customers)
B) Percentage change in price = -20% ($50 reduced to $40)
A/B = 10%/-20% = -0.5
The price elasticity of demand for this service is -0.5, and a price elasticity
of demand less than 1 means that a good is inelastic, meaning that
quantity demanded is relatively unresponsive to a change in price.
So you could argue that she made the wrong decision, as the price
decrease did not greatly affect demand. She might have been better
choosing another strategy, such as better advertising or her services.
You could also argue that she is reducing the price by 20% in return for a
10% increase in volume.
SU 8.6 Short-run Profit Maximization
Price elasticity defined
A product with elasticity of 1.2 has elastic demand. What this means is that
for every 1% rise in the price, demand will fall by 1.2% (similarly, a 1% fall in
the price will lead to a 1.2% rise in demand).
Basically a firm producing an inelastic good can increase revenue by raising the price, as the
fall in demand is more than offset by the increased revenue on the remaining demand.
SU 8.6 Short-run Profit Maximization
Price elasticity defined
• Infinite or perfectly elastic - If it were “perfectly” elastic,
demand would be infinite at all prices less than $3. A perfectly
elastic demand graph is a vertical line. And, when the price is
at $3, you can not tell from the graph what the demand is
since the line is vertical. The demand could be at any value.