Analysis of Cost, Volume, and Pricing to Increase Profitability

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CHAPTER 3

• Analysis of Cost, Volume, and Pricing to Increase
  Profitability

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Learning Objective
To use the contribution margin per unit approach
to calculate the sales volume required to break
even or earn a target profit
LO1
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Determining the Contribution Margin per Unit
Bright Day produces one product called Delatine.
Delatine is a nonprescription herb mixture. The
contribution margin per bottle of Delatine is
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Determining the Break-even Point
Bright Day uses a cost-plus-pricing strategy it
sets prices at cost plus a markup of 50 of cost.
Delatine costs 24 per bottle to manufacture, so
a bottle sells for 36 (24 50 24).
The companys first concern is if it can sell
enough bottles of Delatine to cover its fixed
costs and make a profit!
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Determining the Break-even Point
The break-even point is the point where total
revenue equals total costs (both variable and
fixed). For Bright Day, the cost of advertising
is estimated to be 60,000. Advertising costs are
the fixed costs of the company. We use the
following formula to determine the break-even
point in units.
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Determining the Break-even Point
For Delatine, the break-even point in sales
dollars is 180,000 (5,000 bottles 36 selling
price).
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Determining the Break-even Point
Once all fixed costs have been covered (5,000
bottles sold), net income will increase by 12
per unit contribution margin.
What will be the increase in net income if units
sold increase from 5,000 units to 5,600 units?
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Determining the Break-even Point
What will be the increase in net income if units
sold increase from 5,000 units to 5,600 units?
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Reaching a Target Profit
Bright Days president wants the advertising
campaign to produce profits of 40,000 to the
company.
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Reaching a Target Profit Level
At 36 per unit selling price, the sales dollars
are equal to 300,000, as shown below
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?Check Yourself

• Matrix, Inc. manufactures one model of
  lawnmower that sells for 175 each. Variable
  expenses to produce the lawnmower are 100 per
  unit. Total fixed costs are 225,000 per month,
  and management wants to earn a profit in the
  coming month of 37,500. Matrix must sell the
  following number of lawnmowers
• 3,000.
• 3,500.
• 4,000.
• 4,500.

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Learning Objective
To set selling prices by using cost-plus,
prestige, and target profit
LO2
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Assessing the Pricing Strategy
Cost-Plus Pricing
Prestige Pricing
Target Pricing
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Assessing the Pricing Strategy
The Marketing Department at Bright Day suggests
that a price drop from 36 per bottle to 28 per
bottle will make Delatine a more attractive
product to sell. The president wants to know what
effect such a price drop would have on the
companys stated goal of producing a 40,000
profit.You have been asked to determine the
number of bottles that must be sold to earn the
40,000 profit at the new 28 selling price per
bottle. See if you can provide an answer to the
president before going to the next screen!
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Effects of Changes in Sales Price
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Effects of Changes in Sales Price
The required sales volume in dollars is 700,000
(25,000 units 28 per bottle) as shown below
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Learning Objective
To use the contribution margin per unit to
conduct cost-volume-profit analysis
LO3
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Assessing the Effects of Changes in Variable Costs
Bright Day is considering an alternative mixture
for Delatine along with new packaging. This new
product would sell for 28 per bottle and have a
variable cost per bottle of 12. The president is
not in favor of the new product but wants to know
how many units must be sold to produce the
desired profit of 40,000.You have been asked
to determine the units that must be sold and the
total sales revenue that will be produced!
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Assessing the Effects of Changes in Variable Costs
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Assessing the Effects of Changes in Variable Costs
At 28 per unit selling price, the sales dollars
are equal to 175,000 as shown below
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Assessing the Effects of Changes in Fixed Costs
Bright Days president has asked you to determine
the required sales volume if advertising costs
were reduced to 30,000, from the planned level
of 60,000.
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Learning Objective
To draw and interpret a cost-volume-profit graph
LO4
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Cost-Volume-Profit Graph
We have developed income statements for zero
sales, break-even sales, and ten thousand units.
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Cost-Volume-Profit Graph
180,000
5,000 units
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Cost-Volume-Profit Graph
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Learning Objective
To calculate margin of safety
LO5
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Calculating the Margin of Safety
The margin of safety measures the cushion between
budgeted sales and the break-even point. It
quantifies the amount by which actual sales can
fall short of expectations before the company
will begin to incur losses. With a selling price
of 28 per unit and variable costs of 12 per
unit, and a desired profit of 40,000, budgeted
sales were
Break-even unit sales assuming no profit would be
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Calculating the Margin of Safety
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Management wants to earn a 40,000 profit
onDelatine. The sales volume to achieve
thisprofit level is 8,334 bottles sold.
Marketing advocates a target price of 28
perbottle. The sales volume required to earn
a40,000 profit increases to 25,000 bottles.
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Target costing is applied and fixed costs
arereduced to 30,000. The sales volume to
earnthe desired 40,000 profit is 4,375 units.
In view of the 57.14 margin of
safety,management decides to add Delatine to
itsproduct line.
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Learning Objective
To conduct sensitivity analysis for
cost-volume-profit relationships
LO6
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Performing Sensitivity Analysis Using Spreadsheet
Software
EDITOR INSERT Exhibit 3.2 Here
After reviewing the spreadsheet analysis, Bright
Days management team is convinced it should
undertake radio advertising for Delatine.
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Learning Objective
To use the contribution margin per unit to
conduct cost-volume-profit analysis
LO3
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Decrease in Sales Price with an Increase in Sales
Volume
The marketing manager believes reducing the sales
price per bottle to 25 will increase sales
volume by 625 units. Previous sales volume was
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Decrease in Sales Price with an Increase in Sales
Volume
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Increase in Fixed Costs and Increase in Sales
Volume
After the previous project was rejected, the
advertising manager believes that buying an
additional 12,000 in advertising can increase
sales volume to 6,000 units. The contribution
margin will remain at 16. Should the company buy
the additional advertising?
Profit Contribution margin Fixed cost
Profit (6,000 16) 42,000 54,000
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Change in Several Variables
Management has been able to reduce variable costs
to 8 per bottle and decides to reduce the
selling price per bottle to 25 (so the
contribution margin is now 17). Further,
management believes that if advertising is cut to
22,000, the company can still expect sales
volume to be 4,200 units. Should management
adopt this plan?
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Change in Several Variables
Profit Contribution margin Fixed cost
Profit (4,200 17) 22,000 49,400
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Learning Objective
To use the contribution margin ratio and the
equation method to conduct cost-volume-profit
analysis
LO7
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Contribution Margin Ratio
The contribution margin ratio is the contribution
margin divided by sales, computed using either
total figures or per unit figures. Here is the
total dollar, per unit and contribution margin
(CM) ratio for Bright Day when sales volume is
5,000 bottles.
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Contribution Margin Ratio
Bright Day is considering the introduction of a
new product called Multi Minerals. Here is some
per unit information about Multi Minerals
Bright Day expects to incur 24,000 in fixed
marketing costs in connection with Multi
Minerals. Lets look at the calculation of the
break-even point in units and dollars.
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Contribution Margin Ratio
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Contribution Margin Ratio
Bright Day desires to earn a profit of 8,000 on
the sale of Multi Minerals
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The Equation Method
At the break-even point Sales Variable cost
Fixed cost
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The Equation Method
Lets use our information from Multi Minerals to
solve the equation for the number of units sold.
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?Check Yourself

• Matrix, Inc. manufactures one model of
  lawnmower that sells for 175 each. Variable
  expenses to produce the lawnmower are 100 per
  unit. Total fixed costs are 225,000 per month,
  and management wants to earn a profit in the
  coming month of 37,500. Use the equation method
  to determine how many lawnmowers Matrix must sell
  next month
• 3,000.
• 3,500.
• 4,000.
• 4,500.

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End of Chapter 3