Your CEO has limited knowledge of management accounting but of course, is vitally interested in forecasting profitability under different scenarios. He asked you, the management accountant, to begin your report by answering a few basic questions he's always wondered about. He has also given you some data to review and has asked you to report on the expected profitability under some given scenarios.
Company Data
Company's average selling price (SP) per unit = $40
Product's variable cost per unit = $28
Company's budgeted fixed costs for the upcoming year are expected to be $1,000,000
You need to complete the following:
Write a report of 200–300 words including the following:
What is the difference between break-even analysis and CVP analysis?
In simple terms,
what is contribution margin?
do managers want contribution margin to be a bigger or smaller figure? Why?
Below the break-even point, what does every dollar of contribution margin go toward?
Above the break-even point, what does every dollar of contribution margin go toward?
Include at least 1 page of calculations for the following scenario analyses:
What is the break-even point, in units and dollars, for the basic data?
The sales department thinks it could sell the product at a slightly higher price of $45/unit, but if the price is raised, it may lose 10% of sales volume in units.
What would the expected profitability be if this higher selling price/unit in fact occurred?
Based on this, the price be raised? Why? Why not?
As an alternative increasing the sales price to $45/unit, the CEO is thinking of hiring a new VP of operations to ease his own workload, at a total of $100,000 compensation and benefit cost.
How much more volume, above the break-even unit volume determined in earlier, would have to be sold to cover this additional cost?
Obviously the CEO does not want everyone to work hard just to break even. Using just to the original data given:
What unit volume must be sold for the firm to earn $150,000 of profit?
I'm sorry, but none of the regular Jiskha volunteer teachers is an accounting expert.
Report:
Break-Even Analysis vs CVP Analysis:
Break-even analysis is a financial tool used to determine the point at which a business will neither make a profit nor incur a loss. It examines the relationship between costs, revenue, and profits. It identifies the level of sales needed to cover all costs and achieve a zero-profit position. CVP (Cost-Volume-Profit) analysis, on the other hand, provides insights into the impact of changes in sales volume, costs, and prices on a company's profitability. It helps businesses make decisions regarding pricing, product mix, and cost structure.
Contribution Margin:
Contribution margin is the amount by which revenue exceeds variable costs. It represents the portion of sales revenue that contributes towards covering fixed costs and generating a profit. In simple terms, it is the money left over after subtracting variable costs from sales revenue. Mathematically, contribution margin equals sales revenue minus variable costs.
Desired Contribution Margin:
Managers want contribution margin to be a bigger figure because a higher contribution margin implies that a larger portion of every sales dollar is available to cover fixed costs and generate profits. A higher contribution margin provides greater flexibility for the company to cover unexpected costs, invest in growth initiatives, or withstand economic downturns.
Below the Break-Even Point:
Below the break-even point, every dollar of contribution margin goes towards covering variable costs. Since fixed costs are not yet covered, no portion of the contribution margin is available to generate profit.
Above the Break-Even Point:
Above the break-even point, every dollar of contribution margin first goes towards covering fixed costs. Any additional contribution margin earned beyond covering fixed costs directly contributes to generating profit. Therefore, the more contribution margin earned, the higher the profit will be.
Break-Even Point Calculation:
Break-Even Point (in units) = Fixed Costs / Contribution Margin per unit
Given the basic data:
Average Selling Price (SP) = $40
Variable Cost per unit = $28
Fixed Costs = $1,000,000
1. Break-Even Point in Units:
Break-Even Point (in units) = $1,000,000 / ($40 - $28) = 100,000 units
2. Break-Even Point in Dollars:
Break-Even Point (in dollars) = 100,000 units * $40 = $4,000,000
Expected Profitability Analysis:
Scenario 1: Higher Selling Price
Selling Price per unit = $45
Volume decrease due to price increase = 10%
1. Adjusted Sales Volume:
Adjusted Sales Volume = 100,000 units * (1 - 0.1) = 90,000 units
2. Expected Profitability:
Expected Profitability = (Adjusted Sales Volume * Selling Price) - (Variable Cost per unit * Adjusted Sales Volume) - Fixed Costs
Scenario 2: Hiring a New VP of Operations
Additional Cost for VP of Operations = $100,000
3. Volume for Additional Cost Coverage:
Volume for Additional Cost Coverage = ($1,000,000 + $100,000) / ($40 - $28)
Profit Target Analysis:
Desired Profit = $150,000
4. Unit Volume for Target Profit:
Unit Volume for Target Profit = (Fixed Costs + Desired Profit) / Contribution Margin per unit
By calculating the scenarios and profit target, you can analyze the financial implications of different sales volumes, pricing strategies, and fixed costs on the company's profitability.