Analysis of Cost-Volume Pricing to increase profitability

Analysis of Cost-Volume Pricing to increase profitability Chapter3

Assessing the Pricing StrategyCost-Plus PricingPrestige PricingTarget PricingPrice products at variable cost plus some percentage of the variable, normally 50%.Price products with a premium because the product is new or has a prestigious name brand.Price products at the market price and then control costs to be profitable at the market price.3-22Part IThere are three pricing strategies we will discuss: Cost-plus pricing, prestige pricing, and target pricing.

Part IIUnder cost-plus pricing, the normal policy is to price products at variable cost plus 50 percent of the variable cost. This is the policy Bright Day used to price Delatine.

Part IIIAnother strategy is known as prestige pricing. Many people will pay a premium to be the first to use a new product. Similarly, people will pay more for a product with a prestigious brand name. When using prestige pricing, a premium is added to the product price for these reasons.

Part IVTarget pricing begins by determining the market price at which a product will sell. This becomes the target price. The focus then shifts to developing the product at a cost that will enable the company to be profitable while selling the product at the target price. Since this leads to a target cost, this market-based pricing strategy is also called target costing.

The Basics of Cost-Volume-Profit (CVP) AnalysisContribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted.

The Basics of Cost-Volume-Profit (CVP) AnalysisCM goes to cover fixed expenses.

The Basics of Cost-Volume-Profit (CVP) AnalysisAfter covering fixed costs, any remaining CM contributes to income.The Contribution Approach Consider the following information developed by the accountant at Creative Frames Co.:

The Contribution Approach For each additional unit Creative sells, SR.200 more in contribution margin will help to cover fixed expenses and profit.

The Contribution ApproachEach month Creative must generate at least SR.80,000 in total CM to break even.

The Contribution ApproachIf Creative sells 400 units in a month, it will be operating at the break-even point.

The Contribution Approach If Creative sells one additional unit (401 frames), net income will increase by SR.200.The Contribution ApproachThe break-even point can be defined either as:The point where total sales revenue equals total expenses (variable and fixed).The point where total contribution margin equals total fixed expenses.Contribution Margin RatioThe contribution margin ratio is:

For Creative Frames Co. the ratio is: Contribution margin SalesCM Ratio = SR.200 SR.500= 40%Contribution Margin RatioAt Wind, each SR.1.00 increase in sales revenue results in a total contribution margin increase of 40halalah.

If sales increase by SR.50,000, what will be the increase in total contribution margin? Contribution Margin Ratio

A SR.50,000 increase in sales revenue

Contribution Margin RatioA SR.50,000 increase in sales revenue results in a SR.20,000 increase in CM.(SR.50,000 40% = SR.20,000)Quick Check Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is SR.1.49 and the average variable expense per cup is SR.0.36. The average fixed expense per month is SR.1,300. 2,100 cups are sold each month on average. What is the CM Ratio for Coffee Klatch?a. 1.319b. 0.758c. 0.242d. 4.139Changes in Fixed Costs and Sales VolumeCreative is currently selling 500 frames per month. The companys sales manager believes that an increase of SR.10,000 in the monthly advertising budget would increase bike sales to 540 units.

Should we authorize the requested increase in the advertising budget?

Changes in Fixed Costs and Sales VolumeSales increased by SR.20,000, but net income decreased by SR.2,000.SR.80,000 + SR.10,000 advertising = SR.90,000Changes in Fixed Costs and Sales VolumeThe Shortcut Solution

Break-Even AnalysisBreak-even analysis can be approached in two ways:Equation methodContribution margin method.Equation MethodProfits = Sales (Variable expenses + Fixed expenses)Sales = Variable expenses + Fixed expenses + ProfitsORAt the break-even point profits equal zero.

Equation MethodHere is the information from Creative Frames Co.:

Equation MethodWe calculate the break-even point as follows:Sales = Variable expenses + Fixed expenses + ProfitsSR.500Q = SR.300Q + SR.80,000 + SR.0

Where:Q = Number of frames soldSR.500 = Unit sales priceSR.300 = Unit variable expensesSR.80,000 = Total fixed expenses

Equation MethodWe calculate the break-even point as follows:Sales = Variable expenses + Fixed expenses + ProfitsSR.500Q = SR.300Q + SR.80,000 + SR.0

SR.200Q = SR.80,000

Q = 400 frames

Equation MethodWe can also use the following equation to compute the break-even point in sales dollars.Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + SR.80,000 + SR.0 Where:X = Total sales dollars0.60 = Variable expenses as a percentage of salesSR.80,000 = Total fixed expenses

Contribution Margin MethodThe contribution margin method is a variation of the equation method. Fixed expenses Unit contribution margin =Break-even pointin units sold Fixed expenses CM ratio=Break-even point intotal sales dollarsQuick Check Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is SR.1.49 and the average variable expense per cup is SR.0.36. The average fixed expense per month is SR.1,300. 2,100 cups are sold each month on average. What is the break-even sales in units?a. 872 cupsb. 3,611 cupsc. 1,200 cupsd. 1,150 cupsQuick Check Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is SR.1.49 and the average variable expense per cup is SR.0.36. The average fixed expense per month is SR.1,300. 2,100 cups are sold each month on average. What is the break-even sales in dollars?a. SR.1,300b. SR.1,715c. SR.1,788d. SR.3,129CVP Relationships in Graphic FormViewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way. Consider the following information for CreativeCo.:

CVP GraphFixed expensesUnitsDollarsTotal Expenses

UnitsDollarsCVP GraphTotal Sales

UnitsDollarsCVP GraphBreak-even pointProfit AreaLoss AreaTarget Profit Analysis Suppose Creative Co. wants to know how many frames must be sold to earn a profit of SR.100,000.

We can use our CVP formula to determine the sales volume needed to achieve a target net profit figure.

The CVP EquationSales = Variable expenses + Fixed expenses + ProfitsSR.500Q = SR.300Q + SR.80,000 + SR.100,000

SR.200Q = SR.180,000

Q = 900 framesThe Contribution Margin Approach We can determine the number of frames that must be sold to earn a profit of SR.100,000 using the contribution margin approach. Fixed expenses + Target profit Unit contribution margin=Units sold to attainthe target profit SR.80,000 + SR.100,000 SR.200= 900 framesQuick Check Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is SR.1.49 and the average variable expense per cup is SR.0.36. The average fixed expense per month is SR.1,300. How many cups of coffee would have to be sold to attain target profits of SR.2,500 per month?a. 3,363 cupsb. 2,212 cupsc. 1,150 cupsd. 4,200 cupsThe Margin of SafetyExcess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred.Margin of safety = Total sales - Break-even salesLets calculate the margin of safety for Creative.The Margin of SafetyCreative has a break-even point of SR.200,000. If actual sales are SR.250,000, the margin of safety is SR.50,000 or 100 frames.

The Margin of SafetyThe margin of safety can be expressed as 20 percent of sales.(SR.50,000 SR.250,000)Quick Check Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is SR.1.49 and the average variable expense per cup is SR.0.36. The average fixed expense per month is SR.1,300. 2,100 cups are sold each month on average. What is the margin of safety?a. 3,250 cupsb. 950 cupsc. 1,150 cupsd. 2,100 cups

Operating LeverageA measure of how sensitive net income is to percentage changes in sales.With high leverage, a small percentage increase in sales can produce a much larger percentage increase in net income. Contribution margin Net incomeDegree ofoperating leverage=

Fixed Costs

Smallpercentagechange inrevenueLargepercentagechange inprofitsOperating Leverage

SR.100,000 SR.20,000= 5Operating LeverageWith a measure of operating leverage of 5, if Creative increases its sales by 10%, net income would increase by 50%.

Heres the proof!Operating Leverage

10% increase in sales fromSR.250,000 to SR.275,000 . . .. . . results in a 50% increase inincome from SR.20,000 to SR.30,000.Quick Check Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is SR.1.49 and the average variable expense per cup is SR.0.36. The average fixed expense per month is SR.1,300. 2,100 cups are sold each month on average. What is the operating leverage?a. 2.21b. 0.45c. 0.34d. 2.92

Quick Check At Coffee Klatch the average selling price of a cup of coffee is SR.1.49, the average variable expense per cup is SR.0.36, and the average fixed expense per month is SR.1,300. 2,100 cups are sold each month on average.If sales increase by 20%, by how much should net income increase?a. 30.0%b. 20.0%c. 22.1%d. 44.2%

Note: Verify increase in profit

The Concept of Sales MixSales mix is the relative proportions in which a companys products are sold.Different products have different selling prices, cost structures, and contribution margins.

Lets assume Creative sells frames and carts and see how we deal with break-even analysis.Multi-product break-even analysisCreative Frames Co. provides the following information:

SR.265,000 SR.550,00= 48.2% (rounded)Multi-product break-even analysis

Rounding errorAssumptions of CVP AnalysisSelling price is constant throughout the entire relevant range.Costs are linear throughout the entire relevant range.In multi-product companies, the sales mix is constant.In manufacturing companies, inventories do not change (units produced = units sold).Sheet1Creative Frame Co.Contribution Income StatementFor the Month of SeptemberTotalPer UnitSales (500 frames)$250,000$500Less: variable expenses150,000300Contribution margin100,000$200Less: fixed expenses80,000Net income$20,000

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Sheet1Creative Frame Co.Contribution Income StatementFor the Month of SeptemberTotalPer UnitSales (500 frames)$250,000$500Less: variable expenses150,000300Contribution margin100,000$200Less: fixed expenses80,000Net income$20,000

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Sheet1Creative Frame Co.Contribution Income StatementFor the Month of SeptemberTotalPer UnitSales (500 frames)$250,000$500Less: variable expenses150,000300Contribution margin100,000$200Less: fixed expenses80,000Net income$20,000

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Sheet1TotalPer UnitPercentSales (500 frames)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000

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Sheet1TotalPer UnitPercentSales (500 frames)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000

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Sheet1TotalPer UnitPercentSales (500 frames)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000

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Sheet1Creative Frames Co.Contribution Income StatementFor the Month of SeptemberTotalPer UnitSales (400 frames)$200,000$500Less: variable expenses120,000300Contribution margin80,000$200Less: fixed expenses80,000Net income$ 0

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Sheet1Creative Frames Co.Contribution Income StatementFor the Month of SeptemberTotalPer UnitSales (401 frames)$200,500$500Less: variable expenses120,300300Contribution margin80,200$200Less: fixed expenses80,000Net income$200

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Sheet1TotalPer UnitPercentSales (500 bikes)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000400 frames500 framesSales$200,000$250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net income0.0$20,000

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Sheet1TotalPer UnitPercentSales (500 bikes)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000400 frames500 framesSales$200,000$250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net income0.0$20,000

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Sheet1Current Sales (500 frames)Projected Sales (540 frames)Sales$250,000$270,000Less: variable expenses150,000162,000Contribution margin100,000108,000Less: fixed expenses80,00090,000Net income$20,000$18,000

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Sheet1Increase in CM (40 units X $200)$8,000Increase in advertising expenses10,000Decrease in net income$(2,000)

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Sheet1TotalPer UnitPercentSales (500 frames)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000

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Sheet1Income 300 unitsIncome 400 unitsIncome 500 unitsSales$150,000$200,000$250,000Less: variable expenses90,000120,000150,000Contribution margin$60,000$80,000$100,000Less: fixed expenses80,00080,00080,000Net income (loss)$(20,000)0.0$20,000

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Sheet: Sheet1Sheet: Sheet2Sheet: Sheet3Sheet: Sheet4Sheet: Sheet5Sheet: Sheet6Sheet: Sheet7Sheet: Sheet8Sheet: Sheet9Sheet: Sheet10Sheet: Sheet11Sheet: Sheet12Sheet: Sheet13Sheet: Sheet14Sheet: Sheet15Sheet: Sheet16FCTCTRSheet: Sheet1Sheet: Sheet2Sheet: Sheet3Sheet: Sheet4Sheet: Sheet5Sheet: Sheet6Sheet: Sheet7Sheet: Sheet8Sheet: Sheet9Sheet: Sheet10Sheet: Sheet11Sheet: Sheet12Sheet: Sheet13Sheet: Sheet14Sheet: Sheet15Sheet: Sheet16FCTCTRSheet: Sheet1Sheet: Sheet2Sheet: Sheet3Sheet: Sheet4Sheet: Sheet5Sheet: Sheet6Sheet: Sheet7Sheet: Sheet8Sheet: Sheet9Sheet: Sheet10Sheet: Sheet11Sheet: Sheet12Sheet: Sheet13Sheet: Sheet14Sheet: Sheet15Sheet: Sheet16FCTCTRSheet1TotalPer UnitPercentSales (500 bikes)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000Break-even sales 400 unitsActual sales 500 unitsSales$200,000$250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net income0.0$20,000

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Sheet1TotalPer UnitPercentSales (500 bikes)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000Break-even sales 400 unitsActual sales 500 unitsSales$200,000$250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net income0.0$20,000

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Sheet1TotalPer UnitPercentSales (500 bikes)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000Actual sales 500 framesActual sales 500 unitsSales$250,000$250,000Less: variable expenses150,000150,000Contribution margin100,000100,000Less: fixed expenses80,00080,000Net income$20,000$20,000

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Sheet1Percent increase in sales10%Degree of operating leverage5Percent increase in profits50%

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Sheet1TotalPer UnitPercentSales (500 bikes)$250,000$500100%Less: variable expenses150,00030060%Contribution margin$100,000$20040%Less: fixed expenses80,000Net income$20,000Actual sales (500)Increased sales (550)Sales$250,000$275,000Less variable expenses150,000165,000Contribution margin100,000110,000Less fixed expenses80,00080,000Net income$20,000$30,000

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Sheet1Percent increase in sales20.00%x Degree of operating leverage2.21Percent increase in profit44.20%

Sheet1Actual salesIncreased sales2,1002,520Sales$3,129$3,755Less: Variable expenses756907Contribution margin2,3732,848Less: Fixed expenses1,3001,300Net income$1,073$1,548Percentage change in sales20.0%Percentage change in net income44.2%

Sheet1framesAlbumsTotalSales$250,000100%$300,000100%$550,000100.0%Var. exp.150,00060%135,00045%285,00051.8%Contrib. margin$100,00040%$165,00055%265,00048.2%Fixed exp.170,000Net income$95,000Sales mix$250,00045%$300,00055%$550,000100.0%

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Sheet1framesalbumsTotalSales$158,714100%$193,983100%$352,697100.0%Var. exp.95,22860%87,29345%182,52151.8%Contrib. margin$63,48540%$106,69155%170,17648.2%Fixed exp.170,000Net income$176Sales mix$158,71445%$193,98355%$352,697100.0%

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