Lecture 17b: Contribution in Decision Making Learning outcomes: CVP Analysis On completion of this topic, students should be able

to: apply CVP analysis in a variety of decision-making situations. make decisions in situations where there are limits on the availability of certain factors CVP and Profit Targets A natural extension of break-even analysis is to calculate the amount of sales volume needed to earn a certain level of profit. In order to earn a desired level of profit, the total contribution margin must be equal to the total fixed costs plus the desired amount of profit. Define ProfitT =Target Profit. Total Revenue -Total Costs = ProfitT {(P x QT )-[(VC x QT )+FC ]} = ProfitT {[(P -VC)x Q T ] -FC} = ProfitT [(CM x QT ) - FC ] = Profit T QT =[(ProfitT + FC )/CM ] Margin of Safety This figure denotes the % change in units (sales revenue) that would move the company from its present profitable position to the break-even point. Usually calculated as: Margin of Safety % = Expected sales - Break-even sales X 100 Expected sales Norvik Enterprises Norvik Enterprises is examining the viability of a concert in Paris. _Estimates of Fixed Cost are 60,000. This includes fees paid to performers, the hire of venue and advertising costs. _Variable costs (Pre-Packed Buffet) are likely to be 10 per ticket sold. _The proposed sales price for a ticket is 20. (a) How many Tickets must be sold to break-even? (b) How many Tickets must be sold to earn 3,000 (c) What is the margin of safety at (b) (a) Break-even Contribution margin (CM) = SP-VC= 20-10 = 10 Break-even (units) = FC/CM = 60,000/10 = 6,000 tickets or 120,000 revenue (b) 3,000 profit QuantityT = (ProfitT + FC)/CM = 3,000 + 60,000/10 = 6,300 tickets or 126,000 revenue (c) Margin of safety % (b) = [(6,300 - 6,000)/6,300] = 4.8% More complex examples Dresses By Jenny Dresses by Jenny can purchase dresses for 32 from a local factory; other variable costs amount to 10 per dress. Because she plans to sell these dresses overseas, the local factory allows Jenny to return all unsold dresses and receive a full 32 refund per dress within one year. Jenny can use CVP analysis to examine changes in operating income as a result of selling different quantities of dresses. Assume that the average selling price per dress is 70 and total fixed costs amount to 84,000.

__ ould she show an operating profit or an operating loss if she sells 2,500 dresses W _An operating loss (Profit/Loss =Sales -VC -FC) 175,000 105,000 84,000 ==(14,000) _Contribution margin per unit =Selling Price Variable Cost Per Unit =28 contribution margin per unit _ What is the total contribution margin/Profit Volume ratio when 2,500 dresses are sold? 2,500 x (70 42) = 70,000 and the contribution margin/PV ratio percentage is (28/70) x 100 = 40% _If Jenny sells 3,000 dresses, revenues will be 210,000 and contribution margin would equal 40% x 210,000 =84,000. Target Operating Income Assume that Jenny wants to have an operating income of 14,000. _ How many dresses must she sell and what is the total revenue? (84,000 +14,000) 28 = 3,500 or (FC+ Target .Profit/Contribution Margin %)=(84,000 +14,000) 40%=245,000 (or 3,500 dresses x 70) Advertise or not? Suppose the management of Dresses by Jenny anticipates selling 3,200 dresses unless an advertising campaign that would cost 10,000 to run when it is anticipated that sales will increase to 4,000 dresses. Should Jenny advertise? 3,200 dresses sold with no advertising : Contribution margin (3200*28) Fixed costs Operating income 4,000 dresses sold with advertising: Contribution margin (4000*28) Fixed costs (84000 +10000) Operating income 89,600 84,000 5,600 112,000 94,000 18,000

The 10,000 increase in fixed costs is offset by the 22,400 increase in the contribution. So operating income increases by 12,400. Should Jenny decrease the selling price per dress to 61? _Instead of advertising, management is considering reducing the selling price from 70 to 61 per dress as it is anticipated that this will increase sales to 4,500 dresses. New contribution margin: (SP -VC) =61 -42 =19 or 31.15%) (4,500 x 19) 85,500 Fixed costs 84,000 Operating income 1,500 _ The selling price should not be reduced to 61 as operating income decreases from 5,600 to 1,500. Alternative Fixed/Variable Cost Structures Suppose that the factory Dresses by Jenny is using to obtain the merchandise offers Jenny a decrease the price they charge Jenny from 32 to 25 but charge an annual administrative fee of 30,000. _This gives a new contribution margin of 35 and raises the Contribution Margin % to =50% (35 70) but fixed costs are now 114,000 (84,000 +30,000)

Make or buy decisions The cost of a producing a WERNET is: Variable costs 5 Share of fixed ohds 3 (based on a normal weekly output of 10,000 units) Cost 8 A WERNET sells for 12. A supplier has offered to provide WERNETS at 7 each, should the firm buy them: Contribution per unit Therefore make in. Would your answer be different if: (a) the spare capacity released enabled the firm to produce 5,000 WERNETTAS with a contribution of 5 per unit; and Contribution lost (7-5) x 10,000 Contribution from WERNETTAS Therefore buy in as 5000 extra contribution (b) the fixed costs would be eliminated if WERNETS were bought in. Contribution lost Saving in fixed overheads Therefore buy in as 10,000 extra contribution Limiting Factor Analysis Often when making decisions one factor of production is limited in supply within the time scale of the decision (eg. a special material, skilled labour, or distribution capacity) When seeking to maximising profits, the rule is to: Maximise the CONTRIBUTION PER UNIT OF LIMITING FACTOR Cobbler Ltd manufactures shoes. The management accountant has analysed the performance of the three lines offered as follows: A B C Contribution per pair of shoes 2.00 2.52 3.75 The firm has just scrapped three of its machines, which are irreplaceable, and therefore can no longer produce the same number of shoes that it has in the past. The management accountant notes the machine hours per pair of shoes are as follows: A B C Machine hours per pair (a) 0.50 0.60 1.00 Contribution per unit (b) 2.00 2.52 3.75 Contribution per unit of 4.00 4.20 3.75 limiting factor (b)/(a) Likely demand for a period when there are 600 machine hours available is A B C (20,000) 30,000 (20,000) 25,000 Made in Bought out 7 5

Demand

300

600

700

What should the output be? Produce according contribution per unit of limiting factor M/c hrs 600 x B 360 300 x A 150 90 x C 90 Totals 600 Contribution 1512 600 337.5 2449.5