Module 6

Management’s Decision Making

Ch 6 : Cost-Volume-Profit
Ch 7: Incremental Analysis

Copyright ©2019 John Wiley & Sons Canada, Ltd. 1

 Cost-Volume-Profit Analysis
• Study of the effects of changes of costs and volume on a
company’s profits
• Important in profit planning
• Considers the interrelationships among the five
components of CVP analysis:

Components of CVP analysis

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 Assumptions Underlying CVP Analysis

1. Behaviour of both costs and revenues is linear

throughout the relevant range
2. All costs can be classified as either variable or
fixed
3. Changes in activity are the only factors that affect
costs
4. Inventory levels remain constant - all units
produced are sold
5. When more than one type of product is sold, the
sales mix will remain constant
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 CVP Income Statement

• A statement for internal use

• Classifies costs and expenses as fixed or variable
• Reports contribution margin in the body of the
statement.
Contribution margin = Revenues - Variable costs
• Reports the same income as a traditional income
statement

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 CVP Income Statement: Example
Vargo Video Co produces DVD players.
Relevant data for June:
Unit selling price of DVD player $500
Unit variable costs $300
Total monthly fixed costs $200,000
Units sold 1,600

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 Contribution Margin: Example
To cover fixed costs of $200,000, Vargo Video must sell 1,000
DVD players ($200,000 ÷ $200) before it earns any net income.

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 Contribution Margin: Example

Every DVD sold above 1,000 will generate a

contribution margin of $200

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 Contribution Margin Ratio
CM Ratio shows the percentage of each sales dollar available to
apply toward fixed costs and profits

If Vargo Video’s sales increases by $100,000, net income increases by

$40,000 = CM ratio (40%) x increase in sales ($100,000)

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 Break-Even Analysis
• Break-Even Analysis is the process of finding the
break-even point
• Break-even point
Level of activity, where total revenues=total costs
(both fixed and variable)
Can be calculated or derived
• from a mathematical equation by using
contribution margin
• from a cost-volume-profit (CVP) graph
Expressed either in sales units or in sales dollars

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 Break-Even Analysis
Mathematical Equation - Example
Using the Vargo Video data:

Where: Q = sales volume; $500 = selling price;

$300 = variable cost per unit; $200,000 total fixed costs
To find sales dollars required to break-even:
1,000 units X $500 = $500,000 (break-even sales dollars)
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 Break-Even Analysis
Contribution Margin Technique - Example

Using Vargo Video data:

Formula for break-even point in units using contribution margin

Formula for break-even point in sales dollars using contribution margin ratio
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 Break-Even Analysis
CVP Graph for Vargo Video

CVP graph

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 Break-Even Analysis
Target Operating Income Before Tax
Using the Contribution Margin Approach and the
Vargo Video Data:
Formula for required sales in units:

Formula for required sales in dollars:

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 Margin of Safety
Difference between actual or expected sales and sales at the
break-even point
Example: To determine the margin of safety in dollars for Vargo
Video, assuming that actual (expected) sales are $750,000:
May be expressed in dollars:

May be expressed in ratios:

If sales fall by 33 % then company would be operating at a loss

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Changes in the Business Environment (1 of 2)
• CVP analysis can help management analyse and
respond to changes in business conditions
• Let’s look at an example:
A company selling tablets starts off
with the current situation
Unit Selling Price $400

Unit Variable Cost $200

Total Fixed Costs $180,000

Break Even Sales 900 units or $360,000

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 Changes in the Business Environment(2 of 2)
If add a new equipment to production line it will reduce their
variable costs by $20 but increase fixed costs by $60,000.
This new equipment will enable them to add a new feature
to their tablet resulting in a new sales price of $450
What is the new break even point both in units and dollars?
Unit selling price $450
Unit variable cost $180
Total fixed costs $240,000
Break even sales ?

Fixed Costs/Contribution Margin per unit = New BE Units

$240,000/$270 = 889 units dropped from 900 units
BE Sales = 889 x $450 = $400,050 increased from $360,000

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 LO4

Key Formulas

© 2015 McGraw-Hill Ryerson 17

 LO4

Variable Expense Ratio

Variable expense ratio is the ratio of variable
expenses to sales

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 LO1

Example
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
Less: Fixed expenses 80,000
Net operating income $ 20,000

© 2015 McGraw-Hill Ryerson 19

 LO4

Changes in Fixed Costs and Sales Volume

What is the profit impact if Racing can increase

unit sales from 500 to 540 by increasing the
monthly advertising budget by $10,000?

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 LO4

Changes in Fixed Costs and Sales Volume

$80,000
$80,000 ++ $10,000
$10,000 advertising
advertising == $90,000
$90,000

Sales
Sales increased
increased by
by $20,000,
$20,000, but
but net
net operating
operating
income
income decreased
decreased byby $2,000.
$2,000.
© 2015 McGraw-Hill Ryerson 21
 LO4

Changes in Fixed Costs and Sales Volume

The Shortcut Solution:

Increase in CM (40 units × $200) $ 8,000

Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)

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 LO4

Changes in Variable Costs and Sales Volume

What is the profit impact if Racing can

use higher quality raw materials, thus
increasing variable costs per unit by $10,
to generate an increase in unit sales
from 500 to 580?

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 LO4

Changes in Variable Costs and Sales Volume

580
580 units
units ×× $310
$310 variable
variable cost/unit
cost/unit == $179,800
$179,800

Sales
Sales increase
increase by
by $40,000,
$40,000, and
and net
net operating
operating income
income
increases
increases by
by $10,200.
$10,200.
© 2015 McGraw-Hill Ryerson 24
 LO4

Changes in Variable Costs and Sales Volume

The Shortcut Solution:

CM current $ 200 x 500units = $100,000

CM proposed $ 190 x 580 units = $110,200

Fixed cost is unchanged, therefore

Increase in profit $10,200

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 LO4

Changes in Fixed Cost, Sales Price and Volume

What is the profit impact if Racing (1) cuts

its selling price $20 per unit, (2) increases
its advertising budget by $15,000 per
month, and (3) increases sales from 500
to 650 units per month?

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 LO4

Changes in Fixed Cost, Sales Price and Volume

Sales
Sales increase
increase by
by $62,000,
$62,000, fixed
fixed costs
costs increase
increase by
by
$15,000,
$15,000, and
and net
net operating
operating income
income increases
increases byby $2,000.
$2,000.
© 2015 McGraw-Hill Ryerson 27
 LO4

Changes in Fixed Cost, Sales Price and Volume

The Shortcut Solution:

CM current $ 200 x 500units = $100,000

CM proposed $ 180 x 650 units = $117,000

Change, increase in CM 17,000

Increase in Fixed Costs (15,000)

Increase in profit 2,000

© 2015 McGraw-Hill Ryerson 28

 LO4
Changes in Variable Cost, Fixed Cost and Sales Volume

What is the profit impact if Racing (1) pays

a $15 sales commission per bike sold
instead of paying salespersons flat salaries
that currently total $6,000 per month, and
(2) increases unit sales from 500 to 575
bikes?

© 2015 McGraw-Hill Ryerson 29

 LO4

Changes in Variable Cost, Fixed Cost and Sales Volume

Sales
Sales increase
increase by
by $37,500,
$37,500, variable
variable costs
costs increase
increase by
by
$31,125,
$31,125, but
but fixed
fixed expenses
expenses decrease
decrease by
by $6,000.
$6,000.
© 2015 McGraw-Hill Ryerson 30
 LO4

Changes in Fixed Cost, Sales Price and Volume

The Shortcut Solution:

CM current $ 200 x 500units = $100,000

CM proposed $ 185 x 575 units = $106,375

Change, increase in CM 6,375

Decrease Fixed Costs 6,000

Increase in profit 12,375

© 2015 McGraw-Hill Ryerson 31

 LO4

Change in Regular Selling Price

If Racing has an opportunity to sell 150

bikes to a wholesaler without disturbing
sales to other customers or fixed
expenses, what price would it quote to the
wholesaler if it wants to increase monthly
profits by $3,000?

© 2015 McGraw-Hill Ryerson 32

 LO4

Change in Regular Selling Price

The Shortcut Solution:
$ 3,000 ÷ 150 bikes = $ 20 per bike
Variable cost per bike = 300 per bike
Selling price required = $ 320 per bike

150 bikes × $320 per bike = $ 48,000

Total variable costs = 45,000
Increase in net income = $ 3,000

© 2015 McGraw-Hill Ryerson 33

 Practice Q 1
Sunland Company had sales in 2022 of $1,734,200 on 59,800 units.
Variable costs totaled $717,600, and fixed costs totaled $854,500.
A new raw material is available that will decrease the variable costs
per unit by 20% (or $2.40). However, to process the new raw material,
fixed operating costs will increase by $45,700. Management feel that
one half of the decline in the variable costs per unit should be passed
on to customers in the form of a sales price reduction. The marketing
department expects that this sales price reduction will result in a 10%
increase in the number of units sold.
What will be the increase in operating income if the new proposal is
implemented? Please do not prepare income statements.

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 Solution to practice Q1
Solution

CM before (29-12)= 17 per unit x 59,800units 1,016,600

CM proposed (29-1.20)–(12-3.40) 18.20 x (59,800x1.1) 1,197,196
Increase in CM 180,596
Increase in fixed cost 45,700
Increase in Operating Profit 134,896

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 Cost Structure
Appendix 6 A

Cost structure refers to the relative proportion of

fixed versus variable costs that a company incurs.
Cost structure can have a significant effect on
profitability.

1. Effect on Contribution Margin Ratio

2. Effect on Break-Even Point
3. Effect on Margin of Safety Ratio

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 Cost Structure
Example (1 of 2)
CVP Income Statements for two companies:

1. Effect on Contribution Margin Ratio

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 Cost Structure
Example (2 of 2)
2. Effect on Break-Even Point

3. Effect on Margin of Safety Ratio

Copyright ©2019 John Wiley & Sons Canada, Ltd. 38

 Operating Leverage: Appendix 6 A

The degree of operating leverage provides a measure

of a company’s earnings volatility.
Degree of Operating Leverage = Contribution Margin ÷
Operating Income

If both companies record a 10% decrease in sales.

Vargo Video’s operating income will decrease by 26.7% (2.67 x 10%)
New Wave’s operating income will decrease by 53.3 or (5.33 x 10%)
New Wave has a higher earnings volatility & therefore is more risky
Copyright ©2019 John Wiley & Sons Canada, Ltd. 39
 The indifference point is the level of volume (X) at which
total profits, are the same under both cost structures.

Vargo New Wave

Selling Price $500 / unit $500 / unit
Variable Costs $300 / unit $100 /unit
Fixed Costs $200,000 $ 520,000

$500X-300X -200,000 = $500X-100X-$520000

Indifference point is X= 1,600 units
Which Company will have higher profit above indifference point? i.e. if sells 1601
units
 Red – New Wave (High fixed costs)
Vargo Video (High Variable Costs)

500000

400000

300000

200000
Indifference point
$

100000

0
1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000 2100 2200 2300

-100000

-200000

Units

41
 Chapter 7

Incremental Analysis
 Management’s Decision Making
How Incremental Analysis Works (1 of 2)
• Relevant cost: In incremental analysis, the only factors
to be considered are those costs and revenues that are
different for each alternative & will occur in the future.
• Opportunity cost: In choosing to take one action, the
company must often give up the opportunity to
benefit from some other action. This lost benefit is
called an opportunity cost.
• Sunk cost: Costs that have already been incurred and
will not be changed or avoided by any future decision
are called sunk costs. Sunk costs are not relevant costs.
 Management’s Decision-Making
Types of Incremental Analysis
1. Accept an order at a special price
2. Make or buy component parts or finished products
3. Sell products or process further
4. Retain or replace equipment
5. Eliminate or retain an unprofitable business
segment
6. Allocate limited resources
 #1 Accept an Order at a Special Price

• Obtain additional business by making price

concessions

• Assumes sales of the products in other markets

would not be affected by special order

• Assumes company is not operating at full capacity

Accept an Order at a Special Price – Example (1 of 2)

• Customer offers to buy a special order of 2,000

blenders at $11 per unit from Sunbelt.
• No effect on normal sales; sufficient plant capacity
• Operating at 80% capacity = 100,000 units
• Current fixed manufacturing costs = $400,000 or $4
per unit
• Variable manufacturing cost = $8 per unit
• Normal selling prince = $20 per unit
• Based strictly on total cost of $12 per unit ($8 +
$4), reject offer as cost exceeds selling price of $11
Accept an Order at a Special Price – Example (2 of 2)

No change in fixed costs since within existing capacity – thus

fixed costs are not relevant. Only total variable costs change –
thus they are relevant

Revenue increases $22,000; variable costs increase by

$16,000
Decision: Accept the offer. Income will increase by $6,000.
 #2 Make or Buy - Example
• Outsourcing: The decision to buy parts or services rather
than making them
• Baron Co. incurs the following costs to make 25,000
switches:

Annual product cost data

• Switches can be purchased for $8 per switch ($200,000)
• Eliminates all variable costs and $10,000 of fixed costs;
however, $50,000 of fixed costs remain
 Make or Buy – Example: (cont.)

Incremental analysis—make or buy

Based on analysis of costs under both alternatives:

• Purchasing adds $25,000 to cost of switches
Decision: Continue to make switches.
 Opportunity Costs
Baron Company – Example
• Opportunity cost – the potential benefit that may
be obtained from following an alternative course
of action

• Example: Assume that buying the switches allows

Baron to use the released capacity to generate
$38,000 additional income.
 Opportunity Costs
Baron Company – Example (cont.)

• Thus, the $38,000 lost income is an additional cost

of making the switches

Incremental analysis—make or buy, with opportunity cost

Decision: Based on the analysis, Baron should buy the
switches as the company will earn an additional
$13,000 in Net Income.
 #3 Sell or Process Further
(1 of 10)

• Manufacturers may have to decide, at a given

point in production, whether to sell now or to
process further and sell at a higher price later

• Decision Rule:
• Process further as long as the incremental revenue
from such processing exceeds the incremental
processing costs
 Sell or Process Further
(2 of 10)
Single-product case: Cost to manufacture one
unfinished table:

Per-unit cost of unfinished table

Selling price of unfinished unit is $50
Unused capacity is available to enable the company
to finish the tables
Selling price of finished unit is $60
 Sell or Process Further
(3 of 10)

• Relevant unit costs of finishing tables:

• Direct materials increase $2
• Direct labour increase $4
• Variable manufacturing overhead costs increase by
$2.40 (60% of direct labour increase)
• Fixed manufacturing costs will not increase
 Sell or Process Further
(4 of 10)

• Relevant unit costs of finishing tables:

• Direct materials increase $2
• Direct labour increase $4
• Variable manufacturing overhead costs increase by
$2.40 (60% of direct labour increase)
• Fixed manufacturing costs will not increase
 Sell or Process Further
(5 of 10)

Incremental analysis—sell or process further

Decision: Process further. Incremental revenue $10

exceeds incremental processing costs $8.40; income
increases $1.60 per unit.
 Sell or Process Further
(6 of 10)

Especially appropriate when multiple products are produced

simultaneously
Many end-products are produced from a single raw material
and a common production process
Joint products – multiple end products
• Petroleum – gasoline, lubricating oil, kerosene
• Meat Packing – meat, hides, bones
 Sell or Process Further
(7 of 10)
Joint costs
• all costs incurred prior to split-off point
• allocate to individual products based on relative
sales value
Sunk costs
• already incurred and cannot be changed
• Irrelevant for sell or process further decisions
Joint costs are sunk costs for sell or process further
decisions.
 Sell or Process Further
(8 of 10)
Marais Creamery Decision – Example
Sell cream and skim milk or
Process them further before selling
 Incremental Analysis: Sell or Process Further
(9 of 10)
Sell cream or process further into cottage cheese?
Joint cost allocated to cream $9,000
Processing cream into cottage cheese $10,000

Expected revenue per day:

Cream $19,000
Cottage cheese $27,000

Decision: Do not process the cream further - income decreases by $2,000.

Incremental Analysis: Sell or Process Further
(10 of 10)
Sell skim milk or process further into condensed milk?
Joint cost allocated to skim milk $5,000
Processing skim milk into condensed milk $8,000
Expected revenue per day:
Skim milk $11,000
Condensed milk $26,000

Decision: Process the skim milk further. Income increases by $7,000.

 #4 Retain or Replace Equipment – Example
Assessment of replacement of a factory machine:
Old Machine New Machine
Book value $40,000
Cost of new machine $120,000
Remaining useful life 4 years 4 years
Scrap value $5,000 -0-
Variable costs: Decrease from $160,000 to $125,000 annually

Decision: Replace equipment.

Note: The book value of the old machine does not affect the decision.
#5 Eliminate an Unprofitable Segment (1 of 4)

• Key: Focus on relevant costs

• Consider effect on related product lines
• Fixed costs allocated to the unprofitable segment
must be absorbed by the other segments
• Net income may decrease when an unprofitable
segment is eliminated
• Decision Rule: Retain the segment unless fixed
costs eliminated exceed the contribution margin
lost
 Eliminate an Unprofitable Segment (2 of 4)
Martina Company – Example
Manufactures three models of tennis racquets:
• Profitable lines: Pro and Master
• Unprofitable line: Champ
Condensed Income Statement data:

Should Champ line be eliminated?

 Eliminate an Unprofitable Segment (3 of 4)
Martina Company – Example (cont.)

• If Champ is eliminated, allocate its $30,000 fixed costs: 2/3 to Pro

and 1/3 to Master
• Revised Income Statement data:

Total income has decreased by $10,000 ($220,000 - $210,000)

 Eliminate an Unprofitable Segment (4 of 4)
Martina Company – Example (cont.)
Incremental analysis of Champ provides the same results

Decrease in net income is due to Champ’s contribution margin

of $10,000 that will not be realized if the segment is
discontinued
Decision: Do not eliminate Champ.
 #6 Allocate Limited Resources

• Resources are always limited

• floor space for a retail firm
• raw material, direct labour hours, or machine
capacity for a manufacturing firm
• Management must decide which products to
make and sell to maximize net income
 Allocate Limited Resources (1 of 3)
Bilodeau Company – Example
• Produces standard and deluxe pen and
pencil sets
• Limiting resource – 3,600 machine hours
per month

• Deluxe set has higher contribution margin: $8

• Standard set takes fewer machine hours per unit
 Allocate Limited Resources (2 of 3)
Bilodeau Company – Example (cont.)
Must calculate contribution margin per unit of
limited resource

Standard sets have higher contribution margin per

unit of limited resources
Decision: Shift sales mix to standard sets or increase
machine capacity.
 Allocate Limited Resources (3 of 3)
Bilodeau Company – Example (cont.)

• Alternative: Increase machine capacity from

3,600 to 4,200 hours

• To maximize net income, all 600 hours should be

used to produce standard sets.
 Incremental Analysis
Theory of Constraints

• Approach used to identify and manage constraints

so as to achieve company goals

• Requires identification of constraints

• Continual attempts to reduce or eliminate

constraints
 Management’s Decision-Making
Other Considerations
• Qualitative factors
• Potential effects of decision on employees
and community
• Low morale
• Employee turnover
• Incremental Analysis and Activity-Based
Costing
• Completely consistent with each other
• ABC better identifies relevant costs resulting in
better incremental analysis
 Practice Q 4

Bonita Co. sells product P-14 at a price of $47 a unit. The

per-unit cost data are direct materials $15, direct labour
$10, and overhead $12 (75% variable). Bonita Co. has
sufficient capacity to accept a special order
for 38,900 units, but at a discount of 25% from the
regular price. Selling costs associated with this order
would be $4 per unit. Determine whether Bonita Co.
should accept the special order.

Copyright ©2019 John Wiley & Sons Canada, Ltd. 73

 Solutions to Practice Q 4

Incremental revenue $1,371,225

(38,900 units × ($47 × 75%) per unit)
Incremental cost:
Variable cost (38,900 units × $34 per unit) $1,322,600
$15 + $10 + ($12 × 75%) = 34
Selling cost (38,900 units × $4 per unit)
155,600
1,478,200
Incremental income (loss) (106,975)

Copyright ©2019 John Wiley & Sons Canada, Ltd. 74