Finance for NonFinancial Managers Fifth Edition

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Finance for Non-Financial ManagersFifth Edition

• Slides prepared by
• Pierre G. Bergeron
• University of Ottawa

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Profit Planning and Decision-Making
Chapter Objectives

• Explain various cost concepts related to
  break-even analysis such as fixed and variable
  costs, the relationship between sales revenue and
  costs, the contribution margin, the relevant
  range and relevant costs.
• Draw the break-even chart and calculate the
  break-even point, the cash break-even point, and
  the profit break-even point, and how they can be
  applied in different organizations.
• Differentiate between different types of cost
  concepts such as committed and discretionary
  costs, controllable and non-controllable costs,
  and direct and indirect costs.

Chapter Reference Chapter 9 Profit Planning and
Decision-Making
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Relevance of Break-Even Analysis
Break-even analysis helps to

• Price existing or new products and services.
• Decide whether to introduce a new product or
  service, open a new plant, hire a sales
  representative, open a new sales office, launch
  an advertising program.
• Modernize or automate an existing plant.
• Expand an existing plant.
• Change the cost structure (fixed versus variable).

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1. Fixed and Variable Costs
Fixed costs Period costs Constant costs Standby
costs Characteristic Element of fixedness and
must be paid with passage of time.
Variable costs Direct costs Out-of-pocket
costs Volume costs Characteristic Vary almost
automatically with volume.
Sales commission, direct labour, packing
material, electricity, overtime premiums,
equipment rental, truck expenses
Rent, interest, insurance, property taxes, office
salaries, amortization, telephone
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Connection Between Revenue and Costs

• Factors that affect profit
• Volume of production
• Prices
• Costs (fixed and variable)
• Changes in product mix

Cost per Unit (in )
G
16 14 12 10
H
E
F
C
D
A
B
40 60 80 100
of Capacity
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The Contribution Margin
Sales revenue Less variable costs Direct
material Direct labour Total variable
costs Contribution margin Less fixed costs
Manufacturing Administration Total fixed
costs Operating profit
1,000,000 750,000 250,000 200,000
50,000
500,000 250,000 150,000 50,000
PV Ratio 250,000 1,000,000 .25
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2. J. Smiths Break-Even (Taxi Driver)


Fixed costs
Costs/Revenue


Variable costs


6,000
Trips
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J. Smiths Break-Even (Taxi Driver)
With salary
With salary
No salary
6,000 60,000 12,000 48,000 15,000
30,000 3,000 .80
No. of trips Sales revenue (10.00) Variable
costs (2.00) Contribution margin Fixed
costs Salary Profit P.V. Ratio
5,625 56,250 11,250 45,000 15,000
30,000 0 .80
1,875 18,750 3,750 15,000
15,000 0 0 .80
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Finding the Break-Even Point Using the Formula
Unit selling price 15.00 (P) Fixed
costs 200,000 (F) Unit variable costs
10.00 (V)
Break-even calculation Step 2 200,000
5.00 40,000 units (volume) Step 3 40,000
units X 15.00 600,000 (sales revenue)
Step 1 Contribution margin Selling
price 15.00 Variable costs 10.00 Contribution
margin 5.00
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Break-Even Point Calculation
In Units
Fixed costs Price per unit sold Variable cost
per unit or unit contribution
B.E.P.
200,000 15.00 - 10.00
B.E.P. 40,000 units
X 15.00 600,000
In revenue
Step 2 Find the sales revenue break-even
point B.E.P. 600,000
Step 1 Find the PV ratio PV .333
Unit contribution Unit selling price
5.00 15.00
Fixed costs PV
200,000 .333
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Break-Even Point By Using the PV Ratio
Finding the break-even point when units are not
known, you need to re-structure the PL statement

Step 2 Find the sales revenue break-even
point B.E.P. 600,000
Step 1 Find the PV ratio PV .333
Contribution Sales revenue
200,000 600,000
Fixed costs PV
200,000 .333
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Break-Even Point (Retail Store)
Suits Jackets Shirts Ties Socks
Overcoats Total
No. of units 800 200 700 500 2,500 500 Unit
selling price 300 150 50 50 8 300
Sales revenue 500,000 Variable
costs 275,000
25,000 Total variable costs 300,000
Purchases Sales commission
Contribution margin 200,000
(rent, telephone, salaries, security system)
Fixed costs 100,000 Profit 100,000
Contribution margin 200,000 Sales
revenue 500,000 Fixed costs 100,000 PV
ratio .40
50 of objective OK!!!
.40 or 0.40
250,000
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Cash Break-Even Point
In Units
Fixed costs - Amortization Price per unit
sold Variable cost per unit

200,000 - 50,000 150,000 15.00 - 10.00 5.00
30,000 units
In revenue
450,000
Fixed costs - Amortization PV
150,000 .333
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Profit Break-Even
In Units
Fixed costs Profit objective Price per unit
sold Variable cost per unit

200,000 20,000 220,000 15.00 - 10.00 5.00
44,000 units
In revenue

660,000
Fixed costs Profit objective PV
220,000 .333
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Sensitivity Analysis
Base case Break-even
Break-even in units in
revenue 40,000 600,000
Change in
Fixed costs (increased by 50,000 to 250,000)
50,000 750,000
Selling price (increased by 0.50 to 15.50)
36,364 563,642
Variable costs (decreased by 0.75 to 9.25)
34,782 521,730
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Break-Even Wedges
Company A
Company B
Revenue
Revenue
Total costs
Total costs
PV .40
PV .30
Fixed costs
Fixed costs
Company D
Company C
Revenue
Revenue
Total costs
Total costs
PV .30
PV .40
Fixed costs
Fixed costs
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Where Break-Even Analysis Can be Used

• Company-wide
• Trucking operation
• Plant
• Direct mail advertising
• District or sales territory
• Taxi business
• Retail store
• Movie theatre
• Production centre
• Advertising program
• Department store
• Travel agency
• Product/division
• Hotel business
• Service centre
• Restaurant business
• Machine operation
• Book publishing
• Airline business

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3. Other Cost Concepts
Committed costs Costs that must be incurred in
order to operate a
business. Discretionary fixed costs Costs that
can be controlled by managers.
Controllable costs Costs that operating managers
are accountable for. Non-controllable costs
Costs that are not under the direct control of
managers.
Direct costs Materials and labour expenses that
are directly incurred when
making a product or providing a
service. Indirect costs Costs that are necessary
in the production cycle but that
cannot be clearly allocated to specific
products or services.