CMA Part 2 Financial Decision Making

Transcription

1 CMA Part 2 Financial Decision Making

2 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory CVP = Break-even analysis Allows us to analyze the relationship between revenue and fixed and variable expenses It allows us to study the effects of changes in assumptions about cost behavior and the relevant ranges (in which those assumption are valid) may affect the relationships among revenues, variable costs, and fixed costs at various production levels Cost-volume-profit analysis is a tool to predict how changes in costs and sales levels affect income; conventional CVP analysis requires that all costs must be classified as either fixed or variable with respect to production or sales volume before CVP analysis can be used. It considers the effects of: Sales volume Sales price Product mixes What else? 2

3 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory CVP analysis is done with what assumptions? Cost and revenue relationships are predictable Unit selling prices are constant Changes in inventory are insignificant Fixed costs remain constant over relevant range (see slide 5 & 6) Total variable cost change proportional with volume (see slide 7 & 8) Continued 3

4 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory The revenue (sales) mix is constant All costs are either fixed or variable (long-term all costs are considered as variable) Volume is the sole revenue driver and cost driver The breakeven point is directly related to costs and inversely related to the budgeted margin of safety and the contribution margin Time value of money is ignored 4

5 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory Fixed Costs Total fixed cost remains unchanged in amount when volume of activity varies from period to period within a relevant range. The fixed cost per unit of output decreases as volume increases (and vice versa). When production volume and cost are graphed, units of product are usually plotted on the Horizontal axis and dollars of cost are plotted on the vertical axis. Fixed cost is represented by a horizontal line with no slope (cost remains constant at all levels of volume within the relevant range). Intersection point of line on cost (vertical) axis is at fixed cost amount. Likely that amount of fixed cost will change when outside of relevant range. 5

6 Monthly Basic Telephone Bill Monthly Basic Telephone Bill per Local Call C 1 SU- 8.1 Cost-Volume-Profit (CVP) Analysis Theory Fixed Costs Number of Local Calls Total fixed costs remain constant as activity increases. Number of Local Calls Cost per call declines as activity increases. 6

7 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory Variable Costs Total variable cost changes in proportion to changes in volume of activity. Variable cost per unit remains constant but the total amount of variable cost changes with the level of production. When production volume and cost are graphed Variable cost is represented by a straight line starting at the zero cost level. The straight line is upward (positive) sloping. The line rises as volume increases. 7

8 Total Costs Cost per Minute C 1 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory Minutes Talked Total variable costs increase as activity increases. Minutes Talked Cost per Minute is constant as activity increases. 8

9 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory Mixed Costs Include both fixed and variable cost components. When volume and cost are graphed, Mixed cost is represented by a straight line with an upward (positive) slope. Start of line is at fixed cost point (or amount of total cost when volume is zero) on cost (vertical) axis. As activity level increases, mixed cost line increases at an amount equal to the variable cost per unit. Mixed costs are often separated into fixed and variable components when included in a CVP analysis. 9

10 Total Cost in 1,000 s of Dollars P 1 Scatter Diagrams Draw a line through the plotted data points so that about equal numbers of points fall above and below the line * * * * * * * * * * Estimated fixed cost = 10, Activity, 1,000 s of Units Produced 10

11 Total Cost in 1,000 s of Dollars P 1 Scatter Diagrams Unit Variable Cost = Slope = Δ in cost Δ in units * * * * * * Horizontal distance is the change in activity Activity, 1,000 s of Units Produced 11 * * * * Vertical distance is the change in cost.

12 High-Low Method The following is not in this Study Unit, but it is important to know and be able to calculate. 12

13 The High-Low Method The following relationships between units produced and total cost are observed: Using these two levels of activity, compute: the variable cost per unit. the total fixed cost. 13

14 High-Low Method Units Cost High activity level - December 67,500 $ 29,000 Low activity level - January 17,500 20,500 Change in activity 50,000 $ 8,500 Variable cost per unit is determined as follows: Fixed costs are determined as follows: Total cost = $17,525 + $0.17 per unit produced 14

15 Contribution Margin and its Measures Total Unit Sales Revenue (2,000 units) $ 200,000 $ 100 Less: Variable costs 140, Contribution margin $ 60,000 $ 30 Less: Fixed costs 24,000 Net income $ 36,000 Contribution margin is the amount by which revenue exceeds the variable costs of producing the revenue. Total contribution margin is $60,000 and the contribution margin per unit sold is $30. 15

16 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory Breakeven point is the level of output where total revenues equals total expenses; the point at which all fixed costs have been covered and operating income is zero. What is the break-even point and where is it on a graph on the next page? 16

17 CVP Graph Break-Even Point 17

18 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory BEP = output level at which Total Rev = Total Exp It is also the point at which all fixed cost have been covered and operating income is zero Revenue $100,000 Var. Cost $ 80,000 Gross Margin $ 20,000 Fixed Cost $ 20,000 Oper. Income $ 0 18

19 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory Other terms and definitions Margin of safety is the excess of budgeted sales over BE Sales Mixed costs (See slide 11) are costs that have both a fixed and variable component. For example, the cost of operating an automobile includes some fixed costs that do not change with the number of miles driven (e.g., operating license, insurance, parking, some of the depreciation, etc.) Other costs vary with the number of miles driven (e.g., gasoline, oil changes, tire wear, etc.). Revenue or sales mix is the composition of total revenues in terms of various products Sensitivity analysis (See slide 12) examines the effect on the outcome of not achieving the original forecast or of changing an assumption. Since many decisions must be made due to uncertainty, probabilities can be assigned to different outcomes ( what-if ). 19

20 Total Utility Cost C 1 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory Mixed costs contain a fixed portion that is incurred even when the facility is unused, and a variable portion that increases with usage. Utilities typically behave in this manner. Activity (Kilowatt Hours) Variable Cost per KW Fixed Monthly 20 Utility Charge

21 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory 21

22 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory Unit Contribution Margin (UCM) is an important term used with break-even point or break-even analysis is contribution margin. In equation format it is defined as follows: Contribution Margin = Revenues Variable Expenses The contribution margin for one unit of product or one unit of service is defined as: Contribution Margin per Unit = Revenues per Unit (Sales price) Variable Expenses per Unit Expressed in either percentage of the selling price (contribution margin ratio) or dollar amount Slope of total cost curve plotted so that volume is on the x-axis and dollar value is on the y-axis 22

23 SU 8.1 Cost-Volume-Profit (CVP) Analysis - Theory Break-even point in units Break-even point in dollars Fixed costs UCM Fixed costs CMR 23

24 A 1 Contribution Margin Ratio Total Unit Sales Revenue (2,000 units) $ 200,000 $ 100 Less: Variable costs 140, Contribution margin $ 60,000 $ 30 Less: Fixed costs 24,000 Net income $ 36,000 Contribution margin ratio Contribution margin ratio = = Contribution margin per unit Sales price per unit $30 per unit $100 per unit = 30% 24

25 P 2 Computing the Break-Even Point Total Unit Sales Revenue (2,000 units) $ 200,000 $ 100 Less: Variable costs 140, Contribution margin $ 60,000 $ 30 Less: Fixed costs 24,000 Net income $ 36,000 How much contribution margin must Rydell Company have to cover its fixed costs (break-even)? Answer: $24,000 How many units must Rydell sell to cover its fixed costs (break-even)? Answer: $24,000 $30 per unit = 800 units 25

26 SU 8.1 Cost-Volume-Profit (CVP) Analysis Theory Question 1 Cost-volume-profit (CVP) analysis is a key factor in many decisions, including choice of product lines, pricing of products, marketing strategy, and use of productive facilities. A calculation used in a CVP analysis is the breakeven point. Once the breakeven point has been reached, operating income will increase by the A B C D Gross margin per unit for each additional unit sold. Contribution margin per unit for each additional unit sold. Fixed costs per unit for each additional unit sold. Variable costs per unit for each additional unit sold. 26

27 SU 8.1 Cost-Volume-Profit (CVP) Analysis Theory Question 1 Answer Correct Answer: B At the breakeven point, total revenue equals total fixed costs plus the variable costs incurred at that level of production. Beyond the breakeven point, each unit sale will increase operating income by the unit contribution margin (unit sales price unit variable cost) because fixed cost will already have been recovered. Incorrect Answers: A: The gross margin equals sales price minus cost of goods sold, including fixed cost. C: All fixed costs have been covered at the breakeven point. D: Operating income will increase by the unit contribution margin, not the unit variable cost. 27

28 SU 8.1 Cost-Volume-Profit (CVP) Analysis Theory Question 2 One of the major assumptions limiting the reliability of breakeven analysis is that A B C D Efficiency and productivity will continually increase. Total variable costs will remain unchanged over the relevant range. Total fixed costs will remain unchanged over the relevant range. The cost of production factors varies with changes in technology. 28

29 SU 8.1 Cost-Volume-Profit (CVP) Analysis Theory Question 2 Answer Correct Answer: C One of the inherent simplifying assumptions used in CVP analysis is that fixed costs remain constant over the relevant range of activity. Incorrect Answers: A: Breakeven analysis assumes no changes in efficiency and productivity. B: Total variable costs, by definition, change across the relevant range. D: The cost of production factors is assumed to be stable; this is what is meant by relevant range. 29

30 SU 8.1 Cost-Volume-Profit (CVP) Analysis Theory Question 3 The margin of safety is a key concept of CVP analysis. The margin of safety is the A B Contribution margin rate. Difference between budgeted contribution margin and breakeven contribution margin. C D Difference between budgeted sales and breakeven sales. Difference between the breakeven point in sales and cash flow breakeven. 30

31 SU 8.1 Cost-Volume-Profit (CVP) Analysis Theory Question 3 Answer Correct Answer: C The margin of safety measures the amount by which sales may decline before losses occur. It is the excess of budgeted or actual sales over sales at the BEP. Incorrect Answers: A: The contribution margin rate is computed by dividing contribution margin by sales. The contribution margin equals sales minus total variable costs. B: The margin of safety is expressed in revenue or units, not contribution margin. D: Cash flow is not relevant. 31

32 SU 8.1 Cost-Volume-Profit (CVP) Analysis Theory Question 4 The breakeven point in units increases when unit costs A B C D Increase and sales price remains unchanged. Decrease and sales price remains unchanged. Remain unchanged and sales price increases. Decrease and sales price increases. 32

33 SU 8.1 Cost-Volume-Profit (CVP) Analysis Theory Question 4 Answer Correct Answer: A The breakeven point in units is calculated by dividing total fixed costs by the unit contribution margin. If selling price is constant and costs increase, the unit contribution margin will decline, resulting in an increase of the breakeven point. Incorrect Answers: B: A decrease in costs will cause the unit contribution margin to increase, lowering the breakeven point. C: An increase in the selling price will increase the unit contribution margin, resulting in a lower breakeven point. D: Both a cost decrease and a sales price increase will increase the unit contribution margin, resulting in a lower breakeven point. 33

34 Remember Computing the Break-Even Point We have just seen one of the basic CVP relationships the break-even computation. Break-even point in units = Fixed costs Contribution margin per unit Unit sales price less unit variable cost ($30 in previous example) 34

35 Remember Computing the Break-Even Point The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed costs Contribution margin ratio Unit contribution margin Unit sales price 35

36 SU 8.1 Cost-Volume-Profit (CVP) Analysis Theory Review: What is the difference between gross margin and contribution margin Effect of an increase in CM Effects on BEP by changes in CM 36

37 SU 8.2 CVP Analysis Basic Calculations CVP Applications Target Operating Income Multiple products Choice of products Degree of Operating Leverage (DOL) Problems 8, 9, 10, 12 & 13 starting on page

38 SU 8.2 CVP Analysis Basic Calculations Question 1 Which of the following would decrease unit a contribution margin the most? A B C D A 15% decrease in selling price. A 15% increase in variable expenses. A 15% decrease in variable expenses. A 15% decrease in fixed expenses. 38

39 SU 8.2 CVP Analysis Basic Calculations Question 1 Answer Correct Answer: A Unit contribution margin (UCM) equals unit selling price minus unit variable costs. It can be decreased by either lowering the price or raising the variable costs. As long as UCM is positive, a given percentage change in selling price must have a greater effect than an equal but opposite percentage change in variable cost. The example below demonstrates this point. Continued 39

40 SU 8.2 CVP Analysis Basic Calculations Question 1 Answer Original: UCM = SP UVC = $100 $50 = $50 Lower Selling Price: UCM = (SP.85) UVC = $85 $50 = $35 Higher Variable Cost: UCM = SP (UVC 1.15) = $100 $57.50 = $42.50 Since $35 < $42.50, the lower selling price has the greater effect. 40

41 SU 8.2 CVP Analysis Basic Calculations Question 2 The breakeven point in units sold for Tierson Corporation is 44,000. If fixed costs for Tierson are equal to $880,000 annually and variable costs are $10 per unit, what is the contribution margin per unit for Tierson Corporation? A $0.05 B $20.00 C $44.00 D $

42 SU 8.2 CVP Analysis Basic Calculations Question 2 Answer Correct Answer: B The breakeven point in units is equal to the fixed costs divided by the contribution margin per unit. Thus, the UCM is $20.00 ($880,000 44,000 units). 42

43 SU 8.2 CVP Analysis Basic Calculations Question 3 A manufacturer contemplates a change in technology that would reduce fixed costs from $800,000 to $700,000. However, the ratio of variable costs to sales will increase from 68% to 80%. What will happen to breakeven level of revenues? A Decrease by $301, B Decrease by $500,000. C Decrease by $1,812,500. D Increase by $1,000,

44 SU 8.2 CVP Analysis Basic Calculations Question 3 Answer Correct Answer: D The original breakeven level was: Breakeven point = Fixed costs Contribution margin ratio = $800,000 (1.0.68) = $2,500,000 The new level is: Breakeven point = Fixed costs Contribution margin ratio = $700,000 (1.0.80) = $3,500,000 Thus, there is an increase of $1,000,000 ($3,500,000 $2,500,000). 44

45 SU 8.3 CVP Analysis Target Income Calculations Target Operating Income Fixed costs + Target operating income UCM Target Net Income Fixed costs + Target net income / (1.0 tax rate) UCM Problem 15, 16 and 18 on page

46 Computing Sales (Dollars) for a Target Net Income To convert target net income to before-tax income, use the following formula: Before-tax income = Target net income 1 - tax rate 46

47 SU 8.3 CVP Analysis Target Income Calculations Question 1 The data below pertain to the forecasts of XYZ Company for the upcoming year. Total Cost Unit Cost Sales (40,000 units) $1,000,000 $25 Raw materials 160,000 4 Direct labor 280,000 7 Factory overhead: Variable 80,000 2 Fixed 360,000 Selling and general expenses: Variable 120,000 3 Fixed 225,000 Continued 47

48 SU 8.3 CVP Analysis Target Income Calculations Question 1 How many units does XYZ Company need to produce and sell to make a before-tax profit of 10% of sales? A. 65,000 units. B. 36,562 units. C. 90,000 units. D. 25,000 units. 48

49 SU 8.3 CVP Analysis Target Income Calculations Question 1 Answer Correct Answer: C Revenue minus variable and fixed expenses equals net income. If X equals unit sales, revenue equals $25X, total variable expenses equal $16X ($4 + $7 + $2 + $3), total fixed expenses equal $585,000 ($360,000 + $225,000), and net income equals 10% of revenue. Hence, X equals 90,000 units. $25X - $16X -$585,000 = $25X 10% 6.5X = $585,000 X = 90,000 units 49

50 SU 8.3 CVP Analysis Target Income Calculations Question 2 The data below pertain to the forecasts of XYZ Company for the upcoming year. Total Cost Unit Cost Sales (40,000 units) $1,000,000 $25 Raw materials 160,000 4 Direct labor 280,000 7 Factory overhead: Variable 80,000 2 Fixed 360,000 Selling and general expenses: Variable 120,000 3 Fixed 225,000 Continued 50

51 SU 8.3 CVP Analysis Target Income Calculations Question 2 Assuming that XYZ Company sells 80,000 units, what is the maximum that can be paid for an advertising campaign while still breaking even? A. $135,000 B. $1,015,000 C. $535,000 D. $695,000 51

52 SU 8.3 CVP Analysis Target Income Calculations Question 2 Answer Correct Answer: A The company will break even when net income equals zero. Net income is equal to revenue minus variable expenses and fixed expenses, including advertising. Thus, if X equals advertising cost, the equation is 80,000)($25) (80,000)($16) $585,000 X = 0 $2,000,000 $1,280,000 $585,000 X = 0 X = $135,000 52

53 SU 8.3 CVP Analysis Target Income Calculations Question 3 For one of its divisions, Buona Fortuna Company has fixed costs of $300,000 and a variable-cost percentage equal to 60% of its $10 per unit selling price. It would like to earn a pre-tax income of $90,000 per year from the division. How many units will Buona Fortuna have to sell to earn a pre-tax income of $90,000 per year? A 65,000 units. B C D 75,000 units. 77,250 units. 97,500 units. 53

54 SU 8.3 CVP Analysis Target Income Calculations Question 3 Answer Correct Answer: D Buona Fortuna s unit contribution margin is $4 ($10 unit price $6 unit variable cost). By treating desired profit as an additional fixed cost, the target unit sales can be calculated as follows: Target unit sales = (Fixed costs + Target operating income) UCM = ($300,000 + $90,000) $4 = 97,500 54

55 Computing a Multiproduct Break-Even Point The CVP formulas can be modified for use when a company sells more than one product. The unit contribution margin is replaced with the contribution margin for a composite unit. A composite unit is composed of specific numbers of each product in proportion to the product sales mix. Sales mix is the ratio of the volumes of the various products. 55

56 SU 8.4 CVP Analysis Multi-Product Calculations Multiple Products (or Services) S = FC + VC = Calculated Weighted Average Contribution Margin See example page

57 SU 8.4 CVP Analysis Multi-Product Calculations Choice of Product decisions When resources are limited companies have to choose which products to produce A breakeven analysis of the point where the same operating income or loss will result See example page

58 SU 8.4 CVP Analysis Multi-Product Calculations Special Orders (usually lower price than std.) The assumption are that idle capacity is sufficient to manufacture extra units of a special order. 58

59 SU 8.4 CVP Analysis Multi-Product Calculations Question 1 Moorehead Manufacturing Company produces two products for which the data presented to the right have been tabulated. Fixed manufacturing cost is applied at a rate of $1.00 per machine hour. The sales manager has had a $160,000 increase in the budget allotment for advertising and wants to apply the money to the most profitable product. The products are not substitutes for one another in the eyes of the company s customers. Per Unit XY-7 BD-4 Selling price $4.00 $3.00 Variable manufacturing cost Fixed manufacturing cost Variable selling cost Continued 59

60 SU 8.4 CVP Analysis Multi-Product Calculations Question 1 Suppose Moorehead has only 100,000 machine hours that can be made available to produce additional units of XY-7 and BD-4. If the potential increase in sales units for either product resulting from advertising is far in excess of this production capacity, which product should be advertised and what is the estimated increase in contribution margin earned? A Product XY-7 should be produced, yielding a contribution margin of $75,000. B Product XY-7 should be produced, yielding a contribution margin of $133,333. C Product BD-4 should be produced, yielding a contribution margin of $187,500. D Product BD-4 should be produced, yielding a contribution margin of $250,

61 SU 8.4 CVP Analysis Multi-Product Calculations Question 1 Answer Correct Answer: D The machine hours are a scarce resource that must be allocated to the product(s) in a proportion that maximizes the total CM. Given that potential additional sales of either product are in excess of production capacity, only the product with the greater CM per unit of scarce resource should be produced. XY-7 requires.75 hours; BD-4 requires.2 hours of machine time (given fixed manufacturing cost applied at $1 per machine hour of $.75 for XY-7 and $.20 for BD- 4). XY-7 has a CM of $1.33 per machine hour ($1 UCM.75 hours), and BD-4 has a CM of $2.50 per machine hour ($.50.2 hours). Thus, only BD-4 should be produced, yielding a CM of $250,000 (100,000 $2.50). The key to the analysis is CM per unit of scarce resource. Incorrect Answers: A: Product XY-7 actually has a CM of $133,333, which is lower than the $250,000 CM for product BD-4. B: Product BD-4 has a higher CM at $250,000. C: Product BD-4 has a CM of $250,

62 SU 8.4 CVP Analysis Multi-Product Calculations Question 2 Product A accounts for 75% of a company s total sales revenue and has a variable cost equal to 60% of its selling price. Product B accounts for 25% of total sales revenue and has a variable cost equal to 85% of its selling price. What is the breakeven point given fixed costs of $150,000? A $375,000 B $444,444 C $500,000 D $545,455 62

63 SU 8.4 CVP Analysis Multi-Product Calculations Question 2 Answer Correct Answer: B Using the relationship: sales = total variable costs + total fixed costs, the combined breakeven point can be calculated as follows: S = 0.75S(0.60) S(0.85) + $150,000 S = 0.45S S + $150,000 S S = $150, S = $150,000 S = $444,444 Incorrect Answers: A: This amount is based on the contribution margin of Product A only rather than a weighted average. C: This amount is based on half of the required sales at B s contribution margin. D: This amount is based on an unweighted average of the two contribution margins. 63

64 SU 8.4 CVP Analysis Multi-Product Calculations Question 3 Von Stutgatt International s breakeven point is 8,000 racing bicycles and 12,000 5-speed bicycles. If the selling price and variable costs are $570 and $200 for a racer, and $180 and $90 for a 5-speed respectively, what is the weighted-average contribution margin? A $100 B $145 C $179 D $202 64

65 SU 8.4 CVP Analysis Multi-Product Calculations Question 3 Answer Correct Answer: D Contribution margin equals selling price minus variable costs. The product contribution margins are: Racer: $570 $200 = $370 5-Speed: $180 $90 = $90 The sales mix is: Racer: 8,000 (8, ,000) = 40% 5-Speed: 12,000 (8, ,000) = 60% Multiply the CM by the sales mix for each product, and add the results. Weighted-average CM = ($370 40%) + ($90 60%) = $148 + $54 = $202 65

66 SU 8.4 CVP Analysis Multi-Product Calculations Question 3 Answer Incorrect Answers: A: The sales mix dictates how much of the total CM will come from sales of each product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-average CM. B: The sales mix dictates how much of the total CM will come from sales of each product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-average CM. C: The sales mix dictates how much of the total CM will come from sales of each product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the UCM for racers must be added to 60% of the UCM for 5-speeds to get the weighted-average CM. 66

67 SU 8.4 CVP Analysis Multi-Product Calculations Question 4 Catfur Company has fixed costs of $300,000. It produces two products, X and Y. Product X has a variable cost percentage equal to 60% of its $10 per unit selling price. Product Y has a variable cost percentage equal to 70% of its $30 selling price. For the past several years, sales of Product X have averaged 66% of the sales of Product Y. That ratio is not expected to change. What is Catfur s breakeven point in dollars? A $300,000 B $750,000 C $857,142 D $942,857 67

68 SU 8.4 CVP Analysis Multi-Product Calculations Question 4 Answer Correct Answer: D A helpful approach in a multiproduct situation is to make calculations based on the composite unit, i.e., 2 units of Product X and 3 units of Product Y (a 66% ratio). The selling price of this composite unit is $110 [(2 $10) + (3 $30)]. The UCM of the composite unit is $35 {[2 ($10 $6)] + [3 ($30 $21)]}. Consequently, the breakeven point in composite units is 8, ($300,000 FC $35 UCM), and the breakeven point in sales dollars is $942,857 (8, $110). Incorrect Answers: A: This amount equals the fixed costs. B: This amount assumes a 40% contribution margin ratio. C: This amount assumes a 35% contribution margin ratio. 68

69 SU 8.5 Marginal Analysis Accounting Costs vs. Economic Costs Accounting Costs = The total amount of money or goods expended in an endeavor. It is money paid out at some time in the past and recorded in journal entries and ledgers. The economic cost of a decision depends on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost differs from accounting cost because it includes opportunity cost. As an example, consider the economic cost of attending college. The accounting cost of attending college includes tuition, room and board, books, food, and other incidental expenditures while there. The opportunity cost of college also includes the salary or wage that otherwise could be earning during the period. So for the two to four years an individual spends in school, the opportunity cost includes the money that one could have been making at the best possible job. The economic cost of college is the accounting cost plus the opportunity cost. Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost wages from not working during that period equals $25,000 dollars a year, then the total economic cost of going to college would be $180,000 dollars ($20,000 x 4 years + the interest of $20,000 for 4 years + $25,000 x 4 years). 69

70 SU 8.5 Marginal Analysis Explicit vs. Implicit Costs Implicit cost, also called an imputed cost, implied cost, or notional cost, is the opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor hires. An explicit cost is a direct payment made to others in the course of running a business, such as wage, rent and materials. 70

71 SU 8.5 Marginal Analysis Accounting vs. Economic Profit See Tutorial at Accounting Profit = book income exceeds book expenses Economic Profit = includes Accounting Profit + Implicit costs 71

72 SU 8.5 Marginal Analysis Marginal Revenue and Marginal Cost Marginal Revenue is the additional or incremental revenue of one additional unit of output. See page 321 See that Marginal Revenue is $540 between generating 4 vs. 5 units of output. Marginal Cost is the additional or incremental cost incurred of one additional unit of output. Note that while cost decrease over some range they will at some point begin to increase due to the process becoming lest efficient. Profit Maximization is where MR = MC See page

73 SU 8.5 Marginal Analysis Short-Run Cost Relationship See graph on page 323 Other considerations/applications of CVP Make-or-Buy Capacity Constraints and Product Mix Disinvestments Sell-or-Process further 73

74 SU 8.6 Short-Run Profit Maximization Pure Competition is a market structure in which a very large number of firms sell a standardized product into which entry is very easy in which the individual seller has no control over the product price and in which there is no non-price competition; a market characterized by a very large number of buyers and sellers. Examples : Agricultural products such as potatoes and wheat 74

75 SU 8.6 Short-Run Profit Maximization A Monopoly is a market structure in which one firm sells a unique product into which entry is blocked in which the single firm has considerable control over product price and in which non-price competition may or may not be found. Examples / Importance 1. Public utilities: gas, electric, water, cable TV, and local telephone service companies, are often pure monopolies. 2. First Data Resources (Western Union), Wham-O (Frisbees), and the DeBeers diamond syndicate are examples of "near" monopolies. (See Last Word.) 3. Manufacturing monopolies are virtually nonexistent in nationwide U.S. manufacturing industries. 4. Professional sports leagues grant team monopolies to cities. 5. Monopolies may be geographic. A small town may have only one airline, bank, etc. 75

76 SU 8.6 Short-Run Profit Maximization Monopolistic Competition is a market structure in which many firms sell a differentiated product into which entry is relatively easy in which the firm has some control over its product price and in which there is considerable non-price competition. Examples are grocery stores and gas stations 76

77 SU 8.6 Short-Run Profit Maximization Oligopoly is a market structure in which a few firms sell either a standardized or differentiated product into which entry is difficult in which the firm has limited control over product price because of mutual interdependence (except when there is collusion among firms) and in which there is typically non-price competition. 77

78 SU 8.6 Short-Run Profit Maximization Law of Demand states that all other things remaining unchanged, people demand (buy) more of any good / service if the price of that good / service falls and demand (buy) less if the price increases. Usually represented by a negatively-sloped demand curve which slows that the quantity demanded (quantity of a particular good people intending to buy) declines as price rises and increases as price rises. 78

79 SU 8.6 Short-Run Profit Maximization Elasticity of demand measures how responsive a products demand is to changes in its price level. When we have inelastic demand, a consumer will pay almost any price for the good. Elastic demand therefore means that demand for the product will vary when its price changes. Generally goods which have elastic demand tend to have many substitutes, so if the price of one good increases too much I will substitute out towards a similar good which is cheaper. 79

80 SU 8.6 Short-Run Profit Maximization Calculating Price elasticity of demand Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. There are a number of factors that can determine the price elasticity of demand for a good or service. For example, the demand for luxury items tend to be more elastic than the demand for necessities. For items that are essential, you tend to be less responsive to changes in price. An example of this would be the demand for diamonds tends to be more price elastic than the demand for electricity. Price elasticity of demand is also affected how large a percentage of your total income an item is. We tend to be more elastic in regards to price changes for items that make up a larger percentage of our incomes. For example, if the price of a pack of gum goes up by 10%, I probably wouldn't even notice. On the other hand, if the price of a car I'm considering purchasing goes up by 10%, I would definitely notice and I would probably reconsider the purchase. 80

81 SU 8.6 Short-Run Profit Maximization A third factor that influences the price elasticity of demand is the time frame allowed for response. We tend to be more responsive to changes in price in the long run than in the short run. For example, if the price of gas were to go up overnight to $10/gallon I would still have to put gas in my car tomorrow morning because I have to go to work and I have to go to school. But if the price of gas were to stay at $10/gallon for a year, then I have more options. I could move closer to work, start carpooling, or trade in my car for a hybrid with better gas mileage so that I don't have to buy as much gas. So in the long run, demand tends to be more elastic than in the short run. 81

82 SU 8.6 Short-Run Profit Maximization Price Elasticity Example Antoinette has a beauty salon. She services 100 customers per day. Her usual fee is $50. She wants to expand her business. If she lowers her price (gives everyone a coupon for $10 off), she expects to get an extra 10 customers per day. Calculate the price elasticity of demand. Did she make the correct decision? 82

83 SU 8.6 Short-Run Profit Maximization Price Elasticity Example Answer A) Percentage change in quantity demanded = 10% (100 customers increased to 110 customers) B) Percentage change in price = -20% ($50 reduced to $40) A/B = 10%/-20% = -0.5 The price elasticity of demand for this service is -0.5, and a price elasticity of demand less than 1 means that a good is inelastic, meaning that quantity demanded is relatively unresponsive to a change in price. So you could argue that she made the wrong decision, as the price decrease did not greatly affect demand. She might have been better choosing another strategy, such as better advertising or her services. You could also argue that she is reducing the price by 20% in return for a 10% increase in volume. 83

84 SU 8.6 Short-Run Profit Maximization Price Elasticity Defined A product with elasticity of 1.2 has elastic demand. What this means is that for every 1% rise in the price, demand will fall by 1.2% (similarly, a 1% fall in the price will lead to a 1.2% rise in demand). The rule is: Elasticity > 1 : elastic (% change in demand is greater than % change in price e.g. luxury goods such as cars etc.) Elasticity < 1 : inelastic (% change in demand is less than % change in price e.g. essential goods such as food) Elasticity = 1 : unitary elastic (% change in demand is equal to the % change in price) Basically a firm producing an inelastic good can increase revenue by raising the price, as the fall in demand is more than offset by the increased revenue on the remaining demand. 84

85 SU 8.6 Short-Run Profit Maximization Price Elasticity Defined Infinite or perfectly elastic - If it were perfectly elastic, demand would be infinite at all prices less than $3. A perfectly elastic demand graph is a vertical line. And, when the price is at $3, you can not tell from the graph what the demand is since the line is vertical. The demand could be at any value. Perfectly price inelastic - means that the quantity demanded will not change when price changes. Vertical demand curve Also, perfectly price elastic means if price changes, quantity demanded changes totally, Horizontal Demand Curve 85