Ch6 (ptI)
What do companies w/ a higher proportion of FC have?
- Companies with a relatively higher proportion of fixed costs typically have higher degree of operating leverage risk, as compared with company that has lower proportion of fixed costs. - A company with high degree of operating leverage experience significant volatility in operating income from a relatively small change in sales volume.
What are the 3 ways to measure CM?
- Per unit - In total - Ratio Total CM = Total Sales Revenues - TVC Unit CM = Unit SP - Unit VC CM% = Unit CM/Unit SP CM% = Total CM/ Total Sales Revenues Important Note: CM% + VC% = 100% VC% = Unit VC/Unit SP VC% = Total VC/ Total Sales Revenues
To evaluate future risk and actual risk what is done?
- To evaluate the future risk at the time of planning operations, managers use the planned sales. - To evaluate actual risk when monitoring daily operations during the period, managers use the actual sales. This helps managers to monitor operations during the period and make appropriate corrections at the right time.
What does the value of DOL measure?
- the % Δ in NI that a company anticipates to experience for each 1% Δ in sales volume. Ex: if the DOL for a company is 3, this means that if this company expected sales is projected to increase 1% next period, then the company's NI will increase by 3% next period, and vice versa.
How is a CVP chart developed?
- we need to plot two straight lines: the first line represents the total revenue function and second line represents the total cost function.
What are the 4 ways MOS can be calculated?
1) MOS (in units) = Expected (or actual) sales (in units) - Sales at BE (in units) 2) MOS in ($) = Expected (or actual) sales (in dollars) - Sales at BE (in dollars) 3) MOS ratio ($) = MOS in $ / Total budgeted (actual) sales 4) MOS ratio (in units) = MOS in units / Total budgeted (actual) sales in units
What are the 2 common risk indicators provided by the CVP model?
1) Margin of Safety 2) Operating leverage
What are the equations representing the two functions?
1) Total Revenues (TR) =SP per unit x # of Units sold 2) Total Costs (TC) = FC + (VC per unit x # of Units sold)
Define margin of safety (MOS). How can it be computed?
the amount by which the actual or planned sales exceeds the BE point. In other words, it measures the extent to which sales can drop before profits become 0 & the company starts to incur losses - The MOS can be computed using either the actual or expected sales, depending on the purpose of using the measure
What happens when the cost structure of a company has a higher proportion of FC relative to VC?
the company is exposed to high operating leverage risk as measured by the DOL.
Explain contribution margin (CM)
the difference between Sales Revenues and Variable Costs. This amount is used first to cover the fixed costs. Then, the remaining amount (if any) generates the company's profit.
Define sensitivity analysis
the process of examining how the profit of the company will change in response to projected changes in one or more of the basic factors in the CVP model (i.e., selling price, variable cost per unit, fixed costs, or the target volume).
Define cost structure
the relative proportion of the FC & VC in its TC function. Managers usually have the opportunity to choose between FC & VC
How is the sensitivity analysis performed?
we simply replace the variables that are expected to change into the CVP equation, then solve for the unknown.
What are some common remarks & general conclusions on "what if" analysis?
1. An ↑ in FC will ↑ the BE point by the same ratio; and vice versa. 2. An ↑ in the VC per unit will ↓ the CM per unit and hence ↑ the BE point but not proportionately; & vice versa. 3. An ↑ in the SP per unit will ↑ the contribution margin per unit, and hence ↓ the BE point but not proportionately; & vice versa. 4. If the FC, SP per unit and VC per unit are all changed by the same % in the same direction, then the BE point will remain unchanged. 5. If the unit sales price and unit VC each increased by the same $ amount, then the unit CM remains unchanged and, thus, the BE point will not change. 6. If the unit sales price and unit VC both increased by the same %, the unit CM will ↑and the BE point to ↓. This result is because the SP per unit typically > the variable cost per unit.
What are some consequences of having high risk of operating leverage on CVP relations?
1. High operating leverage firms have relatively higher proportion of FC, lower proportion of VC, higher CM, and higher BEP. 2. High BEP entails Low margin of safety and more exposure to higher operating risk. 3. High risk implies that a given % Change in sales volume, the company will experience more extreme fluctuations on NI. In other words, high operating risk offers firms with greater opportunities for earning higher profits if sales volume ↑; but incurring more losses if sales volume ↓. On the other hand low operating leverage offers greater stability and protection from losses when sales ↓.
As a planning tool, the CVP model provides firm managers with answers the following two questions:
1. How many units of each product that a company should produce and/or sell next period to achieve the planned Target Profit? 2. How much is the total Sales/Service revenues (in Dollars) that a company should generate to achieve the planned Target Profit?
What should be noted w/ the functions?
1. The BE point is the point where the TC line intersects the TR line. At this point, the TR = TC resulting w/ zero profit. 2. Before the BE point, the TC > TR, and the TC line is above the revenue function. 3. If the company operates before (i.e., to the left of) the BE point, the company incurs losses. After the BE point, the TR > TC and TR line is above the total cost line. 4. If the company operates above (i.e., to the right of) the BE point, the company generates net profit. 5. The total profit (or loss) at any given sales volume is the vertical distance between the total revenue and total expense lines. 6. Every additional unit sold above the BE point increases total profit by an amount equals to the unit contribution margin. Similarly, every unit shortage (unsold) below the BE point increases total loss by the amount of the unit contribution margin
What are some important remarks of DOL?
1. The DOL is a factor or an amount that typically carries no label, such as a $ or %. Labeling DOL as 'times' is acceptable. 2. In isolation, the DOL does not provide much insight. However, as a comparison with prior periods or against other companies, the DOL enables managers & investors to evaluate a company's operating risk. 3. The lowest possible value for DOL is 1, which occurs only in the rare case of Zero fixed cost. In this case, the CM = NI = 1.
What are the underlying assumptions of CVP analysis?
1. The behavior of the cost function and the revenues function are linear within the relevant range of activity index. This implies that the price per unit, the variable cost per unit and the total fixed costs will not change as sales volume varies within the relevant range. 2. The selling prices, total fixed costs, and unit variable costs are known with certainty in advance and will remain unchanged during the period. 3. The number of units produced equals the number of units sold. This suggests that there no changes in the level of inventory during the period. 4. Efficiency and productivity of workers is constant. 5. If a firm sells multiple products, we assume that the sales mix of the various products is constant.
What should be noted in relation to taxed income?
1. To incorporate income tax into the analysis, the income tax rate has to be explicitly stated in the problem, otherwise we ignore income tax effects. 2. A change in the tax rate will have no effect on the firm's BE point. At the BE point, the firm has no profit and does not have to pay any income taxes.
Formula for % change in profit
= (DOL)(% change in sales)
What's the formula for X(units)?
= (FC + NI) / (SP-VC)
How does the CVP model relate to sensitivity analysis?
Given the uncertain nature of future business conditions, managers need to be prepared to make the necessary changes in the CVP model. One possible tool to accommodate unexpected changes in the various components of the CVP model is to perform "Sensitivity Analysis".
If the target net income, however, is stated in terms of the bottom line (i.e., net income after-tax), a minor adjustment should be made by converting the target income after-tax income to a net income before-tax figure as follows:
NI before Tax = (NI after tax) / (1 - Tax rate)
Define operating leverage risk exposure
The extent to which an organization uses fixed costs relative to the variable costs in its cost structure
What are some definitions to remember w/ the formulas?
X(units) = the number of units that should be produced and sold to achieve the desired level of profit X($) = the total sales revenues that should be generated to achieve the desired level of profit NI = the desired (target) profit SP = selling price per unit VC = variable cost per unit FC = Total Fixed Costs
What is the MOS ratio useful for?
a useful measure of comparing the relative risk among alternative products or for assessing the riskiness in any given product. A relatively low margin of safety ratio for a product is usually an indication that the product is riskier than higher margin of safety products.
Define Cost-Volume-Profit (CVP) model
a planning and decision-making model that analyzes the relationship between the firm cost structure (i.e., relative proportion of variable and fixed costs) and sales volume and examines the impact of this relationship on the firm profitability.
What does the CVP analysis assume?
assumes that SP per unit, VC cost per unit and TFC are constant and known with certainty at the beginning of the period. In the real-world, however, some of these variables are subject to changes during the period.
What are some examples of alternative cost structure decisions?
build up production capacity based on either labor-intensive approach (which depends heavily on manual workers) or capital intensive approaches (which depends heavily on machinery), renting vs. buying the firm's buildings or copy machines, compensating salespersons based on commission vs. fixed monthly salaries, etc
What is MOS usually viewed as?
is often viewed as "Cushion against Loss". The larger the MOS, the lower risk of reaching the BE point.
How is operating leverage risk measured?
measured by the Degree of Operating Leverage (DOL). DOL = CM / Operating income (NI) *The larger the number, the more risk
What is the minimum target income for any manager? In addition to the CVP model as a planning tool, what else is it used as?
minimum target income for any manager to achieve is to break-even. The breakeven point is the point at which the company makes Zero profit. CVP model is also used to help manager make short-term decision by analyzing the impact of changes in selling price, variable costs, fixed costs, and/or sales volume on the firm's profitability.