Chapter 10 - Cost Volume Profit Analysis

MC QUESTION: All of the following are assumptions of cost-volume profit analysis EXCEPT:

*Variable costs per unit change proportionately with volume (<-THIS IS INCORRECT). Instead, total variable costs changes with volume. Per unit variable cost DOES NOT change. Correct Assumptions: 1. Total fixed costs do not change with a change in volume. 2. Revenues charge proportionately with volume. 3. Sales mix for multi-period situations do not vary with volume changes.

Assumptions of CVP

-Cost and revenue relationships are predictable and linear. (these relationships are true over the relevant range of activity and specified time span) -Unit selling prices do not change. Inventory levels do not change (production = sales) Total variable costs change proportionally with volume, but unit variable cost do not change. Fixed costs remain constant over the relevant range of volume, but unit fixed costs vary indirectly with volume. Relevant range of volume may be based on the time frame being considered. The revenue (sales) mix does not change. Time value of money is ignored.

Short Run Profit maximization varies with the 4 Principal Market Types

1. Pure Competition 2. Monopoly 3. Monopolistic Competition 4. Oligopoly

1. Pure Competition

1. Pure Competition: marginal revenue = average revenue = market price. A firm in pure competition must accept the market price. *Large number of buyers and sellers acting independently and a standardized product (ex: agriculture commodities). Total revenue (TR) is a straight line with a constant positive slope. The price, marginal revenue, and average revenue curves are identical (horizontal line curve). The profit-maximizing quantity to produce is found at the point where the marginal cost curve crosses the marginal revenue. Short run profit maximization is achieved when MARGINAL REVENUE = MARGINAL COST. as long as the next unit of output adds more in revenue than in costs, the firm will increase total profit/decrease total losses.

MC QUESTION: Which of the following would cause a profitable company's margin of safety to decrease?

A decrease in sales units. Margin of safety - excess of budgeted sales over break-even sales; amount by which sales can decline before losses occur.

Cost Relationships in the Short Run

AFC- Average FIXED cost declines for as long as production increases. This is because the fixed amount of cost is being spread over more and more units. (always approaching the x-axis without every intersecting with it) AVC - Average VARIABLE cost declines quickly and then gradually begins increasing. ATC- Average total cost also declines quickly and then gradually begins to increase. General Statement: ATC = AFC + AVC *The distance between the ATC and the AVC curves is always the same as the distance between the AFC curve and the x-axis.*

Marginal Cost

Additional cost incurred by generating one additional unit of output. Typically, unit cost decreases for a while as the process becomes more efficient. Past a certain point, the process becomes LESS efficient and unit cost increases. While total cost increases gradually for a while, at some point it begins to increase SHARPLY. This is reflected in a decreasing, then increasing, marginal cost.

Marginal Revenue

Additional revenue produced by generating one additional unit of output. While total revenue keeps increasing with the sale of additional units, it increases by even smaller amounts. (reflected in a constantly decreasing marginal revenue)

3. Monopolistic Competition

An industry in monopolistic competition has a large number of firms that produce differentiated products. The number is fewer than in pure competition, but is great enough that firms cannot collude (this means they cannot act together to restrict output and fix the price). To maximize profits in the short run, a firm produces at the level of output at which MR=MC.

4. Oligopoly

An oligopoly is an industry with a few large firms. Firms operating in an oligopoly are mutually aware and mutually interdependent. Their decisions as to price, advertising, are to a large extent dependent on the actions of other firms. Prices tend to be rigid (sticky) because of the interdependence among the firms. Ex: If one oligopolist lowers prices, sales will not increase because the other firms will lower prices. As a result, profits in the industry will decline because of the lower prices.

MC QUESTION: In order to avoid pitfalls in relevant-cost analysis, management should focus on:

Anticipated REVENUES and COSTS that differ for each alternative.

Break-Even Formulas to know for CMA

Break-even Point in UNITS: Total Fixed Cost/Contribution Margin Per Unit Break-even Point in SALES= Fixed Costs/Contribution Margin Ratio

Break-Even Sales for Multiple Products

Break-even in Sales Dollars = Fixed Costs/ Weighted Average contribution Margin Ratio Weight Average CMR = (Sales Mix x CM per unit) Break-even Units = Fixed Costs/Contribution margin per unit for a composite units *In a multiple product problem, the break-even point in total units varies with the SALES MIX . The break-even point in units will be lower when the proportion of high contribution margin items is greater. Break-even is higher when the proportion of low contribution margin items is greater. Break-even point depends on the SPECIFIC MIX OF THE PRODUCTS.

Contribution Margin Ratio

CMR = UCM/Unit Selling price OR CMR = Total contribution margin/total sales Breakeven point in dollars = Fixed Costs/CMR

Sunk Costs

Costs either paid or committed (not relevant to future decisions)

Sensitivity Analysis

Examines the effect of not achieving the original forecast or of changing an assumption.

Margin of Safety

Excess of budgeted sales over break-even sales. It is the amount by which sales can decline before losses occur. *Margin of Safety = Planned Sales - Break-even sales*

Profit Maximization

Firm's goal is to maximize profits, not revenues. *Profit is maximized at the output level where marginal revenue = marginal cost* Beyond this point, increasing production results in a level of costs SO HIGH that the total profit is diminished.

Relevant Cost

Future costs that will vary depending on action taken. Ex: costs that would only be incurred in a CERTAIN option. Relevant costs are different per alternative.

2. Monopoly

Industry consists of ONE firm and the product has no close substitutes. Marginal revenue is LESS than price. To increase sales of its product, a monopolist generally must LOWER its price. A monopolist's marginal revenue continuously decreases as it raises output. Past the point where MR = 0, the monopolist's total revenue begins to decrease. The monopolist has the power to set output at the level where profits are maximized (where marginal revenue = marginal cost). This is called "price searching".

Breakeven Point

Level of output at which total revenues equals total expenses. Point at which all fixed costs have been covered and operating income is 0.

Margin of Safety Formulas

Margin of Safety = Planned Sales - Break-even Sales Margin of Safety Ratio = Margin of Safety/Planned Sales

Mixed Costs

Mixed costs combine fixed and variable elements (ex: fixed rental fee + fee to each additional mile)

Contribution Margin

Sales Revenue -All Variable Costs (manufacturing and selling/administrative variable costs) = CONTRIBUTION MARGIN - All fixed costs = Operating Income Contribution Margin represents the amount left over to cover fixed costs.

Target Operating Income

Target Income In Units = (Fixed Costs + Target Operating Income) /Unit Contribution Margin UCM = Unit Sales Price - Unit variable cost *By treating target income as an additional fixed cost, CVP analysis can be applied* Target operating income in break-even analysis is ZERO.

Target Unit Volume

Target Unit Volume = (Fixed Costs) + [Target net income/ (1 - tax rate)]/ Unit Contribution Margin

MC QUESTION: What is the most important difference between a monopoly and a firm facing perfect competition?

The monopolist's marginal revenue is less than its price, while the competitive firm's marginal revenue equals its price. Monopolist must LOWER its price in order to increase quantity. Competitive firm must accept market price.

CVP Analysis and Breakeven Analysis

Tool for understanding the interaction of revenues with fixed and variable costs. CVP Analysis allows management to discern the probable effects of changes in sales volume, sales price, product mix, etc. CVP is used for planning but also to assist in determining whether to accept a special order.

Unit Contribution Margin

UCM = Unit Sales Price - Unit variable cost Breakeven point in units = Fixed Costs/UCM

Variable and fixed costs in the short run

Variable cost per unit remains constant (each unit is sold for the SAME AMOUNT) Variable cost in total varies directly with changes in volume (the more you produce, the higher your total costs are) Fixed cost per unit vary INDIRECTLY with the activity level; as units increases, fixed cost will decrease as it is spread out over more units) Fixed costs in total remain unchanged in the short run (cost is the same every month)

Choice of Product

When resources are limited, a company may produce only a single product. Break-even analysis is calculated by setting the break-even point formulas equal to one another.