Cost-Volume-Profit Analysis

21 Aug No Comments

Cost-Volume-Profit Analysis

University of Phoenix, School of Business

ACC/561

Introduction

I was tasked with preparing an informal memo to address Mary’s suggested changes for a major promotional campaign. I will explain whether Mary’s changes should be adopted and analyze the information given. The compiled messages below are examples provided from the course textbook along with other outside sources.

Break-even Points and Margin of Safety Ratios

 
 =(270,000 / (40-24) ) = 16,875 pair of shoes 
       
 
 =[(270,000+24,000) / (38-24)] = 21,000 pair of shoes
       
 
 =[(20,000*40) – (16,875*40) / (20,000*40)] 
 =(125,000 / 800,000)   
 =16%    
       
 
 =[(24,000*38) – (21,000*38) / (24,000*38)] 
 =(114,000 / 912,000)   
 =13%    

Bargain Shoe Store

CVP Income Statement

 CurrentNew
Sales800,000912,000
Variable Expenses480,000576,000
Contribution margin320,000336,000
Fixed expenses270,000294,000
Net income/(Loss)50,00042,000

According to the break-even points in units and the margin of safety ratios, I believe Mary’s changes will not increase any profit. The comparison of the proposed break-even units are higher than current break-even units. Meaning it requires more units to cover the fixed cost, which is not good. Therefore, Mary’s changes should not be adopted due to the decrease in net income and increase in fixed cost. Increasing sales volume will trigger an increase in fixed costs per unit. As long as total fixed costs do not drop with decreasing sales, the amount of fixed costs applied to each unit will increase. This will result in higher unit costs, reducing the profit earned for each unit.

The above CVP analysis relies on the assumptions that costs are wither strictly fixed or strictly variable. Consistent with these assumptions, as volume decreased total costs decrease. It is important for Mary to understand that the gross profit margin and the contribution margin are not the same. The gross profit margin is the difference between sales and cost of goods sold. Cost of goods sold includes all costs; fixed costs and variable costs. The contribution margin only considers variable costs. Calculating both can give Mary valuable, but different, information.

As you can see, Mary’s campaign will have to sell at least 16,875 shoes in order to cover its fixed and variable costs. Anything it sells after the 16,875 mark will go straight to the CM since the fixed costs are already covered. For instance, if management decided to increase the sales price of the shoes, it would have a drastic impact on the number of units required to sell before profitability. They can also change the variable costs for each shoe by adding more automation to the production process. Lower variable costs equate to greater profits per unit and reduce the total number that must be produced. Outsourcing can also change the cost structure.

One of the most important concepts here is the margin of safety. That’s the difference between the number of units required to meet a profit goal and the required units that must be sold to cover the expenses. It’s the amount of sales the company can afford to lose but still cover its expenditures. It’s also important to keep in mind that all of these models reflect non-cash expense like depreciation. A more advanced break-even analysis calculator would subtract out non-cash expenses from the fixed costs to compute the break-even point cash flow level.

As the owner of a small business, Mary can see any decision she makes about pricing the product, the costs incurred in her business, and sales volume are interrelated. Calculating the breakeven point is just one component of cost-volume-profit analysis, but it’s often an essential first step in establishing a sales price-point that ensures a profit.




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