Chapter 6 Lecture Notes

Cost-Volume-Profit Analysis (CVP) Overview

• CVP analysis examines how changes in cost and volume affect profit.

• Important for planning and maximizing profit.

Sales Mix Concept

• Sales mix defined as the proportion of various products sold.

• Example of sales mix: 2,000 units sold with 1,500 camcorders (75%) and 500 TVs (25%).

• Determining sales mix helps in calculating contribution margins for each product.

  • Contribution Margin: The selling price per unit minus variable costs per unit.

  • Weighted average unit contribution margin is calculated based on sales mix and individual contribution margins.

Breakeven Analysis with Multiple Products

• Need to analyze contribution margins for products when calculating breakeven point.

• If camcorders have a contribution margin of $200 and TVs $500:

  • Weighted average contribution margin = $275 (weighted based on sales mix).

  • Example breakeven scenario:

    • Fixed costs of $275,000.

    • Breakeven units = Fixed Costs / Weighted Average Contribution Margin.

    • 1,000 units at breakeven: 750 camcorders and 250 TVs.

Limited Resources and Profit Maximization

• Production often limited by factors like materials or machinery hours.

• Decision making shifts to maximize contribution margin per limited resource.

  • Example: Camcorders (0.2 hours per unit) vs. TVs (0.625 hours per unit).

    • Camcorders generate $1,000 contribution margin per hour vs. TVs at $800.

• Choose products to manufacture based on contribution margin per machine hour.

• Theory of Constraints:

  • Always constraints limiting production; identify and manage them effectively.

Operating Leverage Concept

• Examines fixed versus variable cost structure and its impact on profitability.

• Control over cost structure while planning:

  • Decisions on salaries versus commissions impact fixed/variable costs.

• Comparing companies:

  • NewWave has higher fixed cost, leading to higher contribution margins per sales dollar compared to Vargo.

  • Higher fixed costs imply more risk with higher operating leverage.

  • NewWave requires $650,000 in sales to break even; Vargo only needs $500,000.

• Margin of Safety Ratio:

  • Measures how sales can decline before hitting losses.

  • NewWave: 19% decline before loss; Vargo: 38% decline before loss.

Importance of Operating Leverage

• Higher operating leverage means greater sensitivity in net income to changes in sales revenue.

• Calculation of Operating Leverage = Contribution Margin / Net Income.

• NewWave's earnings can fluctuate significantly with sales changes compared to more stable Vargo.

• As sales increase, profits for firms with high operating leverage rise steeply and falls sharply when sales decrease.