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More free books @ www.BingEbook.com Chapter 10: Analyzing Profit Behavior You don’t get too far in discussing raising sales price without bumping into a problem concerning variable operating expenses per unit. Most businesses have two types of variable operating expenses. Some vary with sales volume (the number of units sold) and some vary with sales revenue (the number of dollars from sales). For example, sales commissions depend on the dollar amount of sales. In contrast, packing and shipping costs depend on the number of units sold and delivered. Q. increase $3 per unit, which is 20 percent of the $15 sales price increase. So, the net gain in contribution margin per unit is only $12. Therefore, Suppose that Company B (see Figure 10-2 for its profit data) could increase its sales price $15 per unit and sell the same number of units. Assume Company B’s volume-driven variable operating expenses are $15 per unit sold, and its revenuedriven variable operating expenses are 20 percent of sales revenue. How would this $15 sales price increase affect its contribution margin per unit, total contribution margin, and operating profit? A. If the business raises sales price $15, its volume-driven expenses per unit remain the same, but its revenue-driven expenses 15. Suppose that Company B had to drop its sales price $10 due to competitive pressures. All other profit factors remain the same as shown in Figure 10-2. The company’s volume-driven variable expenses are $15 per unit sold, and its revenuedriven variable operating expenses are 20 percent of sales revenue. Determine Company B’s operating profit for this scenario. Also, how does this change affect the company’s breakeven sales volume? Solve It $12 net increase in contribution margin per unit × 50,000 units sales volume = $600,000 contribution margin increase Company B’s fixed operating expenses should remain the same (a sales price increase should have no bearing on a business’s fixed operating expenses). Therefore, the increase in contribution margin would increase the business’s operating profit $600,000. 16. Suppose that Company C increased its sales price $1.50. Sales volume remains the same as shown in Figure 10-2. The company’s revenue-driven variable operating expenses are 10 percent of sales revenue, and its volume-driven variable operating expenses are $0.40 per unit sold. Determine Company C’s operating profit for this scenario. Also, how does this change affect the company’s breakeven sales volume? Solve It 217 More free books @ www.BingEbook.com 218 Part III: Managerial, Manufacturing, and Capital Accounting Making Trade-Offs Among Profit Factors I used to regularly ask my students whether, as future business managers, they would drop sales prices 10 percent in order to increase sales volume 10 percent. Invariably, they would answer, “It depends.” Invariably, I would respond, “No, it doesn’t.” The answer is clear. Unless you’re willing to do anything to increase your market share, trading a 10 percent decrease in sales prices for a 10 percent increase in sales volume is dumb . . . and I mean really dumb. Q. Company B (see Figure 10-2) decides to analyze the impact that dropping its sales price 10 percent to gain a 10 percent increase in sales volume would have on its operating profit. What would Company B’s operating profit be in this scenario? A. The following comparative schedule shows just how devastating this trade-off would be on the company’s operating profit. Operating Profit Result from 10 Percent Sales Price Decrease in Exchange for 10 Percent Sales Volume Increase Sales price Product cost Variable operating expenses: Volume driven expenses Revenue driven expenses at 20% Contribution margin per unit Times Sales volume, in units Equals Total contribution margin Less Fixed Operating expenses Operating profit Before $300.00 $150.00 After $270.00 $150.00 $15.00 $60.00 $75.00 50,000 $3,750,000 $1,950,000 $1,800,000 $15.00 $54.00 $51.00 55,000 $2,805,000 $1,950,000 $855,000 Change ($30.00) ($6.00) ($24.00) 5,000 ($945,000) ($945,000) This comparative schedule shows that operating profit would decrease $945,000, which is a decrease of more than 50 percent of the amount before the trade-off. See why this trade-off is a bad idea? The only argument I got from my students, especially the marketing majors, was that a business may take such an action to gain market share. But that’s another argument. The accountant’s job is to calculate the precipitous drop-off in operating profit in this situation. The reason for the huge drop-off in operating profit is simple enough (although perhaps not immediately obvious). The 10 percent decrease in sales price causes contribution margin per unit to drop from $75 to $51 (see the preceding comparative schedule), which is a plunge of 32 percent in Company B’s contribution margin per unit ($24 decrease ÷ $75 contribution margin per unit before sales price decrease = 32 percent decrease). A paltry 10 percent increase in sales volume can’t make up for such a large drop in contribution margin per unit. More free books @ www.BingEbook.com Chapter 10: Analyzing Profit Behavior 17. Suppose that Company A (see Figure 10-1) were to offer all customers special rebates as a sales incentive. As a result, assume that sales price would decrease $10 per unit, but that annual sales volume would increase to 150,000 units. Assume that the company’s fixed operating expenses would not increase at the higher sales volume level (which may be stretching things a bit). Also assume that its variable operating expenses are all revenue-driven and equal to 15 percent of sales revenue. In terms of the impact on operating profit, would the rebate strategy to increase sales volume be a good trade-off for the company? Solve It 18. The example question in this section shows a scenario for Company B that involves a 10 percent reduction in sales price with a 10 percent increase in sales volume. According to the comparative schedule, it’s clear that a 10 percent sales volume increase isn’t nearly enough. Determine the sales volume level needed at the lower sales price to keep operating profit the same at $1,800,000. Solve It 219 More free books @ www.BingEbook.com 220 Part III: Managerial, Manufacturing, and Capital Accounting Answers to Problems on Analyzing Profit Behavior The following are the answers to the practice questions presented earlier in this chapter. a One of Company A’s marketing managers was overheard to comment, “If we had sold 10 percent more units than we did in the year, our profit would have been 10 percent higher.” Do you agree with this comment? (Figure 10-1 presents Company A’s operating profit report for the year.) Increasing sales volume 10 percent would have increased total contribution margin 10 percent, assuming that sales price, product cost, and variable operating expenses remained the same. So far the this answer is relatively straightforward. The next step concerns what would happen to the company’s total fixed operating expenses at the higher sales volume level. Fixed operating costs don’t increase with an increase in sales volume unless the increase in sales volume is relatively large such that the business would have to expand its capacity to accommodate the higher sales volume. Generally speaking, a business probably can take on a 10 percent sales volume increase without having to increase its capacity, at least in the short run. (Remember, an increase in capacity requires an increase in fixed operating expenses.) Assuming the company’s total fixed operating expenses would have been the same, all of the increase in total contribution margin would “fall down” to operating profit. Operating profit, therefore, would have increased more than 10 percent. The increase in total contribution margin is more than 10 percent of operating profit because operating profit is a smaller amount than the total contribution margin amount. b Instead of the scenario shown in Figure 10-1 assume that Company A had a bad year. The internal operating profit report for this alternative scenario is presented below. Using the three methods explained in this section, analyze why the business suffered a loss for the year. Refer to profit data for Company A at the end of the question in order to produce this answer. Analysis method #1: Contribution margin minus fixed costs Contribution margin per unit Times annual sales volume, in units $18.75 120,000 Equals total contribution margin $2,250,000 Less fixed operating expenses $3,000,000 Equals operating profit (loss) ($750,000) Analysis method #2: Shortfall below breakeven Annual sales volume for year, in units 120,000 Less annual breakeven volume, in units 160,000 Equals shortfall below breakeven, in units (40,000) Times contribution margin per unit Equals operating profit (loss) $18.75 ($750,000) Analysis method #3: Minimizing fixed costs per unit Contribution margin per unit $18.75 Less average fixed operating expenses per unit $25.00 Equals average profit (loss) per unit ($6.25) Times annual sales volume, in units Equals operating profit (loss) 120,000 ($750,000) More free books @ www.BingEbook.com Chapter 10: Analyzing Profit Behavior c Figure 10-2 presents profit performance information for two businesses for their most recent years. Using the three profit analysis methods explained in this section, analyze the profit performance of Company B. (You may note that both businesses in Figure 10-2 earned exactly the same amount of operating profit as the Company A business example for which I explain three profit analysis methods in this section. This similarity allows you to compare the key differences between businesses that earn the same profit.) Refer to profit data Figure 10-2 in order to produce this answer. Analysis method #1: Contribution margin minus fixed costs Contribution margin per unit $75 Times annual sales volume, in units 50,000 Equals total contribution margin $3,750,000 Less fixed operating expenses $1,950,000 Equals operating profit $1,800,000 Analysis method #2: Excess over breakeven Annual sales volume for year, in units 50,000 Less annual breakeven volume, in units 26,000 Equals excess over breakeven, in units 24,000 Times contribution margin per unit Equals operating profit $75 $1,800,000 Analysis Method #3: Minimizing fixed costs per unit Contribution margin per unit $75 Less average fixed operating expenses per unit $39 Equals average profit per unit $36 Times annual sales volume, in units Equals operating profit d 50,000 $1,800,000 Please refer to Figure 10-2. Using the three profit analysis methods explained in this section, analyze the profit performance of Company C. (You may note that both businesses in Figure 10-2 earned exactly the same amount of operating profit as the Company A business example for which I explain three profit analysis methods in this section. This similarity allows you to compare the key differences between businesses that earn the same profit.) Refer to profit data Figure 10-2 in order to produce this answer. Analysis method #1: Contribution margin minus fixed costs Contribution margin per unit Times annual sales volume, in units $3.20 1,500,000 Equals total contribution margin $4,800,000 Less fixed operating expenses $3,000,000 Equals operating profit $1,800,000 221 More free books @ www.BingEbook.com 222 Part III: Managerial, Manufacturing, and Capital Accounting Analysis method #2: Excess over breakeven Annual sales volume for year, in units 1,500,000 Less annual breakeven volume, in units 937,500 Equals excess over breakeven, in units 562,500 Times contribution margin per unit Equals operating profit $3.20 $1,800,000 Analysis Method #3: Minimizing fixed costs per unit Contribution margin per unit $3.20 Less average fixed operating expenses per unit $2.00 Equals average profit per unit $1.20 Times annual sales volume, in units Equals operating profit e 1,500000 $1,800,000 Assume the following: Company B’s Sources of Capital: Debt Owners’ equity Total capital $8,000,000 $4,000,000 $12,000,000 See Figure 10-2 for Company B’s operating profit data for the year. The business recorded $480,000 interest for the year. Calculate its financial leverage gain (or loss) for the year. In this case, debt holders provide two-thirds of the company’s total capital ($8 million of the total $12 million capital). Thus, two-thirds of its $1,800,000 operating profit can be attributed to the debt capital used by the business, which equals $1,200,000 (2⁄3 × $1,800,000 = $1,200,000). The company paid only $480,000 interest on its debt capital. So: $1,200,000 operating profit attributable to debt capital – $480,000 interest on debt capital = $720,000 financial leverage gain Here’s another way to calculate financial leverage gain: The company earned 15 percent return on capital ($1,800,000 operating profit ÷ $12,000,000 total capital = 15.0 percent return on capital). The company paid a 6 percent interest rate on its debt capital ($480,000 interest ÷ $8,000,000 debt = 6 percent interest rate). There’s a favorable 9 percent spread between the two rates. Therefore: 9 percent favorable spread between return on capital and interest rate × $8,000,000 debt = $720,000 financial leverage gain. f Assume the following: Company C’s Sources of Capital: Debt Owners’ equity Total capital $6,000,000 $6,000,000 $12,000,000 See Figure 10-2 for Company C’s profit data for the year. The business recorded $360,000 interest for the year. Calculate its financial leverage gain (or loss) for the year. More free books @ www.BingEbook.com Chapter 10: Analyzing Profit Behavior In this case, debt holders provide one-half of the company’s total capital ($6 million of the total $12 million capital). Thus, one-half of its $1,800,000 operating profit can be attributed to the debt capital used by the business, which equals $900,000 (1⁄2 × $1,800,000 = $900,000). The company paid only $360,000 interest on its debt capital. So: $900,000 operating profit attributable to debt capital – $360,000 interest on debt capital = $540,000 financial leverage gain g Suppose that Company B’s fixed operating expenses were $3,030,000 for the year. Otherwise, other profit factors are the same as in Figure 10-2. Using the sources of capital and interest expense presented in Question 5, calculate Company B’s financial leverage gain (or loss) for the year. For the year, Company B earned $3,750,000 total contribution margin (see Figure 10-2). If its fixed operating expenses were $3,030,000, its operating profit for the year would be only $720,000. Based on this operating profit, Company B’s return on capital would be only 6 percent ($720,000 ÷ $12,000,000 total capital = 6 percent return on capital). In this case, debt supplies two-thirds of total capital. Therefore, two-thirds of its $720,000 operating profit can be attributed to its debt capital, which is $480,000 ($720,000 operating profit × 2⁄3 = $480,000). The company paid $480,000 interest in the year. Thus, its financial leverage gain is zero. Here’s another way to calculate the company’s financial leverage gain/loss for the year: The business earned only 6 percent return on capital, and its interest rate on debt is 6 percent ($480,000 interest ÷ $8,000,000 debt = 6 percent). So, there’s no spread, or difference, between its 6 percent return on capital and its interest rate. Therefore, there’s no financial leverage gain (or loss). h Suppose that Company C’s fixed operating expenses were $4,440,000 for the year. Otherwise, other profit factors are the same as in Figure 10-2. Using the sources of capital and interest expense presented in Question 6, calculate Company C’s financial leverage gain (or loss) for the year. For the year, Company C earned $4,800,000 total contribution margin (see Figure 10-2). If its fixed operating expenses were $4,440,000, its operating profit for the year would be only $360,000. Based on this operating profit, the company’s return on capital would be a very low 3 percent ($360,000 ÷ $12,000,000 total capital = 3 percent return on capital) In this case, debt supplies one half of total capital. Therefore, one half of its $360,000 operating profit can be attributed to its debt capital, which is $180,000 ($360,000 operating profit × 1⁄2 = $180,000). The company paid $360,000 interest in the year. Thus, it has a financial leverage loss equal to $180,000. Here’s another way to calculate the company’s financial leverage loss for the year: The business earned only 3 percent return on capital, and its interest rate on debt is 6 percent ($360,000 interest ÷ $6,000,000 debt = 6.0 percent). So, there’s an unfavorable 3 percent spread between return on capital and interest rate. The company’s financial leverage loss for the year is $180,000 (3 percent unfavorable spread × $6,000,000 debt = $180,000 financial leverage loss for the year). i Suppose Company B sold 10 percent more units during the year than it did according to Figure 10-2. Determine Company B’s operating profit for this scenario. (Assume fixed operating expenses remain the same at the higher sales volume.) For Company B, selling 10 percent additional units equals 5,000 additional units sold. Given that its contribution margin per unit is $75, the increase in its total contribution margin is: 5,000 additional units × $75 contribution margin per unit = $375,000 increase in total contribution margin 223 More free books @ www.BingEbook.com 224 Part III: Managerial, Manufacturing, and Capital Accounting Because fixed operating expenses don’t increase at the higher sales volume level, the gain in total contribution margin increases operating profit $375,000. The 10 percent increase in sales volume increases operating profit 20.8 percent ($375,000 gain in operating profit ÷ $1,800,000 operating profit at the original sales volume level = 20.8 percent increase). The percent gain in operating profit is much larger than the percent increase in sales volume. This magnification effect is called operating leverage. j Suppose Company B sold 5 percent fewer units during the year than it did according to Figure 10-2. Determine Company B’s operating profit for this scenario. (Assume fixed operating expenses remain the same at the lower sales volume.) For Company B, selling 5 percent less units equals 2,500 fewer units sold. Given that its contribution margin per unit is $75, the decrease in its total contribution margin is: 2,500 fewer units × $75 contribution margin per unit = $187,500 decrease in total contribution margin Because fixed operating expenses don’t decrease at the lower sales volume level, the drop in total contribution margin decreases operating profit $187,500. The 5 percent decrease in sales volume decreases operating profit 10.4 percent ($187,500 fall in operating profit ÷ $1,800,000 operating profit at the original sales volume level = 10.4 percent decrease). The percent drop in operating profit is much larger than the percent decrease in sales volume. This magnification effect is called operating leverage. k Suppose Company C sold 5 percent more units during the year than it did according to Figure 10-2. Determine Company C’s operating profit for this scenario. (Assume fixed operating expenses remain the same at the higher sales volume.) For Company C, selling 5 percent additional units equals 75,000 additional units sold. Given that its contribution margin per unit is $3.20, the increase in its total contribution margin is: 75,000 additional units × $3.20 contribution margin per unit = $240,000 increase in total contribution margin Because fixed operating expenses don’t increase at the higher sales volume level, the gain in total contribution margin increases operating profit $240,000. The 5 percent increase in sales volume increases operating profit 13.3 percent ($240,000 gain in operating profit ÷ $1,800,000 operating profit at the original sales volume level = 13.3 percent increase). l Suppose Company C sold 10 percent fewer units during the year than it did according to Figure 10-2. Determine Company C’s operating profit for this scenario. (Assume fixed operating expenses remain the same at the lower sales volume.) For Company C, selling 10 percent less units equals 150,000 fewer units sold. Given that its contribution margin per unit is $3.20, the decrease in its total contribution margin is: 150,000 fewer units × $3.20 contribution margin per unit = $480,000 decrease in total contribution margin Because fixed operating expenses don’t decrease at the lower sales volume level, the drop in total contribution margin decreases operating profit $480,000. The 10 percent decrease in sales volume decreases operating profit 26.7 percent ($480,000 fall in operating profit ÷ $1,800,000 operating profit at the original sales volume level = 26.7 percent decrease). m Suppose that Company B was able to improve (lower) its product cost per unit $10. Assume that all other profit factors for Company B remain the same as shown in Figure 10-2. Determine its operating profit for this scenario. Also, how does this change affect the company’s breakeven sales volume? More free books @ www.BingEbook.com Chapter 10: Analyzing Profit Behavior The complete schedule of changes in this scenario is as follows: Sales price Product cost Variable operating expenses: Volume driven expenses Revenue driven expenses at 20% Contribution margin per unit Times Sales volume, in units Equals Total contribution margin Less Fixed Operating expenses Operating profit Before $300.00 $150.00 After $300.00 $140.00 $15.00 $60.00 $75.00 50,000 $3,750,000 $1,950,000 $1,800,000 $15.00 $60.00 $85.00 50,000 $4,250,000 $1,950,000 $2,300,000 Change ($10.00) + $10.00 + $500,000 + $500,000 As the schedule shows, operating profit increases $500,000, which is a 27.8 percent increase from a 6.7 percent change in product cost ($10 decrease ÷ $150 = 6.7 percent decrease). The company’s breakeven decreases because contribution margin per unit is higher than it was before the product cost change: $1,950,000 fixed operating expenses ÷ $85 contribution margin per unit = 22,941 units breakeven volume At the $75 contribution margin per unit, Company B’s breakeven volume is 26,000 units sales volume. n Suppose that Company C’s product cost increases $0.50 per unit. Assume that all other profit factors for Company C remain the same as shown in Figure 10-2. Determine its operating profit for this scenario. Also, how does this change affect the company’s breakeven sales volume? The impact on contribution margin and operating profit from the seemingly small increase in product cost is shown in the following comparative schedule: Before After Sales price $24.00 $24.00 Less Product cost $18.00 $18.50 $2.80 $2.80 Less Variable operating expenses: Equals Contribution margin per unit Times Sales volume, in units $3.20 $2.70 1,500,000 1,500,000 Change $0.50 ($0.50) Equals Total contribution margin $4,800,000.00 $4,050,000.00 ($750,000.00) Less Fixed Operating expenses $3,000,000.00 $3,000,000.00 Equals Operating profit $1,800,000.00 $1,050,000.00 ($750,000.00) So, operating profit drops $750,000, from $1,800,000 to only $1,050,000, which is a 41.7 percent decrease! The reason is the relatively large drop in contribution margin per unit, from $3.20 to only $2.70, which is a 15.6 percent decline. The importance of maintaining the contribution margin per unit cannot be overstated. If Company C’s product cost increases $0.50 per unit, the company’s breakeven also increases because contribution margin per unit is lower than it was before the product cost change: $3,000,000 fixed operating expenses ÷ $2.70 contribution margin per unit = 1,111,111 units breakeven volume At the $3.20 contribution margin per unit, the breakeven volume is 937,500 units sales volume. 225 More free books @ www.BingEbook.com 226 Part III: Managerial, Manufacturing, and Capital Accounting o Suppose that Company B had to drop its sales price $10 due to competitive pressures. All other profit factors remain the same as shown in Figure 10-2. The company’s volume-driven variable expenses are $15 per unit sold, and its revenue-driven variable operating expenses are 20 percent of sales revenue. Determine Company B’s operating profit for this scenario. Also, how does this change affect the company’s breakeven sales volume? The circumstances cause the company’s operating profit to decrease $400,000, as shown in the following schedule: Before After Change ($10) Sales price $300 $290 Less Product cost $150 $150 Volume driven expenses $15 $15 Revenue driven expenses at 20% $60 $58 ($2) $75 $67 ($8) 50,000 50,000 Equals Total contribution margin $3,750,000 $3,350,000 Less Fixed Operating expenses $1,950,000 $1,950,000 Equals Operating profit $1,800,000 $1,400,000 Less Variable operating expenses: Equals Contribution margin per unit Times Sales volume, in units ($400,000) ($400,000) If Company B’s sales price drops $10, the company’s breakeven increases because contribution margin per unit is lower than it was before the sales price change: $1,950,000 fixed operating expenses ÷ $67 contribution margin per unit = 29,104 units breakeven volume At the $75 contribution margin per unit, the breakeven volume is 26,000 units sales volume. p Suppose that Company C increased its sales price $1.50. Sales volume remains the same as shown in Figure 10-2. The company’s revenue-driven variable operating expenses are 10 percent of sales revenue, and its volume-driven variable operating expenses are $0.40 per unit sold. Determine Company C’s operating profit for this scenario. Also, how does this change affect the company’s breakeven sales volume? The circumstances cause the company’s operating profit to increase $2,025,000, as shown in the following schedule: Sales price Product cost Variable operating expenses: Volume driven expenses Revenue driven expenses at 10% Contribution margin per unit Times Sales volume, in units Equals Total contribution margin Less Fixed Operating expenses Operating profit Before $24.00 $18.00 After $25.50 $18.00 $0.40 $2.40 $3.20 1,500,000 $4,800,000 $3,000,000 $1,800,000 $0.40 $2.55 $4.55 1,500,000 $6,825,000 $3,000,000 $3,825,000 Change + $1.50 + $0.15 + $1.35 + $2,025,000 + $2,025,000 If Company C’s sales price increases $1.50, the company’s breakeven decreases because contribution margin per unit is higher than it was before the sales price change: $3,000,000 fixed operating expenses ÷ $4.55 contribution margin per unit = 659,341 units breakeven volume At the $3.20 contribution margin per unit, the breakeven volume is 937,500 units sales volume.