cost-analysis

A manager should also understand the scalability of

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Unformatted text preview: is the margin of safety. This will give a manager valuable information as they plan for inevitable business cycles. A manager should also understand the scalability of the business. This refers to the ability to grow profits with increases in volume. Compare the income analysis for Leaping Lemming Corporation and Leaping Leopard Corporation: L EAPING LEMMING CORPORATION L EAPING LEOPARD CORPORATION Contribution-based Income Analysis for 20X1 Sales ( 5000 X $1,000) Variable costs ( 5,000 X $900) * Contribution margin Fixed costs Net income $5,000,000 4,500,000 $ 500,000 500,000 $ - Contribution-based Income Analysis for 20X1 100% Sales ( 5000 X $1,000) 90% Variable costs ( 5,000 X $400) 10% Contribution margin Fixed costs Net income $5,000,000 2,000,000 $3,000,000 3,000,000 $ - 100% 40% 60% Both companies “broke even” in 20X1. Which company would you rather own? If you knew that each company was growing rapidly and expected to double sales each year (without any change in cost structure), which company would you prefer? With the added information, you would expect the following outcomes for 20X2: L EAPING LEMMING CORPORATION L EAPING LEOPARD CORPORATION Contribution-based Income Analysis for 20X2 * Sales ( 10,000 X $1,000) Variable costs ( 10,000 X $900) Contribution margin Fixed costs Net income $10,000,000 9,000,000 $ 1,000,000 500,000 $ 500,000 Contribution-based Income Analysis for 20X2 100% Sales ( 10,000 X $1,000) 90% Variable costs ( 10,000 X $400) 10% Contribution margin Fixed costs Net income $10,000,000 4,000,000 6,000,000 3,000,000 $ 3,000,000 100% 40% 60% This analysis reveals that Leopard has a more scalable business model. Its contribution margin is high and once it clears its fixed cost hurdle, it will turn very profitable. Lemming is fighting a never ending battle; sales increases are met with significant increases in variable costs. Be aware that scalability can be a double-edged sword. Pull backs in volume can be devastating to companies like Leopard because the fixed cost burden can be consuming. Whatever the situation, managers need to be fully cognizant of the effects of changes in scale on the bottom-line performance. Download free ebooks at bookboon.com 24 Sensitivity Analysis Cost Analysis 4. Sensitivity Analysis The only sure thing is that nothing is a sure thing. Cost structures can be anticipated to change over time. Management must carefully analyze these changes to manage profitability. CVP is useful for studying sensitivity of profit for shifts in fixed costs, variable costs, sales volume, and sales price. 4.1 Changing Fixed Costs Changes in fixed costs are perhaps the easiest to analyze. To determine a revised break-even level requires that the new total fixed cost be divided by the contribution margin. Let’s return to the example for Leyland Sports. Recall one of the original break-even calculations: Break-Even Point in Sales = Total Fixed Costs / Contribution Margin Ratio $2,000,000 = $1,200,000 / 0.60 If Leyland added a sales manager at a fixed salary of $120,000, the revised break-even would be: $2,200,000 = $1,320,000 / 0.60 Please click the advert In this case, the fixed cost increased from $1,200,000 to $1,320,000, and sales must reach $2,200,000 to break even. This increase in break-even means that the manager needs to produce at least $200,000 of additional sales to justify their post. We will turn your CV into an opportunity of a lifetime Do you like cars? Would you like to be a part of a successful brand? We will appreciate and reward both your enthusiasm and talent. Send us your CV. You will be surprised where it can take you. Send us your CV on www.employerforlife.com Download free ebooks at bookboon.com 25 Sensitivity Analysis Cost Analysis 4.2 Changing Variable Costs In recruiting the new sales manager, Leyland became interested in an aggressive individual who was willing to take the post on a “4% of sales” commission-only basis. Let’s see how this would change the breakeven point: Break-Even Point in Sales = Total Fixed Costs / Contribution Margin Ratio $2,142,857 = $1,200,000 / 0.56 This calculation uses the revised contribution margin ratio (60% - 4% = 56%), and produces a lower break-even point than with the fixed salary ($2,142,857 vs. $2,200,000). But, do not assume that a lower break-even defines the better choice! Consider that the lower contribution margin will “stick” no matter how high sales go. At the upper extremes, the total compensation cost will be much higher with the commission-based scheme. Following is a graph of commission cost versus salary cost at different levels of sales. You can see that the commission begins to exceed the fixed salary at any point above $3,000,000 in sales. In fact, at $6,000,000 of sales, the manager’s compensation is twice as high if commissions are paid in lieu of the salary! What this analysis cannot tell you is how an individual will behave. The sales manager has more incentive to perform, and the added commission may be just the ticket. For example, the company will...
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This note was uploaded on 06/07/2013 for the course BA 201 taught by Professor Cuongvu during the Fall '13 term at RMIT Vietnam.

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