At a fixed salary it is hard to predict how well the

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Unformatted text preview: make more at $6,000,000 in sales than at $3,000,000 in sales, even if the sales manger is paid twice as much. At a fixed salary, it is hard to predict how well the manager will perform, since pay is not tied to performance. You have probably marveled at the salaries of some movie stars and professional athletes. Rest assured that some serious CVP analysis has gone into the contract negotiations for these celebrities. For example, how much additional revenue must be generated by a movie to justify casting a high Download free ebooks at 26 Sensitivity Analysis Cost Analysis dollar movie star (versus using a low-cost unknown actor)? And, you have probably read about deals where musicians get a percentage of the revenue from ticket sales and concessions at a concert. These arrangements are likely based on detailed calculations; what may seem foolish is actually quite logical in terms of a comprehensive CVP analysis. 4.3 Blended Cost Shifts Sometimes, a business will contemplate changes in fixed and variable costs. For example, an airline is considering the acquisition of a new jet. The new jet entails a higher fixed cost for the equipment, but is more fuel efficient. The proper CVP analysis requires that the new fixed cost be divided by the new unit contribution margin to determine the new break-even level. Such analysis is important to evaluate whether an increase in fixed costs is justified. To illustrate, assume Flynn Flying Service currently has a jet with a fixed operating cost of $3,000,000 per year, and a contribution margin of 30%. Flynn is offered an exchange for a new jet that will cost $4,000,000 per year to operate, but produce a 50% contribution margin. Flynn is expecting to produce $9,000,000 in revenue each year. Should Flynn make the deal? The answer is yes. The break-even point on the old jet is $10,000,000 of revenue ($3,000,000/0.30), while the new jet has an $8,000,000 break-even ($4,000,000/0.50). At $9,000,000 of revenue, the new jet is profitable while continuing to use the old jet will result in a loss. 4.4 Per Unit Revenue Shifts Thus far, the discussion has focused on cost structure and changes to that structure. Another approach to changing the contribution margin is via changes in per unit selling prices. So long as these adjustments are made without impacting fixed costs, the results can be dramatic. Let’s return to Leaping Lemming, and see how a 10% increase in sales price would impact the contribution margin and profitability for 20X2. L EAPING LEMMING CORPORATION Income Analysis for 20X2 at Alternative Pricing * Sales ( 10,000 units) Variable costs ( 10,000 X $900) Contribution margin Fixed costs Net income $1,000 per unit scenario $10,000,000 9,000,000 $ 1,000,000 500,000 $ 500,000 $1,100 per unit scenario $11,000,000 9,000,000 $ 2,000,000 500,000 $ 1,500,000 Notice that this 10% increase in price results in a doubling of the contribution margin and a tripling of the net income. Bingo: the solution to increasing profits is to raise prices while maintaining the existing cost structure -- if it were only this easy! Customers are sensitive to pricing and even a small increase can drive customers to competitors. Before raising prices, a company must consider the “price elasticity” of demand for its product. This is fancy jargon to describe the simple reality that demand for a product will drop as its price rises. Download free ebooks at 27 Sensitivity Analysis Cost Analysis So, the real question for Leaping Lemming is to assess how much volume drop can be absorbed when prices are increased. The appropriate analysis requires dividing the continuing fixed costs (plus target or current net income) by the revised unit contribution margin; this results in the required sales (in units) to maintain the current level of profitability. For Lemming to achieve a $500,000 profit level at the revised pricing level, it would need to sell 5,000 units: Units to Achieve a Target Income = (Total Fixed Costs + Target Income) / Contribution Margin Per Unit 5,000 Units = ($500,000 + $500,000) / $200 If Lemming sells at least 5,000 units at $1,100 per unit, it will make at least as much as it would by selling 10,000 units at $1,000 per unit. The unknown is what customer response will be to the $1,100 pricing decision. Many a business has fallen prey to the presumption that they could raise prices with impunity; others have scored homeruns by getting away with such increases. 4.5 Margin Beware Some contracts provide for “cost plus” pricing, or similar arrangements that seek to provide the seller with an assured margin. These agreements are intended to allow the seller a normal and fair profit margin, and no more. However, they can have unintended consequences. Let’s evaluate an example. Pioneer Plastics sells trash bags to Heap Compacting Service. Heap and Pioneer have entered into an agreement that provides Pioneer with a contribution margin of 20% on 1,000,000 bags. Please click the advert Budget-Friendly....
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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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