Marston corporation manufactures disposable thermometers

Chapter 5 Cost-Volume-Profit Relationships

LEARNING OBJECTIVES

After studying Chapter 5 , you should be able to:

· LO1 Explain how changes in activity affect contribution margin and net operating income.

· LO2 Prepare and interpret a cost-volume-profit (CVP) graph and a profit graph.

· LO3 Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net operating income resulting from changes in sales volume.

· LO4 Show the effects on net operating income of changes in variable costs, fixed costs, selling price, and volume.

· LO5 Determine the level of sales needed to achieve a desired target profit.

· LO6 Determine the break-even point.

· LO7 Compute the margin of safety and explain its significance.

· LO8 Compute the degree of operating leverage at a particular level of sales and explain how it can be used to predict changes in net operating income.

· LO9 Compute the break-even point for a multiproduct company and explain the effects of shifts in the sales mix on contribution margin and the break-even point.

BUSINESS FOCUS: Moreno Turns Around the Los Angeles Angels

When Arturo Moreno bought Major League Baseball's Los Angeles Angels in 2003, the team was drawing 2.3 million fans and losing $5.5 million per year. Moreno immediately cut prices to attract more fans and increase profits. In his first spring training game, he reduced the price of selected tickets from $12 to $6. By increasing attendance, Moreno understood that he would sell more food and souvenirs. He dropped the price of draft beer by $2 and cut the price of baseball caps from $20 to $7.

The Angels now consistently draw about 3.4 million fans per year. This growth in attendance helped double stadium sponsorship revenue to $26 million, and it motivated the Fox Sports Network to pay the Angels $500 million to broadcast all of its games for the next ten years. Since Moreno bought the Angels, annual revenues have jumped from $127 million to $212 million, and the team's operating loss of $5.5 million has been transformed to a profit of $10.3 million. ▪

Source: Matthew Craft, “Moreno's Math,” Forbes, May 11, 2009, pp. 84–87.

Cost-volume-profit (CVP) analysis is a powerful tool that helps managers understand the relationships among cost, volume, and profit. CVP analysis focuses on how profits are affected by the following five factors:

· 1. Selling prices.

· 2. Sales volume.

· 3. Unit variable costs.

· 4. Total fixed costs.

· 5. Mix of products sold.

Because CVP analysis helps managers understand how profits are affected by these key factors, it is a vital tool in many business decisions. These decisions include what products and services to offer, what prices to charge, what marketing strategy to use, and what cost structure to maintain. To help understand the role of CVP analysis in business decisions, consider the case of Acoustic Concepts, Inc., a company founded by Prem Narayan.

Prem, who was a graduate student in engineering at the time, started Acoustic Concepts to market a radical new speaker he had designed for automobile sound systems. The speaker, called the Sonic Blaster, uses an advanced microprocessor and proprietary software to boost amplification to awesome levels. Prem contracted with a Taiwanese electronics manufacturer to produce the speaker. With seed money provided by his family, Prem placed an order with the manufacturer and ran advertisements in auto magazines.

MANAGERIAL ACCOUNTING IN ACTION

The Issue

The Sonic Blaster was an almost immediate success, and sales grew to the point that Prem moved the company's headquarters out of his apartment and into rented quarters in a nearby industrial park. He also hired a receptionist, an accountant, a sales manager, and a small sales staff to sell the speakers to retail stores. The accountant, Bob Luchinni, had worked for several small companies where he had acted as a business advisor as well as accountant and bookkeeper. The following discussion occurred soon after Bob was hired:

Prem: Bob, I've got a lot of questions about the company's finances that I hope you can help answer.

Bob: We're in great shape. The loan from your family will be paid off within a few months.

Prem: I know, but I am worried about the risks I've taken on by expanding operations. What would happen if a competitor entered the market and our sales slipped? How far could sales drop without putting us into the red? Another question I've been trying to resolve is how much our sales would have to increase to justify the big marketing campaign the sales staff is pushing for.

Bob: Marketing always wants more money for advertising.

Prem: And they are always pushing me to drop the selling price on the speaker. I agree with them that a lower price will boost our sales volume, but I'm not sure the increased volume will offset the loss in revenue from the lower price.

Bob: It sounds like these questions are all related in some way to the relationships among our selling prices, our costs, and our volume. I shouldn't have a problem coming up with some answers.