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CHAPTER

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CHAPTER Ch 03_Morse.qxd 4/22/05 6:08 PM Page 70 3 Cost-Volume-Profit Analysis and Planning ■ LEARNING OBJECTIVES

3 Cost-Volume-Profit Analysis and Planning

LEARNING OBJECTIVES

COST STRUCTURE AND FIRM PROFITABILITY

After completing this chapter, you should be able to:

LO1

Identify the uses and limitations of traditional cost-volume-profit analysis.

The slowing of commercial activity and technology invest- ments in the early 2000s radically altered the income pro- jections of many firms. These economic changes and their resulting impacts demonstrate a valuable managerial lesson about the impact of cost structure on profitability. Managers at firms such as Inktomi, Microsoft, Yahoo, Cisco Systems, Amazon.com, and Webvan spent heavily on new product development in years leading up to the down- turn of the early 2000s. These investments financed projects such as software development, new hardware technologies, Internet marketing, Web site development, and automated warehouses. The investments generated additional produc- tive and service capacity, but their cost structures were dom- inated by high fixed costs. These fixed costs resulted from both the need to maintain the technology supporting exist- ing systems and the investment necessary to develop the next generation of hardware and software. In an expanding market, managers take advantage of fixed costs to generate profitable growth since additional

LO2

Prepare and contrast contribution and functional income statements.

LO3

Apply cost-volume-profit analysis to find a break-even point and for preliminary profit planning.

LO4

Analyze the profitability of a multiple-product firm with a constant sales mix.

LO5

Apply operating leverage ratio to assess opportunities for profit and the risks of loss.

LO6

Analyze the profitability of organizations that operate with unit and nonunit cost drivers.

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03_Morse.qxd 4/22/05 6:08 PM Page 71 Photomondo/Getty Images customers do not add much additional costs. In

customers do not add much additional costs. In this case, a cost structure dominated by fixed costs is a smart managerial decision. In an unstable or declining economy, however, a high fixed-cost structure is harmful. Just as adding new customers does not markedly increase costs when a firm has a high fixed- cost structure, reducing the number of customers does not lower costs very much. For example, as sales declined at Ink- tomi—a developer of software to manage Web content—prof- its fell sharply. High fixed cost structures are profitable when sales grow but result in rapid deterioration of profits when sales decline. The online grocer Webvan is a striking case of the rela- tion between cost, volume, and profit. With $1 billion of fi- nancing, Webvan’s well-respected management team em- barked on a strategy to use automated warehouses to service customers. These high fixed-cost fulfillment centers held the promise of substantial profitability, but only if Webvan could reach a high customer volume level. Other online grocery firms

adopted strategies requiring less technology and more labor in the fulfillment process. Since labor costs are variable rather than fixed, rival firms would break even at about 40 percent of the customer volume that Webvan required to break even. Although Webvan supporters correctly stated that it would be much more profitable than its rivals once the firm had covered its costs, sales never reached that level. When Webvan ceased operations after exhausting its financing, an observer commented that while demand does exist for an on- line, home-delivery grocery business, management must use great care in deciding its business model and cost structure. High fixed costs can yield huge profits in the right cir- cumstances. Yet, the recent experiences of some firms illus- trate that such cost structures have some inherent risks. The relations among possible cost structures, potential volumes, and opportunities for profit provide a conceptual basis for profitability analysis and planning. This is the focus of this chapter. [Source: Business Week, The Wall Street Journal, 10-K Reports.] 1

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Learning

Objective 1

Chapter 3: Cost-Volume-Profit Analysis and Planning

T his chapter introduces basic approaches to profitability analysis and planning. We begin with an

approach that considers only unit-level cost drivers and conclude by incorporating nonunit cost

drivers. We consider single-product, multiple-product, service organizations, income taxes, and the

effects of cost structure on the relation between profit potential and the risk of loss.

PROFITABILITY ANALYSIS WITH UNIT COST DRIVERS

Profitability analysis involves examining the relationships between revenues, costs, and profits. Per- forming profitability analysis requires an understanding of selling prices and the behavior of activity cost drivers. (Activity cost driver is often referred to as cost driver when the context is clear that we are dis- cussing activity, rather than structural or organizational, cost drivers.) Profitability analysis is widely used in the economic evaluation of existing or proposed products or services. Typically, it is performed be- fore decisions are finalized in the operating budget for a future period. Paralleling our examination of cost behavior, we examine two approaches to profitability analysis.

1. A unit-level approach based on the assumption that units sold or sales dollars is the only activity cost driver.

2. A cost hierarchy approach that incorporates nonunit and unit-level activity cost drivers.

The traditional approach to profitability analysis, which considers only unit-level activity cost driv- ers, is identified as cost-volume-profit (CVP) analysis. It is a technique used to examine the relation- ships among the total volume of an independent variable, total costs, total revenues, and profits for a time period (typically a quarter or year). With CVP analysis, volume refers to a single unit-level activity cost driver, such as unit sales, that is assumed to correlate with changes in revenues, costs, and profits. Cost-volume-profit analysis is useful in the early stages of planning because it provides an easily understood framework for discussing planning issues and organizing relevant data. CVP analysis is widely used by for-profit as well as not-for-profit organizations. It is equally applicable to service, merchandis- ing, and manufacturing firms. In for-profit organizations, CVP analysis is used to answer such questions as these: How many pho- tocopies must the local Kinko’s produce to earn a profit of $80,000? At what dollar sales volume will Burger King’s total revenues and total costs be equal? What profit will General Electric earn at an an- nual sales volume of $30 billion? What will happen to the profit of Duff’s Smorgasbord if there is a 20 percent increase in the cost of food and a 10 percent increase in the selling price of meals? Research Shows 3-1 indicates how the concepts discussed in this and other chapters are important to the success of new businesses.

3-1 RESEARCH SHOWS

Want to Finance a New Business?

About 80 percent of all new businesses fail in the first five years. A major reason for their failure is the lack of equity financing. To obtain financing for a new business, it is necessary to show how the business will make a profit. Five simple steps to help convince cautious investors to risk funds in a new business follow:

1. Project start-up costs and operating budgets.

2. Project income statements.

3. Project cash flow statements.

4. Determine the business’s break-even point.

5. Develop “Plan B.”

The last step is important. Plan B includes “what if” statements offering solutions to potential problems. 2

In not-for-profit organizations, CVP analysis is used to establish service levels, plan fund-raising ac- tivities, and determine funding requirements. How many meals can the downtown Salvation Army serve with an annual budget of $600,000? How many tickets must be sold for the benefit concert to raise $20,000? Given the current cost structure, current tuition rates, and projected enrollments, how much money must Cornell University raise from other sources?

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Key Assumptions

CVP analysis is subject to a number of assumptions. Although these assumptions do not negate the use- fulness of CVP models, especially for a single product or service, they do suggest the need for further analysis before plans are finalized. Among the more important assumptions are:

1. All costs are classified as fixed or variable with unit level activity cost drivers. This assumption is most reasonable when analyzing the profitability of a specific event (such as a concert) or the profitability of an organization that produces a single product or service on a continuous basis.

2. The total cost function is linear within the relevant range. This assumption is often valid within a relevant range of normal operations, but over the entire range of possible activity, changes in efficiency are likely to result in a curvilinear cost function.

3. The total revenue function is linear within the relevant range. Unit selling prices are assumed constant over the range of possible volumes. This implies a purely competitive market for final products or services. In some economic models in which demand responds to price changes, the revenue function is curvilinear. In these situations, the linear approximation is accurate only within a limited range of activity.

4. The analysis is for a single product, or the sales mix of multiple products is constant. The sales mix refers to the relative portion of unit or dollar sales derived from each product or service. If products have different selling prices and costs, changes in the mix affect CVP model results.

5. There is only one activity cost driver—unit or dollar sales volume. The traditional unit-level approach of CVP analysis does not consider other types of cost drivers (batch, product, customer, and so forth). As seen in Chapter 2, this is a limiting assumption, especially in complex organizations with multiple products. Under such circumstances, it is seldom possible to represent the multitude of factors that drive costs for an entire organization with a single cost driver.

When applied to a single product (such as pounds of potato chips), service (such as the number of pages printed), or event (such as the number of tickets sold to a concert), it is reasonable to assume the single independent variable is the cost driver. The total costs associated with the single product, service, or event during a specific time period are often determined by this single activity cost driver. Although cost-volume-profit analysis is often used to understand the overall operations of an or- ganization or business segment, accuracy decreases as the scope of operations being analyzed increases. After introducing profitability analysis with only a single unit-level cost driver, we expand discussion of profitability analysis to include multiple unit-level cost drivers and, finally, a hierarchy of cost drivers.

Profit Formula

The profit associated with a product, service, or event is equal to the difference between total revenues and total costs as follows:

where

R Y

Profit

R

Total revenues

Y

Total costs

The revenues are a function of the unit sales volume and the unit selling price, while total costs for a time period are a function of the fixed costs per period and the variable costs of unit sales as follows:

where

R

Y

pX—— a bX

p

Unit selling price

a

Fixed costs

b

Unit variable costs

X

Unit sales

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74 Chapter 3: Cost-Volume-Profit Analysis and Planning

The equation for profit can then be expanded to include the above details of the total revenue and total cost equations as follows:

pX (a bX)

Given information on the selling price, fixed costs per period, and variable costs per unit, this formula is used to predict profit at any specified activity level. To illustrate, assume that Benchmark Paper Company’s only product is high-quality photocopy pa- per that it manufactures and sells to wholesale distributors at $8.00 per carton. Applying inventory min- imization techniques, Benchmark does not maintain inventories of raw materials or finished goods. In- stead, newly purchased raw materials are delivered directly to the factory, and finished goods are loaded directly onto trucks for shipment. Benchmark’s variable and fixed costs follow.

1. Direct materials refer to the cost of the primary raw materials converted into finished goods. Because the consumption of raw materials increases as the quantity of goods produced increases, direct materials represents a variable cost. Benchmark’s raw materials consist primarily of paper purchased in large rolls and packing supplies such as boxes. Benchmark also treats the costs of purchasing, receiving, and inspecting raw materials as part of the cost of direct materials. All together, these costs total $1.00 per carton of finished product.

2. Direct labor refers to wages earned by production employees for the time they spend working on the conversion of raw materials into finished goods. Based on Benchmark’s manufacturing procedures, direct labor represents a variable cost. These costs are $0.25 per carton.

3. Variable manufacturing overhead includes all other variable costs associated with converting raw materials into finished goods. Benchmark’s variable manufacturing overhead costs include the costs of lubricants for cutting and packaging machines, electricity to operate these machines, and the cost to move materials between receiving and shipping docks and the cutting and packaging machines. These costs equal $1.25 per carton.

4. Variable selling and administrative costs include all variable costs other than those directly associated with converting raw materials into finished goods. At Benchmark, these costs include sales commissions, transportation of finished goods to wholesale distributors, and the cost of processing the receipt and disbursement of cash. These costs amount to $0.50 per carton.

5. Fixed manufacturing overhead includes all fixed costs associated with converting raw materials into finished goods. Benchmark’s fixed manufacturing costs include the depreciation, property taxes, and insurance on buildings and machines used for manufacturing, the salaries of manufacturing supervisors, and the fixed portion of electricity used to light the factory. These costs total $5,000.00 per month.

6. Fixed selling and administrative costs include all fixed costs other than those directly associated with converting raw materials into finished goods. These costs include the salaries of Benchmark’s president and many other staff personnel such as accounting and marketing. Also included are depreciation, property taxes, insurance on facilities used for administrative purposes, and any related utilities costs. These costs equal $10,000.00 per month.

Benchmark’s variable and fixed costs are summarized here.

Variable Costs per Carton

 

Fixed Costs per Month

Manufacturing

 

Manufacturing overhead

 

$ 5,000.00

Direct materials

 

$1.00

Selling and administrative

10,000.00

. Manufacturing overhead

Direct labor

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0.25

1.25

$2.50

Total .

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$15,000.00

Selling and administrative

 

0.50

Total

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$3.00

The cost estimation techniques discussed in Chapter 2 can be used to determine many detailed costs. Least-squares regression, for example, might be used to determine the variable and monthly fixed amount of electricity used in manufacturing. Benchmark manufactures and sells a single product on a

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continuous basis with all sales to distributors under standing contracts. Therefore, it is reasonable to assume that in the short run, Benchmark’s total monthly cost function responds to a single cost driver, cartons sold. Combining all this information, Benchmark’s profit equation is:

Profit $8.00X ($15,000.00 $3.00X)

where

X cartons sold

Using this equation, Benchmark’s profit at a volume of 5,400 units is $12,000.00, computed as ($8.00 5,400) [$15,000.00 ($3.00 5,400)].

CONTRIBUTION AND FUNCTIONAL INCOME STATEMENTS

Contribution Income Statement

To provide more detailed information on anticipated or actual financial results at a particular sales vol- ume, a contribution income statement is often prepared. Benchmark’s contribution income statement for a volume of 5,400 units is in Exhibit 3-1. In a contribution income statement, costs are classi- fied according to behavior as variable or fixed, and the contribution margin (the difference between total revenues and total variable costs) that goes toward covering fixed costs and providing a profit is emphasized.

EXHIBIT 3-1

Contribution Income Statement

Learning

Objective 2

Benchmark Paper Company Contribution Income Statement For a Monthly Volume of 5,400 Cartons

Sales (5,400 Less variable costs Direct materials (5,400 Direct labor (5,400 $0.25) Manufacturing overhead (5,400 $1.25) Selling and administrative (5,400 $0.50)

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$ 5,400

$43,200

 

1,350

6,750

2,700

(16,200)

Contribution margin Less fixed costs Manufacturing Selling and administrative

 

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27,000

 

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5,000

 

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10,000

(15,000)

Profit

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$12,000

Functional Income Statement

Contrast the contribution income statement in Exhibit 3-1 with the income statement in Exhibit 3-2 (next page). This statement is called a functional income statement because costs are classified ac- cording to function (rather than behavior), such as manufacturing, selling, and administrative. This is the type of income statement typically included in corporate annual reports. A problem with a functional income statement is the difficulty of relating it to the profit formula in which costs are classified according to behavior rather than function. The relationship between sales volume, costs, and profits is not readily apparent in a functional income statement. Consequently, we emphasize contribution income statements because they provide better information to internal decision makers.

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EXHIBIT 3-2

Functional Income Statement

Benchmark Paper Company Functional Income Statement For a Monthly Volume of 5,400 Cartons

Sales (5,400 $8.00) . Less cost of goods sold

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$43,200

Direct materials (5,400 $1.00)

$ 5,400

. Variable manufacturing overhead (5,400 $1.25)

Direct labor (5,400 $0.25)

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1,350

6,750

Fixed manufacturing overhead

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5,000

(18,500)

. Less other expenses Variable selling and administrative (5,400 $0.50)

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Gross margin

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2,700

24,700

Fixed selling and administrative

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10,000

(12,700)

Profit .

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$12,000

Measures Using Contribution Margin

While the contribution income statement (shown in Exhibit 3-1) presents information on total sales revenue, total variable costs, and so forth, it is sometimes useful to present information on a per-unit or portion of sales basis.

Total

Per Unit

Ratio to Sales

Sales (5,400 units) Variable costs

 

$43,200

$8

1.000

(16,200)

(3)

(0.375)

Contribution margin

 

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27,000

$5

0.625

Fixed costs

 

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(15,000)

Profit

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$12,000

The per-unit information assists in short-range planning. The unit contribution margin is the difference between the unit selling price and the unit variable costs. It is the amount, $5.00 in this case, that each unit contributes toward covering fixed costs and earning a profit. The contribution margin is widely used in sensitivity analysis (the study of the responsiveness of a model to changes in one or more of its independent variables). Benchmark’s income statement is an eco- nomic model of the firm, and the unit contribution margin indicates how sensitive Benchmark’s income model is to changes in unit sales. If, for example, sales increase by 100 cartons per month, the increase in profit is readily determined by multiplying the 100-carton increase in sales by the $5 unit contribution margin as follows:

100 (carton sales increase) $5 (unit contribution margin) $500 (profit increase)

There is no increase in fixed costs, so the new profit level becomes $12,500 ($12,000 $500) per month. When expressed as a ratio to sales, the contribution margin is identified as the contribution mar- gin ratio. It is the portion of each dollar of sales revenue contributed toward covering fixed costs and earning a profit. In the abbreviated income statement above, the portion of each dollar of sales revenue contributed toward covering fixed costs and earning a profit is $0.625 ($27,000 $43,200). This is Benchmark’s contribution margin ratio. If sales revenue increases by $800 per month, the increase in profits is computed as follows:

$800 (sales increase) 0.625 (contribution margin ratio) $500 (profit increase)

The contribution margin ratio is especially useful in situations involving several products or when unit sales information is not available.

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BREAK-EVEN POINT AND PROFIT PLANNING

The break-even point occurs at the unit or dollar sales volume when total revenues equal total costs. The break-even point is of great interest to management. Until break-even sales are reached, the prod- uct, service, event, or business segment of interest operates at a loss. Beyond this point, increasing lev- els of profits are achieved. Also, management often wants to know the margin of safety, the amount by which actual or planned sales exceed the break-even point. Other questions of interest include the prob- ability of exceeding the break-even sales volume and the effect of some proposed change on the break- even point.

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Learning

Objective 3

Determining Break-Even Point

In determining the break-even point, the equation for total revenues is set equal to the equation for to- tal costs and then solved for the break-even unit sales volume. Using the general equations for total rev- enues and total costs, the following results are obtained. Setting total revenues equal to total costs:

Total revenues Total costs pX a bX

Solving for the break-even sales volume:

In words:

pX bX a (p b)X a X a/(p b)

Break-even unit sales volume

Fixed costs

Selling price per unit Variable costs per unit

Because the denominator is the unit contribution margin, the break-even point is also computed by di- viding fixed costs by the unit contribution margin:

Break-even unit sales volume

Fixed costs

Unit contribution margin

With a $5 unit contribution margin and fixed costs of $15,000 per month, Benchmark’s break-even point is 3,000 units per month ($15,000 $5). Stated another way, at a $5 per-unit contribution mar- gin, 3,000 units of contribution are required to cover $15,000 of fixed costs. With a break-even point of 3,000 units, the monthly margin of safety and expected profit for a sales volume of 5,400 units are 2,400 units (5,400 expected unit sales 3,000 break-even sales) and $12,000 (2,400 unit margin of safety $5 unit contribution margin), respectively.

Profit Planning

Establishing profit objectives is an important part of planning in for-profit organizations. Profit objec- tives are stated in many ways. They can be set as a percentage of last year’s profits, as a percentage of total assets at the start of the current year, or as a percentage of owners’ equity. They might be based on a profit trend, or they might be expressed as a percentage of sales. The economic outlook for the firm’s products as well as anticipated changes in products, costs, and technology are also considered in estab- lishing profit objectives. Before incorporating profit plans into a detailed budget, it is useful to obtain some preliminary information on the feasibility of those plans. Cost-volume-profit analysis is one way of doing this. By manipulating cost-volume-profit relationships, management can determine the sales volume

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3-1 WHAT’S HAPPENING

 

Niche Strategy and a Low Break-Even Point

The American, a Sunday-only newspaper for overseas Americans, operates with a small staff, a hand- ful of personal computers, and used furniture in low-cost facilities on Long Island. Once composed, the paper is electronically sent to Germany, where it is printed and distributed. At a relatively high price of $4, The American obtains most of its revenue from subscriptions rather than advertising. The Ameri- can succeeds by publishing on the one day of the week the Paris-based International Herald Tribune does not. While the Herald’s worldwide daily circulation is 190,000, the American’s Sunday circulation is just over 20,000. “We’re the beneficiaries of the on-line revolution,” observed newspaper founder Hersh Kestin. Given the size of the Herald’s market and The American’s 14,000-copy break-even point, “this was a no-brainer,” says Kestin. 3

corresponding to a desired profit. Management might then evaluate the feasibility of this sales vol- ume. If the profit plans are feasible, a complete budget might be developed for this activity level. The required sales volume might be infeasible because of market conditions or because the required volume exceeds production or service capacity, in which case management must lower its profit ob- jective or consider other ways of achieving it. Alternatively, the required sales volume might be less than management believes the firm is capable of selling, in which case management might raise its profit objective. Assume that Benchmark’s management desires to know the unit sales volume required to achieve a monthly profit of $18,000. Using the profit formula, the required unit sales volume is determined by set- ting profits equal to $18,000 and solving for X, the unit sales volume.

Profit

$18,000 $8X ($15,000 $3X)

Total revenues Total costs

Solving for X

$8X $3X $15,000 $18,000 X ($15,000 $18,000) $5 6,600 units

The total contribution must cover the desired profit as well as the fixed costs. Hence, the target sales volume required to achieve a desired profit is computed as the fixed costs plus the desired profit, all di- vided by the unit contribution margin.

Target unit sales volume

Fixed costs Desired profit Unit contribution margin

What’s Happening 3-1 considers CVP analysis for The American, a small newspaper whose strategic position focuses on a market niche. In contrast, What’s Happening 3-2 considers CVP analysis for Hewlett- Packard, a large manufacturer whose strategic position for personal computers focuses on cost leadership.

3-2 WHAT’S HAPPENING

 

HP’s High Volume, Low Price Break-Even Point

“The wealthiest 1 billion people in the world are pretty well served by IT companies,” says HP’s direc- tor of its e-inclusion program. “We’re targeting the next 4 billion.” The goal of e-inclusion is for HP to be the leader in satisfying a demand for simple and economical computer products for technology- excluded regions of the world. HP already derives 60 percent of its sales overseas, and it plans to build on these beachheads to develop what may be the greatest marketing frontier of the coming decades. With worldwide operations and a low selling price, the HP strategy combines high fixed costs and a low contribution margin, leading to a high break-even point. While the final payoff is unclear, one HP official observed, “You don’t get a harvest until you start planting.” 4

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Cost-Volume-Profit Graph

A cost-volume-profit graph illustrates the relationships among activity volume, total revenues, total

costs, and profits. Its usefulness comes from highlighting the break-even point and depicting revenue,

cost, and profit relationships over a range of activity. This representation allows management to view the relative amount of important variables at any graphed volume. Benchmark’s monthly CVP graph is

in Exhibit 3-3. Total revenues and total costs are measured on the vertical axis, with unit sales measured

on the horizontal axis. Separate lines are drawn for total variable costs, total costs, and total revenues. The vertical distance between the total revenue and the total cost lines depicts the amount of profit or loss at a given volume. Losses occur when total revenues are less than total costs; profits occur when total revenues exceed total costs.

EXHIBIT 3-3

Cost-Volume-Profit Graph*

Total

revenues

and

total

costs

$60,000

50,000

40,000

30,000

20,000

10,000

0

A Profit area B C D E Loss area 0 2,000 4,000 6,000 8,000 Unit
A
Profit
area
B
C
D
E
Loss
area
0
2,000
4,000
6,000
8,000
Unit sales

A:

Total revenues line; $8 per unit

D:

Variable costs line; $3 per unit

B:

Total costs line; $15,000 + $3 per unit

E:

Fixed costs; $15,000

C:

Break-even point; 3,000 units or $24,000

*The three lines are developed as follows:

1. Total variable costs line, D, is drawn between the origin and total variable costs at an arbitrary sales vol- ume. At 8,000 units, total variable costs are $24,000.

2. Total revenues line, A, is drawn through the origin and a point representing total revenues at some arbi- trary sales volume. At 8,000 units, Benchmark’s total revenues are $56,000.

3. Total cost line, B, is computed by layering fixed costs, $15,000 in this case, on top of total variable costs. This gives a vertical axis intercept of $15,000 and total costs of $39,000 at 8,000 units.

The total contribution margin is shown by the difference between the total revenue and the total variable cost lines. Observe that as unit sales increase, the contribution margin first goes to cover the fixed costs. Beyond the break-even point, any additional contribution margin provides a profit.

Profit-Volume Graph

In cost-volume-profit graphs, profits are represented by the difference between total revenues and total

costs. When management is primarily interested in the impact of changes in sales volume on profits and less interested in the related revenues and costs, a profit-volume graph is sometimes used. A profit- volume graph illustrates the relationship between volume and profits; it does not show revenues and costs. Profits are read directly from a profit-volume graph, rather than being computed as the difference

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between total revenues and total costs. Profit-volume graphs are developed by plotting either unit sales or total revenues on the horizontal axis. Benchmark’s monthly profit-volume graph, is presented in Exhibit 3-4. Profit or loss is measured on the vertical axis, and volume (total revenues) is measured on the horizontal axis, which intersects the vertical axis at zero profit. A single line, representing total profit, is drawn intersecting the vertical axis at zero sales volume with a loss equal to the fixed costs. The profit line crosses the horizontal axis at the break-even sales volume. The profit or loss at any volume is depicted by the vertical difference be- tween the profit line and the horizontal axis. The slope of the profit line is determined by the contribu- tion margin. The greater the contribution margin ratio or the unit contribution margin, the steeper the slope of the profit line.

EXHIBIT 3-4

Profit-Volume Graph $20,000 A 15,000 10,000 Profit Total area profit 5,000 B or 0 loss
Profit-Volume Graph
$20,000
A
15,000
10,000
Profit
Total
area
profit
5,000
B
or
0
loss
$20,000
$40,000
(5,000)
Loss
area
(10,000)
(15,000)
Total revenues

A:

Total profit or loss line

B:

Break-even point; $24,000

$60,000

The profit line is drawn by determining and plotting profit or loss at two different volumes and then draw- ing a straight line through the plotted values. Perhaps the easiest values to select are the loss at a volume of zero (with a loss equal to the fixed costs) and the volume at which the profit line crosses the horizontal axis (this is the break-even volume).

Impact of Income Taxes

Income taxes are imposed on individuals and for-profit organizations by government agencies. The amount of an individual’s or organization’s income tax is determined by laws that specify the calcula- tion of taxable income (the income subject to tax) and the calculation of the amount of tax on taxable income. Income taxes are computed as a percentage of taxable income, with increases in taxable income usually subject to progressively higher tax rates. The laws governing the computation of taxable income differ in many ways from the accounting principles that guide the computation of accounting income. Consequently, taxable income and accounting income are seldom the same. In the early stages of profit planning, income taxes are sometimes incorporated in CVP models by assuming that taxable income and accounting income are identical and that the tax rate is con- stant. Although these assumptions are seldom true, they are useful for assisting management in de- veloping an early prediction of the sales volume required to earn a desired after-tax profit. Once man- agement has developed a general plan, this early prediction should be refined with the advice of tax experts. Assuming taxes are imposed at a constant rate per dollar of before-tax profit, income taxes are com- puted as before-tax profit multipled by the tax rate. After-tax profit is equal to before-tax profit minus income taxes.

After-tax profit Before-tax profit (Before-tax profit Tax rate)

After-tax profit can also be expressed as before-tax profit times 1 minus the tax rate.

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After-tax profit Before-tax profit (1 Tax rate)

This formula can be rearranged to isolate before-tax profit as follows:

Before-tax profit

After-tax profit (1 Tax rate)

81

Since all costs and revenues in the profit formula are expressed on a before-tax basis, the most straight- forward way of determining the unit sales volume required to earn a desired after-tax profit is to:

1. Determine the required before-tax profit.

2. Substitute the required before-tax profit into the profit formula.

3. Solve for the required unit sales volume.

To illustrate, assume that Benchmark is subject to a 40 percent tax rate and that management de- sires to earn an after-tax profit of $18,000 for November 2007. The required before-tax profit is $30,000 ($18,000 [1 0.40]), and the unit sales volume required to earn this profit is 9,000 units ([$15,000 $30,000] $5). Income taxes increase the sales volume required to earn a desired after-tax profit. A 40 percent tax rate increased the sales volume required for Benchmark to earn a profit of $18,000 from 6,600 to 9,000 units. These amounts are verified in Exhibit 3-5.

EXHIBIT 3-5

Contribution Income Statement with Income Taxes

 

Benchmark Paper Company Contribution Income Statement Planned for the Month of November 2007

 

Sales (9,000 $8.00). Less variable costs Direct materials (9,000 Direct labor (9,000 $0.25) Manufacturing overhead (9,000 $1.25) Selling and administrative (9,000 $0.50)

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$ 9,000

$72,000

 

2,250

11,250

4,500

(27,000)

Contribution margin Less fixed costs Manufacturing Selling and

 

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45,000

 

5,000

10,000

(15,000)

. Income taxes ($30,000

Before-tax

profit.

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30,000

(12,000)

100%

(40)%

After-tax

profit.

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$18,000

60%

Another way to remember the computation of before-tax profit is shown on the right side of Exhibit 3-5. The before-tax profit represents 100 percent of the pie, with 40 percent going to income taxes and 60 percent remaining after taxes. Working back from the remaining 60 percent ($18,000), we can determine the 100 percent (before-tax profit) by dividing after-tax profit by 0.60.

MULTIPLE-PRODUCT COST-VOLUME-PROFIT ANALYSIS

Unit cost information is not always available or appropriate when analyzing cost-volume-profit rela- tionships of multiple-product firms. Assuming the sales mix is constant, the contribution margin ratio (the portion of each sales dollar contributed toward covering fixed costs and earning a profit) can be

Learning

Objective 4

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82 Chapter 3: Cost-Volume-Profit Analysis and Planning

used to determine the break-even dollar sales volume or the dollar sales volume required to achieve a desired profit. Treating a dollar of sales revenue as a unit, the break-even point in dollars is computed as fixed costs divided by the contribution margin ratio (the number of cents from each dollar of revenue contributed to covering fixed costs and providing a profit).

Dollar break-even point

Fixed costs

Contribution margin ratio

If unit selling price and cost information were not available, Benchmark’s dollar break-even point could be computed as $24,000 ($15,000 0.625). Corresponding computations can be made to find the dollar sales volume required to achieve a de- sired profit as follows.

Target dollar sales volume

Fixed costs Desired profit Contribution margin ratio

To achieve a desired profit of $12,000, Benchmark needs sales of $43,200 ([$15,000 $12,000]

0.625).

These relationships can be graphed by placing sales dollars, rather than unit sales, on the horizon- tal axis. The slope of the variable and total cost lines, identified as the variable cost ratio, presents vari- able costs as a portion of sales revenue. It indicates the number of cents from each sales dollar required to pay variable costs. What’s Happening 3-3 demonstrates how CVP information can be developed from the published financial statements of a multiple-product firm. The effect of changes in the sales mix of multiple-product firms is considered in Appendix 3A to this chapter.

3-3 WHAT’S HAPPENING

 

CVP Analysis Using Financial Statements

Condensed data from Wal Mart’s 2002 and 2003 income statements ($ millions) follow:

 

2003

2002

 

Revenues

$231,577

$205,823

Operating Expenses

(218,282)

(194,244)

Operating Income

$ 13,295

$ 11,579

We can determine Wal Mart’s cost-volume-profit relations by applying the high-low cost estimation method. First, we determine variable costs as a portion of each sales dollar as follows ($ million):

 

Variable cost ratio

$218,282 $194,244 $231,577 $205,823

0.93337

Next, annual fixed costs are determined by subtracting the variable costs for either period (the prod- uct of revenues and the variable cost ratio) from the corresponding total costs.

Annual fixed costs $218,282 ($231,577 0.93337) $2,135.074 million

The contribution margin ratio (1 minus the variable cost ratio) is 0.0663 (1 0.93337). Wal Mart’s an- nual break even point in sales dollars is now computed as $32,203.227 million ($2,135.074 mil-

lion/0.0663).

In 2004 Wal Mart reported an operating income of $15,025 million with revenues of $258,681 million. For this level of revenues, the model developed from 2002 and 2003 data predicts an op- erating profit of $15,100.85 ($258,681 million [($258,681 million 0.93337) 2,135.074 mil- lion]). In this case, because of it’s stable cost structure, the model error is less than one percent.

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ANALYSIS OF OPERATING LEVERAGE

Operating leverage refers to the extent that an organization’s costs are fixed. The degree of operating leverage is computed as the contribution margin divided by before-tax profit as follows.

83

Learning

Objective 5

Degree of operating leverage

Contribution margin

Before-tax profit

The rationale underlying this computation is that as fixed costs are substituted for variable costs, the con- tribution margin as a percentage of income before taxes increases. Hence, a high degree of operating leverage signals the existence of a high portion of fixed costs. As noted in Chapter 1 and illustrated in Exhibit 1-5, the shift from labor-based to automated activities has resulted in a decrease in variable costs and an increase in fixed costs, producing an increase in operating leverage. Operating leverage is a measure of risk and opportunity. Other things being equal, the higher the degree of operating leverage, the greater the opportunity for profit with increases in sales. Conversely, a higher degree of operating leverage also magnifies the risk of large losses with a decrease in sales.

Operating Leverage

 

High

Low

Profit opportunity with sales increase

High

Low

Risk of loss with sales decrease

High

Low

Research Shows 3-2 considers the importance of reducing financial leverage during periods of economic stress. To illustrate, assume that Benchmark Paper Company competes with High-Fixed Paper Company. Information for both companies at a monthly volume of 4,000 units follows:

Benchmark

High-Fixed

Unit selling

$

8.00

$

8.00

Unit variable

(3.00)

(1.50)

Unit contribution margin

$

5.00

$

6.50

Unit sales

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4,000

4,000

Contribution

 

$20,000

$26,000

Fixed costs

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(15,000)

(21,000)

Before-tax profit

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$ 5,000

$ 5,000

Contribution

 

$20,000

$26,000

Before-tax profit

 

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5,000

5,000

Degree of operating

 

4.0

5.2

Although both companies have identical before-tax profits at a sales volume of 4,000 units, High-Fixed has a higher degree of operating leverage and its profits vary more with changes in sales volume. If sales increase by 12.5 percent, from 4,000 to 4,500 units, the percentage of increase in each firm’s profits can be computed as the percent change in sales multiplied by the degree of operating leverage.

3-2 RESEARCH SHOWS

Lower Operating Leverage When in Crisis

Bankruptcy experts recommend that companies facing sales declines take proactive measures to reduce their operating leverage and the associated risks. If the erosion in market size is permanent, firms must reduce facilities and equipment, and the reductions must be permanent. What’s more, to reduce the associated risk of insolvency, firms with high operating leverage should not rely heavily on borrowed funds to acquire property, plant, and equipment assets. 5

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Chapter 3: Cost-Volume-Profit Analysis and Planning

 
 

Increase in

sales .

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Benchmark

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12.5%

High-Fixed

12.5%

 

. Degree of operating leverage

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4.0

 

5.2

 

Increase in

profits .

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50.0%

 

65.0%

 

We can verify this by multiplying each firm’s unit contribution margin by the increase in unit sales.

   

Benchmark

High-Fixed

 

Unit contribution margin

 

$ 5.00

$ 6.50

Unit change in sales

 

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500

500

Change in

profit .

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$2,500

$3,250

Percent increase from $5,000

 

50%

 

65%

 

Management is interested in measures of operating leverage to determine how sensitive profits are

to

changes in sales. Risk-adverse managers strive to maintain a lower operating leverage, even if this re-

sults in some loss of profits. One way to reduce operating leverage is to use more direct labor and less automated equipment. Another way is to contract outside organizations to perform tasks that could be done internally. This approach to reducing operating leverage is further considered in Chapter 4, where we examine the external acquisition of goods and services. While operating leverage is a useful analytic tool, long-run success comes from keeping the overall level of costs down, while providing customers with the products or services they want at competitive prices.

PROFITABILITY ANALYSIS WITH UNIT AND NONUNIT COST DRIVERS

 

Learning

A

major limitation of cost-volume-profit analysis and the related contribution income statement is

Objective 6

the exclusive use of unit-level activity cost drivers. Even when multiple products are considered,

the CVP approach either restates volume in terms of an average unit or in terms of a dollar of sales volume. Additionally, CVP analysis does not consider other categories of cost drivers. As we saw

in Chapter 2, when cost estimation is limited to unit-level cost drivers while actual costs follow an

activity cost hierarchy, there is a high probability of significant errors in cost estimation and cost prediction. We now expand profitability analysis to incorporate nonunit cost drivers. While the addition of multiple levels of cost drivers makes it difficult to develop graphical relationships (illustrating the im- pact of cost driver changes on revenues, costs, and profits), it is possible to modify the traditional con- tribution income statement to incorporate a hierarchy of cost drivers. The expanded framework is not only more accurate, but it encourages management to ask important questions concerning costs and profitability.

Multi-Level Contribution Income Statement

To illustrate the use of profitability analysis with unit and nonunit cost drivers, consider General Distri- bution, a multiple-product merchandising organization with the following cost hierarchy:

Unit-level activities Cost of goods sold Order-level activities Cost of processing order Customer-level activities Mail, phone, sales visits, recordkeeping, etc. Facility-level costs Depreciation, manager salaries, insurance, etc

$0.80 per sales dollar

$20 per order

$200 per customer per year

$120,000 per year

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85

Assume that General Distribution, which is subject to a 40 percent income tax rate, has the follow- ing plans for the year 2007:

Sales

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$3,000,000

Number of sales orders

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3,200

Number of customers

 

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400

While General Distribution’s plans could be summarized in a functional income statement, we have previously considered the limitations of such statements for management. Contribution income state- ments are preferred because they correspond to the cost classification scheme used in CVP analysis. In

this case, General Distribution’s cost structure (unit level, order level, customer level, and facility level) does not correspond to the classification scheme used in traditional contribution income statements (vari- able and fixed). The problem occurs because traditional contribution income statements consider only unit-level cost drivers. When a larger set of unit and nonunit cost drivers is used for cost analysis, an expanded contribution income statement should be used for profitability analysis.

A multi-level contribution income statement for General Distribution is presented in Exhibit 3-6.

Costs are separated using a cost hierarchy and there are several contribution margins, one for each level of costs that responds to a short-run change in activity. In the case of General Distribution, the contri- bution margins are at the unit level, order level, and customer level. Because the facility-level costs do not vary with short-run variations in activity, the final customer-level contribution goes to cover facil- ity-level costs and to provide for a profit. If a company had a different activity cost hierarchy, it would use a different set of contribution margins.

EXHIBIT 3-6

Multi-Level Contribution Income Statement with Taxes

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General Distribution Multi-Level Contribution Income Statement For Year 2007 .

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. Less unit-level costs Cost of goods sold ($3,000,000 0.80)

Sales

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$3,000,000

(2,400,000)

Unit-level contribution margin

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600,000

Less order-level costs Cost of processing order (3,200 orders $20)

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(64,000)

Order-level contribution margin Less customer-level costs Mail, phone, sales visits, recordkeeping, etc.

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536,000

(400 customers $200)

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(80,000)

Customer-level contribution margin Less facility-level costs Depreciation, manager salaries, insurance, etc.

Before-tax profit

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456,000

(120,000)

336,000

. Income taxes ($336,000 0.40)

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(134,400)

After-tax profit

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$

201,600

A number of additional questions of interest to management can be formulated and answered using

the multi-level hierarchy. Consider the following examples:

Holding the number of sales orders and customers constant, what is the break-even dollar sales volume? The answer is found by treating all other costs as fixed and dividing the total nonunit-level costs by the contribution margin ratio. Here the contribution margin ratio indicates how many cents of each sales dollar is available for profits and costs above the unit level.

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86 Chapter 3: Cost-Volume-Profit Analysis and Planning

Unit-level break-even point in dollars with no changes in other costs

Current order- Current customer- Facility-

Contribution margin ratio

level costs

level costs

level costs

($64,000 $80,000 $120,000) (1 0.80) $1,320,000

What order size is required to break even on an individual order? Answering this question might help management to evaluate the desirability of establishing a minimum order size. To break even, each order must have a unit-level contribution equal to the order-level costs. Any additional contribution is used to cover customer- and facility-level costs and provide for a profit.

Break-even order size $20 (1 0.80) $100

What sales volume is required to break even on an average customer? Answering this question might help management to evaluate the desirability of retaining certain customers. Based on the preceding information, an average customer places 8 orders per year (3,200 orders 400 customers). With costs of $20 per order and $200 per customer, the sales to an average customer must generate an annual contribution of $360 ([$20 8] $200). Hence, the break-even level for an average customer is $1,800 ($360 [1 0.80]). Management might consider discontinuing relations with customers with annual purchases of less than this amount. Alternatively, they might inquire as to whether such customers could be served in a less costly manner.

The concepts of multi-level break-even analysis and profitability analysis are finding increasing use as companies such as Federal Express, US West, and Bank of America strive to identify profitable and unprofitable customers. At FedEx, customers are sometimes rated as “the good, the bad, and the ugly.” FedEx strives to retain the “good” profitable customers, turn the “bad” into profitable customers, and ig- nore the “ugly” who seem unlikely to become profitable. What’s Happening 3-4 describes the surpris- ing results of a customer profitability analysis performed by Standard Life Assurance.

3-4 WHAT’S HAPPENING

 

Profitability Analysis Reveals Unprofitable Customers

When it comes to sales, the traditional assumption is the more, the better. The same is true of big ad- vertising campaigns. But executives at Standard Life Assurance, Europe’s largest mutual life insurance company, were surprised to learn that a large advertising campaign was causing the company to load up on customers who held little or no profit potential. It seems that the direct mail campaign was en- couraging elderly couples and stay-at-home mothers to sign up for costly home visits by sales agents. Revenues were up, but the sales were to customers who, according to Standard’s database and statis- tics manager, “loved to sit down and have a cup of tea with someone.” These customers typically bought only one small policy. 6

Variations in Multi-Level Contribution Income Statement

Classification schemes should be designed to fit the organization and user needs. In Chapter 2, when analyzing the costs of a manufacturing company, we used a manufacturing cost hierarchy. While for- matting issues can seem mundane and routine, format is important because the way information is presented encourages certain types of questions while discouraging others. Hence, management ac- countants must inquire as to user needs before developing management accounting reports, just as users of management accounting information should be knowledgeable enough to request appropriate information and know whether the information they are receiving is the information they need. With computers to reduce computational drudgery and to provide a wealth of available data, the most im- portant issues involve identifying the important questions and presenting information to address those questions.

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87

In the case of General Distribution, we used a customer cost hierarchy with information presented in a single column. A multiple-column format is also useful for presenting and analyzing information. Assume that General Distribution’s managment believes that the differences between the government and private sector markets are such that these markets could be better served with separate marketing activities. They would have two market segments, one for the government sector and one for the private sector, giving the following cost hierarchy:

1. Unit-level activities

2. Order-level activities

3. Customer-level activities

4. Market segment activities

5. Facility-level activities

One possible way of presenting General Distribution’s 2008 multi-level income statement with two market segments is shown in Exhibit 3-7. The details underlying the development of this statement are not presented. In developing the statement, we assume the mix of units sold, their cost structure, and the costs of processing an order are unchanged. Finally, we present new market segment costs and assume that the addition of the segments allows for some reduction in previous facility-level costs.

EXHIBIT 3-7

Multi-Level Contribution Income Statement with Segments and Taxes

General Distribution Multi-Level Contribution Income Statement For Year 2008

 

Government

Private

Segment

Segment

Total

. Less unit-level costs Cost of goods sold (0.80)

Sales

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$1,500,000

(1,200,000)

$2,000,000

(1,600,000)

$3,500,000

(2,800,000)

Unit-level contribution margin Less order-level costs Cost of processing order (1,000 $20; 3,000 $20)

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300,000

(20,000)

400,000

(60,000)

700,000

(80,000)

Order-level contribution margin Less customer-level costs Mail, phone, sales visits, recordkeeping, etc.

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280,000

340,000

620,000

(150 $200, 300 $200)

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(30,000)

(60,000)

(90,000)

Customer-level contribution margin

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250,000

280,000

530,000