CHAPTER 6

Financial Modeling
for Short-Term
PowerPoint Presentation by
LuAnn Bean Decision-Making
Professor of Accounting
Florida Institute of Technology

2012 Cengage Learning. All Rights Reserved. May

not be copied, scanned, or duplicated, in whole or in
part, except for use as permitted in a license
distributed with a certain product or service or
otherwise on a password-protected website for
classroom use.

Managerial Accounting 11E

Maher/Stickney/Weil 1

CHAPTER GOAL
This chapter explains and illustrates financial
modeling. Financial modeling can
Provide an overview of an organizations financial
activities
Help managers make specific decisions
Financial modeling relies on concepts of fixed
and variable cost behavior.

2
 LO 1

FINANCIAL MODEL

Financial modeling enables analysts to test

the interaction of economic variables in
a variety of settings. It requires analysts
to develop a set of equations that
represents a companys operating and
financial relations.

3
 LO 2

COST-VOLUME-PROFIT (CVP)

CVP can be used to answer questions such as

What effect on profit can GM expect if it builds a
larger SUV?
How will NBCs profit change if ratings increase
for its evening news program?
How many subscribers must a Dish Network
obtain to break even for the year?
What happens if Verizon reduces fees charged to
customers?

4
E LO 2
H
D EXAMPLE: Early Horizons Daycare
Early Horizons Daycare is a daycare center that defines a
unit of output as service provided for 1 child for a
month. Building capacity is 30 children. An accountant
developed the following estimates:

Price per child per month $ 600

Variable cost per child per month 200

Fixed costs per month 5,000

Continued
5
E LO 2
H
D CAPACITY and COSTS
Early Horizons Daycare has a capacity of 20
units (relevant range), after which it must hire
more staff.
Variable costs include
Snacks and food
Supplies
A portion of insurance
Fixed costs include:
Rent and utilities
A portion of insurance
Minimum staffing

6
 LO 2

BREAK-EVEN POINT: Definition

Is the point in the basic CVP

model where revenues equal
costs.
Total Revenue = Total Costs

7
E LO 2
H
D BREAK-EVEN: Table Format
Using break-even computations:

Sales Revenue (12.5 X $600) $ 7,500

Less Variable costs (12.5 X $200) 2,500

Contribution Margin (CM) $ 5,000

Less Fixed costs 5,000
Operating profit $ 0

8
 LO 2

CONTRIBUTION MARGIN:
Definition

Is the excess of revenue over

variable costs.
Total Revenue Variable Costs

9
E MANAGERS WANT TO KNOW! LO 2
H
D
Can we use
contribution margin
to compute break-
even (BE) volume?

YES!
BE Volume =
Fixed cost / CM per child

10
E LO 2
H CONTRIBUTION MARGIN
D
APPROACH
Using the contribution margin approach:

Break-even Volume = Fixed Costs / CM per child

= $5,000 / $400
= 12.5 children
Click the button to skip
equation approach

11
E LO 2
H
D EQUATION APPROACH
Using the equation approach (Operating profit at
break-even = 0):
Operating profit 0
= Sales revenue - Costs
= Sales revenue -Variable costs (VC) Fixed costs (FC)
= (Unit selling price (SP) Sales volume)
- (VC per unit Sales volume) - FC
($600 - $200) Sales volume = $5,000

Sales volumeBE = $5,000/$400 = 12.5 children/month

12
MANAGERS WANT TO KNOW! LO 2

Can we graph the

relationships in CVP
analysis?

YES!

13
E LO 2
H
D By graphing
revenues
and costs on
same graph,
you can
find BE,
profit and
loss areas.

Break-even Volume = Fixed Costs / CM

EXHIBIT 6.1
14
E LO 2
H
D

Slope of
line is
variable
cost per
unit.

Break-even Volume = Fixed Costs / CM

EXHIBIT 6.2
15
E LO 2
H
D TARGET PROFIT: CM Approach
Sales revenue (20*$600) $ 12,000
Less Variable costs (20*$200) 4,000
Contribution Margin $ 8,000
Less Fixed costs 5,000
Operating profit $ 3,000

Target profit Volume = (Fixed costs + Target Profit) / CM

= ($5,000 + $3,000) / $400

# children = 20

Continued
16
E LO 2
H
D TARGET PROFIT: Equation Approach
Sales revenue (20 X $600) $ 12,000
Less Variable costs (20 X $200) 4,000
Contribution Margin $ 8,000
Less Fixed costs 5,000
Operating profit $ 3,000

Sales revenue Variable costs - Fixed costs = Operating Profit

($600 - $200) Sales volume - $5,000 = $3,000
$400*Sales volume = $8,000
Sales volume = 20 children

Continued
17
E LO 3
H
D TARGET PROFIT: Reminder
Sales revenue (20 X $600) $ 12,000
Less Variable costs (20 X $200) 4,000
Contribution Margin $ 8,000
Less Fixed costs 5,000
Operating profit $ 3,000

Target profit Volume = (Fixed costs + Target Profit) / CM

Continued
18
E LO 3
H
D EARLY HORIZONS DAYCARE:
Sensitivity Analysis
Base Cost FC $500 VC $10 Price $60, Vol. 2
Assumptions Alt #1 Alt #2 Alt #3
Price/child $ 600 $ 600 $ 600 $ 660
VC/child $ 200 $ 200 $ 210 $ 200
Monthly FC $5,000 $4,500 $5,000 $5,000
EXHIBIT 6.3

Children enrolled 20 20 20 18
Model results: IS
Sales revenue $ 12,000 $ 12,000 $ 12,000 $ 11,880
Less VC 4,000 4,000 4,200 3,600
Total CM $8,000 $8,000 $7,800 $ 8,280
Less FC 5,000 4,500 5,000 5,000
Operating profit $3,000 $3,500 $2,800 $ 3,280
19
 LO 3

MARGIN OF SAFETY: Definition

Is the excess of projected (or

actual) sales units over Break-
even unit sales level.
Sales units BE Sales units or
Sales dollars BE Sales dollars

20
 LO 4

COST STRUCTURE: Definition

Refers to the proportion of fixed and
variable costs to total costs.

OPERATING LEVERAGE:
Definition

Is the extent to which an organizations

cost structure is made up of fixed costs.
Note: the higher the fixed costs, the higher the break-
even point. 21
 LO 4

What is the
contribution margin
ratio?

Contribution margin ratio

(CMR) is the contribution
amount per dollar of sales.
CM / Sales

22
E MANAGERS WANT TO KNOW! LO 6
H
D

How can a company

determine the effect of
taxes will be on its
profits?

After tax profits =

Before tax profits X (1 - tax
rate)

23
 LO 7

SUMMARY OF SIMPLIFYING CVP

ASSUMPTIONS
Can separate total costs into fixed and variable
Cost and revenue behavior is linear. Implies
the following in the relevant range
Total fixed costs do not change
Variable costs per unit remain constant
Selling price per unit remains constant
Product mix remains constant over relevant
range

24
E LO 8
H
D USING ABC FOR EHD

Previously, Early Horizons Daycare used

a financial model with only volume
(number of children) as the cost driver.
What if multiple cost drivers using the
cost hierarchy are identified and used?

25
 LO 8

HIERARCHY OF COSTS: Reminder

Activity Category Example
Capacity Size limitations Building size: 30 children

Customer Needs Children transported

Product Production needs Field trips

Batch Batch A room of 5 children

Unit Variable costs Child

26
E LO 8
H
D COST EQUATION

Total Cost =
(Unit-level cost #children) +
(Batch-level cost # rooms) +
(Product-level cost #field trips) +
(Customer-level cost #children transported) +
(Capacity-level costs #facilities)

Continued
27
E LO 8
H
D
EHD: ABC and Sensitivity Analysis
Increase Decrease
Base Case to 22 to 15
Sales $ 12,000 $ 13,200 $ 9,000

EXHIBIT 6.8
Unit-level costs 400 440 300
Batch-level costs 2,800 3,500 2,100
Product-level costs 300 300 300
Customer-level costs 800 800 500
Facility-level costs 4,700 4,700 4,700
Operating profits $ 3,000 $ 3,480 $ 1,100

28
End of CHAPTER 6

29