Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
CMA Part 2 Financial Decision Making SU 8.1 – The Capital Budgeting Process • Capital budgeting is the process of planning and controlling investment for long-term projects. – Will affect the company for many accounting periods going forward – Relatively inflexible once made 2 SU 8.1 – The Capital Budgeting Process – Predicting the need for future capital assets is one of the more challenging tasks • Affected by – – – – Inflation Interest rates Cash availability Market demands – Production capacity is a key driver 3 SU 8.1 – The Capital Budgeting Process • Applications for capital budgeting – Buying equipment – Building facilities – Acquiring a business – Developing a product of product line – Expanding into new markets 4 SU 8.1 – The Capital Budgeting Process • Important to correctly forecast future changes in demand in order to have the correct capacity. • Planning is crucial to anticipate changes in capital markets, inflation, interest rates and money supply. • Consider the tax consequences. – All decisions should be done on an after tax basis 5 SU 8.1 – The Capital Budgeting Process • Costs considered in capital budgeting – Avoidable cost • May be eliminated by ceasing or improving an activity. – Common cost • Shared by all options and is not clearly allocable. – Deferrable cost • May be shifted to the future. – Fixed cost • Does not very within relevant range. – Imputed cost • May not have a specific cash outlay in accounting continued – Incremental cost • Difference in cost of two options. 6 SU 8.1 – The Capital Budgeting Process – Opportunity cost • Maximum benefit forgone based on next alternative, including that of the stockholders (which also establishes the firms hurdle rate). – Relevant cost • Vary with action. • Constant cost don’t affect decision. – Sunk cost • Cannot be avoided. – Weighted-average Cost of Capital • Weighted average of the interest cost of debt (net of tax) and the costs (implicit or explicit) of the components of equity capital to be invested in longterm assets. It is also the “hurdle rate”. 7 SU 8.1 – The Capital Budgeting Process • Stages in Capital Budgeting 1. Identification and definition • Identify the strategy • Define the projects – Revenue, costs, and cash flow – Most difficult stage 2. Search • Each investment to be evaluated be each function of the firms value chain. 8 SU 8.1 – The Capital Budgeting Process 3. Information-acquisition • Costs and benefits of the projects are enumerated • Quantitative financial factors have highest priority • Nonfinancial measures (quantitative and qualitative) 4. Selection • Increase shareholder value. NPV, IRR.. 5. Financing • Debt or equity 6. Implementation and monitoring • Feedback and reporting 9 SU 8.1 – The Capital Budgeting Process • Investment Ranking Steps – Determine Net Investment Costs • Gross cash requirement less cash recovered from trade or sale of existing assets, adjusted for taxes • Investment required includes funds to provide for increases in working capital, i.e. additional receivables and inventories. – Calculating estimated cash flows • • • • Capture increase in revenue, decrease costs Net cash-flow period by period from investment Economic life of the investment Depreciable life – Comparing cash-flows to Net Investment Costs • Evaluate the benefit – Ranking investments • NPV, IRR, Payback 10 SU 8.1 – The Capital Budgeting Process • Book Rate of Return = GAAP NI from Investment Book Value of Investment – Also called accrual accounting rate of return – Don’t use accrual accounting numbers, instead use cash flow • Net Income is affected by company’s choices of accounting methods – Also, do not compare project book rate to company’s book rate of return for investments which could be distorted 11 SU 8.1 – The Capital Budgeting Process • Relevant Cash Flows – Net initial investment • New equipment cost • Working capital requirements, • After tax disposals proceeds – Annual net cash flows • After tax cash collections for operations • Depreciation tax savings – Project termination cash flows • After tax disposal • Working capital recovery See example on page 309 12 SU 8.1 – The Capital Budgeting Process • Other Considerations – Inflation • Raises hurdle rate – Post-audits – Deterrent of bad projects. • • • • Actual to expected cash flow Identify sources of unrealistic estimates Avoid premature evaluations of projects Non-quantitative benefits 13 SU 8.1 – The Capital Budgeting Process Practice Question 1 The relevance of a particular cost to a decision is determined by A Riskiness of the decision. B Number of decision variables. C Amount of the cost. D Potential effect on the decision. 14 SU 8.1 – The Capital Budgeting Process Practice Question 1 Answer Correct Answer: D Relevance is the capacity of information to make a difference in a decision by helping users of that information to predict the outcomes of events or to confirm or correct prior expectations. Thus, relevant costs are those expected future costs that vary with the action taken. All other costs are constant and therefore have no effect on the decision. 15 SU 8.1 – The Capital Budgeting Process Practice Question 2 Lawson, Inc., is expanding its manufacturing plant, which requires an investment of $4 million in new equipment and plant modifications. Lawson’s sales are expected to increase by $3 million per year as a result of the expansion. Cash investment in current assets averages 30% of sales; accounts payable and other current liabilities are 10% of sales. What is the estimated total investment for this expansion? A $3.4 million. B $4.3 million. C $4.6 million. D $5.2 million. 16 SU 8.1 – The Capital Budgeting Process Practice Question 2 Answer Correct Answer: C The investment required includes increases in working capital (e.g., additional receivables and inventories resulting from the acquisition of a new manufacturing plant). The additional working capital is an initial cost of the investment, but one that will be recovered (i.e., it has a salvage value equal to its initial cost). Lawson can use current liabilities to fund assets to the extent of 10% of sales. Thus, the total initial cash outlay will be $4.6 million {$4 million + [(30% – 10%) × $3 million sales]}. 17 SU 8.1 – The Capital Budgeting Process Practice Question 3 What is the net cash outflow at the beginning of the first year that Dickins should use in a capital budgeting analysis? A $(170,000) B $(180,000) C $(192,000) D $(210,000) 18 SU 8.1 – The Capital Budgeting Process Practice Question 3 Answer Correct Answer: D Delivery and installation costs are essential to preparing the machine for its intended use. Thus, the company must initially pay $210,000 for the machine, consisting of the invoice price of $180,000, the delivery costs of $12,000, and the $18,000 of installation costs. 19 SU 8.2 – Risk Analysis and Real Options In Capital Investments • Risk analysis – Attempt to measure the variability of future returns from proposed investment. – Informal method – NPV is calculated and reviewed. – Risk-adjusted discount rates – Adjust rate of return upwards as project becomes more risky. – Certainty equivalent adjustments- from Utility theory – the point where you are indifferent to a choice between a certain sum of money and the expected value of a risky sum. – Simulation analysis – Computer is used to generate many results based upon various assumptions. • Pilot plants – Sensitivity analysis – An iterative process of recalculated returns based on changing assumptions. 20 SU 8.2 – Risk Analysis and Real Options In Capital Investments • Real (managerial or strategic) options – Value of a real option – The difference between the projects NPV with the option vs. without the option. • Usually more valuable the later it is exercised. – Types of real options: • • • • • • • Abandonment (Put option) Follow-up investment Wait and Learn (call option) Flexibility option – vary an input Capacity option – vary an output New geographical markets New product option – follow on products 21 SU 8.2 – Risk Analysis and Real Options In Capital Investments Question 1 Sensitivity analysis, if used with capital projects, A Is used extensively when cash flows are known with certainty. B Measures the change in the discounted cash flows when using the discounted payback method rather than the net present value method. C Is a “what-if” technique that asks how a given outcome will change if the original estimates of the capital budgeting model are changed. D Is a technique used to rank capital expenditure requests. 22 SU 8.2 – Risk Analysis and Real Options In Capital Investments Question 1 Answer Correct Answer: C After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis, which is a trial-and-error method used to determine the sensitivity of the estimates used. For example, forecasts of many calculated NPVs under various assumptions may be compared to determine how sensitive the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may drastically alter the NPV, suggesting that the risk of the investment may be excessive. 23 SU 8.2 – Risk Analysis and Real Options In Capital Investments Question 2 When the risks of the individual components of a project’s cash flows are different, an acceptable procedure to evaluate these cash flows is to A Divide each cash flow by the payback period. B Compute the net present value of each cash flow using the firm’s cost of capital. C Compare the internal rate of return from each cash flow to its risk. D Discount each cash flow using a discount rate that reflects the degree of risk. 24 SU 8.2 – Risk Analysis and Real Options In Capital Investments Question 2 Answer Correct Answer: D Risk-adjusted discount rates can be used to evaluate capital investment options. If risks differ among various elements of the cash flows, then different discount rates can be used for different flows. 25 SU 8.2 – Risk Analysis and Real Options In Capital Investments Question 3 Sensitivity analysis is used in capital budgeting to A Estimate a project’s internal rate of return. B Determine the amount that a variable can change without generating unacceptable results. C Simulate probabilistic customer reactions to a new product. D Identify the required market share to make a new product viable and produce acceptable results. 26 SU 8.2 – Risk Analysis and Real Options In Capital Investments Question 3 Answer Correct Answer: B After a problem has been formulated into any mathematical model, it may be subjected to sensitivity analysis, which is a trial-and-error method used to determine the sensitivity of the estimates used. For example, forecasts of many calculated NPVs under various assumptions may be compared to determine how sensitive the NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may drastically alter the NPV, suggesting that the risk of the investment may be excessive. 27 SU 8.3 – Discounted Cash Flow Analysis • Time Value of Money – – – – Concept: A dollar received in the future is worth less than today. Present Value (PV) – Value today of future payment Future Value (FV) – Future value of an investment today. Annuities – equal payments at equal intervals • Ordinary annuity (in arrears) • Annuity due (in advance) – PV & FV is always greater than ordinary annuity See examples on page 310 through 312 28 SU 8.3 – Discounted Cash Flow Analysis – Hurdle rate • Goal is for companies discount rate to be as low as possible. • WACC or Shareholder’s opportunity cost of capital. • The lower the firm’s discount rate, the lower the “hurdle” the company must clear to achieve profitability 29 SU 8.3 – Discounted Cash Flow Analysis • Net Present Value (NPV) – Project return in $$ – Positive NPV indicates a higher rate of return than the company’s desired rate See example on 313 30 SU 8.3 – Discounted Cash Flow Analysis • Internal Rate of Return (IRR) – Project return in % – IRR shortcomings • • • • Directional changes of cash flows Mutually exclusive projects Varying rates of return Multiple investments 31 SU 8.3 – Discounted Cash Flow Analysis • Cash flows and discounting NPV = Cash flow0 + Cash flow1 + Cash flow2 (1 + r)0 (1 + r)1 (1 + r)2 Comparing Cash Flow Patterns – Page 315 32 SU 8.3 – Discounted Cash Flow Analysis • NPV vs IRR comparison – Reinvestment rate NPV assumes the cash flow can be reinvested at projects discount rate. – Independent projects: • NPV and IRR give same accept/reject decision if projects are independent. • All acceptable independent projects can be undertaken. – Mutually exclusive projects. • • • • • • • • Cost of one greater than other Timing, amounts, and direction of cash flow are different Different useful lives IRR provides 1 rate, NPV can be used with multiple rates. Multiple investments. NPV is adaptable, IRR is not. IRR assumes cash flow is reinvested at IRR rate. NPV assumes reinvestment in the desired rate of return. – NPV and IRR are most sound decision making tools for wealth maximization. NPV profile – Page 317 Select greatest NPV over greatest IRR 33 SU 8.3 – Discounted Cash Flow Analysis Question 1 The net present value (NPV) method of investment project analysis assumes that the project’s cash flows are reinvested at the A Computed internal rate of return. B Risk-free interest rate. C Discount rate used in the NPV calculation. D Firm’s accounting rate of return. 34 SU 8.3 – Discounted Cash Flow Analysis Question 1 Answer Correct Answer: C The NPV method is used when the discount rate is specified. It assumes that cash flows from the investment can be reinvested at the particular project’s discount rate. 35 SU 8.3 – Discounted Cash Flow Analysis Question 2 The net present value of a proposed investment is negative; therefore, the discount rate used must be A Greater than the project’s internal rate of return. B Less than the project’s internal rate of return. C Greater than the firm’s cost of equity. D Less than the risk-free rate. 36 SU 8.3 – Discounted Cash Flow Analysis Question 2 Answer Correct Answer: A The higher the discount rate, the lower the NPV. The IRR is the discount rate at which the NPV is zero. Consequently, if the NPV is negative, the discount rate used must exceed the IRR. 37 SU 8.3 – Discounted Cash Flow Analysis Question 3 Dr. G invested $10,000 in a lifetime annuity for his granddaughter Emily. The annuity is expected to yield $400 annually forever. What is the anticipated internal rate of return for the annuity? A Cannot be determined without additional information. B 4.0% C 2.5% D 8.0% 38 SU 8.3 – Discounted Cash Flow Analysis Question 3 Answer Correct Answer: B The correct answer is 4.0%. $10,000 = $400 ÷ IRR; IRR = 0.040 = 4.0%. 39 SU 8.4 – Payback and Discounted Payback • Payback period is the number of years it take for an asset to pay for itself – Pro • Simple – Cons • No consideration for time value of money • Does not consider cash flow after payback period 40 SU 8.4 – Payback and Discounted Payback • Constant cash flows Payback = Initial net investment Annual expected cash flow • Variable cash flows – Cumulative calculation See example on page 318 41 SU 8.4 – Payback and Discounted Payback • Discounted payback method – Used to overcome the payback methods disregard for time value of money – Pro • More conservative yet still simple – Con • Does not consider cash flow after payback period. See example 42 SU 8.4 – Payback and Discounted Payback • Other payback methods – Bailout payback • Considers salvage value – Payback reciprocal • 1 / payback • Estimate of IRR continued 43 SU 8.4 – Payback and Discounted Payback – Breakeven time • Time require for discounted cash flows to equal 0 • Alternative is to consider the time required for the present value of the cumulative cash inflows to equal the present value of all the expected future cash flows 44 SU 8.4 – Payback and Discounted Payback Question 1 Which one of the following methods for evaluating capital projects is the least useful from an investment analysis point of view? A Accounting rate of return. B Internal rate of return. C Net present value. D Payback. 45 SU 8.4 – Payback and Discounted Payback Question 1 Answer Correct Answer: A The accounting, or book, rate of return is an unsatisfactory means of evaluating capital projects for two major reasons. Because the accounting rate of return uses accrual-basis numbers, the calculation is subject to such accounting judgments as how quickly to depreciate capitalized assets. Also, the accounting rate of return is an average of all of a firm’s capital projects; it reveals nothing about the performance of individual investment choices. 46 SU 8.4 – Payback and Discounted Payback Question 2 The payback reciprocal can be used to approximate a project’s A Profitability index. B Net present value. C Accounting rate of return if the cash flow pattern is relatively stable. D Internal rate of return if the cash flow pattern is relatively stable. 47 SU 8.4 – Payback and Discounted Payback Question 2 Answer Correct Answer: D The payback reciprocal (1 ÷ payback) has been shown to approximate the internal rate of return (IRR) when the periodic cash flows are equal and the life of the project is at least twice the payback period. 48 SU 8.5 – Ranking Investment Projects • Why should we rank investment projects? – Capital rationing • Reasons – Lack of financial resources – Control estimation bias – Unwillingness to issue new equity (to raise new capital) 49 SU 8.5 – Ranking Investment Projects • Methods – Profitability index = NPV Net Investment See example – Internal capital markets – Internal funding – Linear programming – Technique for optimizing resource allocation. 50 SU 8.5 – Ranking Investment Projects Question 1 The profitability index approach to investment analysis A Fails to consider the timing of project cash flows. B Considers only the project’s contribution to net income and does not consider cash flow effects. C Always yields the same accept/reject decisions for independent projects as the net present value method. D Always yields the same accept/reject decisions for mutually exclusive projects as the net present value method. 51 SU 8.5 – Ranking Investment Projects Question 1 Answer Correct Answer: C The profitability index (excess present value index) of an investment is the ratio of the present value of the future net cash flows (or only cash inflows) to the net initial investment. It is a variation of the net present value (NPV) method and facilitates the comparison of different-sized investments. Because it is based on the NPV method, the profitability index will yield the same decision as the NPV for independent projects. However, decisions may differ for mutually exclusive projects of different sizes. 52 SU 8.5 – Ranking Investment Projects Question 2 The method that divides a project’s annual after-tax net income by the average investment cost to measure the estimated performance of a capital investment is the A Internal rate of return method. B Accounting rate of return method. C Payback method. D Net present value (NPV) method. 53 SU 8.5 – Ranking Investment Projects Question 2 Answer Correct Answer: B The accounting rate of return uses undiscounted net income (not cash flows) to determine a rate of profitability. Annual after-tax net income is divided by the average carrying amount (or the initial value) of the investment in assets. 54 SU 8.5 – Ranking Investment Projects Question 3 The technique that measures the estimated performance of a capital investment by dividing the project’s annual after-tax net income by the average investment cost is called the A Bail-out payback method. B Internal rate of return method. C Profitability index method. D Accounting rate of return method. 55 SU 8.5 – Ranking Investment Projects Question 3 Answer Correct Answer: D The accounting rate of return (also called the unadjusted rate of return or book value rate of return) measures investment performance by dividing the accounting net income by the average investment in the project. This method ignores the time value of money. 56 SU 8.6 – Comprehensive Examples Please study the comprehensive page starting on page 253 57 CMA Part 2 Financial Decision Making SU 9.1 – Marginal Analysis • • • Accounting Costs vs. Economic Costs Accounting Costs = The total amount of money or goods expended in an endeavor. It is money paid out at some time in the past and recorded in journal entries and ledgers. The economic cost of a decision depends on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost differs from accounting cost because it includes opportunity cost. – As an example, consider the economic cost of attending college. The accounting cost of attending college includes tuition, room and board, books, food, and other incidental expenditures while there. The opportunity cost of college also includes the salary or wage that otherwise could be earning during the period. So for the two to four years an individual spends in school, the opportunity cost includes the money that one could have been making at the best possible job. The economic cost of college is the accounting cost plus the opportunity cost. – Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost wages from not working during that period equals $25,000 dollars a year, then the total economic cost of going to college would be $180,000 dollars ($20,000 x 4 years + the interest of $20,000 for 4 years + $25,000 x 4 years). 59 SU 9.1 – Marginal Analysis • Explicit vs. Implicit Costs – Implicit cost, also called an imputed cost, implied cost, or notional cost, is the opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor hires. – An explicit cost is a direct payment made to others in the course of running a business, such as wage, rent and materials. 60 SU 9.1 – Marginal Analysis • Accounting vs. Economic Profit See Tutorial at http://www.khanacademy.org/economics-financedomain/microeconomics/firm-economic-profit/economic-profit-tutorial/v/economic-profitvs-accounting-profit • Accounting Profit = book income exceeds book expenses • Economic Profit = includes Accounting Profit + Implicit costs 61 SU 9.1 – Marginal Analysis • Marginal Revenue and Marginal Cost – Marginal Revenue is the additional or incremental revenue of one additional unit of output. – See that Marginal Revenue is $540 between generating 4 vs. 5 units of output. – Marginal Cost is the additional or incremental cost incurred of one additional unit of output. • Note that while cost decrease over some range they will at some point begin to increase due to the process becoming lest efficient. • Profit Maximization is where MR = MC 62 SU 9.1 – Short-Run Profit Maximization • Pure Competition is a market structure in which a very large number of firms sell a standardized product into which entry is very easy in which the individual seller has no control over the product price and in which there is no non-price competition; a market characterized by a very large number of buyers and sellers. – Examples : Agricultural products such as potatoes and wheat 63 SU 9.1 – Short-Run Profit Maximization • A Monopoly is a market structure in which one firm sells a unique product into which entry is blocked in which the single firm has considerable control over product price and in which non-price competition may or may not be found. – Examples / Importance 1. Public utilities: gas, electric, water, cable TV, and local telephone service companies, are often pure monopolies. 2. First Data Resources (Western Union), Wham-O (Frisbees), and the DeBeers diamond syndicate are examples of "near" monopolies. (See Last Word.) 3. Manufacturing monopolies are virtually nonexistent in nationwide U.S. manufacturing industries. 4. Professional sports leagues grant team monopolies to cities. 5. Monopolies may be geographic. A small town may have only one airline, bank, etc. 64 SU 9.1 – Short-Run Profit Maximization • Monopolistic Competition is a market structure in which many firms sell a differentiated product into which entry is relatively easy in which the firm has some control over its product price and in which there is considerable non-price competition. – Examples are grocery stores and gas stations 65 SU 9.1 – Short-Run Profit Maximization • Oligopoly is a market structure in which a few firms sell either a standardized or differentiated product into which entry is difficult in which the firm has limited control over product price because of mutual interdependence (except when there is collusion among firms) and in which there is typically non-price competition. 66 SU 9.1 – Short-Run Profit Maximization • Law of Demand states that all other things remaining unchanged, people demand (buy) more of any good / service if the price of that good / service falls and demand (buy) less if the price increases. – Usually represented by a negatively-sloped demand curve which slows that the quantity demanded (quantity of a particular good people intending to buy) declines as price rises and increases as price rises. 67 SU 9.1 – Short-Run Profit Maximization • Elasticity of demand measures how responsive a products demand is to changes in its price level. – When we have inelastic demand, a consumer will pay almost any price for the good. – Elastic demand therefore means that demand for the product will vary when its price changes. Generally goods which have elastic demand tend to have many substitutes, so if the price of one good increases too much I will substitute out towards a similar good which is cheaper. 68 SU 9.1 – Short-Run Profit Maximization • Calculating Price elasticity of demand – Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. – There are a number of factors that can determine the price elasticity of demand for a good or service. – For example, the demand for luxury items tend to be more elastic than the demand for necessities. For items that are essential, you tend to be less responsive to changes in price. An example of this would be the demand for diamonds tends to be more price elastic than the demand for electricity. – Price elasticity of demand is also affected how large a percentage of your total income an item is. We tend to be more elastic in regards to price changes for items that make up a larger percentage of our incomes. For example, if the price of a pack of gum goes up by 10%, I probably wouldn't even notice. On the other hand, if the price of a car I'm considering purchasing goes up by 10%, I would definitely notice and I would probably reconsider the purchase. 69 SU 9.1 – Short-Run Profit Maximization • A third factor that influences the price elasticity of demand is the time frame allowed for response. We tend to be more responsive to changes in price in the long run than in the short run. For example, if the price of gas were to go up overnight to $10/gallon I would still have to put gas in my car tomorrow morning because I have to go to work and I have to go to school. But if the price of gas were to stay at $10/gallon for a year, then I have more options. I could move closer to work, start carpooling, or trade in my car for a hybrid with better gas mileage so that I don't have to buy as much gas. So in the long run, demand tends to be more elastic than in the short run. 70 SU 9.1 – Short-Run Profit Maximization Price Elasticity Example Antoinette has a beauty salon. She services 100 customers per day. Her usual fee is $50. She wants to expand her business. If she lowers her price (gives everyone a coupon for $10 off), she expects to get an extra 10 customers per day. Calculate the price elasticity of demand. Did she make the correct decision? 71 SU 9.1 – Short-Run Profit Maximization Price Elasticity Example Answer A) Percentage change in quantity demanded = 10% (100 customers increased to 110 customers) B) Percentage change in price = -20% ($50 reduced to $40) A/B = 10%/-20% = -0.5 The price elasticity of demand for this service is -0.5, and a price elasticity of demand less than 1 means that a good is inelastic, meaning that quantity demanded is relatively unresponsive to a change in price. So you could argue that she made the wrong decision, as the price decrease did not greatly affect demand. She might have been better choosing another strategy, such as better advertising or her services. You could also argue that she is reducing the price by 20% in return for a 10% increase in volume. 72 SU 9.1 – Short-Run Profit Maximization Price Elasticity Defined A product with elasticity of 1.2 has elastic demand. What this means is that for every 1% rise in the price, demand will fall by 1.2% (similarly, a 1% fall in the price will lead to a 1.2% rise in demand). The rule is: Elasticity > 1 : elastic (% change in demand is greater than % change in price e.g. luxury goods such as cars etc.) Elasticity < 1 : inelastic (% change in demand is less than % change in price e.g. essential goods such as food) Elasticity = 1 : unitary elastic (% change in demand is equal to the % change in price) Basically a firm producing an inelastic good can increase revenue by raising the price, as the fall in demand is more than offset by the increased revenue on the remaining demand. 73 SU 9.1 – Short-Run Profit Maximization Price Elasticity Defined • Infinite or perfectly elastic - If it were “perfectly” elastic, demand would be infinite at all prices less than $3. A perfectly elastic demand graph is a vertical line. And, when the price is at $3, you can not tell from the graph what the demand is since the line is vertical. The demand could be at any value. • Perfectly price inelastic - means that the quantity demanded will not change when price changes. Vertical demand curve • Also, perfectly price elastic means if price changes, quantity demanded changes totally, Horizontal Demand Curve 74 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory • CVP = Break-even analysis – Allows us to analyze the relationship between revenue and fixed and variable expenses – It allows us to study the effects of changes in assumptions about cost behavior and the relevant ranges (in which those assumption are valid) may affect the relationships among revenues, variable costs, and fixed costs at various production levels – Cost-volume-profit analysis is a tool to predict how changes in costs and sales levels affect income; conventional CVP analysis requires that all costs must be classified as either fixed or variable with respect to production or sales volume before CVP analysis can be used. – It considers the effects of: • Sales volume • Sales price • Product mixes • What else……? 75 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory • CVP analysis is done with what assumptions? – – – – – Cost and revenue relationships are predictable Unit selling prices are constant Changes in inventory are insignificant Fixed costs remain constant over relevant range Total variable cost change proportional with volume Continued 76 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory – The revenue (sales) mix is constant – All costs are either fixed or variable (long-term all costs are considered as variable) – Volume is the sole revenue driver and cost driver – The breakeven point is directly related to costs and inversely related to the budgeted margin of safety and the contribution margin – Time value of money is ignored 77 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory • Fixed Costs – Total fixed cost remains unchanged in amount when volume of activity varies from period to period within a relevant range. – The fixed cost per unit of output decreases as volume increases (and vice versa). – When production volume and cost are graphed, units of product are usually plotted on the Horizontal axis and dollars of cost are plotted on the vertical axis. – Fixed cost is represented by a horizontal line with no slope (cost remains constant at all levels of volume within the relevant range). – Intersection point of line on cost (vertical) axis is at fixed cost amount. – Likely that amount of fixed cost will change when outside of relevant range. 78 Monthly Basic Telephone Bill per Local Call SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory Fixed Costs Monthly Basic Telephone Bill C1 Number of Local Calls Total fixed costs remain constant as activity increases. Number of Local Calls Cost per call declines as activity increases. 79 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory • Variable Costs – Total variable cost changes in proportion to changes in volume of activity. – Variable cost per unit remains constant but the total amount of variable cost changes with the level of production. – When production volume and cost are graphed – Variable cost is represented by a straight line starting at the zero cost level. – The straight line is upward (positive) sloping. The line rises as volume increases. 80 Cost per Minute SU 9.2 – Cost-Volume-Profit (CVP) Analysis - Theory Total Costs C1 Minutes Talked Total variable costs increase as activity increases. Minutes Talked Cost per Minute is constant as activity increases. 81 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory • Mixed Costs – Include both fixed and variable cost components. – When volume and cost are graphed, • Mixed cost is represented by a straight line with an upward (positive) slope. • Start of line is at fixed cost point (or amount of total cost when volume is zero) on cost (vertical) axis. As activity level increases, mixed cost line increases at an amount equal to the variable cost per unit. – Mixed costs are often separated into fixed and variable components when included in a CVP analysis. 82 Scatter Diagrams P1 Total Cost in 1,000’s of Dollars Draw a line through the plotted data points so that about equal numbers of points fall above and below the line. 20 * * * * 10 * ** * ** Estimated fixed cost = 10,000 0 0 1 2 3 4 5 Activity, 1,000’s of Units Produced 6 83 Scatter Diagrams P1 Total Cost in 1,000’s of Dollars Unit Variable Cost = Slope = 20 10 0 * * * * Δ in cost Δ in units * ** * ** Horizontal distance is the change in activity. 0 1 2 3 4 5 Activity, 1,000’s of Units Produced 6 84 Vertical distance is the change in cost. High-Low Method • The following is not in this Study Unit, but it is important to know and be able to calculate. 85 The High-Low Method The following relationships between units produced and total cost are observed: Using these two levels of activity, compute: the variable cost per unit. the total fixed cost. 86 High-Low Method High activity level - December Low activity level - January Change in activity Units 67,500 17,500 50,000 Cost $ 29,000 20,500 $ 8,500 Variable cost per unit is determined as follows: Fixed costs are determined as follows: Total cost = $17,525 + $0.17 per unit produced 87 Contribution Margin and its Measures Sales Revenue (2,000 units) Less: Variable costs Contribution margin Less: Fixed costs Net income Total $ 200,000 140,000 $ 60,000 24,000 $ 36,000 Unit $ 100 70 $ 30 Contribution margin is the amount by which revenue exceeds the variable costs of producing the revenue. Total contribution margin is $60,000 and the contribution margin per unit sold is $30. 88 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory • Breakeven point is the level of output where total revenues equals total expenses; the point at which all fixed costs have been covered and operating income is zero. – What is the break-even point and where is it on a graph on the next page? 89 CVP Graph Break-Even Point 90 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory • BEP = output level at which Total Rev = Total Exp – It is also the point at which all fixed cost have been covered and operating income is zero Revenue Var. Cost Gross Margin Fixed Cost Oper. Income $100,000 $ 80,000 $ 20,000 $ 20,000 $ 0 91 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory • Other terms and definitions – Margin of safety is the excess of “budgeted” sales over BE Sales – Mixed costs (See slide 11) are costs that have both a fixed and variable component. For example, the cost of operating an automobile includes some fixed costs that do not change with the number of miles driven (e.g., operating license, insurance, parking, some of the depreciation, etc.) Other costs vary with the number of miles driven (e.g., gasoline, oil changes, tire wear, etc.). – Revenue or sales mix is the composition of total revenues in terms of various products – Sensitivity analysis (See slide 12) examines the effect on the outcome of not achieving the original forecast or of changing an assumption. Since many decisions must be made due to uncertainty, probabilities can be assigned to different outcomes (“what-if”). 92 C1 SU 9.2 – Cost-Volume-Profit (CVP) Analysis - Theory Total Utility Cost Mixed costs contain a fixed portion that is incurred even when the facility is unused, and a variable portion that increases with usage. Utilities typically behave in this manner. Variable Cost per KW Activity (Kilowatt Hours) Fixed Monthly 93 Charge Utility SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory 94 • • SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory Unit Contribution Margin (UCM) is an important term used with break-even point or break-even analysis is contribution margin. In equation format it is defined as follows: Contribution Margin = Revenues – Variable Expenses The contribution margin for one unit of product or one unit of service is defined as: – Contribution Margin per Unit = Revenues per Unit (Sales price) – Variable Expenses per Unit – Expressed in either percentage of the selling price (contribution margin ratio) or dollar amount – Slope of total cost curve plotted so that volume is on the x-axis and dollar value is on the y-axis 95 SU 9.2 – Cost-Volume-Profit (CVP) Analysis Theory • Break-even point in units Fixed costs UCM • Break-even point in dollars Fixed costs CMR 96 A1 Contribution Margin Ratio Sales Revenue (2,000 units) Less: Variable costs Contribution margin Less: Fixed costs Net income Contribution margin ratio Contribution margin ratio = = Total $ 200,000 140,000 $ 60,000 24,000 $ 36,000 Unit $ 100 70 $ 30 Contribution margin per unit Sales price per unit $30 per unit $100 per unit = 30% 97 P2 Computing the Break-Even Point Sales Revenue (2,000 units) Less: Variable costs Contribution margin Less: Fixed costs Net income Total $ 200,000 140,000 $ 60,000 24,000 $ 36,000 Unit $ 100 70 $ 30 How much contribution margin must Rydell Company have to cover its fixed costs (break-even)? Answer: $24,000 How many units must Rydell sell to cover its fixed costs (breakeven)? Answer: $24,000 ÷ $30 per unit = 800 units 98 SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory Question 1 Cost-volume-profit (CVP) analysis is a key factor in many decisions, including choice of product lines, pricing of products, marketing strategy, and use of productive facilities. A calculation used in a CVP analysis is the breakeven point. Once the breakeven point has been reached, operating income will increase by the A Gross margin per unit for each additional unit sold. B Contribution margin per unit for each additional unit sold. C Fixed costs per unit for each additional unit sold. D Variable costs per unit for each additional unit sold. 99 SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory Question 1 Answer Correct Answer: B At the breakeven point, total revenue equals total fixed costs plus the variable costs incurred at that level of production. Beyond the breakeven point, each unit sale will increase operating income by the unit contribution margin (unit sales price – unit variable cost) because fixed cost will already have been recovered. Incorrect Answers: A: The gross margin equals sales price minus cost of goods sold, including fixed cost. C: All fixed costs have been covered at the breakeven point. D: Operating income will increase by the unit contribution margin, not the unit variable cost. 100 SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory Question 2 One of the major assumptions limiting the reliability of breakeven analysis is that A Efficiency and productivity will continually increase. B Total variable costs will remain unchanged over the relevant range. C Total fixed costs will remain unchanged over the relevant range. D The cost of production factors varies with changes in technology. 101 SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory Question 2 Answer Correct Answer: C One of the inherent simplifying assumptions used in CVP analysis is that fixed costs remain constant over the relevant range of activity. Incorrect Answers: A: Breakeven analysis assumes no changes in efficiency and productivity. B: Total variable costs, by definition, change across the relevant range. D: The cost of production factors is assumed to be stable; this is what is meant by relevant range. 102 SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory Question 3 The margin of safety is a key concept of CVP analysis. The margin of safety is the A Contribution margin rate. B Difference between budgeted contribution margin and breakeven contribution margin. C Difference between budgeted sales and breakeven sales. D Difference between the breakeven point in sales and cash flow breakeven. 103 SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory Question 3 Answer Correct Answer: C The margin of safety measures the amount by which sales may decline before losses occur. It is the excess of budgeted or actual sales over sales at the BEP. Incorrect Answers: A: The contribution margin rate is computed by dividing contribution margin by sales. The contribution margin equals sales minus total variable costs. B: The margin of safety is expressed in revenue or units, not contribution margin. D: Cash flow is not relevant. 104 SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory Question 4 The breakeven point in units increases when unit costs A Increase and sales price remains unchanged. B Decrease and sales price remains unchanged. C Remain unchanged and sales price increases. D Decrease and sales price increases. 105 SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory Question 4 Answer Correct Answer: A The breakeven point in units is calculated by dividing total fixed costs by the unit contribution margin. If selling price is constant and costs increase, the unit contribution margin will decline, resulting in an increase of the breakeven point. Incorrect Answers: B: A decrease in costs will cause the unit contribution margin to increase, lowering the breakeven point. C: An increase in the selling price will increase the unit contribution margin, resulting in a lower breakeven point. D: Both a cost decrease and a sales price increase will increase the unit contribution margin, resulting in a lower breakeven point. 106 Remember Computing the Break-Even Point We have just seen one of the basic CVP relationships – the break-even computation. Fixed costs Break-even point in units = Contribution margin per unit Unit sales price less unit variable cost ($30 in previous example) 107 Remember Computing the Break-Even Point The break-even formula may also be expressed in sales dollars. Fixed costs Break-even point in dollars = Contribution margin ratio Unit contribution margin Unit sales price 108 SU 9.2 – Cost-Volume-Profit (CVP) Analysis – Theory • Review: – What is the difference between gross margin and contribution margin – Effect of an increase in CM – Effects on BEP by changes in CM 109 SU 9.3 – CVP Analysis – Basic Calculations • CVP Applications – Target Operating Income – Multiple products – Choice of products • Degree of Operating Leverage (DOL) 110 SU 9.3 – CVP Analysis – Basic Calculations Question 1 Which of the following would decrease unit a contribution margin the most? A A 15% decrease in selling price. B A 15% increase in variable expenses. C A 15% decrease in variable expenses. D A 15% decrease in fixed expenses. 111 SU 9.3 – CVP Analysis – Basic Calculations Question 1 Answer Correct Answer: A Unit contribution margin (UCM) equals unit selling price minus unit variable costs. It can be decreased by either lowering the price or raising the variable costs. As long as UCM is positive, a given percentage change in selling price must have a greater effect than an equal but opposite percentage change in variable cost. The example below demonstrates this point. Continued 112 SU 9.3 – CVP Analysis – Basic Calculations Question 1 Answer Original: UCM = SP – UVC = $100 – $50 = $50 Lower Selling Price: UCM = (SP × .85) – UVC = $85 – $50 = $35 Higher Variable Cost: UCM = SP – (UVC × 1.15) = $100 – $57.50 = $42.50 Since $35 < $42.50, the lower selling price has the greater effect. 113 SU 9.3 – CVP Analysis – Basic Calculations Question 2 The breakeven point in units sold for Tierson Corporation is 44,000. If fixed costs for Tierson are equal to $880,000 annually and variable costs are $10 per unit, what is the contribution margin per unit for Tierson Corporation? A $0.05 B $20.00 C $44.00 D $88.00 114 SU 9.3 – CVP Analysis – Basic Calculations Question 2 Answer Correct Answer: B The breakeven point in units is equal to the fixed costs divided by the contribution margin per unit. Thus, the UCM is $20.00 ($880,000 ÷ 44,000 units). 115 SU 9.3 – CVP Analysis – Basic Calculations Question 3 A manufacturer contemplates a change in technology that would reduce fixed costs from $800,000 to $700,000. However, the ratio of variable costs to sales will increase from 68% to 80%. What will happen to breakeven level of revenues? A B C D Decrease by $301,470.50. Decrease by $500,000. Decrease by $1,812,500. Increase by $1,000,000. 116 SU 9.3 – CVP Analysis – Basic Calculations Question 3 Answer Correct Answer: D The original breakeven level was: Breakeven point = Fixed costs ÷ Contribution margin ratio = $800,000 ÷ (1.0 – .68) = $2,500,000 The new level is: Breakeven point = Fixed costs ÷ Contribution margin ratio = $700,000 ÷ (1.0 – .80) = $3,500,000 Thus, there is an increase of $1,000,000 ($3,500,000 – $2,500,000). 117 SU 9.4 – CVP Analysis – Target Income Calculations • Target Operating Income Fixed costs + Target operating income UCM • Target Net Income Fixed costs + Target net income / (1.0 – tax rate) UCM 118 Computing Sales (Dollars) for a Target Net Income To convert target net income to before-tax income, use the following formula: Before-tax income = Target net income 1 - tax rate 119 SU 9.4 – CVP Analysis – Target Income Calculations Question 1 The data below pertain to the forecasts of XYZ Company for the upcoming year. Total Cost Unit Cost $1,000,000 $25 Raw materials 160,000 4 Direct labor 280,000 7 80,000 2 Sales (40,000 units) Factory overhead: Variable Fixed Selling and general expenses: 360,000 Variable 120,000 Fixed 225,000 3 Continued 120 SU 9.4 – CVP Analysis – Target Income Calculations Question 1 How many units does XYZ Company need to produce and sell to make a before-tax profit of 10% of sales? A. 65,000 units. B. 36,562 units. C. 90,000 units. D. 25,000 units. 121 SU 9.4 – CVP Analysis – Target Income Calculations Question 1 Answer Correct Answer: C Revenue minus variable and fixed expenses equals net income. If X equals unit sales, revenue equals $25X, total variable expenses equal $16X ($4 + $7 + $2 + $3), total fixed expenses equal $585,000 ($360,000 + $225,000), and net income equals 10% of revenue. Hence, X equals 90,000 units. $25X - $16X -$585,000 = $25X × 10% 6.5X = $585,000 X = 90,000 units 122 SU 9.4 – CVP Analysis – Target Income Calculations Question 2 The data below pertain to the forecasts of XYZ Company for the upcoming year. Total Cost Unit Cost $1,000,000 $25 Raw materials 160,000 4 Direct labor 280,000 7 80,000 2 Sales (40,000 units) Factory overhead: Variable Fixed Selling and general expenses: 360,000 Variable 120,000 Fixed 225,000 3 Continued 123 SU 9.4 – CVP Analysis – Target Income Calculations Question 2 Assuming that XYZ Company sells 80,000 units, what is the maximum that can be paid for an advertising campaign while still breaking even? A. $135,000 B. $1,015,000 C. $535,000 D. $695,000 124 SU 9.4 – CVP Analysis – Target Income Calculations Question 2 Answer Correct Answer: A The company will break even when net income equals zero. Net income is equal to revenue minus variable expenses and fixed expenses, including advertising. Thus, if X equals advertising cost, the equation is 80,000)($25) – (80,000)($16) – $585,000 – X = 0 $2,000,000 – $1,280,000 – $585,000 – X = 0 X = $135,000 125 SU 9.4 – CVP Analysis – Target Income Calculations Question 3 For one of its divisions, Buona Fortuna Company has fixed costs of $300,000 and a variable-cost percentage equal to 60% of its $10 per unit selling price. It would like to earn a pre-tax income of $90,000 per year from the division. How many units will Buona Fortuna have to sell to earn a pre-tax income of $90,000 per year? A 65,000 units. B 75,000 units. C 77,250 units. D 97,500 units. 126 SU 9.4 – CVP Analysis – Target Income Calculations Question 3 Answer Correct Answer: D Buona Fortuna’s unit contribution margin is $4 ($10 unit price – $6 unit variable cost). By treating desired profit as an additional fixed cost, the target unit sales can be calculated as follows: Target unit sales = (Fixed costs + Target operating income) ÷ UCM = ($300,000 + $90,000) ÷ $4 = 97,500 127 Computing a Multiproduct Break-Even Point • The CVP formulas can be modified for use when a company sells more than one product. • The unit contribution margin is replaced with the contribution margin for a composite unit. • A composite unit is composed of specific numbers of each product in proportion to the product sales mix. • Sales mix is the ratio of the volumes of the various products. 128 SU 9.5 – CVP Analysis – Multi-Product Calculations • Multiple Products (or Services) – S = FC + VC = Calculated Weighted Average Contribution Margin 129 SU 9.5 – CVP Analysis – Multi-Product Calculations • Choice of Product decisions – When resources are limited companies have to choose which products to produce • A breakeven analysis of the point where the same operating income or loss will result 130 SU 9.5 – CVP Analysis – Multi-Product Calculations • Special Orders (usually lower price than std.) – The assumption are that idle capacity is sufficient to manufacture extra units of a special order. 131 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 1 Moorehead Manufacturing Company produces two products for which the data presented to the right have been tabulated. Fixed manufacturing cost is applied at a rate of $1.00 per machine hour. The sales manager has had a $160,000 increase in the budget allotment for advertising and wants to apply the money to the most profitable product. The products are not substitutes for one another in the eyes of the company’s customers. Per Unit XY-7 BD-4 Selling price $4.00 $3.00 Variable manufacturing cost 2.00 1.50 Fixed manufacturing cost .75 .20 Variable selling cost 1.00 1.00 Continued 132 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 1 Suppose Moorehead has only 100,000 machine hours that can be made available to produce additional units of XY-7 and BD-4. If the potential increase in sales units for either product resulting from advertising is far in excess of this production capacity, which product should be advertised and what is the estimated increase in contribution margin earned? A Product XY-7 should be produced, yielding a contribution margin of $75,000. B Product XY-7 should be produced, yielding a contribution margin of $133,333. C Product BD-4 should be produced, yielding a contribution margin of $187,500. D Product BD-4 should be produced, yielding a contribution margin of $250,000. 133 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 1 Answer Correct Answer: D The machine hours are a scarce resource that must be allocated to the product(s) in a proportion that maximizes the total CM. Given that potential additional sales of either product are in excess of production capacity, only the product with the greater CM per unit of scarce resource should be produced. XY-7 requires .75 hours; BD-4 requires .2 hours of machine time (given fixed manufacturing cost applied at $1 per machine hour of $.75 for XY-7 and $.20 for BD4). XY-7 has a CM of $1.33 per machine hour ($1 UCM ÷ .75 hours), and BD-4 has a CM of $2.50 per machine hour ($.50 ÷ .2 hours). Thus, only BD-4 should be produced, yielding a CM of $250,000 (100,000 × $2.50). The key to the analysis is CM per unit of scarce resource. Incorrect Answers: A: Product XY-7 actually has a CM of $133,333, which is lower than the $250,000 CM for product BD-4. B: Product BD-4 has a higher CM at $250,000. C: Product BD-4 has a CM of $250,000. 134 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 2 Product A accounts for 75% of a company’s total sales revenue and has a variable cost equal to 60% of its selling price. Product B accounts for 25% of total sales revenue and has a variable cost equal to 85% of its selling price. What is the breakeven point given fixed costs of $150,000? A $375,000 B $444,444 C $500,000 D $545,455 135 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 2 Answer Correct Answer: B Using the relationship: sales = total variable costs + total fixed costs, the combined breakeven point can be calculated as follows: S S = = 0.75S(0.60) + 0.25S(0.85) + $150,000 0.45S + 0.2125S + $150,000 S – 0.6625S = $150,000 0.3375S S = = $150,000 $444,444 Incorrect Answers: A: This amount is based on the contribution margin of Product A only rather than a weighted average. C: This amount is based on half of the required sales at B’s contribution margin. D: This amount is based on an unweighted average of the two contribution margins. 136 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 3 Von Stutgatt International’s breakeven point is 8,000 racing bicycles and 12,000 5-speed bicycles. If the selling price and variable costs are $570 and $200 for a racer, and $180 and $90 for a 5-speed respectively, what is the weighted-average contribution margin? A $100 B $145 C $179 D $202 137 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 3 Answer Correct Answer: D Contribution margin equals selling price minus variable costs. The product contribution margins are: = $370 Racer: $570 – $200 = $90 5-Speed: $180 – $90 The sales mix is: Racer: 8,000 ÷ (8,000 + 12,000) = 40% 5-Speed: 12,000 ÷ (8,000 + 12,000) = 60% Multiply the CM by the sales mix for each product, and add the results. Weighted-average CM = ($370 × 40%) + ($90 × 60%) = $148 + $54 = $202 138 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 3 Answer Incorrect Answers: A: The sales mix dictates how much of the total CM will come from sales of each product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the UCM for racers must be added to 60% of the UCM for 5-speeds to get the weightedaverage CM. B: The sales mix dictates how much of the total CM will come from sales of each product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the UCM for racers must be added to 60% of the UCM for 5-speeds to get the weightedaverage CM. C: The sales mix dictates how much of the total CM will come from sales of each product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the UCM for racers must be added to 60% of the UCM for 5-speeds to get the weightedaverage CM. 139 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 4 Catfur Company has fixed costs of $300,000. It produces two products, X and Y. Product X has a variable cost percentage equal to 60% of its $10 per unit selling price. Product Y has a variable cost percentage equal to 70% of its $30 selling price. For the past several years, sales of Product X have averaged 66% of the sales of Product Y. That ratio is not expected to change. What is Catfur’s breakeven point in dollars? A $300,000 B $750,000 C $857,142 D $942,857 140 SU 9.5 – CVP Analysis – Multi-Product Calculations Question 4 Answer Correct Answer: D A helpful approach in a multiproduct situation is to make calculations based on the composite unit, i.e., 2 units of Product X and 3 units of Product Y (a 66% ratio). The selling price of this composite unit is $110 [(2 × $10) + (3 × $30)]. The UCM of the composite unit is $35 {[2 × ($10 – $6)] + [3 × ($30 – $21)]}. Consequently, the breakeven point in composite units is 8,571.43 ($300,000 FC ÷ $35 UCM), and the breakeven point in sales dollars is $942,857 (8,571.43 × $110). Incorrect Answers: A: This amount equals the fixed costs. B: This amount assumes a 40% contribution margin ratio. C: This amount assumes a 35% contribution margin ratio. 141