- Discuss the importance of Cost Structure and Profit Stability - Discuss the concept of Operating Leverage - Explain how to structure Sales Commissions - Discuss the importance of Sales Mix and Break-Even Analysis [SLIDE 1] We have seen in previous lessons how CVP analysis is useful for calculating the units that need to be sold to break even, or to achieve a target profit. Managers also use CVP analysis to guide other decisions, many of them strategic. One example is if the company is considering whether to incorporate additional features for an existing product. Different choices can affect selling prices, variable cost per unit, fixed costs, units sold and profit. CVP analysis helps managers make product decisions by estimating the expected profitability of these choices. Strategic decisions invariably entail risk. CVP analysis can be used to evaluate how profit will be affected if the original predictions are not achieved; for example, if sales are 10% lower than estimated. Evaluating this risk affects other strategic decisions a company might make. For example, if there is a high probability of a decline in sales, a manager may take actions to change the cost structure to have more variable costs and fewer fixed costs. The cost structure is the relative proportion of fixed and variable costs in an organization. Managers have the ability to choose the levels of fixed and variable costs in their cost structures. This is a strategic decision. Let's look at various factors that managers and management accountants consider as they make this decision. CVP-based sensitivity analysis highlights the risks and returns as fixed costs are substituted for variable costs in a company's cost structure. There are two options an organization can use for cost structure. One is a high fixed cost with a low variable cost and the other is a low fixed cost with a high variable cost. Both options have advantages and disadvantages. For a high fixed cost with a low variable cost, the advantage is that income will be higher in good years but, obviously, income will be lower in bad years. The opposite is true for a low fixed cost with high variable cost structure; however, this option offers greater stability in income across good and bad years. Let's look at the example below and see how the cost structure affects both companies. The contribution format income statements given for two mushroom farms. Richardson Farm depends on migrant workers to help pick mushrooms by hand, whereas Jamison Farm has invested in expensive mushroom-picking machines. Consequently, Richardson Farm has higher variable costs, but Jamison Farm has higher fixed costs:

	Richardson Farm		Jamison Farm
	Amount	Percent	Amount	Percent
Sales	$200,000	100%	$200,000	100%
Variable expenses	120,000	60%	60,000	30%
Contribution margin	80,000	40%	140,000	70%
Fixed expenses	60,000		120,000
Net operating income	$20,000		$20,000

To gain a better understanding, we will assume that each farm experiences a 10% increase in sales and no increase in fixed costs. Our new statements would look as follows:

	Richardson Farm		Jamison Farm
	Amount	Percent	Amount	Percent
Sales	$220,000	100%	$220,000	100%
Variable expenses	132,000	60%	66,000	30%
Contribution margin	88,000	40%	154,000	70%
Fixed expenses	60,000		120,000
Net operating income	$28,000		$34,000

As you can see, Jamison will experience a larger increase in net operating income even though the increase in sales was the same. What happens if there is a 10% decrease in sales for both farms from the original prediction and fixed cost remains the same? Our revised income statements would be as follows:

	Richardson Farm		Jamison Farm
	Amount	Percent	Amount	Percent
Sales	$180,000	100%	$180,000	100%
Variable expenses	108,000	60%	54,000	30%
Contribution margin	72,000	40%	126,000	70%
Fixed expenses	60,000		120,000
Net operating income	$12,000		$6,000

As you can see, Richardson will experience less of a decrease in net operating income even though the decrease in sales was the same. In order to further analyze which option is better, managers would need to look at the break-even points for both cost structures and the margin of safety.

	Richardson Farm	Jamison Farm
Fixed expenses	$60,000	$120,000
Contribution margin ratio	÷ 0.40	÷ 0.70
Dollar sales to break even	$150,000	$171,429
Total current sales (a)	$200,000	$200,000
Break-even sales	150,000	171,429
Margin of safety in sales dollars (b)	$50,000	$28,571
Margin of safety percentage (b) ÷ (a)	25.0%	14.3%

As you can see the margin of safety is greater for Richardson and therefore, is less vulnerable to downturns than Jamison. It is difficult to say which is better since there are advantages and disadvantages to each cost structure. The higher margin of safety offers less risk in periods of lower sales and will offer greater stability in income across good and bad years. As we continue our understanding of CVP analysis, we will discuss the concept of operating leverage. [SLIDE 2] The risk-return tradeoff across alternative cost structures can be measured as operating leverage. Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold and contribution margin. Organizations with a high proportion of fixed costs in their cost structures have high operating leverage. The degree of operating leverage at a given level of sales helps managers calculate the effect of fluctuations in sales on profit. Keep in mind that, in the presence of fixed costs, the degree of operating leverage is different at different levels of sales. The formula to calculate the degree of operating leverage is: Degree of operating leverage = Contribution margin / Net operating income Let's look at our example from the previous slide of the two farms;

	Richardson Farm		Jamison Farm
	Amount	Percent	Amount	Percent
Sales	$200,000	100%	$200,000	100%
Variable expenses	120,000	60%	60,000	30%
Contribution margin	80,000	40%	140,000	70%
Fixed expenses	60,000		120,000
Net operating income	$20,000		$20,000

Using the formula for degree of operating leverage, we get the following: Richardson Farm: $80,000 / $20,000 = 4 Jamison Farm: $140,000 / $20,000 = 7 The degree of operating leverage for Richardson is 4 and Jamison is 7. We can expect Richardson's net operating income to increase four times as fast as their sales and Jamison's to increase at seven times as fast as their sales. Therefore, if there is a 10% increase in sales, Richardson should see a 40% increase in net operating income and Jamison should see a 70% increase. The degree of operating leverage is not a constant and is greatest when sales levels are near break-even and decreases as profits and sales rise. Management can use the degree of operating leverage quickly to estimate what impact various percentage changes in sales will have on profits without having to prepare detailed income statements. If a company operates near its break-even point, even a small percentage increase in sales volume can yield a large percentage increase in profit. As we further our review of cost structure, let's look at how companies determine the structure of paying sales commissions. [SLIDE 3] Companies have several options for compensating salespeople. They can pay a flat salary, salary plus commission, commission-only based on sales or commission-only based on contribution margin. Generally, companies tend to compensate by paying a commission based on sales. This type of compensation leads to lower profits. Companies have to decide if this is the best compensation structure or if there is another option that will increase sales without hurting profits. We review our previous example of Valley Metal Products and see which commission structure is better -- compensation based on sales or based on contribution margin.

	Floor Stand per Unit	Table per Unit
Sales revenue	$90	$75
Less variable costs	50	30
Contribution margin	$40	$45

If Valley Metals is paying 10% commission on sales revenue, then salespeople will push hardest on selling the floor stands since the selling price is higher and would generate a larger commission and lower profits. However, if the company decides to pay 10% commission on contribution margin, then salespeople will steer customers toward the Table because it has the higher contribution margin and would produce a larger commission and larger profits. When companies pay on contribution margin, salespeople tend to sell a mix of products that assist in maximizing the contribution margin, provided fixed costs are not affected by the sales mix. We will continue our discussion of CVP by looking at how sales mix impacts company profits. [SLIDE 4] Most companies sell more than one product to satisfy the needs of different customers. For companies with multiple products, the sales mix will have an effect on the company's contribution margin. Sales mix is the quantities (or proportion) of various products (or services) that constitute total unit sales for a company. Companies try to find the ideal combination or mix that will yield the greatest profits. The sales mix of products for most companies will have different variable and fixed costs and different selling prices for each product. Because of these differences, a sales mix also causes break-even analysis to become more complex. In order to calculate the break-even point for each product, the product's per unit contribution margin must be weighted by the sales mix of the products. We review our previous example of Valley Metal Products and see how break-even analysis for multiple products is calculated and the effect that sales mix plays on the contribution margin and net income. Let's assume that Valley Metal Products sells two types of plant stands: a floor stand model and a smaller tabletop model. If the company sells 700 units, of which 420 units are floor stands and 280 are tabletops, the sales mix would be 3:2. For every three floor stands sold, two tabletops are sold. The sales mix can also be stated in percentages. Of the 700 units sold, 60 percent (420 / 700) are floor stand sales, and 40 percent (280 / 700) are tabletop sales. We will also assume that fixed costs are $36,000 and our per unit price, variable cost and contribution margin are:

	Floor Stand per Unit	Table per Unit
Sales revenue	$90	$75
Less variable costs	40	30
Contribution margin	$50	$45

The first step is to calculate the weighted-average contribution margin for each product by its percentage of the sales mix, as follows:

	Selling Price		Variable Costs		Contribution Margin (CM)		Percentage of Sales Mix		Weighted-Average CM
Floor stand	$90	-	$40	=	$50	*	60%	=	$30
Tabletop	$75	-	$30	=	$45	*	40%	=	18
Weighted-average contribution margin									$48

The next step is to calculate the weighted-average break-even point. The calculation is: Weighted-Average Break-even Point = Total Fixed Costs / Weighted-Average Contribution Margin Weighted-Average Break-even Point = $36,000 / $48 Weighted-Average Break-even Point = 750 units The last step is to calculate the break-even point for each product. The calculation is: Break-even Point per product = Weighted-average Break-even x Percentage of Sales Mix Break-even Point on Floor Stand = 750 units * 60% Break-even Point on Floor Stand = 450 units Break-even Point on Tabletop = 750 units * 40% Break-even Point on Tabletop = 300 units To verify, we can take the contribution margin for each product and subtract fixed costs and we should get zero profit.

Floor stand (450 * 50)	$22,500
Tabletop (300 * 45)	13,500
Total contribution margin	$36,000
Less fixed costs	36,000
Profit	$0

Based on the example, you can see at what point the company's sales mix should be maintained. If there is a change or shift in the sales mix then the break-even point will also change. In general, for any given total quantity of units sold, a shift in sales mix towards units with lower contribution margins (more units of Tabletops compared to Floor stands), decreases operating income. A constant sales mix is an important assumption underlying CVP analysis in multiproduct companies. At no point should management focus on changing the sales mix to lower the breakeven point without taking into account customer preferences and demand. CVP analysis plays an important part in answering a variety of critical questions for an organization's management in order to plan and control the direction of the company. Remember, there are 4 key assumptions in CVP analysis. They are:

The selling price is constant.
Costs are linear and can be accurately divided into variable (constant per unit) and fixed (constant in total) elements.
In multiproduct companies, the sales mix is constant.
In manufacturing companies, inventories do not change (units produced = units sold).

These assumptions are important when performing CVP analysis and assist management in making decisions to benefit the organization and net operating income.