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ProfessorBaojunJiang
CostandProfitabilityAnalysis
Relevantcosts(avoidableandincremental)
Incrementalbreakevenanalysis
DEATH SPIRAL
Discussion:
TheCEO/GeneralManagerofamanufacturerdecided
thattomakeproductlinemanagersmoreaccountable,atthe
endofeach6monthperiod,productsthatdonotcovertheir
averagecostswillnolongerbeallowedforproduction.
Every6months,afewproductsappearedonthekill
listandwereorderedtoceaseproduction.Moreandmore
unprofitableproductshavesurfacedastimegoesby. Whatis
happening?
RELEVANT COSTS
Relevantcosts costsincurredbecauseaproductis
sold,ornotincurredbecauseitisnotsold. Theyinclude
Incremental costs: costsincurredassociatedwithchangesin
pricingandsales(nottotalorfullcost)
o
o
allvariablecosts
somefixedcosts
incrementalfixedcosts(e.g.,adstoinformconsumersofpricechange)
semifixedcosts: fixedoverarangeofsalesbutvaryoutsidetherange
(machine)
futurecostsareusuallyavoidable,pastcostsareusuallysunk
futurereplacementcost,nothistoricalreplacementcost
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EXAMPLE 1
ArockbandperformsontwoSaturdayevenings
everymonth.Theycurrentlyprepareanewsetof
songsforeachperformance(show).
o
Overallcostpershow:
Fixedoverheadcost
Rehearsalcosts
Costpershow(performance)
Variablecost(perticket)
Ticketprice:
o
o
$1,500
$4,500
$2,000
$1
$10
Capacity:1,100spectators
Currently,only900ticketsaresold.
PROPOSALS
Profitmarginisverythin.Butthemanagerdoesnot
believeincreasingthepricecansolvetheproblem.
Shehas3proposals.Whichgivesthehighestprofit?
A.
B.
C.
Sell200ticketsatdiscountedpriceof$4toagroupof
studentswhowouldotherwisenotattendtheshowat
regularprice.
Organizeanadditionalshow(ofthesameSaturday
performance)onSundayat$6toallspectators.The
managerexpectstosell700ticketsbut150ofthose
ticketscorrespondtospectatorswhootherwisewould
attendonSaturday.
OrganizeanewseriesofshowsonalternativeSaturdays
at$10perticket.Themanagerexpectstosell800
tickets.100ofthoseticketscorrespondtospectators
whootherwisewouldattendtheregularshow.
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Discount
Sunday
morning
New
Show
Price
x unit sales
= revenue
- other lost sales
Revenue Gain
Rehearsal Incremental Cost
Show Incremental Cost
Change in Variable Cost
Incremental Cost
CONTRIBUTION MARGIN
Per Unit
Price
Incremental variable cost
Contribution margin
Total
Sales revenue
Total variable costs
Total contribution
contributes to the firm's bottom line (total relevant fixed cost and
profit ).
4000units
$10.00perunit
$5.50perunit
$15,000
1) Westsideisconsideringa5%pricecutwithoutadditionalfixedcost.Byhowmany%wouldsales
needtoincreasetobreakevenprofitforthe5%pricecut?
2)Replacinggoosefeatherswithsyntheticfillerwilldecreasetheunitvariablecostby$0.22.Byhow
many%wouldsaleshavetoincreasetoassurethe5%pricecut?
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3)Assume,forthispart,thecurrentproductioncapacityis4,000.Toincreaseitby1,000,the
companyhastoinstallanotherworkstationatamonthly costof$800.Assumenochangein
variablecostsforparts3),4)and5).Byhowmuchwouldsaleshavetoincreasetojustifya5%
pricecut?
Incrementalbreakevensalescurve
4)Repeattheincrementalbreakevenexercisefora15%pricedecrease,a15%increase,etc.
Youwillfindmanycombinationsofsalesandpricesthatbreakeventhecurrentprofit.Link
thesepoints,youwillobtainanincrementalbreakevensalescurvewithpriceonthevertical
lineandunitsalesonthehorizontalline.
price
Unit Sales
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Actualsalesresponseandmeasuringimpactoncurrentprofit
5)Thecompanydecidestogowitha5%pricecut.Marketingresearchshowsthatactualsales
willincreaseby25%.Evaluatethefinancialimpactofa5%pricecutonthefirmscurrent
profit.
price
Unit Sales
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Inclassgameandexercise.
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NEXT SESSION
EVC,WTP,andValuebasedPricing
Economicvaluetothecustomer
Factorsinfluencingactualwillingnesstopay
ValuebasedpricingandEVCanalysis
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