Cost

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  • Topic: Contribution margin, Management accounting, Variable cost
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  • Published : May 19, 2013
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Cost-Volume-Profit Analysis

Learning Objectives
1. Explain the features of cost-volumeprofit (CVP) analysis 2. Determine the breakeven point and output level needed to achieve a target operating income 3. Understand how income taxes affect CVP analysis 4. Explain how managers use CVP analysis in decision making 5. Explain how sensitivity analysis helps managers cope with uncertainty 6. Use CVP analysis to plan variable and fixed costs 7. Apply CVP analysis to a company producing multiple products

All managers want to know how profits will change as the units sold of a product or service change. Home Depot managers, for example, might wonder how many units of a new product must be sold to break even or make a certain amount of profit. Procter & Gamble managers might ask themselves how expanding their business into a particular foreign market would affect costs, selling price, and profits. These questions have a common “what-if” theme. Examining the results of these what-if possibilities and alternatives helps managers make better decisions. Managers must also decide how to price their products and understand the effect of their pricing decisions on revenues and profits. The following article explains how the Irish rock band U2 recently decided whether it should decrease the prices on some of its tickets during its recent world tour. Does lowering ticket price sound like a wise strategy to you?

How the “The Biggest Rock Show Ever” Turned a Big Profit1 When U2 embarked on its recent world tour, Rolling Stone magazine called it “the biggest rock show ever.” Visiting large stadiums across the United States and Europe, the Irish quartet performed on an imposing 164-foot high stage that resembled a spaceship, complete with a massive video screen and footbridges leading to ringed catwalks. With an ambitious 48-date trek planned, U2 actually had three separate stages leapfrogging its global itinerary—each one costing nearly $40 million dollars. As a result, the tour’s success was dependent not only on each night’s concert, but also recouping its tremendous fixed costs—costs that do not change with the number of fans in the audience. To cover its high fixed costs and make a profit, U2 needed to sell a lot of tickets. To maximize revenue, the tour employed a unique in-theround stage configuration, which boosted stadium capacity by roughly 20%, and sold tickets for as little as $30, far less than most large outdoor concerts. The band’s plan worked—despite a broader music industry slump and global recession, U2 shattered attendance records in most of the venues it played. By the end of the tour, the band played to over

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Source: Gundersen, Edna. 2009. U2 turns 360 stadium into attendance-shattering sellouts. USA Today, October 4. www.usatoday.com/life/music/news/2009-10-04-u2-stadium-tour_N.htm

3 million fans, racking up almost $300 million in ticket and merchandise sales and turning a profit. As you read this chapter, you will begin to understand how and why U2 made the decision to lower prices. Many capital intensive companies, such as US Airways and United Airlines in the airlines industry and Global Crossing and WorldCom in the telecommunications industry, have high fixed costs. They must generate sufficient revenues to cover these costs and turn a profit. When revenues declined at these companies during 2001 and 2002 and fixed costs remained high, these companies declared bankruptcy. The methods of CVP analysis described in this chapter help managers minimize such risks.

Essentials of CVP Analysis
In Chapter 2, we discussed total revenues, total costs, and income. Cost-volume-profit (CVP) analysis studies the behavior and relationship among these elements as changes occur in the units sold, the selling price, the variable cost per unit, or the fixed costs of a product. Let’s consider an example to illustrate CVP analysis. Example: Emma Frost is considering selling GMAT Success, a test prep book...
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