Unit 10: CVP Analysis

Question 1

SHORT-RUN PROFIT MAXIMIZATION

(Marginal revenue and marginal cost)

Answer 1

• Marginal revenue is decreasing (due to inefficiency implications in a monopolistic market: price has to be reduced when more is produced)
• Marginal cost is upward parabolic with costs decreasing due to scale until a certain point when it goes up again
• Point of profit maximization: MARGINAL COST = MARGINAL REVENUE. Beyond that point, costs are so high that profit is diminished.

Question 2

• SHORT-RUN COST RELATIONSHIPS (ATC, AFC, AVC)

Answer 2

• Breaking down total costs (ATC = Avg Total Cost):
  
  • + AFC (Avg fixed cost)
    
    • Decreases asymptotically (fixed amount of cost is spread over more units)
  • +AVC (Avg variable cost)
    
    • Declines quickly and then begins a gradual increase. Marginal cost hits it on the lower end, and is driving the shape. IT ALSO HITS THE ATC on the lower end by transitivity.
  • A FIRM SHOULD KEEP INCREASING PRODUCTION UNTIL MARGINAL COST EQUALS PRICE.

Question 3

Pure competition

Answer 3

• Price = marginal revenue (and = marginal cost) due to competition.
• Short run profit max is achieved ALSO when marginal revenue equals marginal cost.

Question 4

Monopoly vs Monopolistic Competition vs Oligopoly

(Monopoly : marginal revenue is less than price and the concept of “price searching”

Monopolistic competition: large number of firms that produce differentiated products

Oligopoly: mutual dependency on actions)

Answer 4

• Monopoly
  
  • One firm and no close substitutes.
    
    • _Marginal revenue is less than price, because t_o increase sales of its product, a monopolist must lower its price.
    • Thus, a monopolist marginal revenue decreases it raises output. Past the point where MR = 0, the monopolists total revenue begins to decrease.
    • The monopolist has the power to set output at the level where profits are maximized, that is, where MR = MC. This is called “price searching”.
    • WHEN A MONOPOLY EXISTS, CONSUMER WILL FACE HIGHER PRICES AND LOWER OUTPUT THAN IN PERFECT COMPETITION.
• Monopolistic competition
  
  • Large number of firms that produce differentiated products (NOT PERFECT SUBSTITUTES), and they cannot collude.
    
    • To maximize profits (minimize losses) in the short run or long run, a firm in monopolistic competition produces at the level of output at which MR=MC.
• Oligopoly
  
  • Industry with few large firms. Firms operating in a monopoly are mutually aware and mutually interdependent. Their decision as to price, advertising, etc. are to a very large extent dependent on the actions of the other firms.
    
    • Prices tend to be rigid (sticky) because of interdependence among firms.
    • For example, if one oligopolist lowers price, sales will not increase because the other firms will lower prices. As a result, profits in the industry will decline.

Question 5

CVP (Cost Volume Profit) Analysis, BE point and margin of safety

BEP in units vs BEP in sales dollars vs BEP in %

BEP in sales dollars = BEP in % * sales

BEP in % = FIXED COSTS / CM

Answer 5

• Breakeven point for a single product
  
  • BEP = Fixed costs / UCM
  • UCM = Unit sales price – unit variable cost
  • CMR = UCM / UNIT SELLING PRICE (OR TOTAL CM / TOTAL SALES)
  • BEP in sales dollars = Fixed costs / CMR = BEP * UNIT PRICE
  • ONCE THE BREAKEVEN POINT HAS BEEN REACHED, OPERATING INCOME WILL INCREASE WITH THE CM PER UNIT SOLD.
• Margin of safety
  
  • Excess of budgeted sales over breakeven sales
  • Margin of safety ratio
    
    • Margin of safety / planned sales

CHECK QUESTION 15 OF PAGE 369

OVERHEAD ALLOCATED COSTS DO NOT CONTRIBUTE TO FIXED COSTS

Question 6

CVP – Target Income Calculations (Anything on top of the breakeven)

General rule

Target Operating Income

Target Net Income

Answer 6

• General rule
  
  • Operating income = Sales - Variable - Fixed costs
• Target Operating Income

Target income in units = (Fixed costs + Target Operating Income) / UCM

• Target Net Income

Target income in units = (Fixed costs + target net income /(1-tax rate)) / UCM

Question 7

CVP ANALYSIS – MULTI-PRODUCT CALCULATIONS

(MULTI PRODUCT : CALCUALTE COMBINED BREAKEVEN POINT THEN FIND INDIVIDUAL PRODUCTION USING UNITS SALES PROPROTION)

(ALLOCATING SCARCE RESOURCES REQUIRES CM PER SCARCE RESOURCE THINKING)

Answer 7

• Multiproduct breakeven point =
  
  • Total fixed cost / (WA SP – WA VC)
  • OR Total fixed expenses / ( WA UCM)
• Choice of Product
  
  • When resources are limited, a company may produce only a single product.
    
    • A breakeven analysis of the point where the same operating income or loss will result regardless of the product selected, is calculated by setting the breakeven formulas of the individual products equal to each other.
    • Allocating scarce resources : given that only one product has to be produced the one with higher CM per unit of scarce resource should be chosen.