The Basic Profit Equation:
Cost-Volume-Profit analysis (CVP) relates the firm’s cost structure to sales volume and profitability. A formula that facilitates CVP analysis can be easily derived as follows:
Profit = Sales – Expenses
Profit = Sales – (Variable Costs + Fixed Costs)
Profit + Fixed Costs = Sales – Variable Costs
Profit + Fixed Costs = Units Sold x (Unit Sales Price – Unit Variable Cost)
This formula is henceforth called the Basic Profit Equation and is abbreviated:
P + FC = Q x (SP – VC)
Contribution margin is defined as
Sales – Variable Costs
The unit contribution margin is defined as
Unit Sales Price – Unit Variable Cost
Hence, setting the sales price comes last in the traditional approach, but it comes first in target costing.
Target costing is appropriate when SP and Q are predictable, but are not choice variables, such as might occur in well-established competitive markets. In such a setting, merchandisers might know the price that they want to charge for the product, and can probably estimate the sales volume that will be achieved at that price. Target costing has been used successfully by a number of companies including Toyota, which redesigned the Camry around the turn of the century as part of a target costing strategy.
Breakeven: Steve Poplack owns a service station in Walnut Creek. Steve is considering leasing a machine that will allow him to offer customers the mandatory California emissions test. Every car in the state must be tested every two years. The machine costs $6,000 per month to lease. The variable cost per test (i.e., per car inspected) is $10. The amount that Steve can charge each customer is set by state law, and is currently $40.
How many inspections would Steve have to perform monthly to break even from this part of his business?
Q = FC ÷ Unit Contribution Margin
Q = $6,000 ÷ ($40 $10) = 200 inspections
Targeted profits, solving for volume: Refer to the information in the...