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Chapter 5
Profit, Profitability, and Break-Even Analysis
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Learning Objectives
Understand the difference between efficiency and effectiveness.
Distinguish between profit and profitability.
Compare accounting and entrepreneurial profit.
Understand the relationship of profit margin and asset turnover with the earning power of a company.
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Learning Objectives (Continued)
Given the variable costs, revenue, and fixed costs of a business, determine the
eak-even point and contribution margin.
Construct and analyze a
eak-even chart when given variable costs, revenue, and fixed costs of a business.
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Learning Objectives (Continued)
Understand the use of leverage and its relationship to profitability and loss.
Compare and contrast the degree of operating, financial and combined leverage, and their effect on the profitability of a corporation.
Distinguish between Chapter 11, Chapter 13, and Chapter 7 bankruptcy.
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Efficiency and Effectiveness
Efficiency is obtaining the highest possible return with the minimum use of resources.
Effectiveness, on the other hand, is accomplishing a specific task or reaching a goal.
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Profit Versus Profitability
Profit is an absolute number that is earned on an investment.
Accounting profit, for a business, is typically shown at the bottom of an income statement as net income.
Entrepreneurial profit is the amount that is earned above and beyond what the entrepreneur would have earned if he or she had chosen to invest time and money in some other enterprise.
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Profit Versus Profitability (continued)
Profitability can be measured in a business by using a ratio that is obtained by dividing net profit by total assets. Profitability, therefore, is our Return on Investment (assets).
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Earning Powe
The earning power of a company can be defined as the product of two factors:
the company’s ability to generate income on the amount of revenue it receives, which is also known as net profit margin; and
its ability to maximize sales revenue from proper asset employment, also known as total asset turnover.
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Earning Power Formulas
Earning power is equal to net profit margin multiplied by total asset turnover, which is equal to return on investment (total assets).
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Break-Even Analysis
Break-even analysis is a process of determining how many units of production must be sold, or how much revenue must be obtained, before we begin to earn a profit.
For
eak-even Quantity:
where
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Break-Even Analysis (Continued)
Break-even dollars:
For a retail firm:
For a Manufacturing firm:
Where VC is variable cost expressed as a percentage of sales (revenue).
For retail firm: VC percentage =(Cost of Goods Sold)/(Net Sales)
For manufacturing firm: VC percentage = (Variable cost of a unit)/(Unit selling price)
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Break-Even Analysis (Continued)
Contribution margin is the amount of profit that will be made by a company on each unit that is sold above and beyond the
eak-even quantity.
Contribution margin is also the amount the company will lose for each unit of production by which it falls short of the
eak-even point.
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Profit and Break-Even
Desired profit with
eak-even analysis in quantity to produce.
VC is variable cost per unit
Desired profit with
eak-even analysis in dollars.
VC is a percentage of sales dollar (e.g., cost of goods sold as a percent).
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Break-Even Charts
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Leverage
Leverage uses those items that have a fixed cost to magnify the return to a company. Fixed costs can be related to company operations or related to the cost of financing.
Interest expenses paid on the amount of debt incu
ed is the fixed cost of financing.
A firm is heavily financially leveraged if the fixed costs of financing are high.
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Leverage (continued)
Degree of operating leverage (DOL) is the percentage change in operating income divided by the percentage change in sales.
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Leverage (Continued)
Degree of financial leverage (DFL) is the percentage change in earnings per share divided by the percentage change in operating income.
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Leverage (Continued)
Degree of combined leverage (DCL) is the percentage change in earnings per share divided by the percentage change in sales.
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Bankruptcy
Bankruptcy for a business occurs when the liabilities of the firm exceed the assets and the business does not have sufficient cash flow to make payments to creditors. There are essentially three types of bankruptcy: Chapter 11, Chapter 13, and Chapter 7.
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Bankruptcy (Continued)
Chapter 11 bankruptcy occurs when a business seeks court protection while it develops a reorganization plan.
Chapter 13 bankruptcy is reserved for individuals and sole proprietorships and is similar to, but much simpler than, Chapter 11.
Chapter 7 bankruptcy requires liquidation of all assets of the business, and payment to the creditors.
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Bankruptcy (Continued)
Bankruptcy Abuse, Prevention, and Consumer Protection Act.
Signed into law by President Bush April 20, 2005.
Took effect October 17, 2005.
Makes it much more difficult for individuals and business to declare Chapter 7 bankruptcy.
Establishes a means test to determine if an individual filing Chapter 7 is abusing the system.
Imposes Federal guidelines for using the homestead exemption.
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FC = Fixed costs
P = Price charged per unit
VC = Variable cost per unit
Contribution margin = P - VC
FC = Fixed costs
P = Price charged per unit
VC = Variable cost per unit
Contribution margin = P - VC
T5-1
Table 5-1 Balance Sheet, The Tom Jones Company
The Tom Jones Company
Balance Sheet
As of December 31, 2000
Assets
Cu
ent assets
Checking account $ 2,000
Accounts receivable 10,000
Inventory 35,000
XXXXXXXXXXTotal cu
ent assets $ 47,000
Fixed assets
Land $ 50,000
Buildings $ 250,000
Less: Accumulated depreciation 100,000 $ 150,000
Equipment 50,000
Less: Accumulated depreciation 30,000 $ 20,000
XXXXXXXXXXTotal fixed assets $ 220,000
XXXXXXXXXXTotal assets $ 267,000
Liabilities and owner’s equity
Cu
ent liabilities
Accounts payable trade $ 20,000
Notes payable bank 20,000
Taxes payable 3,000
XXXXXXXXXXTotal cu
ent liabilities $ 43,000
Long-term liabilities
Building mortgage $ 200,000
Equipment loan 30,000
XXXXXXXXXXTotal long-term debt $ 230,000
XXXXXXXXXXTotal liabilities $ 273,000
Owner’s equity (6,000)
XXXXXXXXXXTotal liabilities and owner’s equity $ 267,000
T5-2
Table 5-2 Cost Data for Carl’s Toy Trucks
Cost Category Payment Basis Cost ($)
Rent Monthly 2,000.00
Salaries Monthly 5,000.00
Employee benefits Annually 7,000.00
Insurance Quarterly 1,500.00
Property taxes Annually 3,000.00
Wood Per truck 1.25
Paint and finishing Per truck 0.25
Labor Per truck 2.5
Packing and shipping Per truck 2
Break-Even Chart Carl's
Figure 5-1 Break-Even Chart for Carl's Toy Trucks
Revenue 60 55 50 45 40 35 30 25 20 15 10 5 0 600 550 500 450 400 350 300 250 200 150 100 50 0 TC 60 55 50 45 40 35 30 25 20 15 10 5 0 460 430 400 370 340 310 280 250 220 190 160 130 100 Units Sold in Thousand (000)
Dollars in Thousands (000)
Total Revenue
Total Cost = FC + VC
Break-Even Point
Fixed Costs (FC)
Loss
Area
Profit
Area
Break Even Data
Price 10
Variable Cost 6
Fixed Costs 100
UNITS Revenue TC VC
60 600 460 360
55 550 430 330
50 500 400 300
45 450 370 270
40 400 340 240
35 350 310 210
30 300 280 180
25 250 250 150
20 200 220 120
15 150 190 90
10 100 160 60
5 50 130 30
0 0 100 0
Cost CategoryPayment BasisCost ($)
RentMonthly2000.00
SalariesMonthly5000.00
Employee benefitsAnnually7000.00
InsuranceQuarterly1500.00
Property taxesAnnually3000.00
WoodPer truck1.25
Paint and finishingPer truck0.25
LaborPer truck2.50
Packing and shippingPer truck2.00
Table 5-1 Cost Data for