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18 -- Cost and Profit Sensitivity Analysis - YouTube
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[Music]
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I'm Larry Walter this is principles of
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accounting dot-com
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chapter 18 and this module extends the
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examples and thought processes we
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developed in the previous module related
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to CVP analysis and now we're going to
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look more specifically at sensitivity
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analysis where we assume changes in
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variable cost or changes in fixed cost
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or even blended changes or changes in
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revenue functions so recognize that cost
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structures can change over time and
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management must carefully analyze these
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changes to determine the effect on the
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business let's revisit Leyland sports
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from the previous module remember in the
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Leyland sports example we needed sales
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of two million dollars to break-even
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there was a 60% contribution margin and
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a fixed cost pool of $1,200,000 now in
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revising this example we're going to
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assume we hire a sales manager at an
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annual fixed cost of a hundred and
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twenty thousand dollars and that would
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increase our fixed cost pool to 1
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million three hundred and twenty
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thousand if we divide that by our point
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six contribution margin ratio we come up
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with our revised break-even sales of two
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million two hundred thousand dollars in
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other words this is the same break-even
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calculation we did previously but we've
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added additional fixed cost into the
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equation this simply means that by
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adding the sales manager we're going to
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have to see a $200,000 increase in sales
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to justify the expenditure to at least
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cover that fixed cost we can also look
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at changes in variable cost
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if Leyland adds the sales manager but
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instead of paying them a salary instead
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pays them a commission of four percent
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of sales then the revised breakeven is
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two million one hundred forty two
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thousand eight fifty seven this results
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by dividing the continuing fixed cost of
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1 million two by the revised
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contribution margin ratio of 0.56
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in other words instead of having a 60%
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contribution margin we only have a 56%
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contribution margin because each
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additional dollar of sales incurs
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another four cents of cost our
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commission for the sales man
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and so the commission structure may
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appear to be more logical because our
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break-even sales point is two million
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one hundred and forty two thousand
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instead of two million two hundred
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thousand dollars I've graphed this to do
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an analysis however and recognize that
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that's not a constant it really depends
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on the level of sales that are generated
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so here I've plotted the sales managers
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fixed salary at one hundred and twenty
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thousand dollars and done an analysis to
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determine the managers total
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compensation it's constant no matter the
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level of sales in the alternative I also
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prepared a plot of the Commission the
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sloping line if instead of having a
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fixed salary we have a commission there
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are no sales we pay nothing but on the
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other hand if sales are very high out
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here it's a six million dollars then
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we're paying two hundred and forty
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thousand dollars to the sales manager so
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whether we're better off or worse off
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really depends on the level of sales
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what the previous analysis does not show
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our is that human behavior also needs to
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be considered commissions may provide an
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inducement for the sales manager to
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perform at a higher level at six million
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dollars in sales for example the
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Commission based manager makes twice as
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much as they would at the fixed cost of
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a hundred and twenty thousand dollars
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the business is going to be much better
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off with the six million dollar sales
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level all things considered and so
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sometimes the lowest cost option is not
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the best cost option in terms of
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affecting the total profitability of the
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business in the previous example for
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Leyland sports we first modified the
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fixed cost and did an analysis and then
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we modified the variable cost and did an
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analysis to see what the effect is on
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breakeven okay
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many cost changes however involved both
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fixed and variable components shifting
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such is the case for Flynn Flying
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Service Flynn has a jet that it
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currently owns and operates and it costs
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three million dollars per year fixed
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cost to operate it but the contribution
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margin is only thirty percent they're
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offered an even exchange for a new jet
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that has a higher four million dollar
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fixed cost operations per year but it's
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variable cost is lower and it has a
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higher contribution margin at fifty
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percent of sales assuming Flynn expects
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nine million in revenue is it better to
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change or not and so Flynn should make
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this deal the break even on the old jet
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is ten million dollars in other words
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the three million dollars in fixed cost
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divided by the forty percent
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contribution margin ratio tells us that
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we need 10 million in sales to
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break-even whereas the new jet only
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needs eight million in sales to
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break-even that's calculated as the four
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million in fixed cost divided by the 50%
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contribution margin ratio so now perhaps
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you're beginning to appreciate how
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significant the value is of
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understanding your contribution margin
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ratio and your fixed cost structure and
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how quickly you can do analysis of
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business decisions of course this could
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be a double-edged sword if volume levels
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did not reach the nine million dollar
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level or drop below the eight million
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dollar level we might run an analysis
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and find we're better off keeping the
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existing Jets so our assumptions need to
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be valid for our analysis to be valid
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finally we've looked at cost shifts we
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have not talked about revenue shifts and
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so I'm going to look at an example where
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we have a 10% increase in sales price
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for leaping lemming we looked at leaping
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lemming in the previous module as well
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here we've got sales of 10,000 units at
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$1,000 per unit total revenues would be
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10 million dollars if we're able to
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increase the sales price by 10% to
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$1,100 per unit total sales will be 11
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million dollars so it's only a 10%
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increase in sales price but look what it
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does to our net income we go from a
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$500,000 income to a 1 million five
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hundred thousand dollar income I think
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you would agree that's a significant
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change in the profitability of the
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business again this behavior this
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profitability behavior is a function of
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our cost structure now the analysis I
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just looked at assumed rather cavalierly
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that we could get away with raising
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prices 10 percent however customers may
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be very sensitive to pricing it could be
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that we'll see a significant drop in
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demand if we raise our prices 10 percent
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and so further analysis may be required
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a company needs to assess how volume
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drops can be absorbed when prices
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increased for example if
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desires to at least maintain its
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$500,000 of profit when it increases its
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price what level of sales drop could be
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absorbed and we could actually see sales
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be cut in half to only 5,000 units in
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other words a fixed cost of five hundred
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thousand plus our five hundred dollar
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target income that's our pool of cost
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and profit we need to be able to cover
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divided by the $200 per unit
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contribution margin would tell us that
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five thousand units would allow us to
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achieve our target income level another
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issue to consider are cost plus pricing
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agreements that seek to provide the
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seller with an assured margin but no
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more in the Lord you may be buying a
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product and say look we think it's fair
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to allow you to make a 15% profit and so
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let's agree that the selling price for
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our transaction will be based on cost
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plus 15%
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however those agreements can have
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unintended consequences as we will now
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see heap and pioneer have entered into
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an agreement that provides pioneer with
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a contribution margin of 20% on 1
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million bags delivered originally the
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bags were anticipated to cost pioneer $1
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to produce and fixed costs were $100,000
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however assume there was a huge increase
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in the price of petroleum which is a
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base raw material for plastic bags and
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so that the variable production cost
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rose to $3 per unit instead of $1 per
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unit so let's see what happens in this
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case first of all looking at the $1
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scenario I've calculated sales at 1
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million 250 thousand dollars that allows
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us to recover our variable cost of $1
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unit times the million units and gives
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us our contribution margin of 250,000
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dollars which is 20% of sales from which
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we subtract a hundred thousand a fixed
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cost and profitability that we
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anticipate is a hundred and fifty
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thousand dollars but we're entitled to
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pass on our cost increases with the
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$3.00 scenario variable costs are now
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three million dollars a million units at
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three dollars a unit this requires us to
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charge a sales price of three million
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seven hundred and fifty thousand to give
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us our twenty percent contribution
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margin that is 20 percent of three
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million seven hundred fifty thousand
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seven hundred fifty thousand dollars a
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fixed cost or unaffected
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however so our net income is now 650
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thousand dollars a large increase from
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the hundred and fifty thousand we
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previously expected and so this should
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illustrate quite clearly why cost-plus
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contracts can be dangerous the seller
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has very little concern about
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controlling cost because they're passing
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them through and indeed if those
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increase in costs are all variable in
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nature there's no change in fixed cost
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the seller can actually make a great
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deal more as variable costs go up so one
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needs to be very careful in dealing with
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cost plus contracts
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