08/07/2008. Objective. The Cost/ Volume/ Profit Relationship. Introduction. Introduction. The Cost/ Volume/ Profit Equation. Introduction CC3 1

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1 The Cost/ Volume/ Profit Relationship Objective By the end of this course you will be able to: State the Cost/ Volume/ Profit equation and explain the relationship that exists among its components Define the terms variable rate and contribution rage Apply the formulas used to determine sales in dollars, sales in units, variable costs, fixed costs, profit, contribution rate, contribution margin, variable rate and break-even point On our first class we compared income statements of 2 restaurants. We identified that The Grand View Bistro's Food, Beverage and Labor costs were all lower than A taste of Tuscany But good cost-to-sales relationship is not enough to ensure PROFIT. Why? A Higher Food Cost may mean more value for the Customer so you increase repeat business and increase volume, so profit is achieved despite high food cost. A Lower Food Cost may mean less value for the Customer so guests don t come back and volume decreases and desired profit cannot be achieved. This course examines the nature of Cost/ Volume/ profit Relationship Understanding this concept is KEY to fully comprehend cost control in F&B operations Here is an illustration of this concept From the foregoing discussion it should be apparent that there are relationships between sales, cost of sales, cost of labor, cost of overhead and profit. In fact these relationships can be expressed as follow: Sales = Cost of Sales +Cost of Labor + Cost of Overhead + Profit CC3 1

2 Thus in the Grand View Bistro, using the numbers from Figure 3.1 Sales = Cost of Sales +Cost of Labor + Cost of Overhead + Profit $925,000 = $309,825 + $231,250 + $277,500 + $106,375 Because cost of sales is variable, cost of labor includes both fixed and variable elements and cost of overhead is fixed, one could restate this equation as follow: In fact, this is the basic cost/ volume/ profit equation: S=VC+FC+P Some things to keep in mind before we go any further: S = Sales VC = Variable Costs (expressed in % of S) FC = Fixed Costs (expressed in $) P = Profit Let s now crunch some number, shall we? Cost/ Volume/ Profit Analysis in Details: First, we determine the total variable cost for the Grand View Bistro Food Cost, + Beverage Cost + The Variable Labor Cost Second, we determine the total fixed cost for GVB Cost/ Volume/ Profit Analysis in Details: Second, we determine the total fixed cost for GVB Fixed Labor Cost Other controllable expenses Occupancy Costs Interest Depreciation Given the preceding figures The basic Cost/ Volume/ Profit equation for the GVB is: $925,000 = $402,375 + $416,250 + $106,375 CC3 2

3 Variable rate and Contribution Rate Two new terms! Variable rate is the ratio of variable cost to dollar sales. It is determined by dividing variable costs by dollar sales and is expressed in decimal form (similar to a cost percent) Variable rate (VR)= Variable Cost (VC) Sales (S) Variable rate Calculate the VR in this example: $925,000 = $402,375 + $416,250 + $106,375 Variable rate (VR)= Variable Cost (VC) Sales (S) Variable rate (VR)=.435 Variable rate This is the same as stating that 43.5% of dollar sales is needed to cover the variable costs, or that $O.435 of each dollar of sales is required for that purpose. As sales increase, the total dollars spent to cover these costs will increase, but the percentage will not change. Variable rate (VR)=.435 Contribution Rate If 43.5 % of dollar sales is needed to cover variable costs, then the remainder (56.5 %) is available for other purposes, namely: Paying fixed costs Providing profit Contribution Rate () = 1-VR = = The Break-Even Point A restaurant cannot be profitable until all of the fixed costs have been paid. If dollar sales volume is insufficient to cover both VC and FC, the enterprise will clearly operate as a loss. If dollar sales volume is sufficient to cover both VC and FC exactly, but insufficient to give a profit (P=0), it is said to operate at break-even The Break-Even Point The Break-Even Point usually abbreviated BE is defined as the point at which the sum of all costs equals sales, so that profit = Zero, thus: BE is when: S (VC+FC)= 0 CC3 3

4 Cost/ Volume/ Profit Calculations for GVB Here are GVB information: A new formula: Cost/ Volume/ Profit Calculations for GVB This formula can be used to determine the level of dollar sales required to earn any profit that one might choose to put into the equation. To prove that the formula works, one can substitute the preceding figures in the formula: Determine the Break-Even Point for GVB Using the previous formula, replace P par Zero! Contribution Margin Each dollar of sales may be divided into 2 portions: The portion used to cover variable costs associated with the item sold The portion remaining after variable costs have been subtracted from the sales dollar: This portion is called the Contribution Margin (CM) CM = Selling Price Variable costs of that item If a Menu Item sells for $12.00 and its variable cost is $5.00, the contribution margin is.. Contribution Margin When sales reach a level sufficient to cover all variable costs and all fixed costs, with an additional amount left over, that additional amount is obviously Profit. Unit Sales Required to Break-Even Managers often want to know the number of sales required to break-even or to make a desired profit. Calculating that figure will enable managers to determine how many Guests are required. CC3 4

5 Unit Sales Required to Break-Even Example: If the financial records of a small restaurant indicates sales of $48,000 and VC of $18,000 in a period when 3000 Guests were served $48,000/ 3000 Guests = $16.00 Average Sales/ Guest $18,000/ 3000 Guests = $6.00 Average Variable Cost $ $6.00 = $10.00 (Average CM per sale unit) Unit Sales Required to Break-Even or make a desired profit To put it simply: S u = Fixed Costs (+ Desired Profit) Contribution Margin per Unit In the small restaurant of our illustration, assume that Fixed Costs were $30,000 S u = $30,000 = 3,000 Guests required to BE $10 Exercises 1. Apply this formula to The GVB and find the number of customers required to BE assuming that the Average Sales per Guest is $ Apply this formula to The GVB and find the number of customers required to make a Profit of $120, Assuming that The GVB is open 365 days per year, what is the Average Number of Guests required to BE? CC3 5