Contribution Marginal Analysis - Case Study Example

1. Please explain contribution margin analysis. How does it work, and what value does it offer? What are the differences between a conventional income statement and a contribution margin income statement? Contribution marginal analysis is a form of management accounting. It is a tool through which managers can determine the marginal profit per unit. More often it is used in a CVP analysis (cost-profit-volume analysis). Contribution margin can be considered as the percentage or fraction of sales that add or contribute to balance off and liquidate fixed costs. As each unit sale is adding up to the profit being generated, contribution margin shows exactly how amount much each unit that is sold is adding to the profit. Every unit price is broken down into parts, where a certain percentage is kept to cover up a part of the total variable costs. The contribution margin can be derived from the following formula: C (unit revenue) =P (price)-V (unit variable cost) Contribution margin analysis is used to measure operating leverage of a firm, operating leverage measures and shows how the growth in sales is leading to growth in profits. It is most helpful for managers to find the most suitable and profitable combination of fixed costs, variable costs, sales volume and selling price. The contribution margin is calculated by a contribution income statement. It is a reformatted version of the typical income statement. As we know an income statement is one of the most important financial statements for almost every business. The income statement shows the firms financial stability and position over a period of time, it helps investors and creditors to look upon past performances of the business and also predict future financial performance of the firm. Income statements can assess the capability of generating future profit and cash flows via income and expense reports. On the other hand, a contribution margin statement shows the relationship between variable costs and fixed costs, irrelevant to the functions a given cost item is linked to. it provides data which is useful for the internal management of the firm and for short term decision making. Through contribution margin calculation, variable costs and fixed costs are separated, only the variable costs are included in the calculation. It highlights the (CM) contribution margin within the business. 2. Use the contribution margin analysis and income statement to show what happened with Nintendos financial results. How were variable and fixed costs affected in Nintendos plan? What does the contribution margin income statement illustrate that is not as evident in a regular income statement? The consolidated income statement of Nintendo is a multiple step form version of income statement format. This version shows the taxes separately from the expenses column. It is an alternative to the single step form which shows all expenses in a single column, including income tax etc. In the electronics division Nintendo experienced a lot of gains of 422.6 billion from 339.6 billion same quarter of previous year. The marginal contribution shows the operating leverage of a business, from the statements of Nintendo, it is pretty obvious that overseas sales shows better leverage as compared to sales in Japan. The contribution margin of Nintendo for year 2008 is 87% as compared to year 2007 which is 82%. This shows improvement in the operating leverage and also an increase in profits per unit sold in Japan and overseas sales. The contribution margin statement shows the total sales less total variable costs. This shows if fixed coasts are covered, and how much profit is left with. This profit when divided by the total sales, leads to profit contribution per sale unit. These figures can be obtained from the income statement of a organization. 3. What is cost-volume-profit analysis? What are some of the tools? What valuable information can a manager gain from this type of analysis? Apply CVP analysis tools to the Nintendosituation. What are some of your observations? CVP is marginal, short run analysis. CVP (cost-volume-profit) analysis is used to determine at what level of volume is the level of total costs equal, this can be referred to as the break even point. If sales further increase and go beyond the break even point, this results in profit. And any amount beyond the break even results in loss, because it shows that the organization is not selling enough goods to cover up its fixed and variable costs. CVP is based on a linear equations that from a straight line also showing the separation of variable costs and fixed costs. Variable costs can vary at large accordingly to the number of units produced, and costs that do not vary with the production changes are known as fixed costs. CVP analysis allows the managers to determine a target of sales that it has to achieve to cover up its costs and move the organization towards profit. It allows a better focus on short term targets for managers, as they can analyze and compute trade-offs in operational decisions. In the long run all costs are considered fixed. Through CVP analysis an organization can determine what products or services are more profitable to it, hence it can focus on the products with low sales and improve them by better marketing programs etc. In the case of Nintendo, the hardware section for wii has shown great increase in over seas sales, but relatively lower sales in Japan itself. The post season discount Nintendo gave to consumers in Japan actually increased sales for the short run. Ho0wever the software’s provided also influence the purchase of wii console, these software’s need to be regularly innovated and updated to keep the sales of hardware boosting. 4. What financial statement analysis tools or ratios could Nintendo management use to analyze the causes for the decrease in profitability? How could management use these tools to make changes and forecasts for the future? Financial analysis tools are a process which help examine and make comparisons between relationships of financial statements and various financial elements. This is a very important and valuable tool that is used by accounting manager. Investors and creditors, as it helps to examine past financial position the organization and also predict the future performance of the organization. The different types of financial ratios that Nintendo can use is liquidity ratios (current ration, quick ratio, net working capital ratio, return on assets ratio, return on equity ratio, return on common equity ratio), profitability ratios (profit margin ratio, earnings per share) activity analysis ratio (assets turnover ratio, accounts receivable turnover ratio, inventory turn over ratio), capital structure analysis ratio (debt to equity ratio, dividend payout ratio). Liquidity ratio can be used by managers at Nintendo to analyze short term financing and debt. Profitability ratio is one the most important ratios as it shows the return on sales, return on assets and return on equity .Nintendo managers can determine what segment is giving the most profit in return and what segment is low on sales .activity analysis ratios are also known as operational ratios, they show performance of converting of inventory into cost of goods sold. It also shows the firms performance into collecting accounts receivable, this is important for Nintendo as it can compare the results for overseas sales. We already know that most sales of Nintendo wii are in USA and Europe. Leverage ratios consist of the amount of debt used in financing a firms asset, Nintendo can finance through debt or equity. Debt must be paid back however equity is an investment in the company. Nintendo can determine its ability to paying dividends and pricing of shares, past results show that Nintendo’s liability have decreased in 2008 as compared to year 2007. 5. What non-financial performance measures should management use to analyze companyperformance? What competitive factors should they be considering? What do you project for the future ofthe industry? How should your projections be integrated into Nintendos planning, forecasting, andmanagement? Currently the economies of the world are still recovering from the financial crisis led by Wall Street. This crisis has led to many business going into a state of loss or closure. The least effected nations were eastern Asia, however multinational companies were affected the most due to being integrated with almost every nation. Business performance measurement can be on qualitative scale rather than only quantitative. A typical measurement routine of a business is periodically setting goals and measuring success towards accomplishment of those goals. Objective accomplishments can be measure on a definite scale, but subjective factors cannot be measured on a objective scale. Subjective success of a business can be measured through activity based costing, economic value added, quality management, customer value analysis and action0profit linkage model. Non financial measurement of a businesses performance can also be seen through customer satisfaction, lagging (lagging is performance evaluation of past), changes in consumer trends and tastes also indicate the reasons for good behavior or vice versa. The competitive threats and advanced technology can undermine a businesses performance, Nintendo or any other firm must keep an eye on changing industrial trends to keep up with the pace of competition. Measurement of human performance such as unit or individual functionalities show the level of business activity within. 6. (Advanced) How is it that a firm can increase its sales volume, but experience a decrease inprofitability? What steps can managers take to insure that increased profitability results increases in salesvolume? Was there anything Nintendo management should have done differently? What should they dofor the future? There is always a possibility that a firm may experience increase in sales but the profits due not increase simultaneously. This may be due to the fact that operating expenses and other cost of production is increasing. The input cost and factory expenses must be kept at a minimal level. This increases in the expense per unit and decreases the profitability margin per unit. In Nintendo’s case the profitability ratio was very low as compared to previous years sales, a reason for this was that the liability had decreased of the firm, meaning that Nintendo payed off a lot of its short term and long term debt. These payments had been deffered from last year which led to an increase in the expenses of the firm. Taxes were also deferred which had to be paid in 2008 by Nintendo, this was another substantial increase in the expenses for Nintendo to deal with. A business can increase sales by various methods; idea is basically to increase number of users by attracting more users. Increase the usage of current users and by expanding markets. Another method to attain profits while keeping expenses low is simply increasing and improving the gross profit margin. Margin can be increased by raising prices; it can be improved by recovering true cost of sales and by reducing cost of sales. The demand of the product has a great effect on the pricing strategy of the firm, in Nintendo’s cases the demand for Nintendo wii was elastic, and this was proved by the increase in sales after discounts were placed on wii within Japan. Overseas sales were good and the demand seemed inelastic, it was not affected by any downturn or raise in price. Handling, shop floor consumables, freight, poor information and quality all are factors which can contribute to improvement in sales and cost management if properly used. 7. (Advanced) Why would management decide to cut the price of its product? What results was Management hoping to achieve? What other factors are at play that could hinder that goal? A management of a firm can decide to cut the price of its product for various reasons. In the case of Nintendo wii, a slight drop in prices led to a great increase in sales in the post holiday season. This shows the elasticity in the demand for Nintendo wii A management can cut prices in hopes to achieve a competitive advantage over its rivals. The lower costs can attract more customers, customers will prefer buying low cost products, and the company can achieve a monopoly situation. However the firm can lower costs if it attains a comparative advantage, which means it should have the ability to produce the product or service at a lower price than other organizations in the business. However the company must have the resources and efficiency to decrease production costs, they must learn to achieve economies of scale. By lowering prices the management hopes to achieve a increase in sales margin, however this is not suitable if the gross profit remains low, it is possible that increase in sales will not always lead to increase in profits. By lowering costs, there are certain drawbacks the firm might have to face; these may be quality issues, as consumers will assume that low priced products are not worthy or of high quality. Another problem is the low profit margin, as price per unit decrease; it is followed by decrease in contribution margin and profit. The gross profit remains low despite increase in sales volume. Other factors such as foreign laws and government interference may create barriers. As Nintendo is selling its wii overseas too, it must keep in mind the industrial and pricing regulations of that particular nation. Government must aim to protect other industries and [prevent harm that is cost by pricing wars amongst firms. 8. (Advanced) What is the impact of the foreign currency exchange rates on Nintendos profitability?Under what conditions do exchange rates increase profitability? In what ways could they hurt Profitability? How could international firms manage this risk? The exchange rate is the price of one currency expressed in terms of another. Businesses such as Nintendo which are multinationals have to trade with business and individuals of many nations across the globe, through the modes of import and export. They sell goods overseas therefore they are dealing with foreign currency as the payment is done in foreign currency. For these businesses, there is always a problem that is faced due to exchange rates which are constantly changing. These changes are caused by the supply and demand of the currencies on the foreign exchange market. this unpredictability to changing exchange rates has led to problems such as planning ahead without the assurity of foreign currency value, and, the changes in demand and supply of there goods to changes in prices of the product or service. There are a number of reasons what causes the currency rate to change, it is basically caused by the demand and supply level of that particular currency. if a product sells at a lower price than home produced goods, the demand for its import is increased, this eventually leads to increase in demand for that currency. It can be seen through an example; an increase in expected future rate of dollar to pound means a raise on return on pounds (appreciation) above the rate of return on dollars (depreciation). An expected exchange rate increase means that if investors had expected the £ to appreciate, they now expect it to appreciate even more. Likewise, if investors had expected the $ to depreciate they now expect it to depreciate more. Alternatively, if they had expected the £ to depreciate, they now expect it to depreciate less. Likewise, if they had expected the dollar to appreciate they now expect it to appreciate less. In capital markets if another nations rate of interest is higher than the domestic rate of interest, the people will be more willing to invest in their securities rather than their own nation’s securities. Nintendo is selling overseas, they receive most of their payments in foreign currency, as there own currency is in a bad state, they have to pay more yen against the dollar. References http://www.accountingformanagement.com/ http://www.bized.co.uk http://www.nintendo.com Read More