INTRODUCTION TO COST-VOLUME-PROFIT ANALYSIS




Abigail Peabody was a very well-known nature photographer. Over the years she had had a number of best-sellers, and her books adorned the coffee tables of many households worldwide. On this particular day she was contemplating her golden years, which were fast approaching. In particular she was reviewing her year-end investment report and wondering why she was not better prepared. After all, she had been featured in the Sunday New York Times book section, had discussed her works with Martha Stewart, and had been the keynote speaker at the Audubon Society’s annual fund-raiser. She knew it was not her investment advisers’ fault. Their performance over the past years had been better than many of the market indices. She wondered if she was just a poor businessperson.

The last thought struck a pleasant chord. She had a grandson who was a junior at a well-known business school just outside Boston. It was time, anyway, to catch up to his latest business idea. She dialed the number from memory.

He was as lively as usual. “Hi, Abbey, I was just going to call you. How’s the new bird book coming?” [Of her many grandchildren, he had the most irresistible charm.] How she loved his ability to make her feel young—and his ability to remember never to call her anything that began with Grand-.

“Actually, Stephen, that’s why I’m calling. I was just reviewing my retirement portfolio, and I think it’s time for me to renegotiate my royalty structure with my publisher. I could use some help from a bright business mind.”

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“Love to help you. What’s wrong with the current contract? Haven’t you been with them since the beginning?”

“Yes I have, but things have changed. In the old days, they provided me with many services. They brainstormed projects with me, suggested different ideas such as the Baskets of Nantucket best-seller, and edited my work word-by-word and frame-by-frame. They worked hard for me and earned every penny they made on me. I was not the easiest artist to put up with.”

Stephen was interested. “Go on.”

“Well, now I barely talk with them. I am at the point where loyal readers suggest many of my projects. I design them myself, edit them myself, and even help my publisher prepare the promotion materials. They don’t work so hard anymore. I think I have paid my dues. I want a bigger piece of the pie.”

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“That could be a problem, Abbey. I just finished a case study on that industry, and it is very competitive. There are many parts to the industry value system that ultimately ends with someone buying a book (see Exhibit 3.1). It starts with people like you who have the intellectual capital. The next piece of the system is the publisher, who manages the creativity process, supplies the editing, prints the book, and markets it. Wholesalers like Ingram add value to this system by buying books in large quantity from publishers, warehousing them, and selling in smaller quantities to bookstores. Of course, the last piece is the bookstore, where in-store promotion and the final sales process takes place. On, say, a $50 book, the bookstore buys it from the wholesaler for about $35, netting about $15 to cover its costs such as rent and salespeople. The wholesaler buys the book from the publisher in large lot sizes for about $30 a book, giving the wholesaler about $5 to cover its logistics costs. Of the $30 the publisher sells it for, 15% of the retail price, or $7.50 ($50 × 15%) is your royalty, and the rest covers printing, client development, returned books, administrative expenses, and a profit. The publisher really can’t give you too much more since its margin is already very slim. Sorry to disappoint you but that’s how it is.”

Abbey was disappointed. “Stephen, for all that money your parents are paying, doesn’t that business school teach creativity? You have to look at the world and think of what it could be, not what it is today.”

Unembarrassed by Abbey’s chastisement, Stephen, reacted positively. “How much risk do you want to take on this new project, Abbey?”

 

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“That’s more like it. For now, let’s ‘roll the bones’—I mean, assume risk is not an issue. What do you have in mind?”

“Well, this semester I have a Web-marketing course and I need a project. Are you familiar with the World Wide Web?”

“I spend a good part of the day corresponding with friends on it.”

“Good. What you just said to me is that you don’t see too many pieces of the publishing system adding value commensurate with the value they extract. How about setting up your own Web site and selling your latest project yourself? We would have to contract with others to provide the necessary parts of the chain, but selling the book through our Web site is possible. It could fail, and you would have one very unhappy publisher.”

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Abbey thought she was now getting somewhere. “As long as you are getting credit for it, why don’t you develop this idea further. See if it’s possible and what my risks would be. I might even give you a piece of the action.”



Frequently Asked Questions

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Ans: An estimation of the sustainable portion of earnings should be the centerpiece of analyzing business earnings. This task has become a far greater challenge over the past decade as the number of nonrecurring items has increased dramatically. This explosion has been driven by corporate reorganizations and associated activities. Some of the labels attached to these producers of nonrecurring items are restructuring, rightsizing, downsizing, reengineering, redeployment, repositioning, reorganizing, rationalizing, and realignment. view more..
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Ans: The construction of an SEB worksheet always requires a judgment call. One could, of course, avoid all materiality judgments by simply recording all nonrecurring items without regard to their materiality. However, the classification of items as nonrecurring, as well as on occasion their measurement, calls for varying degrees of judgment. Some examples of Baker Hughes items that required the exercise of judgment, either in terms of classification or measurement, are discussed next. view more..
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Ans: The nonrecurring items located in the Baker Hughes annual report are enumerated in the completed SEB worksheet in Exhibit 2.35. Each of the nonrecurring items is recorded on the SEB worksheet. When an item is disclosed for the first, second, third, or fourth time, it is designated by a corresponding superscript view more..
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Ans: Abigail Peabody was a very well-known nature photographer. Over the years she had had a number of best-sellers, and her books adorned the coffee tables of many households worldwide. On this particular day she was contemplating her golden years, which were fast approaching. In particular she was reviewing her year-end investment report and wondering why she was not better prepared. After all, she had been featured in the Sunday New York Times book section, had discussed her works with Martha Stewart, and had been the keynote speaker at the Audubon Society’s annual fund-raiser. She knew it was not her investment advisers’ fault. Their performance over the past years had been better than many of the market indixes. She wondered if she was just a poor businessperson. view more..




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