chapter 6-1 chapter 6 cost–volume– profit analysis: additional issues

Chapter 6-1

CHAPTER CHAPTER 66

COST–VOLUME–COST–VOLUME–PROFIT ANALYSIS: PROFIT ANALYSIS: ADDITIONAL ISSUESADDITIONAL ISSUES

Chapter 6-2

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

1. Describe the essential features of a cost-volume-profit income statement.

2. Apply basic CVP concepts.

3.3. Explain the term sales mix Explain the term sales mix and its effects on break-and its effects on break-even sales.even sales.

4.4. Determine sales mix when a Determine sales mix when a company has limited company has limited resources.resources.

5.5. Understand how operating Understand how operating leverage affects profitability.leverage affects profitability.

Chapter 6-3

Traditional Income StatementTraditional Income Statement

RevenueRevenue

Cost of goods soldCost of goods sold

Gross marginGross margin

Administrative and Administrative and selling expenseselling expense

Operating incomeOperating income

CVP income statementCVP income statement

RevenueRevenue

Variable ExpenseVariable Expense

Contribution marginContribution margin

Fixed ExpenseFixed Expense

Operating incomeOperating income

Formulas and Formats to Be Used in the Chapter

These sound alike but they are differentconcepts

Chapter 6-4

Formula for contribution margin ratio (CMR)Formula for contribution margin ratio (CMR) CM per Unit/Unit Sales PriceCM per Unit/Unit Sales Price

Formula for breakeven in dollarsFormula for breakeven in dollars Fixed Cost/Contribution Margin RatioFixed Cost/Contribution Margin Ratio

Formula for breakeven in unitsFormula for breakeven in units Fixed Cost/Contribution Margin per UnitFixed Cost/Contribution Margin per Unit

Formula for margin of safetyFormula for margin of safety Actual Sales – Breakeven SalesActual Sales – Breakeven Sales

Formulas and Formats to Be Used in the Chapter – Review from Chapter 5

Chapter 6-5

Formula for margin of safety ratioFormula for margin of safety ratio Margin of Safety in Dollars/ Actual or Expected Sales Margin of Safety in Dollars/ Actual or Expected Sales

DollarsDollars Breakeven with multiple productsBreakeven with multiple products

Divide fixed costs by the weighted average unit Divide fixed costs by the weighted average unit contribution margin of all productscontribution margin of all products

Formula for weighted average unit contribution Formula for weighted average unit contribution marginmargin weighted contribution margin per-unit of each productweighted contribution margin per-unit of each product


Chapter 6-6

Formula for margin of safety ratioFormula for margin of safety ratio Margin of Safety in Dollars/ Actual or Expected Margin of Safety in Dollars/ Actual or Expected

Sales DollarsSales Dollars

Breakeven with multiple productsBreakeven with multiple products Divide fixed costs by the weighted average unit Divide fixed costs by the weighted average unit

contribution margin of all productscontribution margin of all products


Chapter 6-7

Formula for breakeven in a company with several Formula for breakeven in a company with several divisions, each of which has many productsdivisions, each of which has many products Calculate the breakeven in terms of sales dollars for Calculate the breakeven in terms of sales dollars for

division or product line (not individual products)division or product line (not individual products)

Formula for weighted average contribution Formula for weighted average contribution margin ratio for company with multiple divisionsmargin ratio for company with multiple divisions (CMR x Sales Mix %) + (CMR x Sales Mix %)(CMR x Sales Mix %) + (CMR x Sales Mix %)

Division One Division Two Division One Division Two


Chapter 6-8

Formula for breakeven in dollars using a Formula for breakeven in dollars using a weighted average contribution margin ratioweighted average contribution margin ratio Fixed Costs/Weighted-Average CMR = BE in $Fixed Costs/Weighted-Average CMR = BE in $


Chapter 6-9

Maximizing net income with a limited Maximizing net income with a limited resourceresource First produce the product with the largest First produce the product with the largest

contribution margin per unit of scarce resourcecontribution margin per unit of scarce resource

Formula for degree of operating leverageFormula for degree of operating leverage Total Contribution Margin in Dollars/Net IncomeTotal Contribution Margin in Dollars/Net Income


Chapter 6-10

Cost-Volume-Profit Analysis: Cost-Volume-Profit Analysis: Additional IssuesAdditional Issues

Cost-Volume-Profit Analysis: Cost-Volume-Profit Analysis: Additional IssuesAdditional Issues

Cost-Volume-Cost-Volume-

Profit (CVP) Profit (CVP)

ReviewReview

Cost-Volume-Cost-Volume-

Profit (CVP) Profit (CVP)

ReviewReview

Cost Structure Cost Structure

and Operating and Operating

LeverageLeverage

Cost Structure Cost Structure

and Operating and Operating

LeverageLeverage

Basic conceptsBasic concepts

Basic computationsBasic computations

CVP and changes in CVP and changes in the business the business environmentenvironment

Effect on contribution Effect on contribution margin rationmargin ration

Effect on break-even Effect on break-even pointpoint

Effect on margin of Effect on margin of safety ratiosafety ratio

Operating leverageOperating leverage

Sales MixSales MixSales MixSales Mix

Break-even sales in Break-even sales in unitsunits

Break-even in Break-even in dollarsdollars

Sales mix with Sales mix with limited resourceslimited resources

Chapter 6-11

Cost-Volume-Profit (CVP) ReviewCost-Volume-Profit (CVP) ReviewCost-Volume-Profit (CVP) ReviewCost-Volume-Profit (CVP) Review

As noted in Chapter 5, CVP analysis is: As noted in Chapter 5, CVP analysis is: the study of the effects of changes in the study of the effects of changes in

costs costs and volume on a and volume on a company’s profitcompany’s profit

CVP analysis is important to profit planningCVP analysis is important to profit planning

CVP analysis is critical in management decisions CVP analysis is critical in management decisions such as:such as:

determining product mix,determining product mix,maximizing use of production facilities,maximizing use of production facilities,

setting selling pricessetting selling pricesLO 1: Describe the essential features ofLO 1: Describe the essential features ofa cost-volume-profit income statement.a cost-volume-profit income statement.

Chapter 6-12

Basic ConceptsBasic ConceptsBasic ConceptsBasic Concepts

Because CVP is so important, management often wants the information reported in a special format income statement.The CVP income statement is for internal use only, classifies costs and expenses as fixed or variable, reports a contribution margin in the body of the statement.

Contribution margin – amount of revenue remaining after deducting all variable costs

The contribution margin is often reported as a total amount and on a per unit basis.

LO 1: Describe the essential features ofLO 1: Describe the essential features ofa cost-volume-profit income statement.a cost-volume-profit income statement.

Chapter 6-13

CVP Income Statement - ExampleCVP Income Statement - ExampleCVP Income Statement - ExampleCVP Income Statement - Example

The CVP income statement for Vargo Video The CVP income statement for Vargo Video Company is illustrated below: (This illustration was Company is illustrated below: (This illustration was also presented as Illustration 5-11 in Chapter 5) also presented as Illustration 5-11 in Chapter 5)

LO 1: Describe the essential features of LO 1: Describe the essential features of a cost-volume-profit income statement.a cost-volume-profit income statement.

Chapter 6-14

CVP Income Statement – Example CVP Income Statement – Example Cont’dCont’d

CVP Income Statement – Example CVP Income Statement – Example Cont’dCont’d

A detailed CVP income statement for Vargo Video A detailed CVP income statement for Vargo Video Company is illustrated below: (This uses the same base Company is illustrated below: (This uses the same base information as the previous statement) information as the previous statement)

LO 1: Describe the essential features ofLO 1: Describe the essential features of a cost-volume-profit income statement.a cost-volume-profit income statement.

Chapter 6-15

Basic Computations – A ReviewBasic Computations – A ReviewBasic Computations – A ReviewBasic Computations – A Review

Break-Even AnalysisBreak-Even Analysis

As noted in Chapter 5, Vargo Company’s As noted in Chapter 5, Vargo Company’s contribution margin per unit is $200 (sales contribution margin per unit is $200 (sales price $500 - $300 variable costs)price $500 - $300 variable costs)

It was also shown that Vargo Company’s It was also shown that Vargo Company’s contribution margin ratio was:contribution margin ratio was:

LO 2: Apply basic CVP concepts.LO 2: Apply basic CVP concepts.

Chapter 6-16


Break-Even AnalysisBreak-Even Analysis

Vargo Company’s break-even point in units or Vargo Company’s break-even point in units or in dollars (using contribution margin ratio) is:in dollars (using contribution margin ratio) is:

In its early stages of operation, a company’s In its early stages of operation, a company’s primary goal is to break-even.primary goal is to break-even.

Failure to break-even will eventually leadFailure to break-even will eventually leadto financial failureto financial failure


Chapter 6-17


Target Net IncomeTarget Net Income

Once a company achieves break-even sales, a Once a company achieves break-even sales, a sales goal can be set that will result in a target sales goal can be set that will result in a target net incomenet income

Assuming Vargo’s target net income is $250,000, Assuming Vargo’s target net income is $250,000, required sales in units and dollars to achieve this required sales in units and dollars to achieve this are:are:


Chapter 6-18


Margin of SafetyMargin of Safety

Remember from Chapter 5, the margin of safety Remember from Chapter 5, the margin of safety tells us how far sales tells us how far sales can dropcan drop before the before the company will operate at a losscompany will operate at a loss

The margin of safety can be expressed The margin of safety can be expressed in dollars in dollars or as a ratioor as a ratio

Assuming Vargo’s sales are $800,000:Assuming Vargo’s sales are $800,000:


Chapter 6-19


CVP and Changes in the Business EnvironmentCVP and Changes in the Business Environment

To better understand CVP analysis, three To better understand CVP analysis, three independent cases involving Vargo company will independent cases involving Vargo company will be be examined.examined.

Each case will use the original data for Vargo Each case will use the original data for Vargo Company:Company:

LO 2: Apply CVP concepts.LO 2: Apply CVP concepts.

Chapter 6-20

Basic Computations – A Review: Case IBasic Computations – A Review: Case IBasic Computations – A Review: Case IBasic Computations – A Review: Case I

Should Vargo Company match a competitor’s 10% Should Vargo Company match a competitor’s 10% discount and reduce selling price to $450 per unit?discount and reduce selling price to $450 per unit?

With variable costs per unit unchanged, a 10% With variable costs per unit unchanged, a 10% discount in selling price will discount in selling price will decreasedecrease the the contribution margin to $150 and contribution margin to $150 and increaseincrease break- break-even sales to 1,333 unitseven sales to 1,333 units

Management must decide how likely it is that Vargo Management must decide how likely it is that Vargo can achieve the increase in sales as well as the can achieve the increase in sales as well as the likelihood of lost sales if the discount is not matchedlikelihood of lost sales if the discount is not matched


Chapter 6-21

Basic Computations – A Review: Case IIBasic Computations – A Review: Case IIBasic Computations – A Review: Case IIBasic Computations – A Review: Case II

Use of new equipment is being considered that Use of new equipment is being considered that will increase fixed costs by 30% and lower will increase fixed costs by 30% and lower variable variable costs by 30%. costs by 30%. What effect will the What effect will the new equipment have on the sales required to new equipment have on the sales required to break-even?break-even?

Fixed costs will increase $60,000 and variable Fixed costs will increase $60,000 and variable costs will decrease $90,000 (variable cost per costs will decrease $90,000 (variable cost per unit =$210).unit =$210).

The change appears positive as break-even point The change appears positive as break-even point is reduced by approximately 10%is reduced by approximately 10%


Chapter 6-22

Basic Computations – A Review: Case Basic Computations – A Review: Case IIIIII

Basic Computations – A Review: Case Basic Computations – A Review: Case IIIIII

Vargo’s supplier of raw materials has increased the cost of raw materials which will increase the variable cost per unit by $25.

Management will not change the selling price of the DVDs.

Management intends to cut fixed costs by $17,500

Vargo currently has a net income of $80,000 on sales of 1,400 DVDs

How many more units will need to be sold to maintain the $80,000 net income?


Chapter 6-23

Basic Computations – A Review: Case IIIBasic Computations – A Review: Case IIIBasic Computations – A Review: Case IIIBasic Computations – A Review: Case III

Variable cost per unit increases to $325 as a result Variable cost per unit increases to $325 as a result of the $25 increase in raw materials costof the $25 increase in raw materials cost

Fixed costs decrease to $182,500Fixed costs decrease to $182,500

Contribution margin per unit is now $175Contribution margin per unit is now $175

If Vargo cannot sell an additional 100 units, If Vargo cannot sell an additional 100 units, management must further reduce costs, increase management must further reduce costs, increase the selling price of the DVDs, or accept a lower net the selling price of the DVDs, or accept a lower net income.income.


Chapter 6-24

Croc Catchers calculates its contribution margin to Croc Catchers calculates its contribution margin to be less than zero. Which statement is true?be less than zero. Which statement is true?

a.a. Its fixed costs are less than the variable cost Its fixed costs are less than the variable cost per unitper unit.

b. Its profits are greater than its total costs.

c. The company should sell more units.

d. Its selling price is less than its variable costs.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 1: Describe the essential LO 1: Describe the essential features of features of

a cost-volume-profit income a cost-volume-profit income statement.statement.


Chapter 6-25

Sales MixSales MixSales MixSales Mix

When a company sells more than one When a company sells more than one productproduct

It is important to understandIt is important to understandits sales mixits sales mix

The The sales mixsales mix is the relative percentage is the relative percentage in which a company sells its products.in which a company sells its products.

If a company’s unit sales are 80% If a company’s unit sales are 80% printers and 20% computers, its printers and 20% computers, its sales mix is 80% to 20%.sales mix is 80% to 20%.

Sales mix is important because Sales mix is important because different products often have very different products often have very different contribution margins.different contribution margins.

LO 3: Explain the term sales mix and its effects on break-even sales.LO 3: Explain the term sales mix and its effects on break-even sales.

Chapter 6-26

Break-Even Sales in UnitsBreak-Even Sales in UnitsBreak-Even Sales in UnitsBreak-Even Sales in Units

A company can compute break-even sales for a mix of two or more products by determining the

Weighted-average unit contribution margin of all products

The weighted-average unit contribution margin is the sum of the weighted contribution margin of each product

LO 3: Explain the term sales mi and its effects on break-even sales.LO 3: Explain the term sales mi and its effects on break-even sales.

Chapter 6-27

Break-Even Sales in Units - ExampleBreak-Even Sales in Units - ExampleBreak-Even Sales in Units - ExampleBreak-Even Sales in Units - Example

Assume that Vargo Company sells two products and has the following sales mix and related information:


Chapter 6-28


First, determine the weighted-average contribution margin for Vargo’s two products:

Second, use the weighted-average unit contribution margin to compute the break-even point in units


Chapter 6-29


With a break-even point of 1,000 units, Vargo must sell:

750 DVD Players (1,000 units x 75%)250 TVs (1,000 units x 25%)

At this level, the total contribution margin will equal the fixed costs of $275,000


Chapter 6-30

Break-Even Sales in DollarsBreak-Even Sales in DollarsBreak-Even Sales in DollarsBreak-Even Sales in Dollars

The calculation of break-even point in units works well if the company has only a few products

Consider 3M which has over 30,000 different products:

3M would need to calculate 30,000 different unit contribution margins

When there are many products, calculate the break-even point in terms of sales dollars for divisions or product lines, NOT individual products


Chapter 6-31

Break-Even Sales in Dollars - ExampleBreak-Even Sales in Dollars - ExampleBreak-Even Sales in Dollars - ExampleBreak-Even Sales in Dollars - Example

Assume that Kale Garden Supply Company has two divisions: Indoor Plants and Outdoor Plants

Each division has hundreds of different plant types

Compute sales mix as a percentage of total dollar sales rather than units sold

andCompute the contribution margin ratio rather than the contribution margin per unit


Chapter 6-32


The information necessary to perform cost-volume-profit analysis is:


Chapter 6-33


First, determine the weighted-average contribution margin ratio for each division:

Second, use the weighted-average unit contribution margin ratio to compute the break-even point in dollars:


Chapter 6-34


With break-even sales of $937,500 and a sales mix of 20% to 80%, Kale must sell:

$187,500 from the Indoor Plant division$750,000 from the Outdoor Plant division

If the sales mix between the divisions changes, the weighted-average contribution margin ratio also changes, resulting in a new break-even point in dollars.

Example - If the sales mix becomes 50% to 50%, the weighted average contribution margin ratio changes to 35%, resulting in a lower break-even point of $857,143.


Chapter 6-35

Net income will be:Net income will be:

a.a. Greater if more higher-contribution margin Greater if more higher-contribution margin units are sold than lower-contribution margin units are sold than lower-contribution margin unitsunits.

b. Greater is more lower-contribution margin units are sold than higher-contribution margin units.

c. Equal as song as total sales remain equal, regardless of which products are sold.

d. Unaffected by changes in the mix of products sold.


LO 3: Explain the term sales mix and its effects on break-even LO 3: Explain the term sales mix and its effects on break-even sales.sales.

Chapter 6-36

Sales Mix with Limited ResourcesSales Mix with Limited ResourcesSales Mix with Limited ResourcesSales Mix with Limited Resources

All companies have limited resources whether it be floor space, raw materials, direct labor hours, etc.

Limited resources force management to decide Limited resources force management to decide which products to sell to maximize net income.which products to sell to maximize net income.

Example: Vargo makes DVD players and TVs. The limiting resource is machine capacity – 3,600 hours per month. Relevant date is as follows:

LO 4: Determine sales mix when a company has limited LO 4: Determine sales mix when a company has limited resources.resources.

Chapter 6-37

Sales Mix with Limited Resources - Sales Mix with Limited Resources - ExampleExample


The TVs seem to be more profitable since they have the higher contribution margin per unit, but they require more machine hours to produce than the DVD Players

To determine the appropriate sales mix, compute the contribution margin per unit of limited contribution margin per unit of limited resource:resource:

Since DVD players have higher contribution margin per machine hour, management should produce more DVD players if demand exists or else increase machine capacity.LO 4: Determine sales mix when a company has limited LO 4: Determine sales mix when a company has limited

resources.resources.

Chapter 6-38

Alternative: Increase machine capacity from 3,600 to 4,200 hours

To maximize net income, all 600 hours should be used to produce and sell DVD players.



Chapter 6-39

Theory of ConstraintsTheory of ConstraintsTheory of ConstraintsTheory of Constraints

Approach used to identify and manage constraints so as to achieve company goals

Requires identification of constraints

Continual attempts to reduce or eliminate constraints

LO 4: Determine sales mix when a company has limited LO 4: Determine sales mix when a company has limited resources.resources.

Chapter 6-40

If the contribution margin per unit is $15 and it margin per unit is $15 and it takes 3.0 machine hours to produce the unit, the takes 3.0 machine hours to produce the unit, the contribution margin per unit of limited resource is:contribution margin per unit of limited resource is:

a.a. $25$25.

b. $5.

c. $4.

d. No correct answer is given.


LO 4: Determine the sales mix when a company has limited LO 4: Determine the sales mix when a company has limited resources.resources.

Chapter 6-41

Cost Structure and Operating LeverageCost Structure and Operating LeverageCost Structure and Operating LeverageCost Structure and Operating Leverage

Cost StructureCost Structure is the relative proportion of fixed versus variable costs that a company incurs

May have a significant effect on profitability

Thus, a company must Thus, a company must carefully choose its carefully choose its cost structure.cost structure.

LO 5: Understand how operating leverage affects LO 5: Understand how operating leverage affects profitability.profitability.

Chapter 6-42

Comparison of Cost StructuresComparison of Cost StructuresComparison of Cost StructuresComparison of Cost Structures

Vargo Video manufactures DVD players using a traditional, labor-intensive manufacturing process

New Wave Company also manufactures DVD players, but uses a completely automated system where factory employees only set up, adjust, and maintain the machinery.

Both companies have the same sales and net income; however, each has different risks and rewards due to changes in sales as a result of their cost structures.

LO 5: Understand how operating leverage affects LO 5: Understand how operating leverage affects profitability.profitability.

Chapter 6-43

Effect on Contribution Margin RatioEffect on Contribution Margin RatioEffect on Contribution Margin RatioEffect on Contribution Margin Ratio

The contribution margin ratio for each company is as follows:

Thus, New Wave contributes 80 cents to net income for each dollar of increased sales while Vargo only contributes 40 cents.

However, New Wave loses 80 cents per dollar of sales decrease while Vargo only loses 40 cents.

New Wave’s cost structure which relies on fixed costs is more sensitive to changes in sales

LO 5: Understand how operating leverage affects profitability.LO 5: Understand how operating leverage affects profitability.

Chapter 6-44

Effect on Break-even PointEffect on Break-even PointEffect on Break-even PointEffect on Break-even Point

The break-even point for each company is as follows:

New Wave needs to generate $150,000 more in sales than Vargo to break-even.

Because of the greater break-even sales required, New Wave is a riskier company than Vargo.


Chapter 6-45

Effect on Margin of Safety RatioEffect on Margin of Safety RatioEffect on Margin of Safety RatioEffect on Margin of Safety Ratio

The margin of safety ratio of each company is as follows:

The difference in the margin of safety ratio reflects the difference in risk between New Wave and Vargo.

Vargo can sustain a 38% decline in sales before operating at a loss versus only a 19% decline for New Wave before it would be operating “in the red.”


Chapter 6-46

Operating LeverageOperating LeverageOperating LeverageOperating Leverage

Operating leverageOperating leverage refers to the extent that net income reacts to a given change in sales.

Higher fixed costs relative to variable costs cause a company to have higher operating leverage.

When sales revenues are increasing, high operating leverage means that profits will increase rapidly – a good thing.

When sales revenues are declining, too much operating leverage can have devastating consequences.


Chapter 6-47

Operating LeverageOperating LeverageOperating LeverageOperating Leverage

The degree of operating leverage provides a measure of a company’s earnings volatility.

The degree of operating leverage is computed by dividing total contribution margin by net income.

The computations for Vargo and New Wave are:

New Wave’s earnings would go up (or down) by about two times (5.33 ÷ 2.67 = 1.99) as much as Vargo’s with an equal increase in sales.


Chapter 6-48

The degree of operating leverage:The degree of operating leverage:

a.a. Can be computed by dividing total contribution margin by net income.

b. Provides a measure of the company’s earnings volatility.

c. Affects a company’s break-even point.

d. All of the above.



Chapter 6-49

Chapter Review - Brief Exercise 6-9 Chapter Review - Brief Exercise 6-9 Chapter Review - Brief Exercise 6-9 Chapter Review - Brief Exercise 6-9

Presto Candle Supply makes candles. The sales mix Presto Candle Supply makes candles. The sales mix (as a percent of total dollar sales) of its three product (as a percent of total dollar sales) of its three product lines is as follows: birthday candles, 30%; standard lines is as follows: birthday candles, 30%; standard tapered candles, 50%; and large scented candles, tapered candles, 50%; and large scented candles, 20%. The contribution margin ratio of each candle 20%. The contribution margin ratio of each candle type is shown below.type is shown below.

Candle TypeCandle Type Contribution Margin Contribution Margin RatioRatio BirthdayBirthday 10% 10%

Standard taperedStandard tapered 20% 20%Large scentedLarge scented 45% 45%

What is the weighted-average contribution margin ratio?

Chapter 6-50

Chapter Review - Brief Exercise 6-9 Chapter Review - Brief Exercise 6-9 Chapter Review - Brief Exercise 6-9 Chapter Review - Brief Exercise 6-9

Type of CandlesType of Candles CMR Sales Mix CMR Sales MixBirthday 10% X 30% = 03%Standard tapered 20% X 50% = 10%Large scented 45% X 20% = 09% Weighted Average Contribution Margin Ratio 22%

If the company’s fixed costs are $440,000 per year, what is the If the company’s fixed costs are $440,000 per year, what is the dollar amount of each type of candle that must be sold to break dollar amount of each type of candle that must be sold to break even? even?

Step 1:Step 1: Fixed Costs $440,000 ÷ WA CMR 22% = $ BEP Fixed Costs $440,000 ÷ WA CMR 22% = $ BEP $2,000,000$2,000,000

Step 2:Step 2:Birthday candlesBirthday candles $2,000,000 X 30% = $ 600,000$2,000,000 X 30% = $ 600,000Standard taperedStandard tapered $2,000,000 X 50% = 1,000,000$2,000,000 X 50% = 1,000,000Large scentedLarge scented $2,000,000 X 20% = 400,000$2,000,000 X 20% = 400,000

Chapter 6-51

AppendixAppendixAbsorption Costing vs. Variable Absorption Costing vs. Variable

CostingCosting


CostingCostingUnder variable costing, product costs consist of:

Direct Materials Direct Labor

Variable Mfg. Overhead

The difference between absorption and variable costing is:

LO 6: Explain the difference between absorption costingLO 6: Explain the difference between absorption costing and variable costing.and variable costing.

Chapter 6-52


CostingCosting


CostingCostingUnder both costing methods, selling and administrative expenses are treated as period costs.

Companies may not use variable costing for external financial reports because GAAP requires that fixed manufacturing overhead be treated as a product cost.

LO 6: Explain the difference between absorption costingLO 6: Explain the difference between absorption costingand variable costing.and variable costing.

Fixed Mfg. Fixed Mfg. OverheadOverhead

Chapter 6-53


CostingCosting


CostingCostingExample – Premium Products

Manufactures Fix-it, a sealant for car windows.

Relevant data for January 2008, the first month of production are:


Chapter 6-54


CostingCosting


CostingCostingExample – Continued

Per unit manufacturing cost under each approach.

The manufacturing cost per unit is $4 ($13 -$9) higher for absorption costing because fixed manufacturing costs are treated as product costs.


Chapter 6-55

AppendixAppendixAbsorption Costing Income StatementAbsorption Costing Income Statement

AppendixAppendixAbsorption Costing Income StatementAbsorption Costing Income Statement


Chapter 6-56

AppendixAppendixVariable Costing Income StatementVariable Costing Income Statement

AppendixAppendixVariable Costing Income StatementVariable Costing Income Statement


Chapter 6-57

AppendixAppendixSummary of Income EffectsSummary of Income Effects

AppendixAppendixSummary of Income EffectsSummary of Income Effects

LO 7: Discuss net income effects under absorption costingLO 7: Discuss net income effects under absorption costingversus variable costing.versus variable costing.

Chapter 6-58

Fixed manufacturing overhead costs are recognized as:Fixed manufacturing overhead costs are recognized as:

a.a. Period costs under absorption costingPeriod costs under absorption costing.

b. Product costs under absorption costing.

c. Product costs under variable costing.

d. Part of ending inventory costs under both absorption and variable costing.


LO 6: Explain the difference between absorption costingLO 6: Explain the difference between absorption costing and variable costing.and variable costing.

Chapter 6-59

The San Marcos is trying to determine its The San Marcos is trying to determine its breakeven point.breakeven point.

The inn has 75 rooms that are rented at $50 a The inn has 75 rooms that are rented at $50 a night. It incurred the following costs during the night. It incurred the following costs during the year.year. Salaries $8,500 per monthSalaries $8,500 per month Utilities $2,000 per monthUtilities $2,000 per month Depreciation $1,000 per monthDepreciation $1,000 per month Maintenance $500 per monthMaintenance $500 per month Maid service $5 per roomMaid service $5 per room Other costs $33 per roomOther costs $33 per room

Exercise 6-1

Chapter 6-60

Determine the breakeven point in rooms per Determine the breakeven point in rooms per month.month.

Breakeven point in rooms for months formula:Breakeven point in rooms for months formula: Fixed Costs/Contribution Margin = BEuFixed Costs/Contribution Margin = BEu

Contribution Margin = $50 - $5 - $35 = $12Contribution Margin = $50 - $5 - $35 = $12 Breakeven in rooms per month = ($8,500 + Breakeven in rooms per month = ($8,500 +

$2,000 + $1,000 + $500)/12 = 1,000 rooms$2,000 + $1,000 + $500)/12 = 1,000 rooms

Exercise 6-1

Chapter 6-61

Determine the breakeven point in dollars.Determine the breakeven point in dollars. Breakeven in dollars formula+Breakeven in dollars formula+

Fixed Costs/Contribution Margin Ratio = BE$Fixed Costs/Contribution Margin Ratio = BE$

Contribution Margin Ratio (CMR) =Contribution Margin Ratio (CMR) = Contribution Margin Per Room/PriceContribution Margin Per Room/Price

Contribution Margin = $50 - $5 - $35 = $12Contribution Margin = $50 - $5 - $35 = $12 Contribution Margin Ratio = $12/$50 = .24Contribution Margin Ratio = $12/$50 = .24 Breakeven in rooms per month = ($8,500 + Breakeven in rooms per month = ($8,500 +

$2,000 + $1,000 + $500)/.24 = $50,000$2,000 + $1,000 + $500)/.24 = $50,000

Exercise 6-1

Chapter 6-62

If the inn plans on renting an average of 50 If the inn plans on renting an average of 50 rooms per day, what is the monthly margin of rooms per day, what is the monthly margin of safety in dollars?safety in dollars?

Expected sales = 50 rooms × $50 × 30 days = Expected sales = 50 rooms × $50 × 30 days = $75,000$75,000

$75,000 - $50,000 = $25,000 margin of safety$75,000 - $50,000 = $25,000 margin of safety What is the margin safety ratio?What is the margin safety ratio? $25,000/$75,000 = 33 1/3rd$25,000/$75,000 = 33 1/3rd

Exercise 6-1

Chapter 6-63

In the month of June, Angelo’s Beauty Salon In the month of June, Angelo’s Beauty Salon gave 3500 haircuts, shampoos, and permanents gave 3500 haircuts, shampoos, and permanents at an average price of $30.at an average price of $30.

During the month, fixed cost were $16,800 and During the month, fixed cost were $16,800 and variable costs were 80% of sales.variable costs were 80% of sales.

Determine the contribution margin in dollars, per Determine the contribution margin in dollars, per unit, and as a ratio.unit, and as a ratio.

Exercise 6-2

Chapter 6-64

Contribution margin in dollars:Contribution margin in dollars: (3,500 × $30) revenue – .8(3,500 × $30) = $21,000(3,500 × $30) revenue – .8(3,500 × $30) = $21,000

Contribution margin per unitContribution margin per unit $21,000/3,500 = $6$21,000/3,500 = $6

Contribution margin ratioContribution margin ratio $6/$30 = 20%$6/$30 = 20%

Exercise 6-2

Chapter 6-65

Compute the margin of safety in dollars and as a Compute the margin of safety in dollars and as a ratioratio

Breakeven in dollars = $16,800/.20 = $84,000Breakeven in dollars = $16,800/.20 = $84,000 Breakeven in units = $16,800/$6 = 2,800Breakeven in units = $16,800/$6 = 2,800 Margin of safety in dollars = (3,500 x $30) - Margin of safety in dollars = (3,500 x $30) -

$84,000 = $21,000$84,000 = $21,000 Margin of safety ratio = $21,000/$105,000 Margin of safety ratio = $21,000/$105,000

= .20% = .20%

Exercise 6-2

Chapter 6-66

Get Company reports the following operating Get Company reports the following operating results for the month of August.results for the month of August. Sales $300,000 (5,000 units)Sales $300,000 (5,000 units) Variable cost $210,000Variable cost $210,000 Fixed cost $70,000Fixed cost $70,000

Exercise 6-3

Chapter 6-67

Management is considering increasing sales Management is considering increasing sales price with 10% with no change in variable costs.price with 10% with no change in variable costs.

Compute the net income to be earned.Compute the net income to be earned.

Exercise 6-3

Sales $300,000 × 1.10 $330,000

Variable costs 210,000

Contribution margin $120,000

Fixed costs 70,000

Operating income $50,000

Chapter 6-68

Management is considering decreasing variable Management is considering decreasing variable expense to 58% of salesexpense to 58% of sales


Exercise 6-3

Sales $300,000

Variable costs 300,000 × .58 174,000


Fixed costs 70,000


Chapter 6-69

Management is considering decreasing fixed Management is considering decreasing fixed costs by $20,000costs by $20,000


Exercise 6-3

Sales $300,000

Variable costs 210,000


Fixed costs 50,000


Chapter 6-70

Grass King manufactures lawnmowers, weed Grass King manufactures lawnmowers, weed trimmers, and chainsaws.trimmers, and chainsaws.

Its sales mix and contribution margin per unit Its sales mix and contribution margin per unit are as follows:are as follows:

Exercise 6-6

Sales Mix Contribution Margin per Unit

Lawnmowers 30% $30

Weed trimmers 50% $20

Chainsaws 20% $40

Grass King has fixed costs of $4,600,000

Chapter 6-71

Compute the number of units of each product Compute the number of units of each product that Grass King must sell in order to break even that Grass King must sell in order to break even under this product mix.under this product mix.

Calculate weighted average contribution margin.Calculate weighted average contribution margin. (.30 × $30) + (.50 × $20) + (.20 × $40) =(.30 × $30) + (.50 × $20) + (.20 × $40) = $9 + $10+ $8 = $27$9 + $10+ $8 = $27 Divide fixed costs by a weighted average Divide fixed costs by a weighted average

contribution margin:contribution margin: 4,600,000/27 = 170,370.37 units4,600,000/27 = 170,370.37 units

Exercise 6-6

Chapter 6-72

Tiger Golf Accessories sells golf shoes, gloves, Tiger Golf Accessories sells golf shoes, gloves, and a laser guided rangefinder that measures and a laser guided rangefinder that measures distance. Shown below are unit cost and sales distance. Shown below are unit cost and sales data.data.

Exercise 6-9

Pair of shoes

Pair of gloves

Rangefinder

Unit sales price $100 $30 $250

Unit variable cost 60 10 200

Unit contribution margin $40 $20 $50

Sales mix 40% 50% 10%

Chapter 6-73

Compute the breakeven point in units for the Compute the breakeven point in units for the company.company.

Weighted average contribution margin =Weighted average contribution margin = (.40 × $40) + (.50 × $20) + (.10 × $50) =(.40 × $40) + (.50 × $20) + (.10 × $50) = $16+ $10+ $5 = $31$16+ $10+ $5 = $31 Divide fixed costs by weighted average Divide fixed costs by weighted average

contribution margincontribution margin $620,000/$31 = 20,000 units$620,000/$31 = 20,000 units

Exercise 6-9

Chapter 6-74

Determine the number of units to be sold at the Determine the number of units to be sold at the breakeven point for each product line.breakeven point for each product line.

Shoes (20,000 X .40) = 8,000 pairs of shoesShoes (20,000 X .40) = 8,000 pairs of shoes Gloves (20,000 X .50) = 10,000 pairs of glovesGloves (20,000 X .50) = 10,000 pairs of gloves Range finders (20,000 X .10) = 2,000 range Range finders (20,000 X .10) = 2,000 range

findersfinders

Exercise 6-9

Chapter 6-75

Verify that the mix of sales determined will Verify that the mix of sales determined will generate a zero net income.generate a zero net income.

Shoes: 8,000 X $40Shoes: 8,000 X $40 = = $320,000$320,000 Gloves: 10,000 X $20 = Gloves: 10,000 X $20 = 200,000 200,000 Range finders: 2,000 X $50 = Range finders: 2,000 X $50 = 100,000 100,000 Total contribution marginTotal contribution margin 620,000 620,000 Fixed costsFixed costs 620,000620,000 Net incomeNet income $ 0$ 0

Exercise 6-9

Chapter 6-76

Dalton Company manufactures and sells two Dalton Company manufactures and sells two products. products.

Relevant per-unit data concerning each product Relevant per-unit data concerning each product follow.follow.

Exercise 6-13

Basic product Deluxe product

Selling price $40 $52

Variable costs $18 $24

Machine hours .5 .7

Chapter 6-77

Compute the contribution margin per machine Compute the contribution margin per machine hour for each product.hour for each product.

Exercise 6-13

Basic Product Deluxe Product

Selling price $40 $52

Variable cost $18 $24

Contribution margin per unit

$22 $28

Divide by machine hours .5 .7

Contribution margin per machine hour

$44 $40

If 1000 additional machine hours are available, which product shouldDalton manufacture?

The product with the highest contribution margin perseveres resource – the basic product.

Chapter 6-78

Total contribution margin if the hours are divided Total contribution margin if the hours are divided equally among the products.equally among the products.

Exercise 6-13

Basic Deluxe Total

Machine hours allocated 500 500 1,000

X Contribution margin per machine hour $44 $40

Contribution margin $22,000 $20,000 $42,000

Chapter 6-79

Total contribution margin if the hours dedicated Total contribution margin if the hours dedicated to the product with the largest contribution to the product with the largest contribution margin per scarce resource.margin per scarce resource.

Exercise 6-13

Basic Deluxe Total

Machine hours allocated 1,000 -0- 1,000

X Contribution margin per machine hour $44 $40

Contribution margin $44,000 -0- $44,000

Chapter 6-80

An investment banker is analyzing two An investment banker is analyzing two companies that specialize in the production and companies that specialize in the production and sale of candied apples.sale of candied apples.

Old Fashion Apples uses a labor-intensive Old Fashion Apples uses a labor-intensive approach, and Mech-Apple uses a mechanized approach, and Mech-Apple uses a mechanized system.system.

CVP income statements for the two companies CVP income statements for the two companies are shown below.are shown below.

E 6-16

Chapter 6-81

Old-Fashioned Apples Mech Apples

Sales $400,000 $400,000

Variable costs 320,000 160,000

Contribution margin 80,000 240,000

Fixed costs 20,000 180,000

Net income 60,000 60,000

E 6-16

The investment banker is interested in acquiring one of these companies. However, she is concerned about the impact each company’s cost structure might have on its profitability.

Chapter 6-82

Calculate each company’s degree of operating Calculate each company’s degree of operating leverage.leverage.

Formula: Contribution margin/Net incomeFormula: Contribution margin/Net income Old-Fashion Apples:Old-Fashion Apples:

80,000/60,000 = 1.33380,000/60,000 = 1.333

Mech-ApplesMech-Apples 240,000/60,000 = 4.0000240,000/60,000 = 4.0000

Mech-Apples is more sensitive to changes in Mech-Apples is more sensitive to changes in sales volume.sales volume.

E 6-16

Chapter 6-83

Determine the effect on each company’s net Determine the effect on each company’s net income if sales decreased by 10% and if sales income if sales decreased by 10% and if sales increased by 5%.increased by 5%.

E 6-16

% Changein Sales X

Degree ofOperatingLeverage =

% Change inNet Income

10% decrease: Old Fashion Mech-Apple

(10%)(10%)

XX

1.334.00

==

(13.3%)(40.0%)

5% increase: Old Fashion Mech-Apple

5%5%

XX

1.334.00

==

6.65%20.0%

Which investment do you think the investment banker choose?

Chapter 6-84

The End!The End!

chapter 6-1 chapter 6 cost–volume– profit analysis: additional issues

Documents

margin of safety formula

margin of safety ratio

largest contribution

dollars formula

unit formula

chapter slide

dollars sales mix

terms of sales dollars