COST–VOLUME–PROFIT ANALYSIS: ADDITIONAL ISSUES CHAPTER 6 COST–VOLUME–PROFIT ANALYSIS: ADDITIONAL ISSUES Managerial Accounting, Fifth Edition

Unit 4 Agenda HouseKeeping Team Discussion Threads Wiley Plus Questions? Cost Volume Profit Highlights CVP Analysis 3 Scenarios for Business Analysis Sales Mix Considerations Assignment Example Quiz Questions

Cost-Volume-Profit Analysis: Additional Issues Cost-Volume-Profit (CVP) Review Sales Mix Cost Structure and Operating Leverage Basic concepts Basic computations CVP and changes in the business environment Break-even sales in units Break-even in dollars Sales mix with limited resources Effect on contribution margin ration Effect on break-even point Effect on margin of safety ratio Operating leverage Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation. Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt. Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets. Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees. Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss: difference between the actual return and the expected return on plan assets and, amortization of the unrecognized net gain or loss from previous periods

Basic Concepts 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. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 1: Describe the essential features of a cost-volume-profit income statement.

CVP Income Statement - Example The CVP income statement for Vargo Video Company is illustrated below: (This illustration was also presented as Illustration 5-11 in Chapter 5.) 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) Illustration 6-1 SO 1: Describe the essential features of a cost-volume-profit income statement.

CVP Income Statement – Example Cont’d A detailed CVP income statement for Vargo Video Company is illustrated below: (This uses the same base information as the previous statement.) 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) Illustration 6-2 SO 1: Describe the essential features of a cost-volume-profit income statement.

Basic Computations – A Review CVP and Changes in the Business Environment To better understand CVP analysis, three independent cases involving Vargo will be examined. Each case will use the original data for Vargo Video: Illustration 6-6 Basic Data 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 2: Apply CVP concepts.

Basic Computations – A Review: Case I Illustration 6-6 Basic Data Should Vargo Video match a competitor’s 10% discount and reduce selling price to $450 per unit? News Sales Price [$500 - (.10 × $500)] = $450. New Contribution Margin ($450 - $300) = $150. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) Illustration 6-7 SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case I Illustration 6-6 Basic Data Should Vargo Video match a competitor’s 10% discount and reduce selling price to $450 per unit? Management must decide how likely it is that Vargo can achieve the increase in sales as well as the likelihood of lost sales if the discount is not matched. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case II Illustration 6-6 Basic Data Use of new equipment is being considered that will increase fixed costs by 30% and lower variable costs by 30%. What effect will the new equipment have on the sales required to break-even? Fixed costs will increase $60,000 and variable costs will decrease $90,000 (variable cost per unit = $210). 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case II Illustration 6-6 Basic Data Fixed costs will increase $60,000 and variable costs will decrease $90,000 (variable cost per unit = $210). The change appears positive as break-even point is reduced by approximately 10%. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) Illustration 6-8 SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case III Illustration 6-6 Basic Data Vargo’s supplier of raw materials has increased the cost of raw materials which will increase the variable cost per unit by $25 to $325. The selling price will remain the same at $500. New contribution margin $175 ($500 - $325). Management intends to cut fixed costs by $17,500 to $ 182,500. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case III Illustration 6-6 Basic Data 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? 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case III Variable cost per unit increases to $325 as a result of the $25 increase in raw materials cost. Fixed costs decrease to $182,500. Contribution margin per unit is now $175. If Vargo cannot sell an additional 100 units, management must further reduce costs, increase the selling price of the DVDs, or accept a lower net income. Illustration 6-9 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 2: Apply basic CVP concepts.

It is important to understand Sales Mix When a company sells more than one product: It is important to understand its sales mix. The sales mix is the relative percentage in which a company sells its products. If a company’s unit sales are 80% printers and 20% computers, its sales mix is 80% to 20%. Sales mix is important because different products often have very different contribution margins. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 3: Explain the term sales mix and its effects on break-even sales.

Break-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. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Units - Example Assume that Vargo Video sells two products and has the following sales mix and related information: Illustration 6-10 Illustration 6-11 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Units - Example 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: Illustration 6-12 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) Illustration 6-13 SO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Units - Example With a break-even point of 1,000 units, Vargo must sell: 750 DVD Players (1,000 units × 75%) 250 TVs (1,000 units × 25%) At this level, the total contribution margin will equal the fixed costs of $275,000 . Illustration 6-14 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 3: Explain the term sales mix and its effects on break-even sales.

Break-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. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 3: Explain the term sales mix and its effects on break-even sales.

Break-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, and Compute the contribution margin ratio rather than the contribution margin per unit. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Dollars - Example The information necessary to perform cost-volume-profit analysis is: 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) Illustration 6-15 SO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Dollars - Example 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: Illustration 6-16 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) Illustration 6-17 SO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Dollars - Example 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. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 3: Explain the term sales mix and its effects on break-even sales.

Sales 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 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: Illustration 6-18 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 4: Determine sales mix when a company has limited resources.

Sales Mix with Limited Resources - Example 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 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. Illustration 6-19 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 4: Determine sales mix when a company has limited resources.

Sales Mix with Limited Resources - Example 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. Illustration 6-20

Theory 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. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 4: Determine sales mix when a company has limited resources.

Operating Leverage Operating 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. 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 5: Understand how operating leverage affects profitability.

Operating 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. Illustration 6-25 1. On the topic, “Challenges Facing Financial Accounting,” what did the AICPA Special Committee on Financial Reporting suggest should be included in future financial statements? Non-financial Measurements (customer satisfaction indexes, backlog information, and reject rates on goods purchases). Forward-looking Information Soft Assets (a company’s know-how, market dominance, marketing setup, well-trained employees, and brand image). Timeliness (no real time financial information) SO 5: Understand how operating leverage affects profitability.

Unit 4 Agenda HouseKeeping Team Discussion Threads Wiley Plus Questions? Cost Volume Profit Highlights CVP Analysis 3 Scenarios for Business Analysis Sales Mix Considerations Assignment Example Quiz Questions

Unit 4 Assignment Example E6-6B Yard-King manufactures lawnmowers, weed-trimmers, and chainsaws. Its sales mix and contribution margin per unit are as follows. Yard-King has fixed costs of $4,620,000. Compute break-even point in units for a company with more than one product. Lawnmowers Weed trimmer Chainsaws Sales Mix 30% 50% 20% Contribution Margin $35 $25 $50

Unit 4 Assignment Example E6-6B Yard-King manufactures lawnmowers, weed-trimmers, and chainsaws. Its sales mix and contribution margin per unit are as follows. Yard-King has fixed costs of $4,620,000. Compute break-even point in units for a company with more than one product. Lawnmowers Weed trimmer Chainsaws Sales Mix 30% 50% 20% Contribution Margin $35 $25 $50 Step 1: Calculate Weighted Average Contribution Margin Lawnmowers Weed trimmer Chainsaws Sales Mix 30% 50% 20% Contribution Margin $35 $25 $50 $10.50 + $12.50 + $10.00 = $33.00 Step 2: Calculate Breakeven in Units Total break-even in units = $4,620,000 / $33 = 140,000 units

Unit 4 Assignment Example E6-6B Yard-King manufactures lawnmowers, weed-trimmers, and chainsaws. Its sales mix and contribution margin per unit are as follows. Yard-King has fixed costs of $4,620,000. Compute break-even point in units for a company with more than one product. Lawnmowers Weed trimmer Chainsaws Sales Mix 30% 50% 20% Contribution Margin $35 $25 $50 Step 3: Mix of Breakeven Sales Lawnmowers Weed trimmer Chainsaws Sales Mix 30% 50% 20% Breakeven Units 140,000 42,000 + 70,000 28,000=

Unit 4 Agenda HouseKeeping Team Discussion Threads Wiley Plus Questions? Cost Volume Profit Highlights CVP Analysis 3 Scenarios for Business Analysis Sales Mix Considerations Assignment Example Quiz Questions

Unit 4 Quiz Example #1 For Danks Company, sales is $500,000, variable expenses are $310,000, and fixed expenses are $140,000. Danks' contribution margin ratio is: 10%. 28%. 38%. 62%.

Contribution Margin / Sales = Contribution Margin Ratio Unit 4 Quiz Example #1 For Danks Company, sales is $500,000, variable expenses are $310,000, and fixed expenses are $140,000. Danks' contribution margin ratio is: 10%. 28%. 38%. CORRECT ANSWER 62%. To Solve: Sales $500,000 Less Variable Expense - 310,000 Contribution Margin 190,000 Contribution Margin / Sales = Contribution Margin Ratio 190,000 / 500,000 = 38%

Unit 4 Quiz Example #2 Iguchi Company sells 2,000 units of Product A annually, and 3,000 units of Product B annually. The sales mix for Product A is : 40%. 60%. 67%. cannot determine from information given.

Unit 4 Quiz Example #2 Iguchi Company sells 2,000 units of Product A annually, and 3,000 units of Product B annually. The sales mix for Product A is : 40%. CORRECT ANSWER 60%. 67%. cannot determine from information given. To Solve: 2,000 +3000 = 5,000 units total Product A Mix: 2,000/5,000 = 40%