Detailed CVP Income Statement Cost-Volume-Profit (CVP) Review Detailed CVP Income Statement Internal Use Only

C-V-P Review - Breakeven Analysis Breakeven in Units? $200,000 / $200 = 1,000 Breakeven in Dollars? 1,000 x $500 = 500,000

C-V-P Review - Breakeven Analysis Breakeven in Units? $200,000 / $200 = 1,000 Breakeven in Dollars? 1,000 x $500 = 500,000 CM as a ratio ? $200 ÷ $500 = 40%. 40% of “Sales” is available to cover Fixed Costs and Profit 800,000 x 40% = 320,000 (200,000 + 120,000)

Ex: Target Net Income: $250,000. C-V-P Review - Target Net Income Required Unit Sales ? 450,000 / $200 = 2,250 units Required Sales Dollars ? 2,250 x $500 = $1,125,000 Required Sales Dollars using CM Ratio? 450,000 40% = $1,125,000 Ex: Target Net Income: $250,000. ($200 / $500)

Margin of Safety Shows how far sales can drop before breakeven point is reached. Informs management of the risk of loss due to changes in sales. Useful when a significant proportion of sales are at risk of decline or elimination, as may be the case when a sales contract is coming to an end. (Burger-King and Coke … Amex and Costco) Small “Margin of Safety” might trigger action to reduce expenses. The opposite situation may also arise, where the MoS is so large that a business is well-protected from sales variations. (May lead to a “take-it-or-leave-it” attitude in negotiations).

C-V-P Review - Breakeven Analysis Breakeven in Units? $200,000 / $200 = 1,000 Breakeven in Dollars? 1,000 x $500 = 500,000 CM as a ratio ? $200 ÷ $500 = 40%. 40% of “Sales” is available to cover Fixed Costs and Profit 800,000 x 40% = 320,000 (200,000 + 120,000)

C-V-P Review – *Margin of Safety Margin of Safety in Dollars ? (Proj. sales – BE sales) $800,000 – $500,000 = $300,000 Margin of Safety Ratio ? 300,000 / 800,000 = 37.5%

Sales Mix Sales mix is the relative percentage in which a company sells its products. If a company’s sells 6,000,000 printers and 2,000,000 computers … its sales mix is 75:25 (or 3 printers to 1 computer) Sales mix is important because … different products often have very different *CM (*contribution margins).

Sales Mix … Break-Even Sales in Units Compute break-even sales for a mix products by determining the weighted-average unit contribution margin. Ex: “V” sells Camcorders AND TV sets in these quantities: 1,500 Camcorders and 500 TVs. Total Units Sold = 2,000 Sales mix, as a percentage of total units sold, is:

Sales Mix … Break-Even Sales in Units 1st determine the weighted-average contribution margin. New Info $200 X .75 = $150 $500 X .25 = $125 $150 + $125 = $275

Sales Mix … Break-Even Sales in Units 2nd use the weighted-average unit contribution margin to compute the break-even point in units New Info

Sales Mix … Break-Even Sales in Units With a break-even point of 1,000 units, V Video must sell: 750 Camcorders (1,000 units x 75%) 250 TVs (1,000 units x 25%) At this level, total CM will equal the fixed costs of $275,000.

Sales Mix - Break-Even Sales in Dollars Works well if the company has many products. Calculates break-even point in terms of sales dollars for divisions or product lines, NOT individual products.

Sales Mix - Break-Even Sales in Dollars Illustration: Kale Garden Supply Company has two divisions.

Sales Mix - Break-Even Sales in Dollars First, determine the weighted-average contribution margin. Second, calculate break-even point in dollars.

Sales Mix - Break-Even Sales in Dollars 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 becomes 50% to 50%, the weighted average contribution margin ratio changes to 35%, resulting in a lower break-even point of $857,143.

Resources are finite (limited) Resources are finite (limited). A business only has so many man hours, so many square feet, and so many machines. Long-term … a company can expand … or grow. Short term … limited resources require business to make decisions about which products to make and in what quantities … to maximize profits. How?   Look at each products use of the limited resource … and maximize contribution margin per hour.

Sales Mix … Limited Resources Ex: V Video makes camcorders & TVs. * Machine capacity is limited to 3,600 hours per month. Additional New Info

Sales Mix … Limited Resources From previous slide Management should produce more camcorders if demand exists or else increase machine capacity.

Sales Mix … Limited Resources Assume V Video can increase capacity from 3,600 to 4,200 hrs. Should the 600 added hours be used to make camcorders or TVs. To maximize net income, all 600 hours should be used to produce and sell camcorders.

Cost Structure & Operating Leverage Cost Structure: proportion of fixed vs variable costs that a company incurs. May have a significant effect on profitability. Company must carefully choose its cost structure. High Operating Leverage. Significantly more fixed vs variable cost = These firms use a lot of fixed costs in their business it is capital intensive.

Cost Structure & Operating Leverage Capital intensive: a lot of fixed costs. Which companies or industries (types of products) ? Greater investments, More sensitive to sales decrease. Economies of scale, More productivity, More profits during up economy. Opposite of Capital Intensive is: Labor intensive: a lot of variable costs. Which companies or industries (types of products) ? More expensive long-term, inefficient & inconsistent, labor shortage. Flexibility to meet demands, Personalization, Reduce variable costs.

Cost Structure and Operating Leverage Extent that net income reacts to a given change in sales. Higher fixed costs vs variable = higher operating leverage. Increasing sales: means profits will increase rapidly. Decreasing sales: can have major consequences.

Hotel-Casino …. Labor or capital intensive ? Ex: GM & FORD Capital intensive (high operating leverage). High fixed costs … machines, robots, buildings etc. Economic slowdown hurts a capital intensive firm much more than a company not quite so capital intensive. Labor intensive (more workers = higher variable costs) has lower operating leverage. Hotel-Casino …. Labor or capital intensive ? Labor intensive typically have an easier time surviving (note “surviving”) than capital intensive firms.

Cost Structure and Operating Leverage Ex: “V” Video has a competitor “NW” Inc. Both make camcorders. “V” uses a labor-intensive (many employees) manufacturing process. “NW” uses an automated system. (Employees only set-up, adjust, and maintain the machinery.) CVP income statements

Cost Structure and Operating Leverage Effect on Contribution Margin Ratio Look at CM ratios.

Cost Structure and Operating Leverage Effect on Contribution Margin Ratio New Wave contributes 80 cents to net income for each dollar of increased sales while Vargo only contributes 40 cents. New Wave’s cost structure which relies on fixed costs is more sensitive to changes in sales.

Cost Structure and Operating Leverage Effect on Break-Even Point Calculate the break-even point. 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.

APPENDIX … ABSORPTION VS VARIABLE Costing All we have covered so far are variations of: Absorption Costing (Job-Order costing, Process costing, Activity-Based-Costing) All factory costs added to the product during manufacture and are assets until sold … then expense as “Cost of Goods Sold. Under Absorption Costing, product costs consist of: Direct Material + Direct Labor + Variable Manufacturing Overhead + Fixed Manufacturing Overhead

Fixed Manufacturing Overhead What costs fall under the category of: Fixed Manufacturing Overhead Premise: A business cannot continue in existence if it does not “cover” it Fixed Manufacturing Overhead? The short answer is that the fixed manufacturing overhead is going to be incurred no matter how much is produced. In the long run, a business must recover those costs to survive. So, how else could you handle Fixed Factory Overhead ? If we don’t inventory it … we then must EXPENSE it. Period Cost Product Cost

APPENDIX … ABSORPTION VS VARIABLE Costing FIXED Manufacturing Costs – not “product” costs … not part of inventory instead “expensed” as a monthly “period cost” Under variable costing, product costs consist of: Direct Materials + Direct Labor + Variable Manufacturing Overhead NO Fixed Manufacturing Overhead

APPENDIX … ABSORPTION VS VARIABLE Costing The difference between absorption and variable costing: Under both costing methods, selling and administrative expenses (corporate) are treated as period costs … BUT, under variable costing “FIXED” Mfg Costs are also considered as period costs and are expensed when incurred (NOT “inventoried” as in absorption costing)

APPENDIX … ABSORPTION VS VARIABLE Costing Comparing Absorption with Variable Costing Ex: PCorp makes “Fix-It”. Relevant data for Fix-It in JAN 2013, the first month of production, are:

APPENDIX … ABSORPTION VS VARIABLE Costing Comparing Absorption with Variable Costing Per unit manufacturing cost under each approach. The mfg cost per unit is $4 ($13 -$9) higher for absorption costing because fixed mfg costs are treated as product costs.

APPENDIX … ABSORPTION VS VARIABLE Costing Absorption Costing Example P Corp

APPENDIX … ABSORPTION VS VARIABLE Costing Variable Costing Example

APPENDIX … ABSORPTION VS VARIABLE Costing Decision-Making Concerns GAAP require that absorption costing be used for the costing of inventory for external reporting purposes. Net income measured under GAAP (absorption costing) is often used internally to evaluate performance, justify cost reductions, or evaluate new projects.

APPENDIX … ABSORPTION VS VARIABLE Costing Decision-Making Concerns Some companies have recognized that net income calculated using GAAP does not highlight differences between variable and fixed costs and may lead to poor business decisions. These companies use variable costing for internal reporting purposes.

APPENDIX … ABSORPTION VS VARIABLE Costing Potential Advantages of Variable Costing The use of variable costing is consistent with cost–volume–profit analysis. Net income under variable costing is unaffected by changes in production levels. Instead, it is closely tied to changes in sales. The presentation of fixed costs in the variable costing approach makes it easier to identify fixed costs and to evaluate their impact on the company’s profitability.

(a) Unit Cost Direct Materials 7.50 Direct Labor 2.45   Direct Materials 7.50 Direct Labor 2.45 Variable Mfg Overhead 5.80 Mfg Cost Per Unit 15.75

Income Statement - Variable Costing Sales (80,000 lures x $25)   2,000,000 Var Costs (80,000 x $15.75) 1,260,000 Var Selling – Admin Exp (80,000 x $3.90) 312,000 1,572,000 Contribution Margin 428,000 Fixed Mfg Overhead 225,000 Fixed Sell – Admin Exp 240,100 465,100 Net Income (Loss) (37,100) Unit Cost   Direct Materials 7.50 Direct Labor 2.45 Variable Mfg Overhead 5.80 Mfg Cost Per Unit 15.75

(c) Unit Cost Direct Materials 7.50 Direct Labor 2.45   Direct Materials 7.50 Direct Labor 2.45 Variable Mfg Overhead 5.80 Fixed Mfg Overhead 2.50 Mfg Cost Per Unit 18.25

Income Statement - Absorption Costing Sales (80,000 lures x $25)   2,000,000 Cost of Goods Sold (80,000 x $18.75) 1,460,000 Gross Profit 40,000 Var Sell-Admin Exp (80,000 x $3.90) 312,000 Fixed Sell – Admin Exp 240,100 465,100 Net Income (Loss) (12,100) Unit Cost   Direct Materials 7.50 Direct Labor 2.45 Variable Mfg Overhead 5.80 Fixed Mfg Overhead 2.50 Mfg Cost Per Unit 18.25

(b) (b) Absorption Costing Labor (Crate builders) 38,000 Material (Wood) 54,000 Var Overhead (Utilities) 2,400 Var Overhead (Nails) 350 Fxd Overhead (Utilities) 18,000 Fxd Overhead (Rent) 21,400 Total Mfg Costs $ 134,150 (a) (a) Variable Costing Labor (Crate builders) 38,000 Material (Wood) 54,000 Var Overhead (Utilities) 2,400 Var Overhead (Nails) 350 Total Mfg Costs $ 94,750 (c) (c) Difference is due to fixed overhead being included as part of manufacturing costs under absorption costing ONLY. This difference amounts to $39,400 ($18,000 + $21,400).