COST–VOLUME–PROFIT ANALYSIS: ADDITIONAL ISSUES CHAPTER 19 COST–VOLUME–PROFIT ANALYSIS: ADDITIONAL ISSUES Accounting, Fourth Edition

Chapter Preview

Study Objectives Describe the essential features of a cost-volume-profit income statement. Apply basic CVP concepts. Explain the term sales mix and its effects on break-even sales. Determine sales mix when a company has limited resources. Understand how operating leverage affects profitability.

Preview of Chapter The relationship between a company’s fixed and variable costs can have a huge impact on its profitability. The current trend is toward companies with cost structures dominated by fixed costs. This has significantly increased the volatility of many companies’ net income. Thus, the use of CVP analysis has additional uses in making sound business decisions.

Cost-Volume-Profit (CVP) Review As noted in Chapter 18, CVP analysis is: the study of the effects of changes in costs and volume on a company’s profit. CVP analysis is important to profit planning. CVP analysis is critical in management decisions such as: determining product mix, maximizing use of production facilities, setting selling prices.

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. 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 18-11 in Chapter 18.) Illustration 19-1 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.) Illustration 19-2 SO 1: Describe the essential features of a cost-volume-profit income statement.

Basic Computations – A Review Break-Even Analysis As noted in Chapter 18, Vargo Video’s contribution margin per unit is $200 (sales price $500 - $300 variable costs). It was also shown that Vargo Video’s contribution margin ratio was: SO 2: Apply basic CVP concepts.

Basic Computations – A Review Break-Even Analysis Vargo Video’s break-even point in units or in dollars (using contribution margin ratio) is: In its early stages of operation, a company’s primary goal is to break-even. Failure to break-even will eventually lead to financial failure. Illustration 19-3 SO 2: Apply basic CVP concepts.

Basic Computations – A Review Target Net Income Once a company achieves break-even sales, a sales goal can be set that will result in a target net income. Assuming Vargo’s target net income is $250,000, required sales in units and dollars to achieve this are: Illustration 19-4 SO 2: Apply basic CVP concepts.

Basic Computations – A Review Margin of Safety Remember from Chapter 5, the margin of safety tells us how far sales can drop before the company will operate at a loss. The margin of safety can be expressed in dollars or as a ratio. Assuming Vargo’s sales are $800,000: Illustration 19-5 SO 2: Apply basic CVP concepts.

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 19-6 Basic Data SO 2: Apply CVP concepts.

Basic Computations – A Review: Case I 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. Illustration 19-6 Illustration 19-7 SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case I Illustration 19-6 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. SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case II Illustration 19-6 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). SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case II Illustration 19-6 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%. Illustration 19-8 SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case III 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. Illustration 19-6 SO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case III 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? Illustration 19-6 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 19-9 SO 2: Apply basic CVP concepts.

Let’s Review Croc Catchers calculates its contribution margin to be less than zero. Which statement is true? a. Its fixed costs are less than the variable cost per 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. SO 1: Describe the essential features of a cost-volume-profit income statement. 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. 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. 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 19-10 Illustration 19-11 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 19-12 Illustration 19-13 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 19-14 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. 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. 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: Illustration 19-15 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 19-16 Illustration 19-17 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. SO 3: Explain the term sales mix and its effects on break-even sales.

Let’s Review Net income will be: a. Greater if more higher-contribution margin units are sold than lower-contribution margin units. b. Greater is more lower-contribution margin units are sold than higher-contribution margin units. c. Equal as long as total sales remain equal, regardless of which products are sold. d. Unaffected by changes in the mix of products sold. 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 19-18 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 19-19 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 19-20

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

Let’s Review $15 ÷ 3 hours = $5 an hour If the contribution margin per unit is $15 and it takes 3.0 machine hours to produce the unit, the contribution margin per unit of limited resource is: a. $25. b. $5. c. $4. d. No correct answer is given. $15 ÷ 3 hours = $5 an hour SO 4: Determine the sales mix when a company has limited resources.

Cost Structure and Operating Leverage Cost 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 carefully choose its cost structure. SO 5: Understand how operating leverage affects profitability.

Comparison 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. Illustration 19-21 SO 5: Understand how operating leverage affects profitability.

Effect 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. Illustration 19-22 SO 5: Understand how operating leverage affects profitability.

Effect 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. Illustration 19-23 SO 5: Understand how operating leverage affects profitability.

Effect 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.” Illustration 19-24 SO 5: Understand how operating leverage affects profitability.

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. 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 19-25 SO 5: Understand how operating leverage affects profitability.

Chapter Review - Brief Exercise 19-9 Briggs Candle Supply makes candles. The sales mix (as a percent of total dollar sales) of its three product lines is as follows: birthday candles, 30%; standard tapered candles, 50%; and large scented candles, 20%. The contribution margin ratio of each candle type is shown below. Candle Type Contribution Margin Ratio Birthday 10% Standard tapered 20% Large scented 45% What is the weighted-average contribution margin ratio?

Chapter Review - Brief Exercise 19-9 Type of Candles CMR Sales Mix Birthday 10% × 30% = 3% Standard tapered 20% × 50% = 10% Large scented 45% × 20% = 9% Weighted Average Contribution Margin Ratio 22% 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 even? Step 1: Fixed Costs: $440,000 ÷ WACMR 22% = $ BEP = $2,000,000 Step 2: Birthday candles $2,000,000 × 30% = $ 600,000 Standard tapered $2,000,000 × 50% = 1,000,000 Large scented $2,000,000 × 20% = 400,000 $2,000,000

Appendix Absorption Costing vs. Variable Costing Under variable costing, product costs consist of: Direct Materials Direct Labor Variable Mfg. Overhead The difference between absorption and variable costing is: Illustration 19A-1 SO 6: Explain the difference between absorption costing and variable costing.

Appendix Absorption Costing vs. Variable Costing Under 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. Fixed Mfg. Overhead SO 6: Explain the difference between absorption costing and variable costing.

Appendix Absorption Costing vs. Variable Costing Example – Premium Products Manufactures Fix-it, a sealant for car windows. Relevant data for January 2012, the first month of production are: Illustration 19A-2 SO 6: Explain the difference between absorption costing and variable costing.

Appendix Absorption Costing vs. Variable Costing Example – 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. Illustration 19A-3 SO 6: Explain the difference between absorption costing and variable costing.

Appendix Absorption Costing Income Statement Illustration 19A-4 SO 6: Explain the difference between absorption costing and variable costing.

Appendix Variable Costing Income Statement Illustration 19A-5 SO 6: Explain the difference between absorption costing and variable costing.

Appendix Summary of Income Effects Illustration 19A-14 SO 7: Discuss net income effects under absorption costing versus variable costing.

Let’s Review Fixed manufacturing overhead costs are recognized as: a. Period 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. SO 6: Explain the difference between absorption costing and variable costing.

Copyright Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.