# COST–VOLUME–PROFIT ANALYSIS: ADDITIONAL ISSUES

## Presentation on theme: "COST–VOLUME–PROFIT ANALYSIS: ADDITIONAL ISSUES"— Presentation transcript:

COST–VOLUME–PROFIT ANALYSIS: ADDITIONAL ISSUES
CHAPTER 6 COST–VOLUME–PROFIT ANALYSIS: ADDITIONAL ISSUES

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. 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)

Formulas and Formats to Be Used in the Chapter
Traditional Income Statement CVP income statement Revenue Cost of goods sold Gross margin Administrative and selling expense Operating income Revenue Variable Expense Contribution margin Fixed Expense Operating income These sound alike but they are different concepts

Formulas and Formats to Be Used in the Chapter – Review from Chapter 5
Formula for contribution margin ratio (CMR) CM per Unit/Unit Sales Price Formula for breakeven in dollars Fixed Cost/Contribution Margin Ratio Formula for breakeven in units Fixed Cost/Contribution Margin per Unit Formula for margin of safety Actual Sales – Breakeven Sales

Formulas and Formats to Be Used in the Chapter
Formula for margin of safety ratio Margin of Safety in Dollars/ Actual or Expected Sales Dollars Breakeven with multiple products Divide fixed costs by the weighted average unit contribution margin of all products Formula for weighted average unit contribution margin  weighted contribution margin per-unit of each product

Formulas and Formats to Be Used in the Chapter
Formula for margin of safety ratio Margin of Safety in Dollars/ Actual or Expected Sales Dollars Breakeven with multiple products Divide fixed costs by the weighted average unit contribution margin of all products

Formulas and Formats to Be Used in the Chapter
Formula for breakeven in a company with several divisions, each of which has many products Calculate the breakeven in terms of sales dollars for division or product line (not individual products) Formula for weighted average contribution margin ratio for company with multiple divisions (CMR x Sales Mix %) + (CMR x Sales Mix %) Division One Division Two

Formulas and Formats to Be Used in the Chapter
Formula for breakeven in dollars using a weighted average contribution margin ratio Fixed Costs/Weighted-Average CMR = BE in \$

Formulas and Formats to Be Used in the Chapter
Maximizing net income with a limited resource First produce the product with the largest contribution margin per unit of scarce resource Formula for degree of operating leverage Total Contribution Margin in Dollars/Net Income

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

Cost-Volume-Profit (CVP) Review
As noted in Chapter 5, 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 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) LO 1: Describe the essential features of a cost-volume-profit income statement.

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

Basic Computations – A Review
Break-Even Analysis As noted in Chapter 5, Vargo Company’s contribution margin per unit is \$200 (sales price \$500 - \$300 variable costs) It was also shown that Vargo Company’s contribution margin ratio was: 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) LO 2: Apply basic CVP concepts.

Basic Computations – A Review
Break-Even Analysis Vargo Company’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 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) LO 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: 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) LO 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: 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) LO 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 company will be examined. Each case will use the original data for Vargo Company: 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) LO 2: Apply CVP concepts.

Basic Computations – A Review: Case I
Should Vargo Company match a competitor’s 10% discount and reduce selling price to \$450 per unit? With variable costs per unit unchanged, a 10% discount in selling price will decrease the contribution margin to \$150 and increase break-even sales to 1,333 units 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) LO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case II
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). 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) LO 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. 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? 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) LO 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. 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) LO 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. LO 1: Describe the essential features of a cost-volume-profit income statement. LO 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) LO 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) LO 3: Explain the term sales mi and its effects on break-even sales.

Break-Even Sales in Units - Example
Assume that Vargo Company sells two products and has the following sales mix and related information: 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) LO 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 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) LO 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 x 75%) 250 TVs (1,000 units x 25%) At this level, the total contribution margin will equal the fixed costs of \$275,000 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) LO 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) LO 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) LO 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) LO 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: 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) LO 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) LO 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 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 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: 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) LO 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. 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) LO 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.

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

Let’s Review 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. LO 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. 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) LO 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. 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) LO 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 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) LO 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. 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) LO 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.” 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) LO 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. 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) LO 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. 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) LO 5: Understand how operating leverage affects profitability.

Let’s Review The degree of operating leverage:
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. LO 5: Understand how operating leverage affects profitability.

Chapter Review - Brief Exercise 6-9
Presto 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 % Standard tapered % Large scented % What is the weighted-average contribution margin ratio?

Chapter Review - Brief Exercise 6-9
Type of Candles CMR Sales Mix Birthday 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 dollar amount of each type of candle that must be sold to break even? Step 1: Fixed Costs \$440,000 ÷ WA CMR 22% = \$ BEP \$2,000,000 Step 2: Birthday candles \$2,000, X % = \$ 600,000 Standard tapered \$2,000, X % = ,000,000 Large scented \$2,000, X % = ,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: 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) LO 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 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) LO 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 2008, the first month of production are: 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) LO 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. 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) LO 6: Explain the difference between absorption costing and variable costing.

Appendix Absorption Costing Income 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) LO 6: Explain the difference between absorption costing and variable costing.

Appendix Variable Costing Income 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) LO 6: Explain the difference between absorption costing and variable costing.

Appendix Summary of Income Effects
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) LO 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. LO 6: Explain the difference between absorption costing and variable costing.

The San Marcos is trying to determine its breakeven point.
Exercise 6-1 The San Marcos is trying to determine its breakeven point. The inn has 75 rooms that are rented at \$50 a night. It incurred the following costs during the year. Salaries \$8,500 per month Utilities \$2,000 per month Depreciation \$1,000 per month Maintenance \$500 per month Maid service \$5 per room Other costs \$33 per room

Determine the breakeven point in rooms per month.
Exercise 6-1 Determine the breakeven point in rooms per month. Breakeven point in rooms for months formula: Fixed Costs/Contribution Margin = BEu Contribution Margin = \$50 - \$5 - \$35 = \$12 Breakeven in rooms per month = (\$8,500 + \$2,000 + \$1,000 + \$500)/12 = 1,000 rooms

Determine the breakeven point in dollars.
Exercise 6-1 Determine the breakeven point in dollars. Breakeven in dollars formula+ Fixed Costs/Contribution Margin Ratio = BE\$ Contribution Margin Ratio (CMR) = Contribution Margin Per Room/Price Contribution Margin = \$50 - \$5 - \$35 = \$12 Contribution Margin Ratio = \$12/\$50 = .24 Breakeven in rooms per month = (\$8,500 + \$2,000 + \$1,000 + \$500)/.24 = \$50,000

Exercise 6-1 If the inn plans on renting an average of 50 rooms per day, what is the monthly margin of safety in dollars? Expected sales = 50 rooms × \$50 × 30 days = \$75,000 \$75,000 - \$50,000 = \$25,000 margin of safety What is the margin safety ratio? \$25,000/\$75,000 = 33 1/3rd

Exercise 6-2 In the month of June, Angelo’s Beauty Salon gave 3500 haircuts, shampoos, and permanents at an average price of \$30. During the month, fixed cost were \$16,800 and variable costs were 80% of sales. Determine the contribution margin in dollars, per unit, and as a ratio.

Contribution margin in dollars: Contribution margin per unit
Exercise 6-2 Contribution margin in dollars: (3,500 × \$30) revenue – .8(3,500 × \$30) = \$21,000 Contribution margin per unit \$21,000/3,500 = \$6 Contribution margin ratio \$6/\$30 = 20%

Exercise 6-2 Compute the margin of safety in dollars and as a ratio Breakeven in dollars = \$16,800/.20 = \$84,000 Breakeven in units = \$16,800/\$6 = 2,800 Margin of safety in dollars = (3,500 x \$30) - \$84,000 = \$21,000 Margin of safety ratio = \$21,000/\$105,000 = .20%

Exercise 6-3 Get Company reports the following operating results for the month of August. Sales \$300,000 (5,000 units) Variable cost \$210,000 Fixed cost \$70,000

Compute the net income to be earned.
Exercise 6-3 Management is considering increasing sales price with 10% with no change in variable costs. Compute the net income to be earned. Sales \$300,000 × 1.10 \$330,000 Variable costs 210,000 Contribution margin \$120,000 Fixed costs 70,000 Operating income \$50,000

Management is considering decreasing variable expense to 58% of sales
Exercise 6-3 Management is considering decreasing variable expense to 58% of sales Compute the net income to be earned. Sales \$300,000 Variable costs 300,000 × .58 174,000 Contribution margin \$126,000 Fixed costs 70,000 Operating income \$56,000

Management is considering decreasing fixed costs by \$20,000
Exercise 6-3 Management is considering decreasing fixed costs by \$20,000 Compute the net income to be earned. Sales \$300,000 Variable costs 210,000 Contribution margin \$90,000 Fixed costs 50,000 Operating income \$40,000

Grass King has fixed costs of \$4,600,000
Exercise 6-6 Grass King manufactures lawnmowers, weed trimmers, and chainsaws. Its sales mix and contribution margin per unit are as follows: 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

Exercise 6-6 Compute the number of units of each product that Grass King must sell in order to break even under this product mix. Calculate weighted average contribution margin. (.30 × \$30) + (.50 × \$20) + (.20 × \$40) = \$9 + \$10+ \$8 = \$27 Divide fixed costs by a weighted average contribution margin: 4,600,000/27 = 170, units

Exercise 6-9 Tiger Golf Accessories sells golf shoes, gloves, and a laser guided rangefinder that measures distance. Shown below are unit cost and sales data. 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%

Exercise 6-9 Compute the breakeven point in units for the company. Weighted average contribution margin = (.40 × \$40) + (.50 × \$20) + (.10 × \$50) = \$16+ \$10+ \$5 = \$31 Divide fixed costs by weighted average contribution margin \$620,000/\$31 = 20,000 units

Exercise 6-9 Determine the number of units to be sold at the breakeven point for each product line. Shoes (20,000 X .40) = 8,000 pairs of shoes Gloves (20,000 X .50) = 10,000 pairs of gloves Range finders (20,000 X .10) = 2,000 range finders

Exercise 6-9 Verify that the mix of sales determined will generate a zero net income. Shoes: 8,000 X \$40 = \$320,000 Gloves: 10,000 X \$20 = ,000 Range finders: 2,000 X \$50 = ,000 Total contribution margin 620,000 Fixed costs ,000 Net income \$

Dalton Company manufactures and sells two products.
Exercise 6-13 Dalton Company manufactures and sells two products. Relevant per-unit data concerning each product follow. Basic product Deluxe product Selling price \$40 \$52 Variable costs \$18 \$24 Machine hours .5 .7

Compute the contribution margin per machine hour for each product.
Exercise 6-13 Compute the contribution margin per machine hour for each product. 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 If 1000 additional machine hours are available, which product should Dalton manufacture? The product with the highest contribution margin perseveres resource – the basic product.

Exercise 6-13 Total contribution margin if the hours are divided equally among the products. Basic Deluxe Total Machine hours allocated 500 1,000 X Contribution margin per machine hour    \$44       \$40                Contribution margin \$22,000 \$20,000 \$42,000

Exercise 6-13 Total contribution margin if the hours dedicated to the product with the largest contribution margin per scarce resource. Basic Deluxe Total Machine hours allocated 1,000 -0- X Contribution margin per machine hour     \$44      \$40                 Contribution margin \$44,000   -0-

E 6-16 An investment banker is analyzing two companies that specialize in the production and sale of candied apples. Old Fashion Apples uses a labor-intensive approach, and Mech-Apple uses a mechanized system. CVP income statements for the two companies are shown below.

E 6-16 Old-Fashioned Apples Mech Apples Sales \$400,000 Variable costs 320,000 160,000 Contribution margin 80,000 240,000 Fixed costs 20,000 180,000 Net income 60,000 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.

Calculate each company’s degree of operating leverage.
Formula: Contribution margin/Net income Old-Fashion Apples: 80,000/60,000 = 1.333 Mech-Apples 240,000/60,000 = Mech-Apples is more sensitive to changes in sales volume.

Degree of Operating Leverage
Determine the effect on each company’s net income if sales decreased by 10% and if sales increased by 5%. % Change in Sales X Degree of Operating Leverage = % Change in Net Income 10% decrease: Old Fashion Mech-Apple (10%) (10%) X X = = (13.3%) (40.0%) 5% increase: Old Fashion Mech-Apple 5% 5% X X == 6.65% 20.0% Which investment do you think the investment banker choose?

The End!