Managerial Accounting - Metropolitan Community College



Managerial Accounting

ACCT 2330

Notes: Chapter 5

See the traditional Income Statement below. What do sales have to be in order for Happy Dan’s to make $1,200 in net income?

Happy Dan’s Hardware Store

Income Statement

For the Year Ended December 31, 2009

|Sales |$48,000 |

|Cost of Goods Sold |20,000 |

|Gross Margin |28,000 |

| | |

|Selling & Admin Expense | |

|Administrative Expenses |11,600 |

|Selling Expenses |16,000 |

|Total Expenses |27,600 |

|Net Income |400 |

The traditional income statement is not organized in a fashion to answer these questions easily.

Additional information:

Sales Volume in units is 4,000

Cost of goods sold is $5 per unit

Administrative expenses are $6,000 plus $1.40 per unit.

Selling expenses are $8,000 plus $2 per unit.

The Basics of Cost-Volume-Profit (CVP) Analysis Cost-volume-profit (CVP) analysis is a key step in many decisions. CVP analysis involves specifying a model of the relations among the prices of products, the volume or level of activity, the unit variable costs, the total fixed costs, and the mix of products sold. This model is used to predict the impact on profits of changes in those parameters.

1. Contribution Margin. Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It contributes towards covering fixed costs and then towards profit.

2. Unit Contribution Margin. When there is a single product, the unit contribution margin can be used to predict changes in the contribution margin and in profits (assuming there is no change in fixed costs) as a result of changes in unit sales. To do this, the unit contribution margin is simply multiplied by the change in unit sales.

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3. Contribution Margin Ratio. The contribution margin (CM) ratio is the ratio of the contribution margin to total sales. It shows how the contribution margin is affected by a given dollar change in total sales. Managers often find the contribution margin ratio easier to work with than the unit contribution margin, particularly when a company has multiple products. This is because the contribution margin ratio is denominated in sales dollars, which is a convenient way to express activity in multi-product firms.

Applications of CVP Concepts CVP analysis is typically used to estimate the impact on profits of changes in selling price, variable cost per unit, sales volume, and total fixed costs. CVP analysis can be used to estimate the effect on profits of a change in any one (or any combination) of these parameters. Target profit analysis is concerned with estimating the level of sales required to attain a specified target profit. Break-even analysis is as a special case of target profit analysis in which the target profit is zero.

Example:

Ace Manufacturing makes a single product, a coffee brewing machine, called “Perfect Pot.”

Ace Mfg can make 10,000 units per year.

The selling price is $160 per unit

The variable costs are $128 per unit

The fixed costs are $160,000

Current sales volume is 5,100 units.

Summary of Applications

1. Calculate Break even point in sales dollars, or units of product.

2. Calculate changes in income as a result of changes in volume

3. Calculate operating leverage

4. Calculate margin of safety

5. Calculate sales required to attaint a specific profit. (Ace wants to make $200,000)

Break-even point using the equation method The break-even point is the level of sales at which profit is zero. It can also be defined as the point where total sales revenue equals total expenses or as the point where contribution margin total equals total fixed expenses. Break-even analysis can be approached either by the equation method or by the contribution margin method. The two methods are logically equivalent.

The Equation Method

Break Even Point in Sales: (Price/Unit)(Units) = (Variable Cost/Units)(Units) + Fixed Cost

Or

Break Even Point in Sales: Sales = (Variable Cost Ratio)(Sales) + Fixed Costs

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Contribution Margin Method

Break Even Unit Sales = Fixed Expenses

Unit Contribution Margin

Break Even Dollar Sales = Fixed Expenses

Contribution Margin Ratio

Target profit analysis. Managers frequently desire to know the number of units that must be sold to attain a target profit. Either the equation method or the contribution margin method discussed previously can be used. In the case of the contribution margin method, the formulas are:

Unit Sales to attain target profit = Fixed Expenses + Target Profit

Unit Contribution Margin

Dollar Sales to attain target profit = Fixed Expenses + Target Profit

Contribution Margin Ratio

The Graphical Representation of the Break Even Point

Graphs of CVP relationships can be used to gain insight into the behavior of expenses and profits. The basic CVP graph is drawn with dollars on the vertical axis and volume in units on the horizontal axis. Total fixed expense is drawn first, and then variable expense is added to the fixed expense in order to draw the total expense line. Finally, the total revenue line is drawn. The total profit (or loss) is the vertical difference between the total revenue and total expense lines.

[pic]

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Margin of Safety The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It is the amount by which sales can drop before losses begin to be incurred. The margin of safety can be computed in terms of dollars, as a percent of current sales, in units, or as a percent of capacity:

Margin of safety in dollars = Total sales - Break-even sales level

or

Margin of Safety Percent = Margin of safety in Dollars

Current Sales in Dollars

or

Margin of Safety in units = Margin of safety in units Or Margin of Safety in Dollars

Current Sales in Units Unit Sales Price

Cost Structure. Cost structure refers to the relative proportion of fixed and variable costs in an organization. The best cost structure for a company depends on many factors, including the long-run trend in sales, year-to-year fluctuations in the level of sales, and the attitudes of owners and managers towards risk. Understanding a company(s cost structure is important for decision making as well as for analysis of performance.

Operating Leverage Operating leverage is a measure of how sensitive net income is to a given percentage change in sales.

1. Degree of operating leverage. The degree of operating leverage at a given level of sales is computed as follows:

Contribution Margin

Net Income

2. The math underlying the degree of operating leverage. The degree of operating leverage can be used to estimate how a given percentage change in sales volume will affect net income at a given level of sales, assuming there is no change in fixed expenses. To verify this, consider the following:

Degree of Operating Percentage Change Percentage Change

Leverage x in Sales = In income

Thus, providing that there is no change in fixed expenses and the other assumptions of CVP analysis are valid, the degree of operating leverage provides a quick way to predict the percentage effect on profits of a given percentage increase in sales. The higher the degree of operating leverage, the larger the increase in net income from a given percentage changes in sales.

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Degree of operating leverage is not constant. The degree of operating leverage is not constant as the level of sales changes. For example, at the break-even point the degree of operating leverage is infinite since the denominator of the ratio is zero. Therefore, the degree of operating leverage should be used with some caution and should be recomputed for each level of sales.

Structuring Sales Commissions. Which model will salespeople push hardest if they are paid a commission of 10% of sales revenue? Which model is more profitable?

Model A Model B

Price $100 $150

Variable Cost Commission 10 15

Other Variable Cost 75 130

Unit CM $ 15 $ 5

Sales Mix. The term sales mix means the relative proportions in which a company(s products are sold. Most companies have a number of products with differing contribution margins. Thus, changes in the sales mix can cause variations in a company’s profits. As a result, the break-even point in a multi-product company is dependent on the mix in which the various products are sold.

Different products typically have different selling prices, costs, and contribution margins.

1. Constant sales mix assumption. The assumption is usually made in CVP analysis that the sales mix will not change. Under the constant sales mix assumption, the break-even level of sales dollars can be computed using the overall contribution margin (CM) ratio. In essence, the assumption is made that the firm has only one product that consists of a basket of its various products in a specified proportion. The contribution margin ratio of this basket can be easily computed by dividing the total contribution margin of all products by total sales.

2.. Changes in sales mix. If the proportions in which products are sold change, then the contribution margin ratio will change. Since the sales mix is not in reality constant, the results of CVP analysis should be viewed with more caution in multi-product firms than in single product firms

Joe’s Stuff

Income Statement

For the Year Ended December 31, 2009

| |Department A |Department B | |

| | | |Total |

|Sales |50,000 |150,000 |200,000 |

|Variable Costs |20,000 |30,000 |50,000 |

|Contribution Margin |30,000 |120,000 |150,000 |

|Fixed Costs | | |135,000 |

|Net Income | | |15,000 |

|Calculate the Break Even Point | | | |

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Limiting Assumptions in CVP Analysis. Simple CVP analysis relies on simplifying assumptions. However, if a manager knows that one of the assumptions is violated, the CVP analysis can often be easily modified to make it more realistic.

1. Selling price is constant. The assumption is that the selling price of a product will not change as the unit volume changes. This is not wholly realistic since there is usually an inverse relationship between price and unit volume. In order to increase volume it is often necessary to drop the price. However, CVP analysis can easily accommodate more realistic assumptions

2. Costs are linear and can be accurately divided into variable and fixed elements. It is assumed that the variable element is constant per unit and the fixed element is constant in total. This implies that operating conditions are stable and there are no major changes in worker efficiency

3. The sales mix is constant in multi-product companies. This assumption is invoked in order to use the simple break-even and target profit formulas in multi-product firms. If unit contribution margins are fairly uniform across products, violations of this assumption will not be important. However, if unit contribution margins differ a great deal, then changes in the sales mix can have a big impact on the overall contribution margin ratio and hence upon the results of CVP analysis.

4. In manufacturing companies, inventories do not change. It is assumed that everything the company produces is sold in the same period. Violations of this assumption result in discrepancies between financial accounting net income and the profits calculated using the contribution approach. This topic is covered in detail in the next chapter.

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In Class Examples

Implements: Large equipment items such as lawnmowers and snow-blowers.

Hardware: All other items sold in the store.

Ace Hardware - Monthly Information

|Customers this Month |8,000 |

|Sales – Implements |$141,400 |

|Variable Costs – Implements |$ 84,840 |

|Sales – Hardware |$262,600 |

|Variable Costs – Implements |$152,308 |

|Fixed Costs |$165,200 |

| | |

Required

1. Contribution format income statement (Include Departments)

2. Calculate the break even point in sales dollars.

3. Calculate the average sale per customer

4. Calculate the break even point in customers.

5. Calculate the Margin of Safety

6. Calculate the degree of operating

7. Calculate the sales dollars needed to earn of profit of $18,000

Jason’s Ford Dealership – Monthly Data

|Vehicles Sold |152 |

|Average Selling Price |$22,000 |

|Average Cost |$18,040 |

|Fixed Costs |$396,000 |

| | |

| | |

Required

1. Contribution format income statement

2. Calculate the break even point in sales dollars.

3. Calculate the break even point in vehicles

4. Calculate the Margin of Safety

5. Calculate the degree of operating

6. Calculate the number of vehicles required to be sold in order to earn $35,000 of profit.

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