Managerial accounting tool for business decision making chapter 06

Profit CVP ReviewCost-Volume-Cost Structure and Operating Leverage Cost Structure and Operating Leverage Basic concepts Basic computations CVP and changes in the business environment Ef

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Study Objectives

1. Describe the essential

features of a

cost-volume-profit income statement

2. Apply basic CVP concepts

3. Explain the term sales mix and

its effects on break-even

sales

4. Determine sales mix when a

company has limited

resources

5. Understand how operating

leverage affects profitability

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Chapter

6-4

Preview of Chapter 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.

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Profit (CVP) Review

Cost-Volume-Cost Structure and Operating Leverage

Cost Structure and Operating Leverage

Basic concepts Basic computations CVP and changes in the business

environment

Effect on contribution margin ration

Effect on break-even point

Effect on margin of safety ratio

Operating leverage

Sales Mix

Break-even sales in units

Break-even in dollars

Sales mix with limited resources

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Chapter

6-6

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:

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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

classifies costs and expenses as fixed fixed or variable or variable,

reports a

reports a contribution margin 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

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Chapter

6-8

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.)

a cost-volume-profit income statement.

Illustration 6-1

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Chapter

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.)

SO 1: Describe the essential features ofIllustration 6-2

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Chapter

6-10

Basic Computations – A Review

Break-Even Analysis

As noted in Chapter 5, 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.

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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 6-3

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Chapter

6-12

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 6-4

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Margin of Safety

Remember from Chapter 5, the margin of safety tells

us how far sales

us how far sales can dropcan drop before the company will

operate at a loss

The margin of safety can be expressed

The margin of safety can be expressed in dollars or in dollars or

as a ratio

Assuming Vargo’s sales are $800,000:

Illustration 6-5

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Chapter

6-14

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:

SO 2: Apply CVP concepts.

Illustration 6-6Basic Data

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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 6-7 Illustration 6-6

Basic Data

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Chapter

6-16

Basic Computations – A Review: Case I

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

Illustration 6-6 Basic Data

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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%

by 30% What effect will the new equipment have on 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)

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Chapter

6-18

Basic Computations – A Review: Case II

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 6-8 Illustration 6-6

Basic Data

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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

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Chapter

6-20

Vargo currently has a net income of $80,000 on sales

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Variable cost per unit increases to $325 as a result of the $25 increase in raw materials cost

Fixed costs decrease to $182,500

Contribution margin per unit is now $175

If Vargo cannot sell an additional 100 units,

management must further reduce costs, increase the selling price of the DVDs, or accept a lower net income

Illustration 6-9

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Chapter

6-22

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

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

Let’s Review

a cost-volume-profit income statement.

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The sales mixsales 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

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Chapter

6-24

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

margin is the sumsum of the weighted

contribution margin of each product

SO 3: Explain the term sales mix and its effects on break-even sales.

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Break-Even Sales in Units - Example

Assume that Vargo Video sells two products and has the following sales mix and related information:

Illustration 6-10

Illustration 6-11

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Chapter

6-26

First, determine the weighted-average contribution margin for Vargo’s two products:

Second, use the weighted-average unit contribution margin to compute the break-even point in units:

Illustration 6-12

Illustration 6-13

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With a break-even point of 1,000 units, Vargo must sell:

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Chapter

6-28

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 even point in terms of sales dollars for

break-even point in terms of sales dollars for divisions or product lines, NOT individual products

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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

Compute sales mix as a percentage of total dollar a percentage of total dollar

sales rather than units sold,

andand

Compute the

Compute the contribution margin ratiocontribution margin ratio rather than

the contribution margin per unit

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Chapter

6-30

The information necessary to perform volume-profit analysis is:

cost-SO 3: Explain the term sales mix and its effects on break-even sales.

Illustration 6-15

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First, determine the weighted-average contribution margin ratio for each division:

Second, use the weighted-average unit contribution margin ratio to compute the break-even point in

dollars:

Illustration 6-16

Illustration 6-17

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Chapter

6-32

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

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Net income will be:

a Greater if more higher-contribution margin units

are sold than lower-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

Let’s Review

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Chapter

6-34

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:

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

Illustration 6-18

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Sales Mix with Limited Resources - Example

The TVs seem to be more profitable since they have the higher contribution margin per unit, but they require

more machine hours to produce than the DVD Players

To determine the appropriate sales mix, compute the

contribution margin per unit of limited resource:

Since DVD players have higher contribution margin per machine hour, management should produce more DVD

players if demand exists or else increase machine

capacity

Illustration 6-19

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Sales Mix with Limited Resources - Example

Illustration 6-20

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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

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Chapter

6-38

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:

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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

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Chapter

6-40

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 different risks and rewards due to changes in sales as

a result of their cost structures.

SO 5: Understand how operating leverage affects profitability.

Illustration 6-21

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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 6-22

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Chapter

6-42

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 6-23

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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

operating “in the red.” “in the red.”

Illustration 6-24

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When sales revenues are declining, too much operating leverage can have devastating consequences.

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