Financial managerial accounting 3rd kieso ch19(cost volume profit analysis additional issues)

Once a company achieves break-even sales, a sales goal can be set that will result in a target net income Illustration: Assuming Vargo’s target net income is $250,000, compute required

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Financial & Managerial

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Chapter Outline

Learning Objectives

LO 1 Apply basic CVP concepts.

LO 2 Explain the term sales mix and its effects on

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Basic CVP Concepts

CVP analysis:

Study of the effects of changes in costs and volume

on a company’s profit

Important to profit planning

Critical in management decisions such as:

LO 1

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Basic Concepts

Management often wants the information reported

in a special format income statement

CVP income statement is for internal use only:

variable

and on a per unit basis

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ILLUSTRATION 19.2

Detailed CVP income statement

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Break-Even Analysis

Vargo Electronic’s CVP income statement (Ill 6.2)

shows that total contribution margin is $320,000, and the company’s contribution margin per unit is $200 Contribution margin can also be expressed as the

contribution margin ratio which is 40% ($200 ÷

n Margin Break-Even Point in

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Break-Even Analysis

Vargo Electronic’s CVP income statement (Ill 6.2)

shows that total contribution margin is $320,000, and the company’s contribution margin per unit is $200 Contribution margin can also be expressed as the

contribution margin ratio which is 40% ($200 ÷

$500)

Fixed

Costs

Unit Contributio

n Ratio Break-Even Point in

Dollars

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Target Net Income

Once a company achieves break-even sales, a sales goal can be set that will result in a target net income

Illustration: Assuming Vargo’s target net income is

$250,000, compute required sales in units to achieve target net income :

on Margin

Sales in Units

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Target Net Income

Once a company achieves break-even sales, a sales goal can be set that will result in a target net income

Illustration: The contribution margin ratio is used to

compute required sales in dollars

Sales in Dollars

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Margin of Safety

a tells us how far sales can drop before the company

will operate at a loss

b can be expressed in dollars or as a ratio.

Illustration: Assume Vargo’s sales are $800,000:

LO 1

Actual (Expected)

Sales

Even Sales

Break-Margin

of Safety

in Dollars

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Margin of Safety

a tells us how far sales can drop before the company

will operate at a loss

b can be expressed in dollars or as a ratio.

Illustration: Vargo’s sales could drop by $300,000, or

37.5%, before the company would operate at a loss

Margin of

Safety in Dollars

Actual (Expected)

Sales

Margin

of Safety Ratio

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CVP and Changes in the Business

Environment (1 of 5)

Illustration: Original cell phone sales and cost data for

Vargo Electronics is as shown

Unit selling price $500

Total fixed costs $200,000

Break-even sales $500,000 or 1,000 units

LO 1

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Case I: A competitor is offering a 10% discount on

the selling price of its camcorders What effect will a 10% discount on selling price ($500 x 10% = $50) have

on the breakeven point?

Fixed Costs

Unit Contribution

Margin

Even Sales

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Case II: Management invests in new equipment that

will lower the amount of direct labor required to

make cell phones They estimate that total fixed costs will increase 30% and variable cost per unit will

decrease 30% What effect will the new equipment have on the sales volume required to break even?

LO 1

Fixed Costs

Margin

Even Sales

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Case III: Vargo’s principal supplier of raw materials

has just announced a price increase The higher cost

is expected to increase the variable cost of cell

phones by $25 per unit Management plans a

cost-cutting program that will save $17,500 in fixed costs per month Vargo is currently realizing monthly net income of $80,000 on sales of 1,400 cell phones

What increase in units sold will be needed to

maintain the same level of net income?

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Computation of required sales

(Fixed Cost + Target

Net Income)

LO 1

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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

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Krisanne Company reports the following for June.

Total Per Unit

LO 1

DO IT! 1 CVP Analysis (1 of 3)

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Using the contribution margin technique, compute the break-even point in units and dollars and margin of safety in dollars assuming

no changes to sales price or costs.

Solution

a Assuming no changes to sales price or costs:

Break-even point in units = 4,167 units (rounded) ($100,000 ÷ $24) Break-even point in sales dollars = $250,000 ($100,000 ÷ 40 a ) Margin of safety in dollars = $50,000 ($300,000 − $250,000)

a $24 ÷ $60

DO IT! 1 CVP Analysis (2 of 3)

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Using the contribution margin technique, compute the break-even point in units and dollars and margin of safety in dollars assuming

changes to sales price and volume as described.

Break-even point in units = 5,556 units (round) ($100,000 ÷ $18 b ) Break-even point in sales dollars = $300,000 ($100,000 ÷ ($18 ÷

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Sales Mix and Break-Even Sales

a Sales mix is the relative percentage in which a

company sells its products

b If a company’s unit sales are 80% printers and 20%

computers, its sales mix is 80% to 20%.

c Sales mix is important because different products

often have very different contribution margins.

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Break-Even Sales in Units (1of 5)

Companies can compute break-even sales for a mix of two or more products by determining the weighted-average unit contribution margin of all the products

Illustration: Vargo Electronics sells not only cell

phones but high-definition TVs Vargo sells its

products in the following amounts: 1,500 cell phones and 500 TVs

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Break-Even Sales in Units (2of 5)

Additional information related to Vargo Electronics

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Break-Even Sales in Units (3 of 5)

First, determine weighted-average contribution

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First, determine weighted-average contribution

margin

Fixed Cost

Weighted-Average Unit Contribution Margin

Break-Even Point in Units

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27

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

 750 cell phones (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

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Break-Even Sales in Dollars

Works well if company has many products.

Calculates 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 (1 of 3)

29

Kale Garden Supply Company has two divisions.

Cost-volume-profit data for

Kale Garden Supply

Contribution margin ratio

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Determine weighted-average contribution margin

Fixed Cost

Weighted-Average Contribution Margin Ratio

Break-even Point in Dollars

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31

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 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

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Break-Even Sales in Dollars

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

Question

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DO IT! 2 Sales Mix Break Even (1 of 5)

Manzeck Bicycles International produces and sells three different types of mountain bikes Information regarding the three models is shown below.

Pro Intermediate Standard Total

Units sold 5,000 10,000 25,000 40,000

Selling price $800 $500 $350

Variable costs $500 $300 $250

The company’s total fixed costs are $7,500,000.

(a) Determine the sales mix as a function of units sold for the three products.

LO 2

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(a) Determine the sales mix as a function of units sold for the three products.

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(b) Determine the weighted-average unit contribution margin.

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(c) Determine the total number of units that the company must sell

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Pro: 50,000 units × 12.5% = 6,250 units

Intermediate: 50,000 units × 25% = 12,500 units

Standard: 50,000 units × 62.5% = 31,250 units

50,000 units

(d) Determine the number of units of each model that the

company must sell to break even.

LO 2

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Sales Mix with Limited Resources (1 of 2)

All companies have limited resources whether it be

floor space, raw materials, direct labor hours, etc.

Management must decide which products to sell to

maximize net income

Illustration: Vargo manufactures cell phones and TVs

Machine capacity is limited to 3,600 hours per month

Cell Phones TVs

Unit contribution margin $200 $500

Machine hours required per unit 2 625

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Sales Mix with Limited Resources (2 of 2)

39

Calculate the contribution margin per unit of limited resource

Cell Phones TVs

Unit contribution margin $200 $500

Machine hours required per unit 2 625

Contribution margin per unit of

Limited resource [(a) ÷ (b)] $1,000 $800

Management should produce more cell phones if

demand exists or increase machine capacity

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Sales Mix with Limited Resources

Approach used to identify and manage constraints so as

to achieve company goals.

Company must continually

 identify its constraints and

 find ways to reduce or eliminate them, where

appropriate.

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Sales Mix with Limited Resources

41

Question

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

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DO IT! 3 Sales Mix with Limited

Resources (1 of 3)

Carolina Corporation manufactures and sells three

different types of high-quality sealed ball bearings for mountain bike wheels The bearings vary in terms of their quality specifications—primarily with respect to their smoothness and roundness They are referred to

as Fine, Extra-Fine, and Super-Fine bearings Machine time is limited More machine time is required to

manufacture the Extra-Fine and Super-Fine bearings

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DO IT! 3 Sales Mix with Limited

Resources (2 of 3)

Additional information is provided below

Extra Super Fine Fine Fine

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DO IT! 3 Sales Mix Limited Resources

(3 of 3)

Extra Super Fine Fine Fine

Variable costs and expenses 4.00 6.50 11.00

What is the contribution margin per unit of limited resource for each type of bearing?

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Operating Leverage and Profitability

45

Cost Structure is the relative proportion of fixed

versus variable costs that a company incurs

May have a significant effect on profitability

Company must carefully choose its cost structure.

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Vargo Electronics and one of its competitors, New Wave

Company Both make cell phones Vargo uses a traditional,

labor-intensive manufacturing process New Wave has

invested in a completely automated system The factory

employees are involved only in setting up, adjusting, and

maintaining the machinery.

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Contribution

Contribution Margin Ratio

Vargo $320,000 ÷ $800,000 = 40%

New Wave $640,000 ÷ $800,000 = 80%

New Wave contributes 80 cents to net income for each dollar of

increased sales while Vargo only contributes 40 cents.

New Wave’s cost structure which relies on fixed costs is more

sensitive to changes in sales.

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Effect on Break-Even Point

49

Fixed Costs

Contribution Margin Ratio

Break-even Point in Dollars

Because of the greater break-even sales required, New Wave is a

riskier company than Vargo.

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Effect on Margin of Safety

The difference in ratios 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.

Computation of margin of safety ratio for two companies

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Operating Leverage

51

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.When sales revenues are declining, too much

operating leverage can have devastating

consequences

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Degree of Operating Leverage

Provides a measure of a company’s earnings volatility Computed by dividing total contribution margin by net

income.

Contribution Margin Net Income

Degree of Operating Leverage

Vargo $320,000 ÷ $120,000 = 2.67

New Wave $640,000 ÷ $120,000 = 5.33

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Operating Leverage

53

Question

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

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DO IT! 4 Operating Leverage (1 of 2)

Rexfield Corp., a company specializing in crime scene investigations, is contemplating an investment in

automated mass-spectrometers Its current process relies on a high number of lab technicians The new equipment would employ a computerized expert

system The company’s CEO has requested a

comparison of the old technology versus the new

technology The accounting department has prepared the following CVP income statements for use in your analysis

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