Chapter 6-1 · PDF fileChapter 6-6 Cost-Volume-Profit (CVP) Review As noted in Chapter 5, CVP...

Chapter 6-1

Chapter 6-2

CHAPTER CHAPTER 66

COSTCOST––VOLUMEVOLUME––PROFIT ANALYSIS: PROFIT ANALYSIS:

ADDITIONAL ISSUESADDITIONAL ISSUES

Managerial Accounting, Fourth Edition

Chapter 6-3

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

1. Describe the essential features of a cost-volume-profit income statement.

2. Apply basic CVP concepts.3.3. Explain the term sales mix Explain the term sales mix

and its effects on breakand its effects on break--even even sales.sales.

4.4. Determine sales mix when a Determine sales mix when a company has limited company has limited resources.resources.

5.5. Understand how operating Understand how operating leverage affects profitability.leverage affects profitability.

Chapter 6-4

Preview of ChapterPreview of ChapterPreview of ChapterPreview of Chapter

The relationship between a company’s fixed and The relationship between a company’s fixed and variable costs can have a huge impact on its variable costs can have a huge impact on its profitabilityprofitability

The current trend is toward companies with cost The current trend is toward companies with cost structures dominated by fixed costsstructures dominated by fixed costs

This has significantly increased theThis has significantly increased thevolatility of many companies’ net incomevolatility of many companies’ net income

Thus, the use of CVP analysis has additional uses in Thus, the use of CVP analysis has additional uses in making sound business decisionsmaking sound business decisions

Chapter 6-5

CostCost--VolumeVolume--Profit Analysis: Profit Analysis: CostCost--VolumeVolume--Profit Analysis: Profit Analysis: Additional IssuesAdditional Issues

CostCost--VolumeVolume--Profit (CVP) Profit (CVP)

ReviewReview

Cost Structure Cost Structure and Operating and Operating

LeverageLeverage

Basic conceptsBasic conceptsBasic computationsBasic computationsCVP and changes in CVP and changes in the business the business environmentenvironment

Effect on contribution Effect on contribution margin rationmargin rationEffect on breakEffect on break--even even pointpointEffect on margin of Effect on margin of safety ratiosafety ratioOperating leverageOperating leverage

Sales MixSales Mix

BreakBreak--even sales in even sales in unitsunitsBreakBreak--even in even in dollarsdollarsSales mix with Sales mix with limited resourceslimited resources

Chapter 6-6

CostCost--VolumeVolume--Profit (CVP) ReviewProfit (CVP) ReviewCostCost--VolumeVolume--Profit (CVP) ReviewProfit (CVP) Review

As noted in Chapter 5, CVP analysis is: As noted in Chapter 5, CVP analysis is: the study of the effects of changes in costs the study of the effects of changes in costs

and volume on a company’s profitand volume on a company’s profit

CVP analysis is important to profit planningCVP analysis is important to profit planning

CVP analysis is critical in management decisions such CVP analysis is critical in management decisions such as:as:

determining product mix,determining product mix,maximizing use of production facilities,maximizing use of production facilities,

setting selling pricessetting selling prices

LO 1: Describe the essential features ofLO 1: Describe the essential features ofa costa cost--volumevolume--profit income statement.profit income statement.

Chapter 6-7

Basic ConceptsBasic ConceptsBasic ConceptsBasic 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.


Chapter 6-8

CVP Income Statement CVP Income Statement -- ExampleExampleCVP Income Statement CVP Income Statement -- ExampleExample

The CVP income statement for Vargo Video Company is The CVP income statement for Vargo Video Company is illustrated below: (This illustration was also presented illustrated below: (This illustration was also presented as Illustration 5as Illustration 5--11 in Chapter 5) 11 in Chapter 5)

LO 1: Describe the essential features of LO 1: Describe the essential features of a costa cost--volumevolume--profit income statement.profit income statement.

Chapter 6-9

CVP Income Statement CVP Income Statement –– Example Cont’dExample Cont’dCVP Income Statement CVP Income Statement –– Example Cont’dExample Cont’d

A detailed CVP income statement for Vargo Video Company is A detailed CVP income statement for Vargo Video Company is illustrated below: (This uses the same base information as the illustrated below: (This uses the same base information as the previous statement) previous statement)


Chapter 6-10

Basic Computations Basic Computations –– A ReviewA ReviewBasic Computations Basic Computations –– A ReviewA Review

BreakBreak--Even AnalysisEven Analysis

As noted in Chapter 5, Vargo Company’s As noted in Chapter 5, Vargo Company’s contribution margin per unit is $200 (sales price contribution margin per unit is $200 (sales price $500 $500 -- $300 variable costs)$300 variable costs)

It was also shown that Vargo Company’s It was also shown that Vargo Company’s contribution margin ratio was:contribution margin ratio was:

LO 2: Apply basic CVP concepts.LO 2: Apply basic CVP concepts.

Chapter 6-11


BreakBreak--Even AnalysisEven Analysis

Vargo Company’s breakVargo Company’s break--even point in units or in even point in units or in dollars (using contribution margin ratio) is:dollars (using contribution margin ratio) is:

In its early stages of operation, a company’s In its early stages of operation, a company’s primary goal is to breakprimary goal is to break--even.even.

Failure to breakFailure to break--even will eventually leadeven will eventually leadto financial failureto financial failure


Chapter 6-12


Target Net IncomeTarget Net Income

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

Assuming Vargo’s target net income is $250,000, Assuming Vargo’s target net income is $250,000, required sales in units and dollars to achieve this are:required sales in units and dollars to achieve this are:


Chapter 6-13


Margin of SafetyMargin of Safety

Remember from Chapter 5, the margin of safety tells Remember from Chapter 5, the margin of safety tells us how far sales us how far sales can dropcan drop before the company will before the company will operate at a lossoperate 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 ratioas a ratio

Assuming Vargo’s sales are $800,000:Assuming Vargo’s sales are $800,000:


Chapter 6-14


CVP and Changes in the Business EnvironmentCVP and Changes in the Business Environment

To better understand CVP analysis, three To better understand CVP analysis, three independent cases involving Vargo company will be independent cases involving Vargo company will be examined.examined.

Each case will use the original data for Vargo Each case will use the original data for Vargo Company:Company:

LO 2: Apply CVP concepts.LO 2: Apply CVP concepts.

Chapter 6-15

Basic Computations Basic Computations –– A Review: Case IA Review: Case IBasic Computations Basic Computations –– A Review: Case IA Review: Case I

Should Vargo Company match a competitor’s 10% Should Vargo Company match a competitor’s 10% discount and reduce selling price to $450 per unit?discount and reduce selling price to $450 per unit?

With variable costs per unit unchanged, a 10% With variable costs per unit unchanged, a 10% discount in selling price will discount in selling price will decreasedecrease the contribution the contribution margin to $150 and margin to $150 and increaseincrease breakbreak--even sales to 1,333 even sales to 1,333 unitsunits

Management must decide how likely it is that Vargo Management must decide how likely it is that Vargo can achieve the increase in sales as well as the can achieve the increase in sales as well as the likelihood of lost sales if the discount is not matchedlikelihood of lost sales if the discount is not matched


Chapter 6-16

Basic Computations Basic Computations –– A Review: Case IIA Review: Case IIBasic Computations Basic Computations –– A Review: Case IIA Review: Case II

Use of new equipment is being considered that will Use of new equipment is being considered that will increase fixed costs by 30% and lower variable increase fixed costs by 30% and lower variable costs 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 breakthe sales required to break--even?even?Fixed costs will increase $60,000 and variable costs Fixed costs will increase $60,000 and variable costs will decrease $90,000 (variable cost per unit =$210).will decrease $90,000 (variable cost per unit =$210).

The change appears positive as breakThe change appears positive as break--even point is even point is reduced by approximately 10%reduced by approximately 10%


Chapter 6-17

Basic Computations Basic Computations –– A Review: Case IIIA Review: Case IIIBasic Computations Basic Computations –– A Review: Case IIIA 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?


Chapter 6-18

Basic Computations Basic Computations –– A Review: Case IIIA Review: Case IIIBasic Computations Basic Computations –– A Review: Case IIIA Review: Case III

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

Fixed costs decrease to $182,500Fixed costs decrease to $182,500

Contribution margin per unit is now $175Contribution margin per unit is now $175

If Vargo cannot sell an additional 100 units, If Vargo cannot sell an additional 100 units, management must further reduce costs, increase the management must further reduce costs, increase the selling price of the DVDs, or accept a lower net income.selling price of the DVDs, or accept a lower net income.


Chapter 6-19

Croc Catchers calculates its contribution margin to be Croc Catchers calculates its contribution margin to be less than zero. Which statement is true?less than zero. Which statement is true?

a.a. Its fixed costs are less than the variable cost Its fixed costs are less than the variable cost per unitper 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 ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 1: Describe the essential features of LO 1: Describe the essential features of a costa cost--volumevolume--profit income statement.profit income statement.


Chapter 6-20

Sales MixSales MixSales MixSales Mix

When a company sells more than one productWhen a company sells more than one productIt is important to understandIt is important to understand

its sales mixits sales mixThe The sales mixsales mix is the relative percentage in is the relative percentage in which a company sells its products.which a company sells its products.If a company’s unit sales are 80% If a company’s unit sales are 80%

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

Sales mix is important because Sales mix is important because different products often have very different products often have very different contribution margins.different contribution margins.

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

Chapter 6-21

BreakBreak--Even Sales in UnitsEven Sales in UnitsBreakBreak--Even Sales in UnitsEven 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

LO 3: Explain the term sales mi and its effects on breakLO 3: Explain the term sales mi and its effects on break--even sales.even sales.

Chapter 6-22

BreakBreak--Even Sales in Units Even Sales in Units -- ExampleExampleBreakBreak--Even Sales in Units Even Sales in Units -- ExampleExample

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


Chapter 6-23


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


Chapter 6-24


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


Chapter 6-25

BreakBreak--Even Sales in DollarsEven Sales in DollarsBreakBreak--Even Sales in DollarsEven 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 differentunit 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


Chapter 6-26

BreakBreak--Even Sales in Dollars Even Sales in Dollars -- ExampleExampleBreakBreak--Even Sales in Dollars Even Sales in Dollars -- ExampleExample

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

andCompute the contribution margin ratio rather than the contribution margin per unit


Chapter 6-27


The information necessary to perform cost-volume-profit analysis is:


Chapter 6-28


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:


Chapter 6-29


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.


Chapter 6-30

Net income will be:Net income will be:

a.a. Greater if more higherGreater if more higher--contribution margin units contribution margin units are sold than lowerare sold than lower--contribution margin unitscontribution 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.



Chapter 6-31

Sales Mix with Limited ResourcesSales Mix with Limited ResourcesSales Mix with Limited ResourcesSales 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 Limited resources force management to decide which products to sell to maximize net income.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:

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

Chapter 6-32

Sales Mix with Limited Resources Sales Mix with Limited Resources -- ExampleExampleSales Mix with Limited Resources Sales Mix with Limited Resources -- ExampleExample

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 thecontribution margin per unit of limited resource: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.


Chapter 6-33

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.

Sales Mix with Limited Resources Sales Mix with Limited Resources -- ExampleExampleSales Mix with Limited Resources Sales Mix with Limited Resources -- ExampleExample

Chapter 6-34

Theory of ConstraintsTheory of ConstraintsTheory of ConstraintsTheory 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


Chapter 6-35

If the contribution margin per unit is $15 and it takes margin per unit is $15 and it takes 3.0 machine hours to produce the unit, the contribution 3.0 machine hours to produce the unit, the contribution margin per unit of limited resource is:margin per unit of limited resource is:

a.a. $25$25.

b. $5.

c. $4.

d. No correct answer is given.


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

Chapter 6-36

Cost Structure and Operating LeverageCost Structure and Operating LeverageCost Structure and Operating LeverageCost Structure and Operating Leverage

Cost StructureCost 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 Thus, a company must carefully choose its cost carefully choose its cost structure.structure.

LO 5: Understand how operating leverage affects profitability.LO 5: Understand how operating leverage affects profitability.

Chapter 6-37

Comparison of Cost StructuresComparison of Cost StructuresComparison of Cost StructuresComparison 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.


Chapter 6-38

Effect on Contribution Margin RatioEffect on Contribution Margin RatioEffect on Contribution Margin RatioEffect 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


Chapter 6-39

Effect on BreakEffect on Break--even Pointeven PointEffect on BreakEffect on Break--even Pointeven 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.


Chapter 6-40

Effect on Margin of Safety RatioEffect on Margin of Safety RatioEffect on Margin of Safety RatioEffect 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.”


Chapter 6-41

Operating LeverageOperating LeverageOperating LeverageOperating Leverage

Operating leverageOperating 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.


Chapter 6-42

Operating LeverageOperating LeverageOperating LeverageOperating 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.


Chapter 6-43

The degree of operating leverage:The degree of operating leverage:

a.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.



Chapter 6-44

AllAll About YouAbout YouAllAll About YouAbout You

Big Decisions for Your Energy FutureThe cost of wind powered electricity is as low as 3 or 4 cents per kilowatt hour (about the same as coal).

It costs about $77,500 to install a residential solar-powered system. It would take 50 years without subsidies to recover your cost or ten years with subsidies.

Industrial plants using solar power have a cost of 30 cents per kilowatt hour. A new approach could lower this to 9 – 12 cents.

EPA Energy Star designated products could save 30% in energy use as well as about $12 billion on utility bills.

Chapter 6-45

AllAll About YouAbout YouAllAll About YouAbout You

What Do You Think?What Do You Think?Do you think that it is possible to compare coal with alternative energy sources without considering environmental costs?

Should environmental costs be incorporated into decision formulas when evaluating new power plants?

Chapter 6-46

Chapter Review Chapter Review -- Brief Exercise 6Brief Exercise 6--9 9 Chapter Review Chapter Review -- Brief Exercise 6Brief Exercise 6--9 9

Presto Candle Supply makes candles. The sales mix Presto Candle Supply makes candles. The sales mix (as a percent of total dollar sales) of its three (as a percent of total dollar sales) of its three product lines is as follows: birthday candles, 30%; product lines is as follows: birthday candles, 30%; standard tapered candles, 50%; and large scented standard tapered candles, 50%; and large scented candles, 20%. The contribution margin ratio of each candles, 20%. The contribution margin ratio of each candle type is shown below.candle type is shown below.

Candle TypeCandle Type Contribution Margin RatioContribution Margin RatioBirthdayBirthday 10%10%Standard taperedStandard tapered 20%20%Large scentedLarge scented 45%45%

What is the weighted-average contribution margin ratio?

Chapter 6-47

Chapter Review Chapter Review -- Brief Exercise 6Brief Exercise 6--9 9 Chapter Review Chapter Review -- Brief Exercise 6Brief Exercise 6--9 9 Type of CandlesType of Candles CMR Sales MixCMR Sales MixBirthday 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 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 dollar amount of each type of candle that must be sold to break even? even?

Step 1:Step 1: Fixed Costs $440,000 Fixed Costs $440,000 ÷÷ WA CMR 22% = $ BEP WA CMR 22% = $ BEP $2,000,000$2,000,000

Step 2:Step 2:Birthday candlesBirthday candles $2,000,000 X 30% = $ 600,000$2,000,000 X 30% = $ 600,000Standard taperedStandard tapered $2,000,000 X 50% = 1,000,000$2,000,000 X 50% = 1,000,000Large scentedLarge scented $2,000,000 X 20% = 400,000$2,000,000 X 20% = 400,000

Chapter 6-48

AppendixAppendixAppendixAppendixAbsorption Costing vs. Variable CostingAbsorption Costing vs. Variable Costing

Under variable costing, product costs consist of:Direct Materials

Direct LaborVariable Mfg. Overhead

The difference between absorption and variable costing is:

LO 6: Explain the difference between absorption costingLO 6: Explain the difference between absorption costingand variable costing.and variable costing.

Chapter 6-49


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. Fixed Mfg. OverheadOverhead

Chapter 6-50


Example – Premium Products

Manufactures Fix-it, a sealant for car windows.

Relevant data for January 2008, the first month of production are:


Chapter 6-51


Example – ContinuedPer 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.


Chapter 6-52

AppendixAppendixAppendixAppendixAbsorption Costing Income StatementAbsorption Costing Income Statement


Chapter 6-53

AppendixAppendixAppendixAppendixVariable Costing Income StatementVariable Costing Income Statement


Chapter 6-54

AppendixAppendixAppendixAppendixSummary of Income EffectsSummary of Income Effects

LO 7: Discuss net income effects under absorption costingLO 7: Discuss net income effects under absorption costingversus variable costing.versus variable costing.

Chapter 6-55

Fixed manufacturing overhead costs are recognized as:Fixed manufacturing overhead costs are recognized as:

a.a. Period costs under absorption costingPeriod 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.



Chapter 6-56

Copyright © 2008 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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Chapter 6-1 · PDF fileChapter 6-6 Cost-Volume-Profit (CVP) Review As noted in Chapter 5, CVP...

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