Managerial Accounting, 8th Edition PDF

Managerial Accounting 8th Edition Weygandt Kimmel Kieso Chapter 6 Cost-Volume-Profit Analysis: Additional Issues Prepared by Coby Harmon University of California, Santa Barbara Westmont Col...

Managerial Accounting 8th Edition Weygandt Kimmel Kieso Chapter 6 Cost-Volume-Profit Analysis: Additional Issues Prepared by Coby Harmon University of California, Santa Barbara Westmont College Chapter Outline Learning Objectives LO 1 Apply basic CVP concepts. LO 2 Explain the term sales mix and its effects on break- even sales. LO 3 Determine sales mix when a company has limited resources. LO 4 Indicate how operating leverage affects profitability. Copyright ©2017 John Wiley & Son, Inc. 2  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:  determining product mix,  maximizing use of production facilities,  setting selling prices. LO 1 Copyright ©2017 John Wiley & Son, Inc. 3  Basic CVP Concepts Basic Concepts Management often wants the information reported in a special format income statement. CVP income statement is for internal use only:  Costs and expenses classified as fixed or variable.  Reports contribution margin as a total amount and on a per unit basis. LO 1 Copyright ©2017 John Wiley & Son, Inc. 4  Basic CVP Concepts ILLUSTRATION 6.1 Basic CVP income statement Basic Concepts LO 1 Copyright ©2017 John Wiley & Son, Inc. 5  ILLUSTRATION 6.2 Detailed CVP income statement LO 1 Copyright ©2017 John Wiley & Son, Inc. 6  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). Unit Contribution Break-Even Fixed Costs ÷ Margin = Point in Units $200,000 ÷ $200 = 1,000 units ILLUSTRATION 6.3 Break-even point in units LO 1 Copyright ©2017 John Wiley & Son, Inc. 7  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). Contribution Break-Even Fixed Costs ÷ Margin Ratio = Point in Dollars $200,000 ÷.40 = $500,000 ILLUSTRATION 6.4 Break-even point in dollars LO 1 Copyright ©2017 John Wiley & Son, Inc. 8  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 : Unit (Fixed Costs + Contribution Sales in ÷ = Target Net Income) Margin Units ($200,000 + $250,000) ÷ $200 = 2,250 units ILLUSTRATION 6.5 Target net income in units LO 1 Copyright ©2017 John Wiley & Son, Inc. 9  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. (Fixed Costs + Contribution Sales in ÷ = Target Net Income) Margin Ratio Dollars ($200,000 + $250,000) ÷.40 = $1,125,000 ILLUSTRATION 6.6 Target net income in dollars LO 1 Copyright ©2017 John Wiley & Son, Inc. 10  Margin of Safety tells us how far sales can drop before the company will operate at a loss. can be expressed in dollars or as a ratio. Illustration: Assume Vargo’s sales are $800,000: Actual Margin of (Expected) Break-Even Safety in - = Sales Sales Dollars $800,000 - $500,000 = $300,000 ILLUSTRATION 6.7 Margin of safety in dollars LO 1 Copyright ©2017 John Wiley & Son, Inc. 11  Margin of Safety tells us how far sales can drop before the company will operate at a loss. 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 Actual Margin of Margin of Safety (Expected) Safety ÷ = in Dollars Sales Ratio $300,000 ÷ $800,000 = 37.5% ILLUSTRATION 6.8 Margin of safety ratio LO 1 Copyright ©2017 John Wiley & Son, Inc. 12  CVP and Changes in the Business Environment Illustration: Original cell phone sales and cost data for Vargo Electronics is as shown. Unit selling price $500 Unit variable cost $300 Total fixed costs $200,000 Break-even sales $500,000 or 1,000 units LO 1 Copyright ©2017 John Wiley & Son, Inc. 13  CVP and Changes in the Business Environment Case I: A competitor is offering a 10% discount on the selling price of its cell phones. What effect will a 10% discount on selling price ($500 x 10% = $50) have on the breakeven point? Unit Contribution Break- ÷ = Fixed Costs Margin Even Sales $200,000 ÷ $150 = 1,333 units ($450 - $300) (rounded) ILLUSTRATION 6.10 Computation of break-even sales in units LO 1 Copyright ©2017 John Wiley & Son, Inc. 14  CVP and Changes in the Business Environment 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? ILLUSTRATION 6.11 Unit Contribution Break- ÷ = Fixed Costs Margin Even Sales $260,000 ÷ ($500 - $210) = 897 units (rounded) LO 1 Copyright ©2017 John Wiley & Son, Inc. 15  CVP and Changes in the Business Environment 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? LO 1 Copyright ©2017 John Wiley & Son, Inc. 16  CVP and Changes in the Business Environment Variable cost per unit increases to $325 ($300 + $25). Fixed costs are reduced to $182,500 ($200,000 - $17,500). Contribution margin per unit becomes $175 ($500 - $325). Unit (Fixed Cost + Target Contribution Sales in ÷ = Net Income) Margin Units ($182,500 + $80,000) ÷ $175 = 1,500 ILLUSTRATION 6.12 Computation of required sales LO 1 Copyright ©2017 John Wiley & Son, Inc. 17  Basic CVP Concepts 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 Copyright ©2017 John Wiley & Son, Inc. 18  DO IT! 1 CVP Analysis Krisanne Company reports the following for June. Total Per Unit Sales (5,000 units) $300,000 $60 Variable costs 180,000 36 Contribution margin 120,000 $24 Fixed expenses 100,000 Net income $ 20,000 To increase net income, management is considering reducing the selling price by 10%, with no changes to unit variable costs or fixed costs. Management is confident that this change will increase unit sales by 25%. LO 1 Copyright ©2017 John Wiley & Son, Inc. 19  DO IT! 1 CVP Analysis 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 ÷.40a) Margin of safety in dollars = $50,000 ($300,000 − $250,000) a$24 ÷ $60 LO 1 Copyright ©2017 John Wiley & Son, Inc. 20  DO IT! 1 CVP Analysis 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 ÷ $18a) Break-even point in sales dollars = $300,000 ($100,000 ÷ 0,33b) Margin of safety in dollars = $37,500 ($337,500c − $300,000) a: 18 =(60-10%x60)-36 = 54-36=$18 b: 18 ÷ 54 = 33,33% c: (5,000+ 25%x5,000) x 54 = 6,250x54= $337,500 LO 1 Copyright ©2017 John Wiley & Son, Inc. 21  Sales Mix and Break-Even Sales 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. LO 2 Copyright ©2017 John Wiley & Son, Inc. 22  Break-Even Sales in Units 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. Cell Phones TVs 1,500 units ÷ 2,000 units = 500 units ÷ 2,000 units = 75% 25% LO 2 Copyright ©2017 John Wiley & Son, Inc. 23  Break-Even Sales in Units Additional information related to Vargo Electronics. Cell Phones TVs 1,500 units ÷ 2,000 units = 500 units ÷ 2,000 units = 75% 25% Unit Data Cell Phones TVs Selling price $500 $1,000 Variable costs 300 500 Contribution margin $200 $500 Sales mix—units 75% 25% Fixed costs = $275,000 LO 2 Copyright ©2017 John Wiley & Son, Inc. 24  Break-Even Sales in Units First, determine weighted-average contribution margin. Unit Data Cell Phones TVs Selling price $500 $1,000 Variable costs 300 500 Contribution margin $200 $500 Sales mix—units 75% 25% Fixed costs = $275,000 ILLUSTRATION 6.15 LO 2 Copyright ©2017 John Wiley & Son, Inc. 25  Break-Even Sales in Units Second, use the weighted-average unit contribution margin to compute the break-even point in units. ILLUSTRATION 6.15 Break-Even Weighted-Average Unit Point in ÷ Fixed Cost Contribution Margin = Units $275,000 ÷ $275 = 1,000 units ILLUSTRATION 6.16 Break-even point in units Copyright ©2017 John Wiley & Son, Inc. 26 LO 2  Break-Even Sales in Units 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. ILLUSTRATION 6.17 LO 2 Copyright ©2017 John Wiley & Son, Inc. 27  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. LO 2 Copyright ©2017 John Wiley & Son, Inc. 28  Break-Even Sales in Dollars Kale Garden Supply Company has two divisions. ILLUSTRATION 6.18 Cost-volume-profit data for Kale Garden Supply ILLUSTRATION 6.19 Contribution margin ratio LO 2 Copyright ©2017 John Wiley & Son, Inc. 29  Break-Even Sales in Dollars First, determine weighted-average contribution margin. ILLUSTRATION 6.20 Second, Weighted-Average Break-even calculate Fixed Cost ÷ Contribution = Point in break-even Margin Ratio Dollars point in $300,000 ÷.32 = $937,500 dollars. ILLUSTRATION 6.20 LO 2 Copyright ©2017 John Wiley & Son, Inc. 30  Break-Even Sales in Dollars 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. LO 2 Copyright ©2017 John Wiley & Son, Inc. 31  Break-Even Sales in Dollars Question Net income will be: a. Greater if more higher-contribution margin units are sold than lower-contribution margin units. b. Greater if 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. LO 2 Copyright ©2017 John Wiley & Son, Inc. 32  DO IT! 2 Sales Mix Break Even 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 Copyright ©2017 John Wiley & Son, Inc. 33  DO IT! 2 Sales Mix Break Even (a) Determine the sales mix as a function of units sold for the three products. Pro Intermediate Standard Total Units sold 5,000 10,000 25,000 40,000 Selling price $800 $500 $350 Variable costs $500 $300 $250 Solution Pro = 5,000/40,000 = 12.5% Intermediate = 10,000/40,000 = 25% Standard = 25,000/40,000 = 62.5% LO 2 Copyright ©2017 John Wiley & Son, Inc. 34  DO IT! 2 Sales Mix Break Even (b) Determine the weighted-average unit contribution margin. Pro Intermediate Standard Total Units sold 5,000 10,000 25,000 40,000 Selling price $800 $500 $350 Variable costs $500 $300 $250 Solution [.125 × ($800 − $500)] + [.25 × ($500 − $300)] + [.625 × ($350 − $250)] = $150 LO 2 Copyright ©2017 John Wiley & Son, Inc. 35  DO IT! 2 Sales Mix Break Even (c) Determine the total number of units that the company must sell to break even. Pro Intermediate Standard Total Units sold 5,000 10,000 25,000 40,000 Selling price $800 $500 $350 Variable costs $500 $300 $250 Solution $7,500,000 ÷ $150 = 50,000 units LO 2 Copyright ©2017 John Wiley & Son, Inc. 36  DO IT! 2 Sales Mix Break Even (d) Determine the number of units of each model that the company must sell to break even. Pro Intermediate Standard Total Units sold 5,000 10,000 25,000 40,000 Selling price $800 $500 $350 Variable costs $500 $300 $250 Solution 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 LO 2 Copyright ©2017 John Wiley & Son, Inc. 37  Sales Mix with Limited Resources 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. ILLUSTRATION 6.22 Cell Phones TVs Unit contribution margin $200 $500 Machine hours required per unit.2.625 Copyright ©2017 John Wiley & Son, Inc. LO 3 38  Sales Mix with Limited Resources Calculate the contribution margin per unit of limited resource. ILLUSTRATION 6.23 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. Copyright ©2017 John Wiley & Son, Inc. LO 3 39 Sales Mix with Limited Resources If Vargo is able to increase machine capacity from 3,600 hours to 4,200 hours, the additional 600 hours could be used to produce either the cell phones or TVs. Illustration 6-24 Cell phones TVs Machine hours (a) 600 600 Contribution margin per unit of $1,000 $800 limited resource (b) Contribution margin (a) x (b) $600,000 $480,000 To maximize net income, all 600 hours should be used to produce and sell cell phones. 40  Sales Mix with Limited Resources Theory of constraints 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. Copyright ©2017 John Wiley & Son, Inc. LO 3 41  Sales Mix with Limited Resources 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. Copyright ©2017 John Wiley & Son, Inc. LO 3 42  DO IT! 3 Sales Mix with Limited Resources 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. LO 3 Copyright ©2017 John Wiley & Son, Inc. 43  DO IT! 3 Sales Mix with Limited Resources Additional information is provided below. Extra Super Fine Fine Fine Selling price $6.00 $10.00 $16.00 Variable costs and expenses 4.00 6.50 11.00 Contribution margin $2.00 $3.50 $5.00 Machine hours required 0.02 0.04 0.08 LO 3 Copyright ©2017 John Wiley & Son, Inc. 44  DO IT! 3 Sales Mix Limited Resources Extra Super Fine Fine Fine Selling price $6.00 $10.00 $16.00 Variable costs and expenses 4.00 6.50 11.00 Contribution margin $2.00 $3.50 $5.00 Machine hours required 0.02 0.04 0.08 What is the contribution margin per unit of limited resource for each type of bearing? LO 3 Copyright ©2017 John Wiley & Son, Inc. 45  Operating Leverage and Profitability 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. LO 4 Copyright ©2017 John Wiley & Son, Inc. 46  Operating Leverage and Profitability 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. ILLUSTRATION 6.25 Vargo New Wave Sales $800,000 $800,000 Variable costs 480,000 160,000 Contribution margin 320,000 640,000 Fixed costs 200,000 520,000 Net income $120,000 $120,000 LO 4 Copyright ©2017 John Wiley & Son, Inc. 47  Operating Leverage and Profitability Vargo New Wave Sales $800,000 $800,000 Variable costs 480,000 160,000 Contribution margin 320,000 640,000 Fixed costs 200,000 520,000 Net income $120,000 $120,000 ILLUSTRATION 6.26 Contribution Contribution ÷ Sales = Margin Margin Ratio Vargo $320,000 ÷ $800,000 = 40% New Wave $640,000 ÷ $800,000 = 80% LO 4 Copyright ©2017 John Wiley & Son, Inc. 48  Operating Leverage and Profitability Contribution Contribution ÷ Sales = Margin 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. LO 4 Copyright ©2017 John Wiley & Son, Inc. 49  Effect on Break-Even Point ILLUSTRATION 6.27 Break-even Fixed Contribution Point in ÷ = Costs Margin Ratio Dollars Vargo $200,000 ÷.40 = $500,000 New Wave $520,000 ÷.80 = $650,000 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. LO 4 Copyright ©2017 John Wiley & Son, Inc. 50  Effect on Margin of Safety ILLUSTRATION 6.28 Computation of margin of safety ratio for two companies 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. LO 4 Copyright ©2017 John Wiley & Son, Inc. 51  Operating Leverage 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. LO 4 Copyright ©2017 John Wiley & Son, Inc. 52  Degree of Operating Leverage Provides a measure of a company’s earnings volatility. Computed by dividing total contribution margin by net income. Degree of Contribution Operating ÷ Net Income = Margin Leverage Vargo $320,000 ÷ $120,000 = 2.67 New Wave $640,000 ÷ $120,000 = 5.33 ILLUSTRATION 6.29 LO 4 Copyright ©2017 John Wiley & Son, Inc. 53  Operating Leverage 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. Copyright ©2017 John Wiley & Son, Inc. LO 4 54  DO IT! 4 Operating Leverage 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. LO 4 Copyright ©2017 John Wiley & Son, Inc. 55  DO IT! 4 Operating Leverage Old New Sales $2,000,000 $2,000,000 Variable costs 1,400,000 600,000 Contribution margin 600,000 1,400,000 Fixed costs 400,000 1,200,000 Net income $200,000 $200,000 Compute the degree of operating leverage. Degree of Contribution Operating ÷ Net Income = Margin Leverage Old $600,000 ÷ $200,000 = 3.00 New $1,400,000 ÷ $200,000 = 7.00 LO 4 Copyright ©2017 John Wiley & Son, Inc. 56  Appendix 6A: Absorption Costing vs. Variable Costing Under variable costing, product costs consist of: Direct Materials Direct Labor Variable Manufacturing Overhead Difference between absorption and variable costing is: Absorption Costing Variable Costing Fixed Product Cost Manufacturing Period Cost Overhead ILLUSTRATION 6A.1 LO 5 Copyright ©2017 John Wiley & Son, Inc. 57  Absorption Costing vs. Variable Costing The difference between absorption and 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. LO 5 Copyright ©2017 John Wiley & Son, Inc. 58  Absorption vs. Variable Costing (1 of 2) Illustration: Premium Products Corporation manufactures a sealant, called Fix-It, for car windshields. Relevant data for Fix-It in January 2020, the first month of production is shown. Selling price $20 per unit. Units Produced 30,000; sold 20,000; beginning inventory zero. Variable unit costs Manufacturing $9 (direct materials $5, direct labor $3, and variable overhead $1). Selling and administrative expenses $2. Fixed costs Manufacturing overhead $120,000. Selling and administrative expenses $15,000. ILLUSTRATION 6.A2 LO 5 Copyright ©2017 John Wiley & Son, Inc. 59  Absorption vs. Variable Costing (2 of 2) Per unit manufacturing cost under each approach. ILLUSTRATION 6A.3 Type of Cost Absorption Variable Direct materials $5 $5 Direct labor 3 3 Variable manufacturing overhead 1 1 Fixed manufacturing overhead ($120,000 ÷ 30,000 units produced) 4 0 Manufacturing cost per unit $13 $9 Manufacturing cost per unit is $4 ($13 -$9) higher for absorption costing because fixed manufacturing costs are treated as product costs. LO 5 Copyright ©2017 John Wiley & Son, Inc. 60  Absorption Costing Example ILLUSTRATION 6A.4 LO 5 Copyright ©2017 John Wiley & Son, Inc. 61  Variable Costing Example ILLUSTRATION 6A.5 LO 5 Copyright ©2017 John Wiley & Son, Inc. 62  Absorption Costing vs. Variable Costing Question 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. Copyright ©2017 John Wiley & Son, Inc. LO 5 63  Decision-Making Concerns Generally accepted accounting principles require that absorption costing be used for the costing of inventory for external reporting purposes. Net income measured under GAAP (absorption costing) is often used internally to  evaluate performance,  justify cost reductions, or  evaluate new projects. LO 5 Copyright ©2017 John Wiley & Son, Inc. 64  Decision-Making Concerns Net income calculated using GAAP does not highlight differences between variable and fixed costs and may lead to poor business decisions. Some companies use variable costing for internal reporting purposes. LO 5 Copyright ©2017 John Wiley & Son, Inc. 65  Advantages of Variable Costing 1. Net income computed under variable costing is unaffected by changes in production levels. 2. Variable costing readily supports cost-volume-profit analysis. 3. Net income computed under variable costing is closely tied to changes in sales levels and therefore provides a more realistic assessment of a company’s success or failure. 4. The presentation of fixed and variable cost components on the variable costing income statement makes it easier to identify these costs. LO 5 Copyright ©2017 John Wiley & Son, Inc. 66  DO IT! 5 Variable Costing (1 of 3) Franklin Company produces and sells tennis balls. The following costs are available for the year ended December 31, 2020. The company has no beginning inventory. In 2020, 8,000,000 units were produced, but only 7,500,000 units were sold. The unit selling price was $0.50 per ball. Costs and expenses were as follows. Variable costs per unit Direct materials $0.10 Direct labor 0.05 Variable manufacturing overhead 0.08 Variable selling and administrative expenses 0.02 Annual fixed costs and expenses Manufacturing overhead $500,000 Selling and administrative expenses 100,000 LO 5 Copyright ©2017 John Wiley & Son, Inc. 67  DO IT! 5 Variable Costing (2 of 3) Variable costs per unit Direct materials $0.10 Direct labor 0.05 Variable manufacturing overhead 0.08 Variable selling and administrative expenses 0.02 Annual fixed costs and expenses Manufacturing overhead $500,000 Selling and administrative expenses 100,000 a. Compute the cost of one unit using variable costing. Direct materials $0.10 Direct labor 0.05 $0.23 Variable manufacturing overhead 0.08 LO 5 Copyright ©2017 John Wiley & Son, Inc. 68  DO IT! 5 Variable Costing (3 of 3) b. Prepare a 2020 income statement using variable costing. LO 5 Copyright ©2017 John Wiley & Son, Inc. 69 Copyright Copyright © 2018 John Wiley & Sons, Inc. 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