Financial Statement Analysis and Managerial Accounting PDF
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Università Cattolica del Sacro Cuore
Martina Marazzi
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This document is an excerpt from a text about Financial Statement Analysis and Managerial Accounting, covering topics such as Cost-Volume-Profit (CVP) analysis and using examples of a hypothetical company called Racing Bicycle Company (RBC).
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lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Example This equaon can be used to show the prot RBC earns if it sells 401. Noce, the answer of $200 mirrors our earlier soluon. CVP RELATIONSHIPS IN EQUATION FORM – DETAIL BREAKDOWN When a company has...
lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Example This equaon can be used to show the prot RBC earns if it sells 401. Noce, the answer of $200 mirrors our earlier soluon. CVP RELATIONSHIPS IN EQUATION FORM – DETAIL BREAKDOWN When a company has only one product, we can further rene this equaon as shown on this slide: Example This equaon can also be used to show the $200 prot RBC earns if it sells 401 bikes. CVP RELATIONSHIPS IN EQUATION FORM – USING UNIT CONTRIBUTION MARGIN It is oen useful to express the simple prot equaon in terms of the unit contribuon margin (Unit CM) as follows: – – Example Learning Objecve 2: Prepare and interpret a cost volume-prot (CVP) graph and a prot graph CVP RELATIONSHIPS IN GRAPHIC FORM 10 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi The relaonships among revenue, cost, prot, and volume can be expressed graphically by preparing a CVP graph. Racing Bicycle developed contribuon margin income statements at 0, 200, 400, and 600 units sold. We will use this informaon to prepare the CVP graph. PREPARING THE CVP GRAPH 1. In a CVP graph, unit volume is usually represented on the horizontal (X) axis and dollars on the vercal (Y) axis 2. Draw a line parallel to the volume axis to represent total xed expenses 3. Choose some sales volume, say 400 units, and plot the point represenng total expenses (xed and variable). Draw a line through the data point back to where the xed expenses line intersects the dollar axis 4. Choose some sales volume, say 400 units, and plot the point represenng total sales. Draw a line through the data point back to the point of origin PREPARING THE CVP GRAPH – SIMPLE FORM An even simpler form of the CVP graph is called the prot graph: Learning Objecve 3: Use the contribuon margin rao (CM rao) to compute changes in contribuon margin and net operang income resulng from changes in sales volume CONTRIBUTION MARGIN RATIO (CM RATIO) AND THE VARIABLE EXPENSE RATIO The contribuon margin as a percentage of sales is referred to as the contribuon margin rao (CM rao). The rao is computed as follows: For RBC, the contribuon margin rao is calculated as follows: For each $1.00 increase in sales results in a total contribuon margin increase of 40%. The CM rao can also be calculated by dividing the contribuon margin per unit by the selling price per unit: For RBC, the contribuon margin rao is calculated as follows: 11 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi The variable expenses as a percentage of sales is referred to as the variable expense rao. This rao is computer as follows: For RBC, the variable expense rao is calculated as follows: Having dened the two terms, it bears emphasizing that the contribuon margin rao and the variable expense rao can be mathemacally related to one another: For RBC, the contribuon margin rao is calculated as follows: APPLICATIONS OF CONTRIBUTION RATIO If RBC increases sales from 400 to 500 bikes ($50,000), contribuon margin will increase by $20,000 ($50,000 × 40%). Here is the proof: A $50,000 increase in sales revenue results in a $20,000 increase in CM ($50,000 × 40% = $20,000) APPLICATIONS OF CONTRIBUTION RATIO – INCREASE IN SALES VOLUME The relaonship between prot and the CM rao can be expressed using the following equaon: If RBC increased its sales volume to 500 bikes, what would management expect prot or net operang income to be? Learning Objecve 4: Show the eects on net operang income of changes in variable costs, xed costs, selling price, and volume Example 1 What is the prot impact if Racing Bicycle can increase unit sales from 500 to 540 by increasing the monthly adversing budget by $10,000? Sales increased by $20,000, but net operang income decreased by $2,000. A shortcut soluon using incremental analysis: 12 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Increase in CM (40 units x $200) Increase in adversing expenses Decrease in net operang income $ 8.000,00 $ 10.000,00 $ -2.000,00 Example 2 What is the prot impact if Racing Bicycle can use higher quality raw materials, thus increasing variable costs per unit by $10, to generate an increase in unit sales from 500 to 580? Sales increase by $40,000 and net operang income increases by $10,200. Example 3 What is the prot impact if RBC: 1. Cuts its selling price $20 per unit, 2. Increases its adversing budget by $15,000 per month, and 3. Increases sales from 500 to 650 units per month? Sales increase by $62,000, xed costs increase by $15,000, and net operang income increases by $2,000. Example 4 What is the prot impact if RBC: 1. Pays a $15 sales commission per bike sold instead of paying salespersons at salaries that currently total $6,000 per month, and 2. Increases unit sales from 500 to 575 bikes? Sales increase by $37,500, xed expenses decrease by $6,000, and net operang income increases by $12,375. Example 5 If RBC has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers or xed expenses, what price would it quote to the wholesaler if it wants to increase monthly prots by $3,000? $ 3,000 ÷ 150 bikes Variable cost per bike Selling price required $ 20,00 $ 300,00 $ 320,00 per bike 150 bikes × $320 per bike per bike Total variable costs per bike Increase in net operang income $ 48.000,00 $ 45.000,00 $ 3.000,00 Learning Objecve 5: Determine the break-even point BREAK-EVEN ANALYSIS The equaon and formula methods can be used to determine the unit sales and dollar sales needed to achieve a target prot of zero. Let’s use the RBC informaon to complete the break-even analysis. The equaon method relies on the basic prot equaon introduced earlier in the chapter. Because Racing Bicycle has only one product, we’ll use the contribuon margin form of this equaon to perform the break-even calculaons. We calculate break-even by solving the equaon below. In a single product situaon, the equaon method for computer the unit sales at break-even is: 13 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi BREAK-EVEN ANALYSIS: FORMULA METHOD The formula method is a shortcut version of the equaon method. It centres on the idea discussed earlier in the chapter that each unit sold provides a certain amount of contribuon margin that goes toward covering xed expenses. BREAK-EVEN ANALYSIS: DOLLAR SALES Suppose Racing Bicycle wants to compute the sales dollars required to break-even (earn a target prot of $0). Let’s use the equaon method and the formula method to solve this problem. The equaon method is shown on this slide: Learning Objecve 6: Determine the level of sales needed to achieve a desired target prot TARGET PROFIT ANALYSIS In target prot analysis, we esmate what sales volume is needed to achieve a specic target prot. We can also compute the number of units that must be sold to aain a target prot using either: Equaon Method or Formula Method TARGET PROFIT ANALYSIS – EQUATION METHOD Our goal is to solve for the unknown “Q,” which represents the quanty of units that must be sold to aain the target prot. Suppose RBC’s management wants to know the how many bikes must be sold to earn a target prot of $100,000. TARGET PROFIT ANALYSIS – FORMULA METHOD The formula method uses the following equaon: Suppose RBC wants to know how many bikes must be sold to earn a prot of $100,000. TARGET PROFIT ANALYSIS – FORMULA METHOD AND EQUATION METHOD SALES DOLLARS We can also compute the target prot in terms of sales dollars using either the equaon method or the formula method. Suppose RBC’s management wants to know the sales volume that must be generated to earn a target prot of $100,000. Equaon Method 14 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Formula Method Learning Objecve 7: Compute the margin of safety and explain its signicance THE MARGIN OF SAFETY IN DOLLARS The margin of safety is the excess of budgeted or actual sales dollars over the break-even volume of sales dollars. It is the amount by which sales can drop before losses are incurred. The higher the margin of safety, the lower the risk of not breaking even and incurring a loss. Let’s look at RBC and determine the margin of safety: If we assume that RBC has actual sales of $250,000, given that we have already determined the break-even sales to be $200,000, the margin of safety is $50,000 as shown. THE MARGIN OF SAFETY PERCENTAGE RBC’s margin of safety can be expressed as 20% of sales ($50,000 ÷ $250,000). THE MARGIN OF SAFETY IN UNITS The margin of safety can be expressed in terms of the number of units sold. The margin of safety at RBC is $50,000, and each bike sells for $500; hence, RBC’s margin of safety is 100 bikes. COST STRUCTURE AND PROFIT STABILITY Cost structure refers to the relave proporon of xed and variable costs in an organizaon. Managers oen have some latude in determining their organizaon’s cost structure. There are advantages and disadvantages to high xed cost (or low variable cost) and low xed cost (or high variable cost) structures. – – An advantage of a high xed cost structure is that income will be higher in good years compared to companies with lower proporon of xed costs A disadvantage of a high xed cost structure is that income will be lower in bad years compared to companies with lower proporon of xed costs Companies with low xed cost structures enjoy greater stability in income across good and bad years. Leaning Objecve 8: Compute the degree of operang leverage at a parcular level of sales and explain how it can be used to predict changes in net operang income OPERATING LEVERAGE Operang leverage is a measure of how sensive net operang income is to percentage changes in sales. It is a measure, at any given level of sales, of how a percentage change in sales volume will aect prots. To illustrate, let’s revisit the contribuon income statement for RBC. OPERATING LEVERAGE – CHANGE IN PROFIT With an operang leverage of 5, if RBC increases its sales by 10%, net operang income would increase by 50%. Percent increase in sales Degree of operang leverage $ 10% 5,00 15 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Percent increase in prots 50% STRUCTURING SALES COMMISSIONS Companies generally compensate salespeople by paying them either a commission based on sales or a salary plus a sales commission. Commissions based on sales dollars can lead to lower prots in a company. Example Pipeline Unlimited produces two types of suroards, the XR7 and the Turbo. The XR7 sells for $100 and generates a contribuon margin per unit of $25. The Turbo sells for $150 and earns a contribuon margin per unit of $18. The sales force at Pipeline Unlimited is compensated based on sales commissions. If you were on the sales force at Pipeline, you would push hard to sell the Turbo even though the XR7 earns a higher contribuon margin per unit. To eliminate this type of conict, commissions can be based on contribuon margin rather than on selling price alone. Learning Objecve 9: Compute the break-even point for a mulproduct company and explain the eects of shis in the sales mix on contribuon margin and the break-even point So far, we operated with companies selling just one product (we never had an example of a company selling two dierent products), but this is not possible. Usually, even in the case of small companies, the products sold are several. – – – Sales mix is the relave proporon in which a company’s products are sold Dierent products have dierent selling prices, cost structures, and contribuon margins When a company sells more than one product, breakeven analysis becomes more complex Let’s assume RBC sells bikes and carts and that the sales mix between the two products remains the same. Bikes comprise 45% of RBC’s total sales revenue and the carts comprise the remaining 55%. RBC provides the following informaon: JOB-ORDER COSTING: CALCULATING UNIT PRODUCT COSTS Now, we are approaching the cost classicaon that disnguish between product cost and period cost since we start to think about how to cost a product and the next problem is understanding how to assign this cost to the product. We start to consider a product that is very visible, and a product that is very visible is a job order: now we need to understand how to compute its cost. JOB-ORDER COSTING Job-order cosng systems are used when: 1. Many dierent products are produced each period 2. Products are manufactured to order 3. The unique nature of each order requires tracing or allocang costs to each job and maintaining cost records for each job Examples of companies that would use job-order cosng include: 16 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi 1. Boeing (aircra manufacturing) 2. Bechtel Internaonal (large scale construcon) 3. Walt Disney Studios (movie producon) The dierence between product and period costs is that product costs are typically related to the manufacturing, while period costs are typically non-manufacturing (beyond the factory = service), but product costs have a very specic and disncve feature, which that they are inventoriable, so they can be capitalised when the product that is manufactured is not sold and therefore this product cost becomes the value of the inventory, while period costs cannot be capitalized, and so they would go straight to the P/L. The st two costs that we associate easily with the product (the job order) are direct material and direct labor, but the main problem is related to the associaon of the manufacturing overhead to each individual job. These manufacturing overheads include indirect materials and indirect labors, which, as the word indirect says, cannot be traced directly (not observable), so there are a bunch of other items that needs to be assigned to each individual job and we need to nd a way to allocate these manufacturing overheads to each individual job. Learning Objecve 1: Compute a predetermined overhead rate WHY USE AN ALLOCATION BASE? An allocaon base, such as direct labor hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to individual jobs. We use an allocaon base because: a. It is impossible or dicult to trace overhead costs to parcular jobs b. Manufacturing overhead consists of many dierent items ranging from the grease used in machines to the producon manager’s salary c. Many types of manufacturing overhead costs are xed even though output uctuates during the period In order to be fair and associate a fair amount of overhead to the job, what we have to do is to aggregate and esmate all the manufacturing overhead over a signicant amount of me (1 year) and then we predetermine the overhead rate. This cosng needs to be determined when the job is completed because most of the mes the cost is used to determine the selling price, so the company needs to have all the elements. MANUFACTURING OVERHEAD APPLICATION The predetermined overhead rate (POHR) used to apply overhead to jobs is determined before the period begins: Ideally, the allocaon base is a cost driver (cost driver means the items that makes or inuences the total cost, what is driving the cost) that causes overhead, and we will see that in some cases the cost changes because of the volume, while in other cases the cost changes because of other reasons that are not volume related. THE NEED FOR A PREDETERMINE OVERHEAD RATE Predetermined overhead rates that rely upon esmated data are oen used because: 1. Actual overhead for the period is not known unl the end of the period, thus inhibing the ability to esmate job costs during the period 2. Actual overhead costs can uctuate seasonally, thus misleading decision makers COMPUTING PREDETERMINED OVERHEAD RATES The predetermined overhead rate is computed before the period begins using a four-step process: 1. Esmate the total amount of the allocaon base (the denominator) that will be required for next period’s esmated level of producon. 2. Esmate the total xed manufacturing overhead cost for the coming period and the variable manufacturing overhead cost per unit of the allocaon base. 3. Use the following equaon to esmate the total amount of manufacturing overhead: 17 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Where: – Y = The esmated total manufacturing overhead cost – a = The esmated total xed manufacturing overhead cost – b = The esmated variable manufacturing overhead cost per unit of the allocaon base – X = The esmated total amount of the allocaon base 4. Compute the predetermined overhead rate (by dividing the total amount of overhead by the number of esmated hours) The predetermined overhead rate is complicated because, aer esmang the total amount of overhead and the total amount of hours used as allocaon based, the manufacturing overhead are xed and variable. Consumpon and electricity bills are variable overhead, in fact they are overhead, but they depend on the volume of acvity, while depreciaon of the facilies is sll an overhead, but xed. Learning Objecve 2: Apply overhead cost to jobs using a predetermined overhead rate OVERHEAD APPLICATION RATE PearCo esmates that it will require 160,000 direct labor-hours to meet the coming period’s esmated producon level. In addion, the company esmates total xed manufacturing overhead at $200,000, and variable manufacturing overhead costs of $2.75 per direct labor hour. Y = a + bX Y = $200,000 + ($2.75 per direct labor-hour × 160,000 direct labor hours) Y = $200,000 + $440,000 Y = $640,000 RECORDING MANUFACTURING OVERHEAD We use this type of informaon to cost the jobs, which means that the job has used 8 hours, so we mulply it by the rate and there we got the informaon. This piece of informaon is available at the me when the job is completed, so the company doesn’t need to wait unl the end of the year to know how much the actual manufacturing overhead and actual direct labor hours used are, and so the company is able to determine the price for the customers. Learning Objecve 3: Compute the total cost and the unit product cost of a job using a plantwide predetermined overhead rate CALCULATING TOTAL COST OF JOB AND UNIT PRODUCT COST JOB-ORDER COSTING – A MANAGERIAL PERSPECTIVE Inaccurately assigning manufacturing costs to jobs adversely inuences planning and decisions made by managers. 1. Job-order cosng systems can accurately trace direct materials and direct labor costs to jobs 2. Job-order cosng systems oen fail to accurately allocate the manufacturing overhead costs used during the producon their respecve jobs Choosing an Allocaon Base 18 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Job-order cosng systems oen use allocaon bases that do not reect how jobs actually use overhead resources. The allocaon base in the predetermined overhead rate must drive the overhead cost to improve job cost accuracy. A cost driver is a factor that causes overhead costs. Many companies use a single predetermined plantwide overhead rate to allocate all manufacturing overhead costs to jobs based on their usage of direct-labor hours. 1. It is oen overly simplisc and incorrect to assume that direct-labor hours is a company’s only manufacturing overhead cost driver 2. If more than one overhead cost driver can be idened, job cost accuracy is improved by using mulple predetermined overhead rates Learning Objecve 4: Compute the total cost and the unit product cost of a job using mulple predetermined overhead rates INFORMATION TO CALCULATE MULTIPLE PREDETERMINED OVERHEAD RATES Dickson Company has two producon departments, Milling and Assembly. The company uses a job-order cosng system and computes a predetermined overhead rate in each producon department. The predetermined overhead rate in the Milling Department is based on machine-hours and in the Assembly Department it is based on direct labor-hours. The company uses cost-plus pricing (and a markup percentage of 75% of total manufacturing cost) to establish selling prices for all of its jobs. At the beginning of the year, the company made the following esmates: STEP 1 – CALCULATE THE PREDETERMINED OVERHEAD COST FOR EACH DEPARTMENT During the current month the company started and completed Job 407. It wants to use its predetermined departmental overhead cost and rate for the Milling and Assembly Departments. STEP 2 – CALCULATE THE PREDETERMINED OVERHEAD RATE FOR EACH DEPARTMENT During the current month the company started and completed Job 407. It wants to use its predetermined departmental overhead cost and rate for the Milling and Assembly Departments. STEP 3 – CALCULATE THE AMOUNT OF OVERHEAD APPLIED FROM BOTH DEPARTMENTS TO A JOB Use the POR calculated on the previous slide to determine the overhead applied from both departments to Job 407: STEP 4 – CALCULATE THE TOTAL JOB COST FOR JOB 407 We can use the informaon given to calculate the amount of the total cost of Job 407. Here is the calculaon: 19 Downloaded by Chiara Davoli ([email protected])
