Financial Statement Analysis and Managerial Accounting PDF

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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 Accounng | Marna Marazzi Example This equaon can be used to show the prot RBC earns if it sells 401. Noce, the answer of $200 mirrors our earlier soluon. CVP RELATIONSHIPS IN EQUATION FORM – DETAIL BREAKDOWN When a company has...

lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Example This equaon can be used to show the prot RBC earns if it sells 401. Noce, the answer of $200 mirrors our earlier soluon. CVP RELATIONSHIPS IN EQUATION FORM – DETAIL BREAKDOWN When a company has only one product, we can further rene this equaon as shown on this slide: Example This equaon can also be used to show the $200 prot RBC earns if it sells 401 bikes. CVP RELATIONSHIPS IN EQUATION FORM – USING UNIT CONTRIBUTION MARGIN It is oen useful to express the simple prot equaon in terms of the unit contribuon margin (Unit CM) as follows: – – Example Learning Objecve 2: Prepare and interpret a cost volume-prot (CVP) graph and a prot graph CVP RELATIONSHIPS IN GRAPHIC FORM 10 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi The relaonships among revenue, cost, prot, and volume can be expressed graphically by preparing a CVP graph. Racing Bicycle developed contribuon margin income statements at 0, 200, 400, and 600 units sold. We will use this informaon 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 vercal (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 represenng 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 represenng 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 prot graph: Learning Objecve 3: Use the contribuon margin rao (CM rao) to compute changes in contribuon margin and net operang income resulng from changes in sales volume CONTRIBUTION MARGIN RATIO (CM RATIO) AND THE VARIABLE EXPENSE RATIO The contribuon margin as a percentage of sales is referred to as the contribuon margin rao (CM rao). The rao is computed as follows: For RBC, the contribuon margin rao is calculated as follows: For each $1.00 increase in sales results in a total contribuon margin increase of 40%. The CM rao can also be calculated by dividing the contribuon margin per unit by the selling price per unit: For RBC, the contribuon margin rao is calculated as follows: 11 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi The variable expenses as a percentage of sales is referred to as the variable expense rao. This rao is computer as follows: For RBC, the variable expense rao is calculated as follows: Having dened the two terms, it bears emphasizing that the contribuon margin rao and the variable expense rao can be mathemacally related to one another: For RBC, the contribuon margin rao is calculated as follows: APPLICATIONS OF CONTRIBUTION RATIO If RBC increases sales from 400 to 500 bikes ($50,000), contribuon 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 relaonship between prot and the CM rao can be expressed using the following equaon: If RBC increased its sales volume to 500 bikes, what would management expect prot or net operang income to be? Learning Objecve 4: Show the eects on net operang income of changes in variable costs, xed costs, selling price, and volume Example 1 What is the prot impact if Racing Bicycle can increase unit sales from 500 to 540 by increasing the monthly adversing budget by $10,000? Sales increased by $20,000, but net operang income decreased by $2,000. A shortcut soluon using incremental analysis: 12 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Increase in CM (40 units x $200) Increase in adversing expenses Decrease in net operang income $ 8.000,00 $ 10.000,00 $ -2.000,00 Example 2 What is the prot 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 operang income increases by $10,200. Example 3 What is the prot impact if RBC: 1. Cuts its selling price $20 per unit, 2. Increases its adversing 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 operang income increases by $2,000. Example 4 What is the prot 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 operang 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 prots 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 operang income $ 48.000,00 $ 45.000,00 $ 3.000,00 Learning Objecve 5: Determine the break-even point BREAK-EVEN ANALYSIS The equaon and formula methods can be used to determine the unit sales and dollar sales needed to achieve a target prot of zero. Let’s use the RBC informaon to complete the break-even analysis. The equaon method relies on the basic prot equaon introduced earlier in the chapter. Because Racing Bicycle has only one product, we’ll use the contribuon margin form of this equaon to perform the break-even calculaons. We calculate break-even by solving the equaon below. In a single product situaon, the equaon method for computer the unit sales at break-even is: 13 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi BREAK-EVEN ANALYSIS: FORMULA METHOD The formula method is a shortcut version of the equaon method. It centres on the idea discussed earlier in the chapter that each unit sold provides a certain amount of contribuon 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 prot of $0). Let’s use the equaon method and the formula method to solve this problem. The equaon method is shown on this slide: Learning Objecve 6: Determine the level of sales needed to achieve a desired target prot TARGET PROFIT ANALYSIS In target prot analysis, we esmate what sales volume is needed to achieve a specic target prot. We can also compute the number of units that must be sold to aain a target prot using either: Equaon Method or Formula Method TARGET PROFIT ANALYSIS – EQUATION METHOD Our goal is to solve for the unknown “Q,” which represents the quanty of units that must be sold to aain the target prot. Suppose RBC’s management wants to know the how many bikes must be sold to earn a target prot of $100,000. TARGET PROFIT ANALYSIS – FORMULA METHOD The formula method uses the following equaon: Suppose RBC wants to know how many bikes must be sold to earn a prot of $100,000. TARGET PROFIT ANALYSIS – FORMULA METHOD AND EQUATION METHOD SALES DOLLARS We can also compute the target prot in terms of sales dollars using either the equaon method or the formula method. Suppose RBC’s management wants to know the sales volume that must be generated to earn a target prot of $100,000. Equaon Method 14 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Formula Method Learning Objecve 7: Compute the margin of safety and explain its signicance 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 relave proporon of xed and variable costs in an organizaon. Managers oen have some latude in determining their organizaon’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 proporon 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 proporon of xed costs Companies with low xed cost structures enjoy greater stability in income across good and bad years. Leaning Objecve 8: Compute the degree of operang leverage at a parcular level of sales and explain how it can be used to predict changes in net operang income OPERATING LEVERAGE Operang leverage is a measure of how sensive net operang 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 aect prots. To illustrate, let’s revisit the contribuon income statement for RBC. OPERATING LEVERAGE – CHANGE IN PROFIT With an operang leverage of 5, if RBC increases its sales by 10%, net operang income would increase by 50%. Percent increase in sales Degree of operang leverage $ 10% 5,00 15 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Percent increase in prots 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 prots in a company. Example Pipeline Unlimited produces two types of suroards, the XR7 and the Turbo. The XR7 sells for $100 and generates a contribuon margin per unit of $25. The Turbo sells for $150 and earns a contribuon 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 contribuon margin per unit. To eliminate this type of conict, commissions can be based on contribuon margin rather than on selling price alone. Learning Objecve 9: Compute the break-even point for a mulproduct company and explain the eects of shis in the sales mix on contribuon 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 dierent products), but this is not possible. Usually, even in the case of small companies, the products sold are several. – – – Sales mix is the relave proporon in which a company’s products are sold Dierent products have dierent selling prices, cost structures, and contribuon 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 informaon: JOB-ORDER COSTING: CALCULATING UNIT PRODUCT COSTS Now, we are approaching the cost classicaon that disnguish 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 cosng systems are used when: 1. Many dierent products are produced each period 2. Products are manufactured to order 3. The unique nature of each order requires tracing or allocang costs to each job and maintaining cost records for each job Examples of companies that would use job-order cosng include: 16 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi 1. Boeing (aircra manufacturing) 2. Bechtel Internaonal (large scale construcon) 3. Walt Disney Studios (movie producon) The dierence 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 specic and disncve 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 associaon 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 Objecve 1: Compute a predetermined overhead rate WHY USE AN ALLOCATION BASE? An allocaon base, such as direct labor hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to individual jobs. We use an allocaon base because: a. It is impossible or dicult to trace overhead costs to parcular jobs b. Manufacturing overhead consists of many dierent items ranging from the grease used in machines to the producon 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 esmate all the manufacturing overhead over a signicant amount of me (1 year) and then we predetermine the overhead rate. This cosng 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 allocaon base is a cost driver (cost driver means the items that makes or inuences 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 esmated data are oen used because: 1. Actual overhead for the period is not known unl the end of the period, thus inhibing the ability to esmate 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. Esmate the total amount of the allocaon base (the denominator) that will be required for next period’s esmated level of producon. 2. Esmate the total xed manufacturing overhead cost for the coming period and the variable manufacturing overhead cost per unit of the allocaon base. 3. Use the following equaon to esmate the total amount of manufacturing overhead: 17 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Where: – Y = The esmated total manufacturing overhead cost – a = The esmated total xed manufacturing overhead cost – b = The esmated variable manufacturing overhead cost per unit of the allocaon base – X = The esmated total amount of the allocaon base 4. Compute the predetermined overhead rate (by dividing the total amount of overhead by the number of esmated hours) The predetermined overhead rate is complicated because, aer esmang the total amount of overhead and the total amount of hours used as allocaon based, the manufacturing overhead are xed and variable. Consumpon and electricity bills are variable overhead, in fact they are overhead, but they depend on the volume of acvity, while depreciaon of the facilies is sll an overhead, but xed. Learning Objecve 2: Apply overhead cost to jobs using a predetermined overhead rate OVERHEAD APPLICATION RATE PearCo esmates that it will require 160,000 direct labor-hours to meet the coming period’s esmated producon level. In addion, the company esmates 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 informaon to cost the jobs, which means that the job has used 8 hours, so we mulply it by the rate and there we got the informaon. This piece of informaon is available at the me when the job is completed, so the company doesn’t need to wait unl 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 Objecve 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 inuences planning and decisions made by managers. 1. Job-order cosng systems can accurately trace direct materials and direct labor costs to jobs 2. Job-order cosng systems oen fail to accurately allocate the manufacturing overhead costs used during the producon their respecve jobs Choosing an Allocaon Base 18 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Job-order cosng systems oen use allocaon bases that do not reect how jobs actually use overhead resources. The allocaon 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 oen overly simplisc 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 idened, job cost accuracy is improved by using mulple predetermined overhead rates Learning Objecve 4: Compute the total cost and the unit product cost of a job using mulple predetermined overhead rates INFORMATION TO CALCULATE MULTIPLE PREDETERMINED OVERHEAD RATES Dickson Company has two producon departments, Milling and Assembly. The company uses a job-order cosng system and computes a predetermined overhead rate in each producon 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 esmates: 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 informaon given to calculate the amount of the total cost of Job 407. Here is the calculaon: 19 Downloaded by Chiara Davoli ([email protected])

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