Unit one Cost-Volume-Profit Analysis PDF

Cost-Volume-Profit Analysis, Absorption, and Variable Costing  The two most common methods of costing inventories in manufacturing companies are variable costing and absorption costing.  We describe each in this section and then discuss...

Cost-Volume-Profit Analysis, Absorption, and Variable Costing  The two most common methods of costing inventories in manufacturing companies are variable costing and absorption costing.  We describe each in this section and then discuss them in detail, using a hypothetical telescope-manufacturing company as an example.  Variable costing is a method of inventory costing in which all variable manufacturing costs (direct and indirect) are included as inventoriable costs(product cost).  All fixed manufacturing costs are excluded from inventoriable costs and are instead treated as costs of the period in which they are incurred.  Note that variable costing is an imprecise term to describe this inventory-costing method because only variable manufacturing costs are inventoried; variable nonmanufacturing costs are still treated as period costs and are expensed.  Another common term used to describe this method is direct costing.  This term is also imprecise because variable costing considers variable manufacturing overhead (an indirect cost) as inventoriable, while excluding direct marketing costs  Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs.  That is, inventory “absorbs” all manufacturing costs. The job costing system is an example of absorption costing.  Under both variable costing and absorption costing, all variable manufacturing costs are inventoriable costs and all nonmanufacturing costs in the value chain (such as research and development and marketing), whether variable or fixed, are period costs and are recorded as expenses when incurred.   The actual production for 2017 is 8,000 units. As a result, there is no production-volume variance for manufacturing costs in 2017. A later example, based on data for 2018, does include production-volume variances. However, even in that case, the income statement contains no variances other than the production-volume variance. Variances are written off to cost of goods sold in the period (year) in which they occur.  Required: Based on the preceding information, calculate Stassen’s inventoriable costs per unit produced in 2017 under variable and absorbastion costing  the main difference between variable costing and absorption costing is the accounting for fixed manufacturing costs:  Under variable costing, fixed manufacturing costs are not inventoried; they are treated as an expense of the period.  Under absorption costing, fixed manufacturing costs are inventoriable costs. In our example, the standard fixed manufacturing cost is $135 per unit ($1,080,000 /, 8,000 units) produced.  Cost-volume-profit (CVP) analysis studies the behavior and relationship among total revenues, total costs, and operating income as changes occur in the units sold, the selling price, the variable cost per unit, or the fixed costs of a product. 1. Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units produced and sold. 2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. 3. When graphed, the behavior of total revenues and total costs is linear (straight- line) in relation to output units within the relevant range (and time period). 4. The unit selling price, unit variable costs, and fixed costs are known and constant. 5. The analysis either covers a single product or assumes that the sales mix when multiple products are sold will remain constant as the level of total units sold changes. 6. All revenues and costs can be added and compared without taking into account the time value of money. 7. Inventory change is zero. This means that the quantity of output sold in the period is the same as the quantity of output produced in the same period.  The major terms and key concepts that are used in CVP analysis are operating income, net income, and contribution margin.  Operating income equal Total revenues from operations minus Cost of goods sold and operating costs (excluding income taxes) Net income: is operating income plus non- operating revenues minus non operating costs minus income tax.  Contribution margin (CM)  Contribution margin per unit (UCM)  Contribution margin percentage (CM%)  Variable cost percentage (VC%)  For the purpose of illustration, let’s consider the following example. Example: Emma Frost is considering selling GMAT Success, a test prep book and software package for the business school admission test, at a college fair in Chicago. Emma knows she can purchase this package from a wholesaler at $120 per package, with the privilege of returning all unsold packages and receiving a full $120 refund per package. She also knows that she must pay $2,000 to the organizers for the booth rental at the fair. She will incur no other costs. Emma predicts that she can charge a price of $200 per package for GMAT Success. A. Calculate the unit contribution margin B. Calculate the contribution margin percentage C. Using a contribution income statement, calculate the total contribution margin, and operating income (operating loss) assuming that i. 0 units are sold ii. 1 units are sold iii. 5 units are sold iv. 25 units are sold v. 40 units are sold  The breakeven point (BEP) is that quantity of output sold at which total revenues equal total costs—that is, the quantity of output sold that results in $0 of operating income.  Reason for calculating breakeven point by the manager Mainly because they want to avoid operating losses, and the breakeven point tells them what level of sales they must generate to avoid a loss.  Method to calculate breakeven point 1. equation method, 2. contribution margin method and 3. graph method.  For the purpose of illustration of the three methods, using the data given for Emma Frost earlier, calculate the breakeven quantity and revenue of Emma Frost using: 1. Equation method 2. Contribution margin method 3. Graphic method  While the breakeven point tells managers how much they must sell to avoid a loss, managers are equally interested in how they will achieve the operating income targets underlying their strategies and plans.  In our example, selling 25 units at a price of $200 assures Emma that she will not lose money if she rents the booth.  we next describe how Emma determines how much she needs to sell to achieve a targeted amount of operating income.  We illustrate target operating income calculations by asking the following question: o How many units must Emma sell to earn an operating income of $1,200? o How many revenues needed to earn an operating income of $1,200? And show the operating income on the profit volume graph  Net income is operating income plus non-operating revenues (such as interest revenue) minus non-operating costs (such as interest cost) minus income taxes. For simplicity, throughout this chapter we assume non-operating revenues and non- operating costs are zero. Thus,  Net income = Operating income - Income taxes  Until now, we have ignored the effect of income taxes in our CVP analysis. In many companies, the income targets for managers in their strategic plans are expressed in terms of net income. That’s because top management wants subordinate managers to take into account the effects their decisions have on operating income after income taxes.  Some decisions may not result in large operating incomes, but they may have favorable tax consequences, making them attractive on a net income basis—the measure that drives shareholders’ dividends and returns.  example, Emma may be interested in knowing the quantity of units and revenues she must sell to earn a net income of $960, assuming an income tax rate of 40%.  We return to our GMAT Success example to illustrate how CVP analysis can be used for strategic decisions concerning advertising and selling price.  Suppose Emma anticipates selling 40 units at the fair and Emma’s operating income will be $1,200. Emma is considering placing an advertisement describing the product and its features in the fair brochure. The advertisement will be a fixed cost of $500. Emma thinks that advertising will increase sales by 10% to 44 packages. Should Emma advertise?  As you become more familiar with CVP analysis, try evaluating decisions based on differences rather than mechanically working through the contribution income statement.  Having decided not to advertise, Emma is considering whether to reduce the selling price to $175. At this price, she thinks she will sell 50 units. At this quantity, the test-prep package wholesaler who supplies GMAT Success will sell the packages to Emma for $115 per unit instead of $120. Should Emma reduce the selling price?  Before choosing strategies and plans about how to implement strategies, managers frequently analyze the sensitivity of their decisions to changes in underlying assumptions. Sensitivity analysis is a “what-if” technique that managers use to examine how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes.  In the context of CVP analysis, sensitivity analysis answers questions such as, “What will operating income be if the quantity of units sold decreases by 5% from the original prediction?” and “What will operating income be if variable cost per unit increases by 10%?”  Sensitivity analysis broadens managers’ perspectives to possible outcomes that might occur before costs are committed.  One aspect of sensitivity analysis is margin of safety. The margin of safety is the excess of an organization’s expected future sales (in either revenue or units) above the breakeven point.  Margin of safety in revenues(MSR) =Budgeted (or actual) revenues - Breakeven revenues  Margin of safety (in units) (MSQ)=Budgeted (or actual) sales quantity-Breakeven quantity  The margin of safety answers the “what-if” question: If budgeted revenues are above breakeven and drop, how far can they fall below budget before the breakeven point is reached? Sales might decrease as a result of a competitor introducing a better product, or poorly executed marketing programs, and so on.  Assume that Emma has fixed costs of $2,000, a selling price of $200, and variable cost per unit of $120. From the above example , if Emma sells 40 units. Therefore, what is Emma margin of safety in units and revenues?  Sometimes margin of safety is expressed as a percentage: Margin of safety percentage(MS%)= Margin of safety in dollars/ Budgeted (or actual) revenues  In our example, margin of safety percentage = $3,000/$8,000= 37.5%  This result means that revenues would have to decrease substantially, by 37.5%, to reach breakeven revenues. The high margin of safety gives Emma confidence that she is unlikely to suffer a loss.  Managers have the ability to choose the levels of fixed and variable costs in their cost structures. This is a strategic decision. In this section, we describe various factors that managers and management accountants consider as they make this decision.  Alternative Fixed-Cost/Variable-Cost Structures  CVP-based sensitivity analysis highlights the risks and returns as fixed costs are substituted for variable costs in a company’s cost structure.  Suppose the Chicago college fair organizers offer Emma three rental alternatives:  Option 1: $2,000 fixed fee  Option 2: $800 fixed fee plus 15% of GMAT Success revenues  Option 3: 25% of GMAT Success revenues with no fixed fee  Show the three option using profit volume graph and choice from the option based on risk tolerance?  The risk-return trade-off across alternative cost structures can be measured as operating leverage. Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold and contribution margin.  Organizations with a high proportion of fixed costs in their cost structures, as is the case under Option 1, have high operating leverage.  The line representing Option 1 in profit volume graph is the steepest of the three lines. Small increases in sales lead to large increases in operating income. Small decreases in sales result in relatively large decreases in operating income, leading to a greater risk of operating losses. At any given level of sales,  Degree of operating leverage = Contribution margin /Operating income  What is Emma GMAT success degree of operating leverage at sales of 40 units for the three rental options.  These results indicate that, when sales are 40 units, a percentage change in sales and contribution margin will result in 2.67 times that percentage change in operating income for Option 1, but the same percentage change (1.00) in operating income for Option 3.  Consider, for example, a sales increase of 50% from 40 to 60 units. Contribution margin will increase by 50% under each option. Operating income, however, will increase by 2.67 X 50% = 133% from $1,200 to $2,800 in Option 1, but it will increase by only 1.00 X 50% = 50% from $1,200 to $1,800 in Option 3. The degree of operating leverage at a given level of sales helps managers calculate the effect of sales fluctuations on operating income.  Sales mix is the relative proportion of quantities of products (or services) that constitute total unit sales. If the proportions of the mix change, the cost volume profit relationships also change.  Unlike in the single product (or service) situation, there is no unique breakeven number of units for a multiple- product situations. The breakeven quantity depends on the sales mix. One possible assumption is that the budgeted sales mix will not change at different levels of total unit sales.  For the illustration purpose, consider the following information obtained from the accountant of Ramos Company. Suppose Ramos Co. is currently producing and selling two different products, known as product A and product B. The budgeted income statement of the company is shown below:  Product A Product B Total Sales in units 300,000 75,000 375,000 Sales @$8, and $5 2,400,000 375,000 2,775,000 Vc @$7 & $3 2,100,000 225,000 2,325,000 CM @$1 & $2 300,000 150,000 450,000 Fixed costs 180,000 Operating income $270,000  Additional information: the company assumed that 4 units of product A are produced and sold for every 1 unit of product B, and this budgeted sales (relative proportion of 4:1) will not change at different levels of total sales.  Required: Calculate the breakeven quantity using: A. Equation method. B. Weighted-average contribution margin per unit method. C. Weighted- average contribution margin percentage method. o Thus far, our CVP analysis has focused on a merchandising company mainly. CVP can also be applied to decisions by manufacturing companies like Ramos Co. or Harar Brewery factory, service companies like Commercial Bank of Ethiopia, and nonprofit organizations like the United Way and care Ethiopia. To apply CVP analysis in service and nonprofit organizations, we need to focus on measuring their output, which is different from the tangible units sold by manufacturing and merchandising companies.  Example: Consider an agency of the Massachusetts Department of Social Welfare with a $900,000 budget appropriation (its revenues) for 2011. This nonprofit agency’s purpose is to assist handicapped people seeking employment. On average, the agency supplements each person’s income by $5,000 annually. The agency’s only other costs are fixed costs of rent and administrative salaries equal to $270,000. The agency manager wants to know how many people could be assisted in 2011.  Suppose the manager is concerned that the total budget appropriation for 2012 will be reduced by 15% to $900,000 X (1 - 0.15) = $765,000. The manager wants to know how many handicapped people could be assisted with this reduced budget. Assume the same amount of monetary assistance per person: Fixed cost  A fixed cost remains unchanged in amount when the volume of activity varies from period to period within a relevant range.  For example, $5,000 in monthly rent paid for a factory building remains the same whether the factory operates with a single eight hour shift or around the clock with three shifts.  This means that rent cost is the same each month at any level of output from zero to the plant’s full productive capacity.  Notice that while total fixed cost does not change as the level of production changes, the fixed cost per unit of output decreases as volume increases.  For instance, if 20 units are produced when monthly rent is $5,000, the average rent cost per unit is $250 (computed as $5,000/20 units). When production increases to 100 units per month, the average cost per unit decreases to $50 (computed as $5,000/100 units).  When production volume and costs are graphed, units of product are usually plotted on the horizontal axis and dollars of cost are plotted on the vertical axis.  Fixed costs then are represented as a horizontal line because they remain constant at all levels of production.  Fixed cost + variable cost = mixed cost   A variable cost changes in proportion to changes in volume of activity. The direct materials cost of a product is one example of a variable cost.  If one unit of product requires materials costing $20, total materials costs are $200 when 10 units of product are manufactured, $400 for 20 units, $600 for 30 units, and so on.  Notice that variable cost per unit remains constant but the total amount of variable cost changes with the level of production.  A mixed cost includes both fixed and variable cost components. For example, compensation for sales representatives often includes a fixed monthly salary and a variable commission based on sales.  Like a fixed cost, it is greater than zero when volume is zero; but unlike a fixed cost, it increases steadily in proportion to increases in volume.  A step-wise cost reflects a step pattern in costs. Salaries of production supervisors often behave in a step-wise manner in that their salaries are fixed within a relevant range of the current production volume.  However, if production volume expands significantly (for example, with the addition of another shift), additional supervisors must be hired.  This means that the total cost for supervisory salaries goes up by a lump-sum amount. Similarly, if volume takes another significant step up, supervisory salaries will increase by another lump sum.  This behavior reflects a step-wise cost, also known as a stair-step cost. Then, when volume significantly changes, it shifts to another level for that range (step).  A variable cost, as explained, is a linear cost; that is, it increases at a constant rate as volume of activity increases.  A curvilinear cost, also called a nonlinear cost, increases at a non constant rate as volume increases. When graphed, curvilinear costs appear as a curved line  Sparkle Car Wash Supplier sells a hose washer for $0.25 that it buys from the manufacturer for $0.12. Variable selling costs are $0.02 per house washer. Breakeven is currently at a sales volume of $10,600 per month. What are the monthly fixed costs associated with the washer?  A firm has the following income statement for a month.  Sales: 3,000 units at $80/unit $240,000  Less: Cost of Goods Sold:  Variable Production Cost 180,000  Fixed Production Cost 19,800  Gross Margin 40,200  Less: Selling and Administrative Expenses  Variable Selling Cost 21,000  Fixed Selling Expenses 7,500  Net Income before Taxes $ 11,700  Required: 1. Find the firm’s breakeven output.  2. If it wishes to have a monthly net income before taxes of $18,000 and its cost structure remains as above, what quantity of output will it need to sell?  3. If its variable production costs increase by $4 per unit, what will be its breakeven output?  4. After the increase in costs in (iii), what output will it need to sell if it wishes to have the $18,000 monthly pretax profit stated earlier?  5. Given the variable production cost increase but no change in fixed costs, what will be the firm’s monthly profit if it sells 4,000 units of output per month?  Suppose that Magik Bicycles wants to produce a new mountain bike called Magik bike III and has forecast the following information.  Price per bike $800  Variable cost per bike $300  Fixed costs related to bike production $5,500,000  Target profit $200,000  Estimated sales 12,000 bikes  Required: 1. Find the total contribution margin. 2. Find the breakeven quantity and revenue by using equation method. 3. Find the breakeven quantity and revenue by using contribution margin method. 4. Find the breakeven quantity and revenue by using graphic method. 5. Compute the margin of safety in units and in dollar and explain the result. 6. Calculate the degree of operating leverage and explain the result. 7. How many magik bikes should magic bicycles sell to reach target operating income of $200,000? 8. Suppose that Magik Bicycles plans for an after-tax profit of $180,000 and its tax rate is 40%. How many magik bikes should magic bicycles sell to reach the target net income?