CHAPTER Cost-Volume-Profit Analysis: Additional Issues ASSIGNMENT CLASSIFICATION TABLE Study Objectives Questions Brief Exercises Exercises A Problems B Problems 1A, 2A 1B, 2B Describe the essential features of a cost-volume-profit income statement 1, 2, 3, 1, 2, 3, 4, 5, Apply basic CVP concepts 2, 4, 5, 1, 2, 3, 4, 5, 1, 2, 3, 4, 1A, 2A, 4A 1B, 2B, 4B Explain the term sales mix and its effects on break-even sales 7, 8, 7, 8, 9, 10 6, 7, 8, 9, 10 4A 4B Determine sales mix when a company has limited resources 10, 11 11, 15 11, 12, 13 3A 3B Understand how operating leverage affects profitability 12, 13, 14, 15, 16 12, 13, 14 14, 15, 16 5A 5B *6 Explain the difference between absorption costing and variable costing 17 16, 17, 18 17, 18, 19 6A, 7A 6B, 7B *7 Discuss net income effects under absorption costing versus variable costing 19, 20, 21, 22 19 18 6A, 7A 6B, 7B *8 Discuss the merits of absorption versus variable costing for management decision making 18 7A 7B *Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix to the chapter 6-1 ASSIGNMENT CHARACTERISTICS TABLE Problem Number Description Difficulty Level Time Allotted (min.) 1A Compute break-even point under alternative courses of action Moderate 20–30 2A Compute break-even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment Moderate 20–30 3A Determine sales mix with limited resources Simple 10–15 4A Determine break-even sales under alternative sales strategies and evaluate results Moderate 20–30 5A Compute degree of operating leverage and evaluate impact of operating leverage on financial results Moderate 20–30 *6A Prepare income statements under absorption costing and variable costing for a company with beginning inventory, and reconcile differences Moderate 20–30 *7A Prepare absorption and variable costing income statements and reconcile differences between absorption and variable costing income statements when sales level and production level change Discuss relative usefulness of absorption costing versus variable costing Moderate 20–30 1B Compute break-even point under alternative courses of action Moderate 20–30 2B Compute break-even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment Moderate 20–30 3B Determine sales mix with limited resources Simple 10–15 4B Determine break-even sales under alternative sales strategies and evaluate results Moderate 20–30 5B Compute degree of operating leverage and evaluate impact of operating leverage on financial results Moderate 20–30 *6B Prepare income statements under absorption costing and variable costing for a company with beginning inventory, and reconcile differences Moderate 20–30 *7B Prepare absorption and variable costing income statements and reconcile differences between absorption and variable costing income statements when sales level and production level change Discuss relative usefulness of absorption costing versus variable costing Moderate 20–30 6-2 6-3 Determine sales mix when a Q6-11 company has limited resources Understand how operating leverage affects profitability Explain the difference between absorption costing and variable costing Discuss net income effects under absorption costing versus variable costing Discuss the merits of absorption versus variable costing for management decision making *4 *5 **6 *7 **8 Broadening Your Perspective Explain the term sales mix and its effects on break-even sales *3 Q6-12 Q6-13 Q6-15 Q6-7 Q6-8 Apply basic CVP concepts *2 Q6-1 Q6-3 Describe the essential features of a cost-volume-profit income statement E6-6 E6-7 E6-8 E6-9 E6-2 E6-3 E6-4 E6-5 P6-1A P6-2A BE6-1 P6-1A P6-2A P6-4A P6-1B P6-2B P6-4A P6-1B P6-2B P6-4B P6-3B E6-11 E6-12 E6-13 E6-10 E6-6 P6-4A E6-7 P6-4B E6-8 P6-4A BE6-1 P6-1A P6-2A P6-1B P6-2B P6-1A P6-2A P6-1B P6-2B E6-18 P6-6B E6-18 E6-19 P6-7B E6-19 P6-6A P6-6A P6-7A P6-7B P6-7A P6-6B P6-7B Synthesis Evaluation Decision Making All About Managerial Analysis Across the You Ethics Case Organization P6-7A P6-7B Q6-19 P6-6A P6-7B P6-6A BE6-19 P6-7A P6-7A E6-18 P6-6B P6-6B BE6-16 BE6-17 BE6-18 E6-17 P6-5A P6-5B P6-3A P6-3B P6-4B P6-4B Analysis Q6-16 BE6-14 E6-16 E6-14 BE6-12 E6-14 P6-5A E6-15 BE6-13 E6-15 P6-5B E6-16 BE6-11 E6-12 BE6-15 E6-13 E6-11 P6-3A BE6-7 BE6-8 BE6-9 BE6-10 BE6-2 BE6-3 BE6-4 BE6-5 BE6-6 E6-1 BE6-2 BE6-3 BE6-4 BE6-5 BE6-6 Application Communication Real-World Focus Exploring the Web Q6-18 Q6-19 Q6-22 Q6-20 Q6-21 Q6-17 Q6-14 Q6-10 Q6-8 Q6-9 Q6-2 Q6-4 Q6-5 Q6-6 Q6-2 Q6-4 Knowledge Comprehension *1 Study Objective Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems BLOOM’S TAXONOMY TABLE STUDY OBJECTIVES DESCRIBE THE ESSENTIAL FEATURES OF A COSTVOLUME-PROFIT INCOME STATEMENT APPLY BASIC CVP CONCEPTS EXPLAIN THE TERM SALES MIX AND ITS EFFECTS ON BREAK-EVEN SALES DETERMINE SALES MIX WHEN A COMPANY HAS LIMITED RESOURCES UNDERSTAND HOW OPERATING LEVERAGE AFFECTS PROFITABILITY *6 EXPLAIN THE DIFFERENCE BETWEEN ABSORPTION COSTING AND VARIABLE COSTING *7 DISCUSS NET INCOME EFFECTS UNDER ABSORPTION COSTING VERSUS VARIABLE COSTING *8 DISCUSS THE MERITS OF ABSORPTION VERSUS VARIABLE COSTING FOR MANAGEMENT DECISION MAKING 6-4 CHAPTER REVIEW Cost-Volume-Profit Income Statement (S.O 1) The Cost-Volume-Profit (CVP) income statement classifies costs as variable or fixed and computes a contribution margin Contribution margin is the amount of revenue remaining after deducting variable costs It is often stated both as a total amount and on a per unit basis Desossa Music Player Company CVP Income Statement For the Month Ended June 30, 2009 Sales Variable expenses Cost of goods sold Selling expenses Administrative expenses Total variable expenses Contribution margin Fixed expenses Cost of goods sold Selling expenses Administrative expenses Total fixed expenses Net income Total $420,000 Per Unit $120 245,000 175,000 70 $ 50 $200,000 35,000 10,000 50,000 25,000 19,500 94,500 $ 80,500 Basic Computations (S.O 2) Desossa Music Players’ CVP income statement shows that total contribution margin (sales minus variable expenses) is $175,000, and the company’s contribution margin per unit is $50 The contribution margin ratio (contribution margin divided by sales) is 41.67% ($50 ÷ $120) Desossas’ break-even point in units (using contribution margin per unit) or in dollars (using contribution margin ratio) are calculated as follows: Fixed cost $94,500 ÷ ÷ Contribution margin per unit $50 = = Break even point in units 1,890 units Fixed cost $94,500 ÷ ÷ Contribution margin ratio 4167 = = Break even point in dollars $226,800 Assuming Desossa’s management has a target net income of $100,000, the required sales in units and dollars to achieve its target net income are calculated as follows: (Fixed cost + Target net income) ÷ Contribution margin per unit ($94,500 + $100,000) ÷ $50 = = Required sales in units 3,890 units (Fixed cost + Target net income) ÷ ($94,500 + $100,000) ÷ = = Required sales in dollars $466,762 Contribution margin ratio 4167 6-5 Desossas’ margin of safety in dollars or as a ratio are calculated as follows: Actual (expected) sales $420,000 – – Break-even sales $226,800 = Margin of safety in dollars = $193,200 Margin of safety in dollars ÷ Actual (expected) sales = $193,200 ÷ $420,000 = Margin of safety ratio 46% CVP and Changes in the Business Environment To better understand how CVP analysis works, let’s assume that shipping costs have increased significantly causing the unit variable cost to increase by 10%, what effect will this have on Desossas’ break-even point? Answer: A 10% increase in variable costs increases the per unit variable cost to $77 [$70 + ($70 X 10%)] The new contribution margin per unit is therefore $43 ($120 – $77) Thus the new break even point in units is calculated as follows: Fixed cost $94,500 ÷ ÷ Contribution margin per unit $43 = = Break even point in units 2,198 units Sales Mix (S.O 3) Sales mix is the relative percentage in which a company sells its multiple products For example, if 60% of product A is sold for every 40% of product B, the sales mix of the product is 60% to 40% Break-even sales can be computed for a mix of two or more products by determining the weighted average unit contribution margin of all the products Assume that Seth Inc sells tables and chairs in a ratio of four chairs for every one table The sales mix in percentages is 20% (1/5) for tables and 80% (4/5) for chairs The following is the per unit data for Seth Inc.: Unit Data Selling price Variable costs Contribution margin Sales mix-units Fixed costs = $192,000 Tables $100 60 $ 40 20% Chairs $20 10 $10 80% To compute break-even for Seth Inc., we use the weighted average contribution margin as follows: Tables Chairs Sales Sales  Unit   Unit   Contribution X Mix  +  Contribution X Mix =      Margin Percentage  Margiin Percentage ($40 X 20) + ($10 X 80) 6-6 = Weighted – Average Unit Contribution Margin $16 Fixed Costs ÷ $192,000 ÷ Weighted – Average Unit Contribution Margin $16 = 12,000 units To break even, Seth must sell 2,400 (12,000 X 20%) tables and 9.600 (12,000 X 80%) chairs At any level of units sold, net income will be greater if more high contribution margin units are sold than low contribution margin units An analysis of these relationships generally shows that a shift from low-margin sales to high margin sales may increase net income, even though there is a decline in total units sold The formula for computing the break-even point in dollars is fixed costs divided by the weightedaverage contribution margin ratio To compute a company’s weighted-average contribution ratio, multiply each division’s contribution margin ratio by its percentage of total sales and then sum these amounts Seth Inc’s contribution margin ratio for sales of tables is 40 ($40/$100) and for chairs is 50 ($10/$20) The weighted-average contribution margin ratio is calculated as follows: Tables Chairs  Contribution Sales Mix   MarginRatio X Percentage (.40 X 20) Weighted - Average  Contribution Sales Mix  +  = X  atio  MarginRatio Percentage ContributionMarginRa + (.50 X 80) = 48 The break-even point in dollars is calculated as follows: Fixed costs ÷ $192,000 ÷ Weighted – Average ContributionMarginRa atio 48 = = Break - even point inDollars $400,000 Sales Mix with Limited Resources 10 (S.O 4) When a company has limited resources (e.g., floor space, raw materials, direct labor hours), management must decide which products to make and sell in order to maximize net income Assume that Seth Inc has limited machine capacity which is 2,600 hours per month Relevant data consist of the following: Contribution margin per unit Machine hours required per unit Tables $40 Chairs $10 16 The contribution margin per unit of limited resource is calculated as follows: Contribution margin per unit (a) Machine hours required (b) Contribution margin per unit of limited resource [(a) ÷ (b)] Tables $40 Chairs $10 16 $50 $62.50 6-7 If Seth Inc increases machine capacity hours by 400 hours per month, it would be better to use the hours to produce more chairs Machine hours (a) Contribution margin per unit of limited resource (b) Contribution margin [(a) X (b)] Tables 400 Chairs 400 $ 50 $20,000 $ 62.50 $25,000 Cost Structure and Operating Leverage 11 (S.O 5) Cost structure refers to the relative proportion of fixed versus variable costs that a company incurs In most cases, increased reliance on fixed costs increases a company’s risk When sales are increasing, profits can increase at a high rate, but when sales decline, losses can also increase at a high rate Companies can change their cost structure by using more sophisticated robotic equipment and reducing it later, or vice versa The equipment would increase the fixed costs whereas labor increases variable costs Variable Costing vs Absorption Costing *12 (S.O 6) There are two approaches to product costing a Under full or absorption costing all manufacturing costs are charged to the product This is also the approach required under generally accepted accounting principles b Under variable costing only direct materials, direct labor, and variable manufacturing overhead costs are treated as product costs; fixed manufacturing overhead costs are recognized as period costs (expenses) when incurred *13 The primary difference between variable and absorption costing is that under variable costing the fixed manufacturing overhead is charged as an expense in the current period The result is that absorption costing will show a higher net income number than variable costing whenever units produced exceed units sold The reason: the cost of the ending inventory is higher under absorption costing than under variable costing *14 Assume Thibodeau Company manufactures candy bars and has the following information: Volume Information Candy bars in beginning inventory Candy bars produced Candy bars sold 2008 20,000 40,000 30,000 Financial Information Selling price per candy bar Variable manufacturing cost per candy bar Fixed manufacturing cost per year Fixed manufacturing cost per candy bar Variable selling and administrative expense per candy bar Fixed selling and administrative expense 6-8 $1.00 $ 40 $12,000 $ 30 $ 05 $ 4,000 The absorption costing income statement and variable costing income statement are shown below: Thibodeau Company Income Statement For the Year Ended 2008 Absorption Costing Sales (30,000 X $1.00) Cost of goods sold [30,000 X ($.40 + $.30)] Gross profit Variable selling and administrative expenses (30,000 X $.05) Fixed selling and administrative expenses Net income $30,000 21,000 9,000 $1,500 4,000 5,500 $ 3,500 Thibodeau Company Income Statement For the Year Ended 2008 Variable Costing Sales (30,000 X $1.00) Variable costs of good sold (30,000 X $.40) Variable selling and administrative expenses (30,000 X $.05) Contribution margin Fixed manufacturing overhead Fixed selling and administrative expense Net income $30,000 $12,000 1,500 12,000 4,000 13,500 16,500 16,000 $ 500 *15 (S.O 7) The effects of the alternative costing methods on income from operations are: Effects on Income Circumstance From Operations Units produced exceed units sold Income under absorption costing is higher than under variable costing Units produced are less than units sold Income under absorption costing Is lower than under variable costing Units produced equal units sold Income will be equal under both approaches *16 (S.O 8) One of the problems with absorption costing is that management may be tempted to overproduce in a given period in order to increase net income Therefore, to avoid this overproduction, variable costing is often used internally to evaluate management decision-making 6-9 *17 The following are potential advantages of variable costing: a Net income computed under variable costing is unaffected by changes in production levels b The use of variable costing is consistent with cost-volume-profit and incremental analysis c Net income computed under variable costing is closely tied to changes in sales levels giving a more realistic assessment of a company’s success or failure d The presentation of fixed and variable cost components on the face of the variable costing income statement makes it easier to identify these costs and understand their effect on the business 6-10 a The break-even point in units is computed by dividing fixed costs by the weighted-average unit contribution margin b The weighted-average unit contribution margin is computed by adding the products of Product A’s unit contribution margin X its percentage of sales and Product B’s unit contribution margin X its percentage of sales TEACHING TIP ILLUSTRATION 6-2 provides formulas for computing the break-even point in units and dollars, and for the weighted-average unit contribution margin and contribution margin ratio Also available as teaching transparency c At any level of units sold, net income will be greater if higher contribution margin units are sold than lower contribution margin units d A shift from low-margin sales to high-margin sales may increase net income even though there may be a decline in total units sold Conversely, a shift from high- to low-margin sales may result in a decrease in net income, even though there may be an increase in total units sold The calculation of the break-even point in units works well if a company has only a small number of products In a company with many products, break-even sales in dollars is calculated using the weighted-average contribution margin ratio a The break-even point in dollars is computed by dividing fixed costs by the weighted-average contribution margin ratio b The weighted-average contribution margin ratio is computed by adding the products of Division A’s contribution margin ratio X its percentage of sales and Division B’s contribution margin ratio X its percentage of sales 6-12 c C If a higher percentage of a company’s sales come from the division with a higher contribution margin ratio, the weighted-average contribution margin ratio would increase, which would lower the break-even point in dollars Limited resources When a company has limited resources (i.e machine hours), it is necessary to find the contribution margin per unit of limited resource Contribution margin per unit of limited resource is computed by dividing the contribution margin/unit of each product by the number of units of limited resource/required for each product The contribution margin per unit of limited resource is then multiplied by the units of limited resource to determine total contribution margin and which product maximizes net income As discussed in Chapter 1, evaluating constraints is called the theory of constraints According to this theory, companies must continually identify their constraints and find ways to reduce or eliminate them D Cost Structure and Operating Leverage Cost structure is the relative proportion of fixed versus variable costs that a company incurs Cost structure can have a significant effect on profitability Operating leverage is the degree to which a company’s net income reacts to a change in sales Operating leverage is determined by a company’s relative use of fixed versus variable costs a Companies with high fixed costs relative to variable costs have high operating leverage 6-13 b When a company’s sales revenue is increasing, high operating leverage is good because it means that profits will increase rapidly However, when sales are declining, too much operating leverage can have devastating consequences The degree of operating leverage provides a measure of a company’s earnings volatility and can be used to compare companies Degree of operating leverage is computed by dividing total contribution margin by net income TEACHING TIP ILLUSTRATION 6-3 provides the formula for computing the degree of operating leverage Emphasize that companies with high fixed costs have high operating leverage A cost structure that relies on higher fixed costs, and consequently has higher operating leverage, is not necessarily bad Operating leverage can add considerably to a company’s profitability when used carefully *E Absorption Costing Versus Variable Costing Under absorption costing, all manufacturing costs are charged to, or absorbed by, the product This approach is used for external reporting under generally accepted accounting principles Under variable costing, only variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead costs) are considered product costs Companies recognize fixed manufacturing overhead costs as period costs (expenses) when incurred under variable costing Selling and administrative expenses are period costs under both absorption and variable costing 6-14 Companies use the cost-volume-profit format in preparing a variable costing income statement The one primary difference between variable and absorption costing is that under variable costing companies charge fixed manufacturing overhead as an expense in the current period, instead of being deferred to a future period through the ending inventory as under absorption costing Absorption costing will show a higher net income than variable costing whenever units produced exceed units sold since fixed overhead costs are deferred to a future period as part of the ending inventory cost When units produced and sold are the same, net income will be equal under the two costing approaches because there is no increase in ending inventory, and therefore no deferral of fixed overhead costs to future periods through the ending inventory When units produced are less than units sold, net income under absorption costing is less than net income under variable costing because fixed manufacturing overhead cost in beginning inventory is charged to the current year income under absorption costing TEACHING TIP ILLUSTRATION 6-4 shows the relationship between production and sales and its effect on net income under absorption costing and variable costing Also available as teaching transparency *F Decision-Making Concerns For external reporting purposes, companies must report financial information using GAAP, which requires that absorption costing be used for the costing of inventory 6-15 Some companies have recognized that net income calculated using GAAP does not highlight differences between variable and fixed costs and may lead to poor business decisions Therefore, some companies use variable costing for internal reporting purposes When production exceeds sales, absorption costing reports a higher net income than variable costing because some fixed manufacturing costs are not expensed in the current period, but are deferred to future periods as part of inventory Management may be tempted to overproduce in a given period in order to increase net income, but this decision may not be in the company’s best interest since the buildup of inventories will lead to additional costs to the company in the long run Variable costing avoids the temptation to overproduce because net income under this approach is not affected by changes in production levels *G Potential Advantages of Variable Costing Variable costing has several potential advantages relative to absorption costing: a Net income computed under variable costing is unaffected by changes in production levels b The use of variable costing is consistent with cost-volume-profit analysis and incremental analysis c Net income computed under variable costing is closely tied to changes in sales, and provides a more realistic assessment of the company’s success or failure 6-16 d The presentation of fixed and variable cost components on the variable costing income statement makes it easier to identify these costs and understand their effect on the company’s results TEACHING TIP ILLUSTRATION 6-5 provides a listing of the potential advantages of variable costing 6-17 20 MINUTE QUIZ Circle the correct answer True/False The CVP income statement classifies costs as variable or fixed and computes a contribution margin True False The margin of safety indicates how much sales must increase before a company will be operating at a profit True False Sales mix is the relative percentage in which each product is sold when a company sells more than one product True False The break-even point in dollars is computed by dividing fixed costs by the weightedaverage contribution margin True False When a company has limited resources, management must decide which product to make and sell in order to maximize contribution margin ratio True False Contribution margin per unit of limited resource is obtained by dividing the contribution margin per unit of each product by the number of units of the limited resource required for each product True False Operating leverage refers to the extent to which a company’s net income reacts to a given change in production True False Companies that have higher fixed costs relative to variable costs have higher operating leverage True False *9 Under variable costing, all variable costs are considered product costs True False *10 Fixed manufacturing costs are a product cost under absorption costing but are a period cost under variable costing True False 6-18 Multiple Choice For a company selling multiple products, the break-even point in dollars is computed by dividing fixed costs by the a contribution margin per unit b contribution margin ratio c weighted-average contribution margin per unit d weighted-average contribution margin ratio In order to maximize net income a company should produce and sell the product with the highest a contribution margin ratio b contribution margin per unit c contribution margin per unit of limited resource d weighted-average unit contribution margin Operating leverage refers to the extent to which a company’s net income reacts to a given change in a fixed costs b production c sales d variable costs *4 Under variable costing, all of the following are considered product costs except a direct materials b direct labor c variable manufacturing overhead d variable selling and administrative expenses *5 All of the following are potential advantages of variable costing except that a its use is consistent with cost-volume-profit and incremental analysis b variable costing net income is affected by changes in production levels c variable costing net income is closely tied to changes in sales levels d the presentation of fixed and variable cost components makes it easier to identify these costs 6-19 ANSWERS TO QUIZ True/False True False True False False *9 *10 True False True False True Multiple Choice *4 *5 d c c d b 6-20 ILLUSTRATION 6-1 CVP INCOME STATEMENT EXAMPLE COMPANY CVP Income Statement For the Month Ended May 31, 2008 Total Sales (14,000 units) Variable costs Contribution margin Fixed costs Net income $350,000 210,000 140,000 100,000 $40,000 6-21 Per Unit $25 15 $10 ILLUSTRATION 6-2 BREAK-EVEN POINT IN UNITS AND DOLLARS Break-even Fixed = Point in Units Costs Weighted-average Unit Contribution Margin Product A Product B Percentage Unit Unit Percentage Weighted-average of of + Contribution x Unit Contribution = Contribution x Sales Margin Margin Sales Margin Break-even Fixed Point in Dollars = Costs Weighted-average Contribution Margin Ratio Division A Division B Contribution Percentage Contribution Percentage Weighted-average x Margin of x of Margin + = Contribution Ratio Sales Sales Ratio Margin Ratio 6-22 ILLUSTRATION 6-3 DEGREE OF OPERATING LEVERAGE Degree of Operating Leverage = Contribution Margin Net Income Operating leverage is determined by a company's relative use of fixed versus variable costs A company with high operating leverage will experience a sharp increase in net income with an increase in sales 6-23 ILLUSTRATION 6-4 EFFECT OF PRODUCTION AND SALES ON ABSORPTION AND VARIABLE INCOME Circumstances Income under Absorption Costing Variable Costing = Toothbrushes produced = Toothbrushes Sold > Toothbrushes produced > Toothbrushes Sold < Toothbrushes produced < Toothbrushes Sold 6-24 ILLUSTRATION 6-5 POTENTIAL VARIABLE COSTING ADVANTAGES Variable costing net income is unaffected by changes in production levels Using variable costing is consistent with cost-volume-profit and incremental analysis Variable costing net income provides a more realistic assessment of a company's success or failure The presentation of fixed costs makes it easier to identify them and understand their effect on company profitability 6-25 ... two or more products by determining the weighted-average unit contribution margin of all the products 6-11 a The break-even point in units is computed by dividing fixed costs by the weighted-average... point in dollars is computed by dividing fixed costs by the weighted-average contribution margin ratio b The weighted-average contribution margin ratio is computed by adding the products of Division... fixed costs divided by the weightedaverage contribution margin ratio To compute a company’s weighted-average contribution ratio, multiply each division’s contribution margin ratio by its percentage