MANAGERIAL ACCOUNTING 7e Al L. Hartgraves Wayne J. Morse

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1 MANAGERIAL ACCOUNTING 7e Al L. Hartgraves Wayne J. Morse Learning Objective 1 CHAPTER 3 Cost Volume Profit Analysis and Planning Identify the uses and limitations of traditional cost volume profit analysis. 2 Profitability Analysis Cost-Volume-Profit Analysis Involves examining the relationships among revenues, costs, and profits Widely used in the economic evaluation of existing or proposed products or services Performed before decisions are finalized CVP A technique to examine the relationships among total volume of an independent variable, total costs, total revenues, and profits for a time period What you need to understand to perform profitability analysis Selling Prices Behavior of activity cost drivers Useful in the early stages of planning Provides an easily understood framework for discussing planning issues and organizing relevant data 3 4 CVP Use in For-Profit Companies CVP Use in Not-For-Profit Companies Provides answers to questions such as How many cappuccinos must Starbucks sell to earn total profit of $50,000? At what sales volume will McDonald s total revenues and total costs be equal? What profit will Office Max earn at sales volume of $200 million? What will happen to Disney s profit if ticket selling prices are increased by 10% and fixed costs increase by 8%? Used by not for profit entities to Establish service levels Plan fund raising events Determine funding requirements Answers questions such as How many homeless people can the Homeless Center house with a budget of $400,000? How much money must be raised from alumni at Princeton to provide 50 full scholarships? 5 6 1

2 CVP Assumptions The Profit Formula 1. All costs are classified as fixed or variable. 2. The total cost function is linear within the relevant range. 3. The total revenue function is linear within the relevant range. 4. The analysis is for a single product, or the sales mix of multiple products is constant. 5. There is only one activity cost driver: unit or dollar sales volume. Accuracy decreases as the scope of operations being analyzed increases. Profit ( ) of a product, service or event Total revenues (R) minus total costs (Y): Revenues (R) are a function of unit sales volume (X) and unit selling price (p): Total costs for a time period (Y) are a function of fixed costs per period (a) and unit variable costs (b): R Y R px Y a+ bx 7 8 Expanded Profit Formula Using the Profit Formula Used to predict profit at any specified activity level, represented by X. To use the profit formula Separate all the company s costs into variable and fixed components Nature of costs Variable Costs Direct Materials The cost of the primary raw materials converted into finished goods Direct Labor Wages earned by production employees converting raw materials into finished goods 9 10 Variable and Fixed Components Example Using the Profit Equation Variable Costs Fixed Costs Variable manufacturing overhead All other variable costs associated with converting raw materials into finished goods Variable selling and administrative costs All variable costs not directly associated with converting raw materials into finished goods Fixed manufacturing overhead All fixed costs associated with converting raw materials into finished goods Fixed selling and administrative costs All fixed costs not directly associated with converting raw materials into finished goods Chillin Time produces and sells one product, ice cream bars, for $1.50 each. To ensure top quality, no inventories are maintained. Estimated costs are: Variable Costs Per Ice Cream Bar Fixed Costs Per Month Manufacturing costs: Manufacturing overhead $1,200 Direct materials $0.43 Selling and administrative 580 Direct labor 0.32 Total $1,780 Manufacturing overhead 0.20 $0.95 Selling and administrative 0.15 Total $1.10 Profit Formula to earn $1,000 $1,000 $1.50X $1,780 $1.10X X 6,950 ice cream bars Chillin Time must sell 6,950 ice cream bars each month to result in $1,000 profit

3 Learning Objective 2 Income Statement Formats Contribution Income Statement Functional Income Statement Prepare and contrast contribution and functional income statements. Costs are classified according to behavior Variable Fixed Contribution margin Total revenues less total variable costs Represents the amount that goes toward covering fixed costs and providing a profit Costs are classified according to function Manufacturing Selling and administrative Gross Margin Total revenues less cost of goods sold Represents the amount that goes toward covering other expenses and providing a profit Contribution Income Statement Example Functional Income Statement Example CHILLIN TIME Contribution Income Statement For a Monthly Volume of 6,950 Ice Cream Bars Sales (6,950 x $1.50) $10,425. Less variable costs: Direct materials (6,950 x $0.43) $2,988 Direct labor (6,950 x $0.32) 2,224 Manufacturing overhead (6,950 x $0.20) 1,390 Selling and administrative (6,950 x $0.15) 1,043 (7,645) Contribution margin 2,780. Less fixed costs: Manufacturing 1,200 Selling and administrative 580 (1,780) Profit $ 1,000. CHILLIN TIME Functional Income Statement For a Monthly Volume of 6,950 Ice Cream Bars Sales (6,950 x $1.50) $10,425. Less cost of goods sold: Direct materials (6,950 x $0.43) $2,988 Direct labor (6,950 x $0.32) 2,224 Variable manufacturing overhead (6,950 x $0.20) 1,390 Fixed manufacturing overhead 1,200 (7,802) Gross margin 2,623. Less other expenses: Variable selling and administrative (6,950 x $0.15) 1,043 Fixed selling and administrative 580 (1,623) Profit $ 1, Analysis Using Contribution Margin Ratio Sensitivity analysis How a model responds to changes in one or more independent variables Unit contribution margin Indicates how sensitive and income model is to a change in unit sales Contribution margin The portion of every sales dollar contributed toward covering fixed costs and earning a profit Contribution Margin Example Chillin Time s contribution income appears below: Total Per Unit Sales (6,950 units) $ 10,425 $ 1.50 Variable costs (7,645) (1.10) Contribution margin 2, Fixed costs (1,780) Profit $ 1,000 Contribution margin per unit Contribution margin ratio $ $1.10 $0.40 [$ $1.10] / $

4 Sensitivity Analysis Example Total Per Unit Ratio to Sales Sales (6,950 units) $10,425. $ Variable costs (7,645) (1.10) (0.733) Contribution margin 2,780. $ Fixed costs (1,780) Profit $ 1,000. If sales increase by 100 ice cream bars per month, by how much will net income increase? 100 x $0.40 $40 Learning Objective Apply cost volume profit analysis to find a break even point and for preliminary profit planning. 3 If sales increase by $1,050 per month, by how much will net income increase? $1,050 x $ Break-Even Point Break-Even Point Occurs when total revenues equal total costs Can be unit sales volume, or Dollar sales volume Operating below break even Company operates at a loss Operating above break even Company operates at a profit Break even unit sales volume Fixed costs Selling price per unit Variable costs per unit Fixed costs Contribution margin per unit CVP example #1 CVP example #1 Question: Happy Daze Game Company produces and sells video games. The games sell for $15 each. The variable production cost is $3 per game. Fixed operating costs total $504,000 per year. How many games must Happy Daze sell in one year in order to break even? Solution: games Happy Daze must sell 42,000 games per year in order to break even (earn a profit $0) 4

5 CVP example #1 If actual sales for Happy Daze Game Company were 50,000 games, what is the Margin of Safety? Solution: Actual Sales Breakeven Sales Margin of Safety CVP example #2 Question: Martinez Company sells a variety of products, all priced with a mark up of 33% over variable cost. Fixed costs total $250,000 per year. What level of sales revenue is required to break even? Solution: CVP example #2 Solution: CVP example #2 Variable Cost Mark Up Sales Price Sales Var Cost C.M. Contribution margin as a percentage of sales is the contribution margin ratio. $ Break-Even Point Example Chillin Time sells ice cream bars with a $1.10 unit variable cost for $1.50 each. How many bars must it sell to break even? Fixed costs Contribution margin per unit Chillin Time s Break Even Unit Sales Volume Profit Planning Target Profit If Chillin Time wants to earn a monthly profit of $800, how many ice cream bars must it sell? Target unit sales volume Chillin Time s Target Unit Sales Volume Fixed costs + Desired profit Contribution margin per unit

6 Cost-Volume-Profit Graph Cost-Volume-Profit Graph Total costs line $1,780 + $1.10 per unit Total Revenues and Total Costs $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 Total revenue line $1.50 per unit Unit Sales Variable costs line $1.10 per unit 31 Total Revenues and Total Costs $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 Total revenue line $1.50 per unit Unit Sales Variable costs line $1.10 per unit 32 Cost-Volume-Profit Graph Profit-Volume Graph Total Revenues and Total Costs $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 Break-even point 4,450 units Unit Sales 33 Total Profit or (Loss) $900 - $600 - $300 - $0 - ($300) - ($600) - ($900) - Break even point $6,675 Profit area $4,000 $8,000 $12,000 Loss Total Revenues area Total profit or loss line 34 Profit-Volume Graph With Taxes Impact of Income Taxes Total Profit or (Loss) $900 - $600 - $300 - $0 - ($300) - ($600) - ($900) - Break even point $6,675 Loss area Total Revenues Note Profit that line the tax after rate tax: does not slope affect b(1-tax break-even. rate) Profit area $4,000 $8,000 $12,000 Total profit or loss line 35 Determining the unit sales volume required to earn a desired after tax profit: Step 1: Step 2: Step 3: Before tax profit Determine the required before tax profit. Substitute the required before tax profit into the profit formula. Solve for the required unit sales volume. After tax profit (1 tax rate) 36 6

7 Impact of Income Taxes Example Chillin Time sells ice cream bars with a $1.10 unit variable cost for $1.50 each. It is subject to a 30 percent income tax rate. How many ice cream bars must Chillin Time sell to earn a desired monthly after tax profit of $840? After tax profit Before tax profit (1 tax rate) $840 $1,200 (1 0.30) $1,780 + $1,200 Target unit sales volume $1.50 $1.10 7,450 ice cream bars 37 Contribution Income Statement with Income Taxes Sales (7,450 x $1.50) $11,175 Less variable costs: Direct materials (7,450 x $0.43) $3,204 Direct labor (7,450 x $0.32) 2,384 Variable manufacturing overhead (7,450 x $0.20) 1,490 Variable selling and administrative (7,450 x $0.15) 1,118 8,195 Contribution margin 2,980 Less fixed costs: Fixed manufacturing overhead 1,200 Fixed selling and administrative 580 1,780 Before-tax profit 100% 1,200 Income taxes ($1,200 30%) 30% 360 After-tax profit 70% $ Learning Objective 5 Operating Leverage What is operating leverage? A measure of the extent that an organization s costs are fixed Apply operating leverage ratio to assess opportunities for profit and the risks of loss. Degree of operating leverage High degree of operating leverage Contribution margin Income before taxes Signals the existence of a high portion of fixed costs High operating leverage Low operating leverage Operating Leverage Risk and Opportunity Sales Increase High opportunity for profit increases Low opportunity for profit increases Sales Decrease High risk of loss Low risk of loss Measuring Expected Change in Profit Taco King and Mexi Land are competitors and reported the same sales revenue and before tax profit during May: Taco King Mexi Land Sales $40,000 $40,000 Variable costs (22,000) (8,000) Contribution margin 18,000 32,000 Fixed costs (8,000) (22,000) Before-tax profit $10,000 $10,000 The higher the degree of operating leverage The greater the opportunity for profit with increases in sales, AND The greater the risk of large losses when sales decrease If sales drop by 20% for both, which company suffers more? Degree of operating leverage Taco King Mexi Land $18,000 $32, $10,000 $10,000 Decrease in profit 1.8 x 20% 36% 3.2 x 20% 64% Decline in Profit Decline in Profit Mexi Land s higher operating leverage results in a larger profit decline

8 Operating Leverage Operating Leverage Operating leverage can be used to answer the question: How much does profit increase from a percentage increase in sales? increase in profits % increase in sales operating leverage e.g. An increase in sales of will increase profits for a company with operating leverage of. Operating leverage can be used to answer the question: How much does profit increase from a percentage increase in sales? increase in profits % increase in sales operating leverage e.g. An increase in sales of will increase profits for a company with operating leverage of. 8