Chapter 12 Module 5. AMIS 310 Foundations of Accounting

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1 Chapter 12, Module 5 AMIS 310: Foundations of Accounting Slide 1 CHAPTER 1 MODULE 1 AMIS 310 Foundations of Accounting Professor Marc Smith Hi everyone, welcome back. Let s continue discussing the idea of contribution margin and I d like to jump right into the third example from our lecture problems posted on our website. Here is what it says. The following information is available for XYZ Company for And they give us just 3 pieces of information selling price per unit is $25, variable cost per unit are $19.80, and our total fixed costs $468,000. And the first two requirements is what I want to jump right into are to calculate the contribution margin per unit and the contribution margin ratio. We can jump right into that because we ve already seen how to do this. AMIS 310 Professor Marc Smith

2 Please go to the next slide with me. AMIS 310: Foundations of Accounting Slide 2 : Example #3 a. Contribution margin per unit = = $5.20 This means that for every unit sold, $5.20 of the selling price is available to pay fixed costs and contribute toward a profit b. Contribution margin ratio = = 20.8% This means that for every unit sold, 20.8% of the selling price is available to pay fixed costs and contribute toward a profit To calculate our contribution margin per unit it is the selling price given as $25 per unit minus the variable cost per unit given as $ The contribution margin per unit $5.20. This means for every unit that we sell we have $5.20 to pay our fixed costs and contribute toward a profit. That is the whole idea of contribution margin. How much of our sales are available to pay the fixed costs and contribute to a profit. So for every unit that we sell, we have $5.20 to do that. To calculate the contribution margin ratio, well we know the CM ratio is the contribution margin per unit divided by the selling price per unit. AMIS 310 Professor Marc Smith

3 $5.20 calculated in Part a divided by the $25 selling price per unit gives us a contribution margin ratio of 20.8%. And what this means and really the CM per unit and the CM ratio are telling me the same story as we are about to see just telling it to me in a different way. For every unit that we sell, we have 20.8% of the sales to contribute to a profit and pay our fixed costs. That is the same thing as saying for every unit we sell we have $5.20 to pay our fixed costs and contribute to a profit. One expressed as a dollar per unit; one expressed as a percentage of the sales. But they tell me the same story. Now go ahead to the next slide with me. Slide 3 : C-V-P Analysis Cost-Volume-Profit Analysis is a way of determining how revenues, costs, and profits behave (change) as the volume of activity changes Typical starting point in a CVP analysis: find the break-even point AMIS 310 Professor Marc Smith

4 We need to do a little bit of discussion before continuing the problem. We want to talk a little bit about what is called C-V-P analysis. It stands for cost-volume-profit analysis. C-V-P analysis is a way of determining how revenues, costs, and profits will react (i.e. change) given some change in the level of activity. So given there is going to be some activity change, what affect will that have on revenues, profits, and costs? The typical starting point, the common starting point in a typical C-V-P analysis is to find what is called the break-even point. We want to find the break-even point. Go ahead to the next slide with me. Slide 4 : Break-Even Point The break-even point is the point where: no profit is earned (or loss incurred) Sales = Variable Costs + Fixed Costs QUESTION: Why would a company be interested in the break-even point? The break-even point is the point where no profit is earned. AMIS 310 Professor Marc Smith

5 We make nothing but we also lose nothing. It is the point where we have no profit and we incur no loss. AMIS 310: Foundations of Accounting So it is the point where the sales we earn are exactly equal to our costs. So the sales revenue equals the variable costs plus the fixed costs. If the break-even point is the point where we don t make any profit, I have a question. Why would we care about this? Why would a company be interested in knowing what the break-even point is? Well, go ahead to the next slide with me. Slide 5 : Break-Even Point ANSWER: It aids in decision-making by giving managers a minimum target revenue as well as providing some insight as to the viability of offering a new product or entering a new market The break-even point (in units) represents the number of units that must be sold to break-even The answer is in decision making the break-even point kind of gives us a minimum target revenue to shoot for. AMIS 310 Professor Marc Smith

6 It tells us basically hey, this is the minimum that we can do. AMIS 310: Foundations of Accounting We want to do at least this prefer to do a lot more than this but we certainly don t want to be below this. It also gives some indication as to the viability of offering a new product or entering a new market. If for example we are interested in maybe offering a new product let s say we make and sell chalk. And we re kind of thinking well, maybe we re making and selling white chalk maybe we ought to make and sell red chalk too. So marketing folks go do a marketing study and tell me given the current economic conditions and the current competition that is out there, how many boxes of red chalk can I typically sell each year? They ll go do their study; they ll come back and tell us. And if what they come back and tell us is a lot, a lot less than where we had determined the break-even point to be. That may not be the most viable option for us to pursue. We may need to look at different alternatives. So the break-even point kind of gives us the jumping off point. It s sort of a target minimum or indicates how viable certain things could be. The break-even point in units represents the number of units that we need to sell simply to break even. How many units do we need to sell to customers for our sales to equal our variable plus fixed costs? How many units do we need to sell to customers where the net income earned is exactly 0? AMIS 310 Professor Marc Smith

7 That is the break-even point in units. AMIS 310: Foundations of Accounting Now, go ahead to the next slide with me. Slide 6 : Break-Even Point (units) Sales revenues Variable costs Fixed costs = Net income NOTES: 1. Sales revenues = selling price per unit x number of units 2. Variable costs = variable cost per unit x number of units 3. At the break-even point, net income = 0 Remember our basic income statement. Sales revenue minus variable costs minus fixed costs equals our net income. To determine our break-even point in units I d like to make a couple of points. Key point number 1 the sales revenue, we can calculate that by taking the selling price per unit and multiplying by the number of units that we actually sold. Key point number 2 to calculate our variable costs we can take the variable cost per unit remember it is constant at every level of activity. Take the variable costs per unit times the number of units that are sold. AMIS 310 Professor Marc Smith

8 And remember key point number 3 at the break-even point the net income is exactly 0. No profit earned, no loss incurred. Given that and given the basic structure of our income statement, let s go to the next slide. Slide 7 : Example #3 c. Break Even in Units 0 = ($25 x Units) ($19.80 x Units) $468,000 0 = ($5.20 x Units) $468,000 ($5.20 x Units) = $468,000 Units = 90,000 Proof Sales (90,000 $25) $2,250,000 Less: Variable costs 1,782,000 Contribution margin $468,000 Less: Fixed costs 468,000 Net income $ 0 And let s do requirement C of the problem. It asks us to calculate the break-even point in units. Now, based on what we just saw, we can set up a nice basic algebra equation. The number of units sold times the selling price per unit ($25), that s our sales minus the variable costs per unit times the number of units sold. That is our variable costs minus $468,000. AMIS 310 Professor Marc Smith

9 Those are our fixed costs which are constant at $468,000 no matter how many units we sell. It is not a function of activity. And all that equals our net income which at the break-even point is 0. Now, we just need to do a little bit of algebra. When we do the algebra, we have 0 equals 5.20x (x being our units) minus $468,000. Solve for x and we can determine we must sell 90,000 units simply to breakeven. We need to sell 90,000 units to simply earn a profit of 0. Let s check that. Let s do an income statement. In fact, pause me for a minute and you do it. Set up a income statement assuming we sell 90,000 units and verify that comes down to a net income of 0. Once you do it, it will only take you a minute, unpause me and let s check it together. We ll set up our income statement. We can calculate our sales 90,000 units times $25. Our variable costs, the 90,000 units times the $19.80 variable cost per unit. That is our contribution margin which is $468,000 subtract the fixed costs which are also $468,000. And we ve just proved if we sell 90,000 units, we break even. AMIS 310 Professor Marc Smith

10 No profit earned; no loss incurred. Go ahead to the next slide with me. Slide 8 : Example #3 Alternative formula to calculate the break-even point in units: Number of units = Total Fixed costs Contribution margin per unit $468,000 $5.20 = 90,000 units An alternative formula to calculating the break-even point in units if you don t like the little algebra equation. A formula to do it would be to take your total fixed costs dividing it by your contribution margin per unit. That will tell us the break-even point in units. If we do it in our problem total fixed costs of $468,000divide by the contribution margin per unit (we calculated that in part A) $5.20. That tells us just like we saw previously, we must sell 90,000 units simply to break even. Go ahead to the next slide with me. AMIS 310 Professor Marc Smith

11 Slide 9 : Break-Even Point QUESTION: If the company sells 90,001 units, will it earn a profit or incur a loss and how much? ANSWER: It will earn a profit $5.20 CM per unit I have a question for you what if the company sold 90,001 units? Would we have a profit or would we incur a loss and how much? Well, the easy answer is we re selling more than break even. So we know we are going to earn a profit. Are you able to tell me the amount of the profit? Well, it would be $5.20. That is our contribution margin per unit. Remember that tells me every unit we sell how much we have to pay our fixed costs and contribute to a profit. So I need to sell 90,000 units to pay my fixed costs. But once they are paid they are paid. AMIS 310 Professor Marc Smith

12 Every unit I sell above that I can stick $5.20 in my pocket as profit. Go ahead to the next slide with me. Slide 10 : Break-Even Point QUESTION: If the company sells 89,998 units, will it earn a profit or incur a loss and how much? ANSWER: It will incur a loss $10.40 (CM per unit x 2) And let s change the assumption. What if the company sold 89,998 units? Would they show a profit, a loss, and how much? Well again, the easy answer is it would be a loss. We re selling less than the break-even point so we are not going to make a profit. The question is what would be the amount of the loss? It would be $ We are 2 units short of break-even. AMIS 310 Professor Marc Smith

13 We had to sell 90,000 to break even. AMIS 310: Foundations of Accounting So we are 2 units short of breaking even so each unit contributes $5.20. So the total loss would be $ And that is really the way to consider or think about contribution margin. And it is very useful in these kinds of scenarios to determine well, if we don t quite the target, we don t sell what we want to sell, how much are we going to end up losing? Or if we sell beyond the target, what is the amount of the profit going to be? When we come back in the next module, we ll continue working through our example. AMIS 310 Professor Marc Smith