Accounting concepts and terms Ch.3

Event

A possible relevant occurrence in a decision model

Revenue Driver

A variable, such as volume, that causally affects revenues.

Part 2: Important concepts and notes involving income taxes and CVP

After-tax profit (Net Income) can be calculated by: Net Income = Operating Income * (1-Tax Rate) Net income can be converted to operating income for use in CVP equation Operating Income = Net Income/(1-Tax Rate) Notes: The CVP equation will continue to use operating income. We'll use this conversion formula to obtain the operating income value when provided with Net Income.

Margin of Safety Continued

An indicator of risk, the margin of safety (MOS), measures the distance between budgeted sales and breakeven sales: MOS = Budgeted Sales - BE Sales The MOS ratio removes the firm's size from the output, and expresses itself in the form of a percentage: MOS Ratio = MOS ÷ Budgeted Sales

Breakeven Point

At the breakeven point, a firm has no profit or loss at the given sales level. Breakeven is where: Sales - Variable Costs - Fixed Costs = 0 The quantity of output sold at which total revenues equal total costs (quantity of output sold that results in $0 of operating income.

Breakeven Point by Revenues

Calculation of breakeven revenues Breakeven Revenue = Fixed Costs /Contribution Margin Percentage To calculate breakeven in sales dollars, divide fixed costs by contribution margin percentage.

Foundational Assumptions USED in CVP ANALYSIS

Changes in production/sales volume are the sole cause for cost and revenue changes. Total costs consist of fixed costs and variable costs. Revenue and costs behave and can be graphed as a linear function (a straight line). Selling price, variable cost per unit, and fixed costs are all known and constant. In many cases only a single product will be analyzed. If multiple products are studied, their relative sales proportions are known and constant. The time value of money (interest) is ignored

Degree of Operating leverage

Contribution margin divided by operating income at any given level of sales. Effects that fixed costs have on changes in operating income as changes occur in units sold and hence in contribution margin

Probability Distribution

Describes the likelihood (or the probability) that each of the mutually exclusive and collectively exhaustive set of events will occur.

Examples of Target Operating Income

For OPERATING INCOME of $2,000 Revenue=(FC+TOI)/CM% Revenue = (2,000+2,000)/.40 =

Gross Margin Percentage

Gross margin divided by revenues

Contribution income statement

Income statement that groups costs into variable costs and fixed costs to highlight the contribution margin.

CVP analysis Continued

It is used to decide whether or not to advertise, whether or not to increase or decrease prices

Probability

Likelihood or chance that an event will occur.

CVP (Cost Volume Profit) Analysis

Managers to use _ to study the behavior of and relationship among these elements as changes occur in the # units sold, selling price, the variable cost per unit or the fixed costs of a product. Managers like to use "what-if" analysis to examine the possible outcomes of different decisions so they can make the best one.

Operating Leverage equation

Operating Leverage X % Change in Sales If sales increase 50% and operating leverage is 1.67, you should expect operating income to increase 83.5%.

Net Income

Operating income plus non-operating revenues (such as interest revenue) minus non-operating costs (such as interest cost) minus income taxes.

Outcomes

Predicted economic results of the various possible combinations of actions and events in a decision model.

Cost-Volume-Profit Equation

Revenue-Variable Costs-Fixed Costs=Operating Income **Selling Price * Quantity of Units Sold = Revenue Unit Variable Costs * Quantity of Units Sold = Variable Costs Revenue - Variable Costs = Contribution Margin Contribution Margin - Fixed Costs = Operating Income**

Breakeven Point, extended: Profit Planning

The breakeven point formula can be modified to become a profit planning tool by adding Target Operating Income to fixed costs in the numerator. Quantity of Units = (Fixed Costs+Target Operating Income) Required to Be Sold Contribution Margin per Unit

CVP for SERVICE and Not-For-Profit organizations

The challenge here is to focus on a measure of output which is generally going to be different from the measure of "units sold" that we've been dealing with so far. example, a service agency might measure how many persons they assist or an airline might measure how many passenger miles they fly.

Uncertainty

The possibility that an actual amount will deviate from an expected amount.

Sales mix

The quantities (or proportion of various products that constitute a company's total unit sales.

Breakeven Point by Number of Units

To calculate breakeven in units, divide fixed costs by contribution margin PER UNIT. Calculation of breakeven number of units Breakeven Units = Fixed Costs/Contribution Margin

Part 1: Important concepts and notes involving income taxes and CVP

We've been ignoring the effect of income taxes thus far but must now recognize that in many companies, managers' income targets are expressed in terms of net income rather than operating income. The key is to convert target net income into the corresponding target operating income which is what we use in our CVP formulae. The conversion formula, also shown on this slide, is net income divided by (1 - tax rate) = operating income.

Expected Value also called expected monetary value

Weighted average of the outcomes of a decision with the probability of each outcome serving as the weight.

Decision Table

a summary of the alternative actions, events, and outcomes, and probabilities of events in a decision model

Choice Criterion

an objective that can be quantified, such as maximize income or minimize costs.

Operating Leverage

describes the effect that fixed costs have on changes in operating income as changes occur in units sold and contribution margin. OL = Contribution Margin/ Operating Income ***Remember what fixed costs are. They are costs that do not change, in the short run, with the level of sales. These costs will exist whether sales are higher or lower, within that relevant range.***

Sensitivity analysis

is a what-if technique we use to examine how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes. This type of analysis can answer, for an example, the question: What will operating income be if the quantity of units sold decreases by 5% from the original prediction?

Margin of Safety

is an aspect of sensitivity analysis that answers the specific question: if budgeted revenues are currently above breakeven, how far can they fall before the breakeven point is reached. The amount by which budgeted (or actual) revenues exceed breakeven revenues. The answer to this question gives managers information they can use to take action and potentially prevent a fall in revenues below breakeven.

Contribution margin per unit

is selling price minus unit variable cost per unit or can be obtained by taking contribution margin divided by number of units sold.

Cost Structure

is simply the relationship of fixed costs and variable costs to total costs. We can use CVP-based sensitivity analysis to highlight the risks and returns, as fixed costs are substituted for variable costs in a company's cost structure. The risk-return trade-off across alternative cost structures can be measured as operating leverage.

CVP: Contribution Margin CM= Total revenues-Total variable costs

revenue LESS variable costs LESS fixed costs EQUAL operating income, we can subtract variable costs from revenue to obtain contribution margin. Manipulation of the basic equations yields an extremely important and powerful tool extensively used in cost accounting: contribution margin (CM).

Sales Mix on CVP

the contribution margin for the one product, we will use an average contribution margin. The average CM is calculated based on a defined product mix. In other words, the CM is determined based on a specific relationship of sales of product 1 to total sales and sales of product 2 to total sales. If that relationship of sales changes, so will our average CM.

Other way to calculate Contribution Margin

which is equal to the contribution margin per unit multiplied by the number of units sold.

Contribution margin percentage or called contribution ratio

which is the contribution margin per unit divided by unit selling price or Contribution margin divided by revenue. Contribution/revenue