Test 2

Quick Check 1: Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. An average of 2,100 cups are sold each month. What is the CM Ratio for Coffee Klatch?

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Quick Check 1: Which method will produce the highest values for work in process and finished goods inventories?

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Unit product cost is determined as follows:

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Common costs should not be arbitrarily allocated to segments based on the rationale that "someone has to cover the common costs" for two reasons:

1.This practice may make a profitable business segment appear to be unprofitable. 2.Allocating common fixed costs forces managers to be held accountable for costs they cannot control.

There are two keys to building segmented income statements:

A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Operating leverage

A measure of how sensitive net operating income is to percentage changes in sales. It is a measure, at any given level of sales, of how a percentage change in sales volume will affect profits.

There are advantages and disadvantages to high fixed cost (or low variable cost) and low fixed cost (or high variable cost) structures.

An advantage of a high fixed cost structure is that income will be higher in good years compared to companies with lower proportion of fixed costs. A disadvantage of a high fixed cost structure is that income will be lower in bad years compared to companies with lower proportion of fixed costs. Companies with low fixed cost structures enjoy greater stability in income across good and bad years.

A segment

Any part or activity of an organization about which a manager seeks cost, revenue, or profit data. Examples: An individual store, A sales territory, A service center.

The relationships among revenue, cost, profit, and volume can be expressed graphically by preparing a

CVP Graph

Variable costing income is only affected by

Changes in unit sales It is not affected by the number of units produced. As a general rule, when sales go up, net operating income goes up, and vice versa.

Chapter 6

Chapter 6

Traceable fixed costs

Costs arise because of the existence of a particular segment and would disappear over time if the segment itself disappeared.

Failure to trace costs directly

Costs that can be traced directly to specific segments of a company should not be allocated to other segments.

The company wide break-even point is computed by

Dividing the sum of the company's traceable fixed expenses and common fixed expenses by the company's overall contribution margin ratio.

See Slide 21

Do it

Variable Costing

Fixed manufacturing costs are capacity costs and will be incurred even if nothing is produced.

Absorption Costing

Fixed manufacturing costs must be assigned to products to properly match revenues and costs.

In a CVP graph, unit volume is usually represented on the

Horizontal Axis (X) and dollars on the vertical (Y) axis.

Once a company prepares a contribution format segmented income statement,

It can use the statement to make decisions and perform break-even analysis.

Traceable Fixed Costs

It is important to realize that the traceable fixed costs of one segment may be a common fixed cost of another segment. For example, the landing fee paid to land an airplane at an airport is traceable to the particular flight, but it is not traceable to first-class, business-class, and economy-class passengers.

Sales, variable expenses, and contribution margin can also be expressed on a

Per unit basis

The relationship between profit and the CM ratio can be expressed using the following equation:

Profit = (CM ratio × Sales) - Fixed expenses

When a company has only one product we can further refine this equation

Profit = (P × Q - V × Q) - Fixed expenses

The contribution format income statement can be expressed in the following equation:

Profit = (Sales - Variable expenses) - Fixed expenses

Break-Even Point

Profit = Unit CM × Q - Fixed expenses

Having defined the two terms, it bears emphasizing that the contribution margin ratio and the variable expense ratio can be mathematically related to one another:

See Slide 30

An even simpler form of the CVP graph is called

The Profit Graph

Contribution Margin (CM)

The amount remaining from sales revenue after variable expenses have been deducted.

Sales mix

The relative proportion in which a company's products are sold. •Different products have different selling prices, cost structures, and contribution margins. •When a company sells more than one product, break-even analysis becomes more complex as the following example illustrates.

Cost structure

The relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization's cost structure.

Examples of common fixed costs include:

The salary of the CEO of General Motors is a common fixed cost of the various divisions of General Motors. The cost of heating a Safeway or Kroger grocery store is a common fixed cost of the various departments.

Margin of Safety in Dollars

Total Sales - Break Even Sales

It is often useful to express the simple profit equation in terms of the unit contribution margin (Unit CM) as follows:

Unit CM = Selling price per unit - Variable expenses per unit Unit CM = P - V Profit = (P × Q - V × Q) - Fixed expenses Profit = (P - V) × Q - Fixed expenses Profit = Unit CM × Q - Fixed expenses

Costs assigned to a segment should include all costs attributable to that segment from the company's entire

Value Chain

The variable expenses as a percentage of sales is referred to as the variable expense ratio. This ratio is computed as follows:

Variable Expenses / Sales

There are more Quick Checks within the slides but you have to look at the slides.

Yep

Both U.S. GAAP andIFRS require

absorption costing for external reports.

Variable costing categorizes

costs as variable and fixed so it is much easier to use this income statement format for CVP analysis.

CM is used first to

cover fixed expenses. Any remaining CM contributes to net operating income.

The CM ratio can also be calculated by

dividing the contribution margin per unit by the selling price per unit.

The contribution income statement is helpful to managers in

judging the impact on profits of changes in selling price, cost, or volume. The emphasis is on cost behavior.

Commissions based on sales dollars can lead to

lower profits in a company.

Since absorption costing is required for external reporting,

most companies also use it for internal reports rather than incurring the additional cost of maintaining a separate variable cost system for internal reporting.

Companies generally compensate salespeople by

paying them either a commission based on sales or a salary plus a sales commission.

Both U.S. GAAP and IFRS require

publically traded companies to include segmented financial data in their annual reports. Companies must report segmented results to shareholders using the same methods that are used for internal segmented reports. This requirement motivates managers to avoid using the contribution approach for internal reporting purposes because if they did they would be required to: -Share this sensitive data with the public. -Reconcile these reports with applicable rules for consolidated reporting purposes.

The equation and formula methods can be used to determine

the unit sales and dollar sales needed to achieve a target profit of zero.

In target profit analysis,

we estimate what sales volume is needed to achieve a specific target profit.

We can compute the number of units that must be sold to attain a target profit using either:

◦(1) Equation method ◦(2) Formula method.

Quick Check 2: Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. An average of 2,100 cups are sold each month. What is the break-even sales dollars?

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Quick Check 3: Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. An average of 2,100 cups are sold each month. What is the break-even sales in units?

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Quick Check 4: Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. Use the formula method to determine how many cups of coffee would have to be sold to attain target profits of $2,500 per month.

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Quick Check 5: Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. Use the formula method to determine the sales dollars that must be generated to attain target profits of $2,500 per month.

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Quick Check 6: Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. An average of 2,100 cups are sold each month. What is the margin of safety expressed in cups?

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Quick Check 7: Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. An average of 2,100 cups are sold each month. What is the operating leverage?

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Quick Check 8: At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, the average fixed expense per month is $1,300, and an average of 2,100 cups are sold each month.If sales increase by 20%, by how much should net operating income increase?

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Quick Check: How much of the common fixed expense of $200,000 can be avoided by eliminating the bar? (See Slide 54)

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Quick Check: Suppose square feet is used as the basis for allocating the common fixed expense of $200,000. How much would be allocated to the bar if the bar occupies 1,000 square feet and the restaurant 9,000 square feet?

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To simplify CVP calculations, managers typically adopt the following assumptions with respect to these factors:

1.Selling price is constant. The price of a product or service will not change as volume changes. 2.Costs are linear and can be accurately divided into variable and fixed components. The variable costs are constant per unit and the fixed costs are constant in total over the entire relevant range. 3.In multiproduct companies, the mix of products sold remains constant.

Common Fixed Costs

Arise because of the overall operation of the company and would not disappear if any particular segment were eliminated.

Absorption costing income is influenced by

Changes in unit sales and units of production. Net operating income can be increased simply by producing more units even if those units are not sold.

Segment Margin

Computed by subtracting the traceable fixed costs of a segment from its contribution margin, is the best gauge of the long-run profitability of a segment.

Degree of Operating Leverage

Contribution Margin / Net Operating Income

The contribution margin as a percentage of sales is referred to as the contribution margin ratio (CM ratio). This ratio is computed as follows:

Contribution Margin / Sales

Unit Sales to Break Even

Fixed Expenses / Unit CM

The difference between absorption and variable income

Fixed Manufacturing Overhead / Units Produced

Dollar Sales to Attain the Target Profit

Target Profit + Fixed Expenses / CM Ratio

Unit Sales to Attain the Target Profit

Target Profit + Fixed Expenses / CM per Unit

The margin of safety

The excess of budgeted or actual sales dollars over the break-even volume of sales dollars. It is the amount by which sales can drop before losses are incurred. The higher the margin of safety, the lower the risk of not breaking even and incurring a loss.

Because absorption costing assigns fixed manufacturing overhead costs to units produced, it gives the impression that fixed manufacturing overhead is variable with respect to the number of units produced, but it is not. The result can be inappropriate pricing decisions and product discontinuation decisions.

True

Variable costing correctly identifies the

additional variable costs incurred to make one more unit It also emphasizes the impact of total fixed costs on profits.

Preparing a CVP Graph

Draw a line parallel to the volume axis to represent total fixed expenses. Choose some sales volume, say 400 units, and plot the point representing total expenses (fixed and variable). Draw a line through the data point back to where the fixed expenses line intersects the dollar axis. Choose some sales volume, say 400 units, and plot the point representing total sales. Draw a line through the data point back to the point of origin. Break-even point(400 units or $200,000 in sales)

We do not need to prepare an income statement to estimate profits at a particular sales volume.

Simply multiply the number of units sold above break-even by the contribution margin per unit.

Inappropriate allocation base

Some companies allocate costs to segments using arbitrary bases. Costs should be allocated to segments only when the allocation base actually drives the cost being allocated.

Examples of traceable fixed costs include:

The salary of the Fritos product manager at PepsiCo is a traceable fixed cost of the Fritos business segment of PepsiCo. The maintenance cost for the building in which Boeing 747s are assembled is a traceable fixed cost of the 747 business segment of Boeing.