Accounting Exam 2

Often the most direct route to a business decision is an incremental analysis. What is meant by an incremental analysis?

Incremental analysis focuses on the changes in revenues and costs that will result from a particular action.

Break- even point

The break-even point is the level of sales at which profits are zero.

What is meant by the term sales mix? What assumption is usually made concerning sales mix in CVP analysis?

The sales mix is the relative proportions in which a company's products are sold. The usual assumption in cost-volume-profit analysis is that the sales mix will not change.

What is the danger in allocating common fixed costs among products or other segments of an organization?

Allocations of common fixed costs can make a product (or other segment) appear to be unprofitable, whereas in fact it may be profitable.

Explain how a shift in the sales mix could not result in both a higher break-even point and a lower net operating income.

A higher break-even point and a lower net operating income could result if the sales mix shifted from high contribution margin products to low contribution margin products. Such a shift would cause the average contribution margin ratio in the company to decline, resulting in less total contribution margin for a given amount of sales. Thus, net operating income would decline. With a lower contribution margin ratio, the break-even point would be higher because more sales would be required to cover the same amount of fixed costs.

In response from your immediate supervisor, you have prepared a CVP graph portraying the cost and revenue characteristics of your company's product and operations. Explain how the lines on the graph and the break-even point would change if (a) the selling price per unit decreased, (b) fixed cost increased throughout the entire range of activity portrayed on the graph, and © variable cost per unit increased.

(a) If the selling price decreased, then the total revenue line would rise less steeply, and the break-even point would occur at a higher unit volume. (b) If the fixed cost increased, then both the fixed cost line and the total cost line would shift upward and the break-even point would occur at a higher unit volume. (c) If the variable cost per unit increased, then the total cost line would rise more steeply and the break-even point would occur at a higher unit volume.

Define the following terms: incremental cost, opportunity cost, and sunk cost.

An incremental cost (or benefit) is the change in cost (or benefit) that will result from some proposed action. An opportunity cost is the benefit that is lost or sacrificed when rejecting some course of action. A sunk cost is a cost that has already been incurred and that cannot be changed by any future decision.

Give at least four examples of possible constraints.

Any resource that is required to make products and get them into the hands of customers could be a constraint. Some examples are machine time, direct labor time, floor space, raw materials, investment capital, supervisory time, and storage space. While not covered in the text, constraints can also be intangible and often take the form of a formal or informal policy that prevents the organization from furthering its goals.

How will relating product contribution margins to the amount of the constrained resource they consume help a company maximize its profits?

Assuming that fixed costs are not affected, profits are maximized when the total contribution margin is maximized. A company can maximize its total contribution margin by focusing on the products with the greatest amount of contribution margin per unit of the constrained resource.

How does opportunity cost enter into a make or buy decision?

If a company decides to make a part internally rather than to buy it from an outside supplier, then a portion of the company's facilities have to be used to make the part. The company's opportunity cost is measured by the benefits that could be derived from the best alternative use of the facilities.

What guideline should be used in determining whether a joint product should be sold at the split- off point or processed further?

If the incremental revenue from further processing exceeds the incremental costs of further processing, the product should be processed further.

Airlines sometimes offer reduced rates during certain times of the week to members of a business person's family if they accompany him or her on trips. How does the concept of relevant costs enter into the decision by the airline to offer reduced rates of this type?

Most costs of a flight are either sunk costs, or costs that do not depend on the number of passengers on the flight. Depreciation of the aircraft, salaries of personnel on the ground and in the air, and fuel costs, for example, are the same whether the flight is full or almost empty. Therefore, adding more passengers at reduced fares when seats would otherwise be empty does little to increase the total costs of operating the flight, but increases the total contribution and total profit.

" Variable costs and differential costs mean the same thing." Do you agree? Explain.

No. A variable cost is a cost that varies in total amount in direct proportion to changes in the level of activity. A differential cost is the difference in cost between two alternatives. If the level of activity is the same for the two alternatives, a variable cost will not be affected and it will be irrelevant.

"Sunk costs are easy to spot- they're the fixed costs associated with a decision." Do you agree? Explain.

No. Not all fixed costs are sunk—only those for which the cost has already been irrevocably incurred. A variable cost can be a sunk cost if it has already been incurred.

" All future costs are relevant in decision making." Do you agree? Why?

No. Only those future costs that differ between the alternatives are relevant.

Are variable costs always relevant costs? Explain.

No. Variable costs are relevant costs only if they differ in total between the alternatives under consideration.

"If a product is generating a loss, then it should be discontinued." Do you agree? Explain.

Not necessarily. An apparent loss may be the result of allocated common costs or of sunk costs that cannot be avoided if the product is dropped. A product should be discontinued only if the contribution margin that will be lost as a result of dropping the product is less than the fixed costs that would be avoided. Even in that situation the product may be retained if it promotes the sale of other products.

Prentice Company is considering dropping one of its product lines. What costs of the product line would be relevant to this decision? What costs would be irrelevant?

Only those costs that would be avoided as a result of dropping the product line are relevant in the decision. Costs that will not be affected by the decision are irrelevant.

Operating Leverage

Operating leverage measures the impact on net operating income of a given percentage change in sales. The degree of operating leverage at a given level of sales is computed by dividing the contribution margin at that level of sales by the net operating income at that level of sales.

Contribution Margin Ratio

The contribution margin (CM) ratio is the ratio of the total contribution margin to total sales revenue. It can also be expressed as the ratio of the contribution margin per unit to the selling price per unit. It is used in target profit and break-even analysis and can be used to quickly estimate the effect on profits of a change in sales revenue.

From a decision- making point of view, should joint costs be allocated among joint products?

Joint costs should not be allocated among joint products for decision-making purposes. If joint costs are allocated among the joint products, then managers may think they are avoidable costs of the end products. However, the joint costs will continue to be incurred as long as the process is run regardless of what is done with one of the end products. Thus, when making decisions about the end products, the joint costs are not avoidable and are irrelevant.

Define the following terms: joint products, joint costs, and split-off point.

Joint products are two or more products that are produced from a common input. Joint costs are the costs that are incurred up to the split-off point. The split-off point is the point in the manufacturing process where joint products can be recognized as individual products.

Relevant cost

A relevant cost is a cost that differs in total between the alternatives in a decision.

In all respects, Company A and Company B are identical except that Company A's costs are mostly variable, whereas Company B's costs are mostly fixed. When sales increase, which company will tend to realize the greatest increase in profits? Explain.

All other things equal, Company B, with its higher fixed costs and lower variable costs, will have a higher contribution margin ratio than Company A. Therefore, it will tend to realize a larger increase in contribution margin and in profits when sales increase.

Margin of Safety

The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It is the amount by which sales can drop before losses begin to be incurred.