Accounting 211 Chapter 5 Notes

Break-Even Analysis (p203)

Break-even analysis is a special case of target profit analysis in which the target profit is zero. Unit Sales to Break Even = FC / Unit CM

Cost Structure & Profit Stability (p207)

Cost structure refers to the relative proportion of fixed and variable costs in an organization.

TPA in Terms of Sales Dollars (p203)

Sales to attain Target Profit * Unit Cost

TPA Formula Method (p202)

Unit Sales to attain Target Profit = (Target Profit + FC) / Unit CM

Cost Volume Profit Analysis CVP (p188)

Cost-volume-profit (CVP) analysis is a powerful tool that helps managers understand the relationships among cost, volume, and profit. CVP analysis focuses on how profits are affected by the following five factors: Selling prices. Sales volume. Unit variable costs. Total fixed costs. Mix of products sold.

Uses for CVP (p188)

Because CVP analysis helps managers understand how profits are affected by these key factors, it is a vital tool in many business decisions. These decisions include What products and services to offer What prices to charge What marketing strategy to use What cost structure to implement.

Breakeven's Dependence on Sales Mix (p212)

Because a company's breakeven point is arrived at by totaling the breakeven point of all product lines, as shift in the sales mix will cause a shift in the Breakeven Point.

Profit Graph (p194)

Profit = Unit CM * Q - FC Because this is a linear equation, it plots as a single straight line. To plot the line, compute the profit at two different sales volumes, plot the points, and then connect them with a straight line. Profit is on the vertical axis and volume is on the horizontal axis. Note that the profit steadily increases to the right of the break-even point as the sales volume increases and that the loss becomes steadily worse to the left of the break-even point as the sales volume decreases.

Assumptions of CPV Analysis (p213)

A number of assumptions commonly underlie CVP analysis: 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 elements. The variable element is constant per unit, and the fixed element is constant in total over the entire relevant range. 3. In multiproduct companies, the sales mix is constant. 4. In manufacturing companies, inventories do not change. The number of units produced equals the number of units sold. While these assumptions may be violated in practice, the results of CVP analysis are often "good enough" to be quite useful. Perhaps the greatest danger lies in relying on simple CVP analysis when a manager is contemplating a large change in volume that lies outside of the relevant range.

Target Profit AnalysisTPA (p202)

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

Contribution Income Statement (p189)

Sales - VC = Contribution Margin Contribution Margin - FC = Net Op. Income Sales, VC and Contribution Margin expressed in "per units" is also helpful. Equation: Profit = (Sales - VC) - FC

CVP Graph (p192)

A CVP graph highlights CVP relationships over wide ranges of activity. In a CVP graph (sometimes called a break-even chart), unit volume is represented on the horizontal (X) axis and dollars on the vertical (Y) axis. To prepare a CVP graph: 1. Draw a line parallel to the volume axis to represent total fixed expense. 2. Choose some volume of unit sales and plot the point representing total expense (fixed and variable) at the sales volume you have selected. After the point has been plotted, draw a line through it back to the point where the fixed expense line intersects the dollars axis. 3. Again choose some sales volume and plot the point representing total sales dollars at the activity level you have selected. Draw a line through this point back to the origin. The break-even point is where the total revenue and total expense lines cross.

TPA Equation Method (p202)

An example is to define what level of sales do you need to achieve a specific profit level. Profit = Unit CM * Q - FC to Unit CM * Q = Profit + FC to Q= (Profit + FC) / Unit CM

Structuring Sales Commissions (p206)

Companies usually compensate salespeople by paying them a commission based on sales, a salary, or a combination of the two. Commissions based on sales dollars can lead to lower profits if the CM is higher on products with a lower sales price.

Incremental Analysis (p199)

Considers only the revenue, cost, and volume that will change if a new program is implemented. Change in FC decision you take the new (forecasted sales - VC) - new FC) to get the new Net Operating Income (NOI) and compare it to the old NOI. Change in VC is handled the same way as the change in FC. (Expected CM - Present CM) - Change in FC will show the effect on NOI

Contribution Margin (p186)

Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus, it is the amount available to cover fixed expenses and then to provide profits for the period. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period.

Operating Leverage (p208)

Operating leverage is a measure of how sensitive net operating income is to a given percentage change in dollar sales. Operating leverage acts as a multiplier. If operating leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income. Degree of Operating Leverage is CM / NOI The degree of operating leverage can be used to quickly estimate what impact various percentage changes in sales will have on profits, without the necessity of preparing detailed income statements.

Break Even Point (p190)

The break-even point is the level of sales at which profit is zero. Once the break-even point has been reached, net operating income will increase by the amount of the unit contribution margin for each additional unit sold. To estimate the profit at any sales volume above the break-even point, simply multiply the number of units sold in excess of the break-even point by the unit contribution margin.

Sales Mix (p211)

The term sales mix refers to the relative proportions in which a company's products are sold. The idea is to achieve the combination, or mix, that will yield the greatest profits. Changes in the sales mix can cause perplexing variations in a company's profits. A shift in the sales mix from high-margin items to low-margin items can cause total profits to decrease even though total sales may increase. Conversely, a shift in the sales mix from low-margin items to high-margin items can cause the reverse effect—total profits may increase even though total sales decrease. It is one thing to achieve a particular sales volume; it is quite another to sell the most profitable mix of products.

Variable Expense Ratio (p196)

The variable expense ratio is the ratio of variable expenses to sales. It can be computed by dividing the total variable expenses by the total sales, or in a single product analysis, it can be computed by dividing the variable expenses per unit by the unit selling price. VER = VE / Sales

Contribution Margin (CM) Ratio (p195)

The contribution margin as a percentage of sales is referred to as the contribution margin ratio (CM ratio). Equation is: CM Ratio = Total CM / Total Sales in Units The CM ratio shows how the contribution margin will be affected by a change in total sales. Example: CM ratio of 40% means that for each dollar increase in sales, total CM will increase by 40 cents ($1 sales × CM ratio of 40%). Net operating income will also increase by 40 cents, assuming that fixed costs are not affected by the increase in sales. Generally, the effect of a change in sales on the contribution margin is expressed in equation form as: Generally, the effect of a change in sales on the contribution margin is expressed in equation form as: Change in CM = CM Ratio * Change in Sales The relation between profit and the CM ratio can also be expressed using the following equation: Profit = (CM Ratio * Sales) - FC The CM ratio is particularly valuable in situations where the dollar sales of one product must be traded off against the dollar sales of another product. In this situation, products that yield the greatest amount of contribution margin per dollar of sales should be emphasized.

Margin of Safety MOS (p205)

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. MOS in dollars = Total Budgeted or Actual Sales - Break Even Sales MOS Percentage = MOS in Dollars / Total Budgeted or Actual Sales in Dollars MOS in Units Sold = (Total Budgeted or Actual Sales - Break Even Sales) / Unit Sales Price. NOTE: this method is only applicable to a single-product company. These calculations will tell you what decrease in sales volume will result in Break Even.