AC 361 Exam 2 (Chapter 5,6,7)

NOI =

Contribution margin - Fixed MOH - Fixed S&A Expenses

Variable costing income is only affected by

changes in unit sales. NOI 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.

Degree of operating leverage =

contribution margin / net operating income

absorption costing income statement categorizes costs by

function

Sales Mix: Profits will be

greater if high-margin rather than low-margin items makes up a relatively large proportion of total sales

Cost volume profit (CVP) analysis:

helps managers make many important decisions such as what products and services to offer, what prices to charge, what marketing strategy to use, what cost structure to maintain.

Variable costing and absorption costing NOI can be reconciled by

how much FMOH was deferred in, or released from

Advantage of high fixed cost structure:

income will be higher in good years compared to companies with lower proportion of fixed costs

Disadvantage of high fixed cost structure

income will be lower in bad years compared to companies with lower proportion of fixed costs

Cost structure:

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

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

dollar sales for a segment to break even =

segment traceable fixed expenses / segment CM ratio

CM ratio:

shows how the contribution margin will be affected by a change in sales volume

Change in contribution margin equation:

shows the impact on net operating income of a change in the sales volume and can be computed by multiplying the CM ratio by the corresponding change in dollar sales

Break-even point formula method:

the formula method is a shortcut of the equation method (Profit = Unit CM x Q - Fixed Expense) and it centers on the idea that each unit sold provides a certain amount of contribution margin that goes toward covering fixed expenses.

Any allocation of common costs to segments reduces

the value of the segment margin as a measure of long-run segment profitability and segment performance.

Cost-volume-profit (CVP) analysis requires that we break costs down into

their variable and fixed components.

A shift in sales mix from low-margin items to high-margin items can cause

total profits may increase even though total sales decrease

A shift in sales mix from high-margin items to low-margin items can cause

total profits to decrease even though total sales may increase

Single Product: Profit =

(P x Q - V x Q) - Fixed Expenses

Profit (Net Operating Income) =

(Sales - Variable expenses) - Fixed Expenses

Dollar sales for company to break even =

(traceable fixed expenses + common fixed expenses) / overall CM ratio

Net operating income =

(unit sales - unit sales to break even) × unit contribution margin

Margin of Safety:

- excess of budgeted or actual sales dollars over the break-even sales dollar - 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

Degree of Operating Leverage

- is a measure at a given level of sales of how a percentage - change in sales volume will affect profits - Is not a constant - It is greatest at sales levels near the break-even point and decreases as sales and profits rise

Operating Leverage

- is a measure of how sensitive net operating income is to a given percentage change in the unit sales, - acts as a multiplier - if operating leverage is high, a small percentage increase in unit sales can produce a much larger percentage increase in net operation income

Two keys to building segmented income statements

1. A contribution format should be used because it separates fixed from variable costs and it enables the calculation of a contribution margin. 2. Traceable fixed costs should be separated from common fixed costs to enable the calculation of a segment margin.

Absorption costing NOI may or may not agree with the results of CVP Analysis because:

1. Absorption costing income statements can be confusing and are easily misinterpreted 2. Absorption costing assigns fixed manufacturing overhead costs to units produced, a portion of fixed manufacturing overhead resides in inventory when units remain unsold. The potential result is positive operating income when the number of units sold is less than the breakeven point. 3. 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.

Inappropriate methods for assigning traceable costs among segments:

1. Failure to trace costs directly 2. Inappropriate allocation base

Absorption Costing (Full Cost Method):

1. Manufacturing costs as product costs, regardless of whether they are variable or fixed. 2. The cost of a unit of product consists of DM, DL, both Variable and Fixed MOH. 3. absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing costs. 4. Because absorption costing includes all manufacturing costs in product costs, it is frequently referred to as the full cost method 5. Fixed MOH included in work process inventory then are transferred to finished goods. 6. Only when units are sold do costs flow to INCOME STATEMENT as part of COGS

Common mistakes of Segmented Income Statements

1. Omission of costs 2. Inappropriate methods for assigning traceable costs among segments 3. Arbitrarily Dividing Common Costs Among Segments

Variable Costing (direct costing or marginal costing):

1. Only those manufacturing costs that vary with output are treated as product costs (DM, DL, Variable MOH) 2. Fixed manufacturing overhead is treated as a period cost and, like selling and administrative expenses, it is reported as an expense on the income statement in its entirety each period. 3. the cost of a unit of product in inventory or in cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost. 4. Variable costing is sometimes referred to as direct costing or marginal costing 5. Fixed MOH are period costs and reported on INCOME STATEMENT as PERIOD EXPENSES

Selling and Administrative Expenses:

1. Selling and administrative expenses are never treated as product costs regardless of costing method 2. Always treated as period costs and reported as EXPENSES on the INCOME STATEMENT as INCURRED

Cost volume profit assumptions:

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.

Segment margin decision making: Once a company prepares a contribution format segmented income statement, it can use the statement to make decisions and perform break-even analysis because

1. The segment margin is the best gauge of the long-run profitability of a segment because it includes only those costs that are caused by the segment 2. If a segment can't cover its own costs the segment should be dropped 3. Break-even analysis

Identifying Traceable Fixed Costs:

1. Treat as traceable costs only those costs that would disappear over time if the segment itself disappeared (ex: a division of the company is sold or discontinued) 2. 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.)

Two applications of the contribution format income statement:

1. Variable costing income statements rely on contribution format (used for internal), and contrasting with absorption costing income statements (used for external) 2. Preparing segmented income statements

3 concepts variable and absorption costing:

1. both income statement formats include product costs and period costs, although they define these cost classifications differently. 2. variable costing income statements are grounded in the contribution format. They categorize expenses based on cost behavior—variable expenses are reported separately from fixed expenses. Absorption costing income statements ignore variable and fixed cost distinctions. 3. variable and absorption costing net operating incomes often differ from one another. The reason for the difference always relates to the fact that variable costing and absorption costing income statements account for fixed manufacturing overhead differently.

omission of costs

1. costs assigned to a segment should include all costs attributable to that segment from the company's entire value chain 2. since absorption costing is regarded as required for external financial reporting and only manufacturing costs are included in product costs under that method, many companies that use absorption costing for internal purposes will omit upstream and downstream costs from their analysis 3. results may be management will develop and maintain products that in the long-run result in losses

arbitrarily dividing common costs among segments

1. some companies assign nontraceable costs to segments 2. adding common costs to the real cost of a segment may make an otherwise profitable segment appear to be unprofitable 3. if this segment is then eliminated then a snowball effect will result

Differences occur between absorption and variable costing because under absorption costing:

1. some fixed MOH is capitalized in inventories instead of being expenses on the income statement 2. If inventories increase during a period, some of the fixed MOH of the current period will be deferred in ending inventories 3. When units produced exceeds the units sold (inventories increase) NOI is higher under absorption than variable costing, because some of the FMOH of the period is deferred in inventories 4. When units produced is less than units sold (inventories decrease) NOI is lower, because OH of previous periods is released from inventories 5. When units produced and units sold are equal, no change in inventories and NOI is the same

The effect of a change in sales volume on the contribution margin is expressed in equation form as:

Change in contribution margin = CM ratio x Change in sales

Cost volume profit graph (break-even chart):

A CVP graph highlights CVP relationships over wide ranges of activity a) unit volume on the horizontal (X) axis, dollars on the vertical (Y) axis

Traceable Fix Cost:

A fixed cost that is incurred because of the existence of a particular business segment and that would be eliminated if the segment were eliminated. Example: salary of the Fritos product manager at PepsiCo, liability insurance at Disney World

Common Fixed Cost

A fixed cost that supports more than one business segment, but is not traceable in whole or in part to any one of the business segments.

Segment Margin:

A segment's contribution margin less its traceable fixed costs. It represents the margin available after a segment has covered all of its own traceable costs.

Incremental analysis:

An analytical approach that focuses only on those costs and revenues that change as a result of a decision.

Contribution margin ratio (CM ratio):

CM ratio = Contribution Margin / Sales or CM ratio = 1 - Variable expense ratio

The relationship between profit and the CM ratio can also be expressed using the following equation: Change in Profit =

CM ratio x Change in Sales - Change in fixed expenses

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

CM ratio x Sales - Fixed Expenses or in terms of changes

The relationship between profit and the CM ratio can also be expressed using the following equation: Change in Net Operating Income =

CM ratio x change in total sales

downstream costs

Costs incurred after the manufacturing process is complete, such as delivery costs and sales commissions.

upstream costs

Costs incurred before beginning the manufacturing process, such as research and development costs.

Variable Costing Unit Product cost=

DM +DL+Variable MOH = Unit Product Cost

Target Profit Analysis in Terms of Dollar Sales:

Dollar Sales to attain the target profit = (Target profit + Fixed Expenses)/CM Ratio

Break-even in Dollar Sales:

Dollar sales to break even = Fixed Expenses / CMratio

Steps for Preparing the CVP Graph:

Draw a line parallel to the volume axis to represent total fixed expense 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 had been plotted, draw a line through it back to the point where the fixed expense line intersects the dollars axis 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

Target profit analysis:

Estimating the level of sales needed to achieve a desired target profit.

Formula for margin of safety:

Margin of safety in dollars = total budgeted (or actual) sale - Break-even sales Margin of safety percentage = Margin of safety in dollars / Total budgeted (or actual) sales in dollars

Break-even point

Once the break-even point is reached, the sale of an additional unit increases contribution margin by an amount that is equal to the increase in net operating income.

The relation between percentage change in unit sales and percentage change in net operating income is given by:

Percentage change in net operating income = degree of operating leverage x percentage change in sales

Contribution Margin =

Total sales - variable COGS - S&A Expenses

Unit contribution margin (Unit CM) =

Selling Price per unit - Variable expenses per unit = P - V

Single Product: Sales =

Selling price per unit x Quantity sold = P x Q

Break-even point:

The level of sales at which profit is zero.

Profit =

Unit CM x Q - Fixed Expenses

Variable Costing COGS =

Unit product cost x Units Sold

Target profit analysis formula method

Unit sales to attain the target profit = (Target profit + Fixed Expenses)/Unit CM

Break-even point formula method in a single product situation:

Unit sales to break even = Fixed Expenses / Unit CM

Total S&A Expense =

Variable S&A Ex. + Fixed S&A Ex.

Variable expense ratio:

Variable expense ratio = Variable Expenses / Sales

Single Product: Variable Expenses =

Variable expenses per unit x Quanity Sold = V x Q

Segment

a part or activity of an organization about which managers would like cost, revenue, or profit data

Profit graph (simpler form of CVP graph):

a) graph based on equation Profit = Unit CM x Q - Fixed Expenses b) linear equation that plots a single straight line c) to plot line, compute the profit at two different sales volumes, plot the points, then connect with a straight line d) profit increases to the right of the break-even point as sales volume increases e) loss becomes worse to the left of the break-even point as sales volume decreases

Contribution margin:

a) is the amount remaining from sales revenue after variable expenses have been deducted b) is the amount to cover fixed expenses and then provide profits/losses for the period (net income/net operating loss)

Segment margin is useful in major decisions that:

affect capacity such as dropping a segment

Common Fixed costs are not

allocated to segments

When a company sells more than one product, break-even analysis is more complex because

different products will have different selling prices, different costs, and different contributions margins

Companies with LOW FIXED COST STRUCTURES

enjoy greater stability in income across good and bad years

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.

Anticipated profit or loss:

is measured by the vertical distance between the total revenue line (sales) and the total expense line (variable expense plus fixed expense)

Break-even point on graph:

is where total revenue and total expense lines cross.

FMOH that is deferred in or released from inventories can be determined as:

manufacturing overhead deferred in (released from) inventory = fixed manufacturing overhead in ending inventories - fixed manufacturing overhead in beginning inventories

To estimate the effect on profits for a planned increase in sales:

multiply the increase in units sold by the unit CM

The variable costing net operating income for each period can always be computed by

multiplying the number of units sold by the contribution margin per unit and then subtract total fixed expenses

Break-even point

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 total revenue equals total cost

Changes in sales mix can cause

perplexing variations in company's profits

Variable costing income statements categorize costs as

variable and fixed, and it is much easier to use this income statement format to perform CVP analysis than attempting to use the absorption costing format, which mixes together variable and fixed costs.