Chapter 19 Cost-Volume-Profit Analysis: Additional Issues

Required Sales in UNITS

(Fixed Costs + Target Net Income)/CM # = Required Sales in UNITS

Required Sales in DOLLARS

(Fixed Costs + Target Net Income)/CM ratio% =Required Sales in DOLLARS

Determining Sales Mix with Limited Resources

All companies have limited resources whether it be floor space, raw materials, direct labor hours, etc. Management must decide which products to sell to maximize net income.

Theory of Constraints

Approach used to identify and manage constraints so as to achieve company goals. Company must continually -identify its constraints and -find ways to reduce or eliminate them, where appropriate.

DEGREE OF OPERATING LEVERAGE Formula

Contribution Margin / Net Income = DEGREE OF OPERATING LEVERAGE

CVP income statement is for internal use only

Costs and expenses classified as fixed or variable. Reports contribution margin as a total amount and on a per unit basis.

Variable Costing

Direct Materials Direct Labor Variable Manufacturing Overhead Period Cost

Operating Leverage

Extent that net income reacts to a given change in sales. Higher fixed costs relative to variable costs cause a company to have higher operating leverage. When sales revenues are increasing, high operating leverage means that profits will increase rapidly. When sales revenues are declining, too much operating leverage can have devastating consequences.

Break-Even Sales in DOLLARS Steps

First, determine the weighted-average contribution margin Weighted-Average Unit CM = (unit CM x Sales Mix%) + (unit CM x Sales Mix%) +(unit CM x Sales Mix%) Second, calculate break-even point in dollars. Fixed Costs / Weighted-Avg CM RATIO% = Break-Even Point in DOLLARS

Break-Even Sales in Units Steps

First, determine the weighted-average contribution margin. Weighted-Average Unit CM = (unit CM x Sales Mix%) + (unit CM x Sales Mix%) +(unit CM x Sales Mix%) Second, use the weighted-average unit contribution margin to compute the break-even point in units Fixed Costs / Weighted-Average Unit CM = Break-Even Points in UNITS

Break-Even Points in DOLLARS

Fixed Costs / (in decimals)CM ratio% = Break-Even in DOLLARS

Break-Even Points in UNITS

Fixed Costs / Unit CM = Break-Even Points in UNITS

Decision-Making Concerns

Generally accepted accounting principles require that absorption costing be used for the costing of inventory for external reporting purposes. Net income measured under GAAP (absorption costing) is often used internally to -evaluate performance, -justify cost reductions, or -evaluate new projects. Some companies have recognized that net income calculated using GAAP does not highlight differences between variable and fixed costs and may lead to poor business decisions. These companies use variable costing for internal reporting purposes.

Net income will be

Greater if more higher-contribution margin units are sold than lower-contribution margin units.

Margin of Safety in RATIO%

Margin of Safety in DOLLARS/ Actual (Expected) Sales = Margin of Safety in RATIO%

Target Net Income

Once a company achieves break-even sales, a sales goal can be set that will result in a target net income (Fixed Costs + Target Net Income)/CM # = Required Sales in UNITS

Fixed manufacturing overhead costs are recognized as:

Product costs under absorption costing.

DEGREE OF OPERATING LEVERAGE

Provides a measure of a company's earnings volatility. Computed by dividing total contribution margin by net income.

Break-Even Sales in Units

Sales mix is the relative percentage in which a company sells its products. If a company's unit sales are 80% printers and 20% computers, its sales mix is 80% to 20%. Sales mix is important because different products often have very different contribution margins

Cost-Volume-Profit Analysis

The study of the effects of changes in costs and volume on a company's profit. Important to profit planning. Critical in management decisions such as: -determining product mix, -maximizing use of production facilities, -setting selling prices.

Potential Advantages of Variable Costing

The use of variable costing is consistent with cost-volume-profit analysis. Net income under variable costing is unaffected by changes in production levels. Instead, it is closely tied to changes in sales. The presentation of fixed costs in the variable costing approach makes it easier to identify fixed costs and to evaluate their impact on the company's profitability.

The difference between absorption and variable costing:

Under both costing methods, selling and administrative expenses are treated as period costs. Companies may not use variable costing for external financial reports because GAAP requires that fixed manufacturing overhead be treated as a product cost. Variable Costing uses Period Cost Absorption Costing uses Product Cost

Weighted-Average Unit CM

Weighted-Average Unit CM = (unit CM x Sales Mix%) + (unit CM x Sales Mix%) +(unit CM x Sales Mix%)

Break-Even Sales in Dollars

Works well if the company has many products. Calculates break-even point in terms of sales dollars for -divisions or -product lines, -NOT individual products.

The degree of operating leverage:

a. Can be computed by dividing total contribution margin by net income. b. Provides a measure of the company's earnings volatility. c. Affects a company's break-even point.

By determining the weighted-average unit contribution margin of all the products.

companies can compute break-even sales for a mix of two or more products

Sales mix

is the relative percentage in which a company sells its products.

Cost Structure

is the relative proportion of fixed versus variable costs that a company incurs. -May have a significant effect on profitability. -Company must carefully choose its cost structure.

Margin of Safety in DOLLARS

tells us how far sales can drop before the company will operate at a loss. can be expressed in dollars or as a ratio (Fixed Costs + Target Net Income) - Break-Even Sales = Margin of Safety in DOLLARS