Principles of managerial Accounting

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Discuss opportunity costs and sunk costs in an investing decision framework?

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ACCT Cost–Volume–Profit Analysis Learning Objectives Introduction W I ome of the more important decisions managers make involve L analyzing the relationships among the cost, volume, and profitS by a company. ability of products produced and services provided Cost–volume–profit (CVP) analysis focuses on the relationships among O the following five factors and the overall profitability of a company: N , 1. The prices of products or services S 2. The volume of products or services produced and sold J A 4. The total fixed costs M 5. The mix of products or services produced I As in any form of analysis involving projections of E the future, certain 3. The per-unit variable costs After studying the material in this chapter, you should be able to: LO1 Use the contribution margin in its various forms to determine the impact of changes in sales on income. LO2 Analyze what-if decisions by using CVP analysis. LO3 Compute a company’s breakeven point in single- and multiproduct environments. LO4 Analyze target profit before and after the impact of income tax. LO5 Compute a company’s operating leverage and understand the relationship of leverage to cost structure. assumptions must be considered. The major assumptions are as follows: 5 relevant range. In other words, we 1. The selling price is constant throughout the entire 0 change as the volume changes. assume that the sales price of the product will not 5 discussed in Chapter 5, although 2. Costs are linear throughout the relevant range. As costs may behave in a curvilinear fashion, they can 1 often be approximated by a linear relationship between cost and volume within the relevant range. B 3. The sales mix used to calculate the weighted-average U contribution margin is constant. 4. The amount of inventory is constant. In other words, the Cost–volume–profit number of units produced is equal to the number of units sold. (CVP) analysis A tool that focuses on the relationships among Although some of these assumptions are often vioa company’s profits and (1) the prices lated in real business settings, the violations are usually of products or services, (2) the volume of minor and have little or no impact on management deciproducts or services, (3) the per-unit variable sions. CVP analysis can still be considered valid and very costs, (4) the total fixed costs, and (5) the mix useful in decision making. of products or services produced. 120 Chapter 6: Cost–Volume–Profit Analysis 9781305323339, Managerial ACCT2, Second Edition, Sawyers/Jackson/Jenkins - © Cengage Learning. All rights reserved. No distribution allowed without express authorization. CHAPTER 6 W I L S O N , "T-$%NPOJUPSTCFDPNFNPSFBOENPSFQPQVMBS  IJHIFSQSPEVDUJPOBMMPXTDPNQBOJFTUPEFDSFBTF DPTUT‰BGVOEBNFOUBMDPODFQUPG$71BOBMZTJT 5 0 5 1 LO1 The Contribution Margin B and Its Uses U A © kolvenbach/Alamy ACCT J A M I E s mentioned in Chapter 5, the traditional income statement required for external financial reporting focuses on function (product costs versus period costs) in calculating the cost of goods sold and a company’s gross profit. Gross profit is the difference between sales and cost of goods sold. However, because cost of goods sold includes both fixed costs (facility-level costs, such as rent) and variable costs (unit-level costs, such as direct materials), the behavior Gross profit The difference of cost of goods sold and gross profit is difficult to prebetween sales and cost of goods sold. dict when production increases or decreases. Chapter 6: Cost–Volume–Profit Analysis 9781305323339, Managerial ACCT2, Second Edition, Sawyers/Jackson/Jenkins - © Cengage Learning. All rights reserved. No distribution allowed without express authorization. 121 In contrast, the contribution margin income statement is structured by behavior rather than by function. In Exhibit 6-1, a traditional income statement and a contribution margin income statement are shown side by side so that you can see the difference. As you can see, although the net income is the same for both statements, the traditional statement focuses on the function of the costs, whereas the contribution margin income statement focuses on the behavior of the costs. In the traditional income statement, the cost of goods sold and selling, general, and administrative The contribution margin income statement is structured to emphasize cost behavior as opposed to cost function. Exhibit 6-1 Comparison of Income Statements Contribution Margin Sales $1,000 Less: Cost of goods sold: Variable costs Fixed costs $350 150 Total cost of goods sold 500 Gross profit $ 500 Less: S, G, & A costs: Variable costs Fixed costs $ 50 250 Total S, G, & A costs Net operating income 300 $ 200 Sales W I L S O N , J (S, G, & A) costs include both variable and fixed costs.A In the contribution margin income statement, costs are M separated by behavior (variable versus fixed) rather than by function. Note, however, that the contributionI margin income statement combines product and periodE costs. Variable costs include both variable product costs (direct materials) and variable selling, general, and administrative costs (commissions on sales), whereas fixed5 costs likewise include both product and period costs. 0 5 Contribution Margin per Unit 1 To illustrate the many uses of the contribution marginB income statement in managerial decision making, let’sU look at the income statement of Happy Daze Games. Happy Daze, unlike large established firms such as Contribution margin per unit The sales price per unit of product, less all variable costs to produce and sell the unit of product; used to calculate the change in contribution margin resulting from a change in unit sales. 122 $1,000 Less: Variable costs: Manufacturing costs S, G, & A costs $350 50 Total variable costs 400 Contribution margin Less: Fixed costs: Manufacturing costs S, G, & A costs $ 600 $150 250 Total fixed costs 400 Net operating income $ 200 © Cengage Learning 2013 Traditional Blizzard Entertainment and Bioware Corp., is a start-up company and produces just one game but plans to increase its product line to include more games in the near future. A contribution margin income statement for Happy Daze Game Company follows. Total Per Unit Sales (8,000 units) $100,000 $12.50 Less: Variable costs 72,000 9.00 $ 28,000 $ 3.50 Contribution margin Less: Fixed costs Net operating income (loss) 35,000 $ (7,000) Note that, in addition to the total sales, variable costs, and contribution margin, per-unit cost information is also shown in the statement. Happy Daze sells each game for $12.50, and the variable cost of manufacturing each game is $9.00. As you can see, the contribution margin per unit is $3.50 and can be found by subtracting the per-unit variable costs of $9.00 from the per-unit Chapter 6: Cost–Volume–Profit Analysis 9781305323339, Managerial ACCT2, Second Edition, Sawyers/Jackson/Jenkins - © Cengage Learning. All rights reserved. No distribution allowed without express authorization. sales price of $12.50. The contribution margin per unit can also be calculated by dividing the contribution margin (in dollars) by the number of units sold: Contribution margin (in $) Units sold 28,000 = $3.50 = 8,000 Contribution margin (per unit) = What exactly does this tell us? It tells us that every game that is sold adds $3.50 to the contribution margin. Assuming that fixed costs don’t change, net operating income increases by the same $3.50. What happens if sales increase by 100 games? Because we know that the contribution margin is $3.50 per game, if sales increase by 100 games, net operating income will increase by $350 ($3.50 × 100). In a similar fashion, W if sales were to decrease by 200 games, then net operating I income would decrease by $700 ($3.50 × −200). As summarized in Exhibit 6-2, the use of contribuL tion margin per unit makes it very easy to predict how S both increases and decreases in sales volume affect conO tribution margin and net income. The contribution margin per unit and the contribution margin ratio will remain constant as long as sales vary in direct proportion to volume. The contribution margin ratio is calculated by dividing the contribution margin in dollars by sales in dollars: Contribution margin ratio = Contribution margin (in $) Sales (in $) N , Exhibit 6-2 The Impact of Changes in Sales on Contribution Margin and Net Income Net operating income (loss) J A $97,500 70,200 M $27,300 I 35,000 E $ (7,700) Change in income Decreased by $700 7,800 units Sales (sales price, $12.50/unit) Less: Variable costs ($9/unit) Contribution margin ($3.50/unit) Less: Fixed costs 5 0 5 Contribution Margin Ratio The contribution margin income statement can1 also be presented in terms of percentages, as shown in the Bfollowing income statement: U (200-unit decrease × $3.50) Total Percentage Sales (8,000 units) $100,000 100 Less: Variable costs 72,000 72 Contribution margin Less: Fixed costs $ 28,000 35,000 Net operating income (loss) $ ( 7,000) 28 ($28,000/$100,000) Original Total 8,000 units $100,000 Increased by 100 units 8,100 units $101,250 72,000 72,900 $ 28,000 $ 28,350 35,000 35,000 $ (7,000) $ (6,650) Increased by $350 (100-unit increase × $3.50) © Cengage Learning 2013 Decreased by 200 units The contribution margin ratio can be viewed as the amount of each sales dollar contributing to the payment of fixed costs and increasing net operating profit; that is, 28 cents of each sales dollar contributes to the payment of fixed costs or increases net income. Contribution margin ratio The contribution margin divided by sales; used to calculate the change in contribution margin resulting from a dollar change in sales. Chapter 6: Cost–Volume–Profit Analysis 9781305323339, Managerial ACCT2, Second Edition, Sawyers/Jackson/Jenkins - © Cengage Learning. All rights reserved. No distribution allowed without express authorization. 123 Like the contribution margin per unit, the contribution margin ratio will remain constant as long as sales vary in direct proportion to volume. Like contribution margin per unit, the contribution margin ratio allows us to very quickly see the impact of a change in sales on contribution margin and net operating income. As you saw in Exhibit 6-2, a $1,250 increase in sales (100 units) will increase contribution margin by $350 ($1,250 × 28%). Assuming that fixed costs don’t change, this $350 increase in contribution margin increases net operating income by the same amount. Likewise, in Exhibit 6-2, we decreased sales by 200 units ($2,500), resulting in a decrease in contribution margin and net operating income of $700 ($2,500 × 28%). LO2 What-If Decisions Using CVP W ontinuing with our example, we note that HappyI Daze had a net loss of $7,000 when 8,000 unitsL were sold. At that level of sales, the total contribution S margin of $28,000 is not sufficient to cover fixed costs of $35,000. The CEO of the company would like toO consider options to increase net income while main-N taining the high quality of the company’s products. , After consultation with marketing, operations, and C accounting managers, the CEO identifies three options that she would like to consider in more depth: J 1. Reducing the variable costs of manufacturing the A product 2. Increasing sales through a change in the sales incentive structure or commissions (which would also increase variable costs) 3. Increasing sales through improved features and © Lusoimages/Shutterstock.com increased advertising 124 M I E Option 1—Reduce Variable Costs When variable costs are reduced, the contribution margin will increase. So the question becomes, What can be done to reduce the variable costs of manufacturing? Happy Daze could find a less expensive supplier of raw materials. The company could also investigate the possibility of reducing the amount of labor used in the production process or of using lower wage employees in the production process. In either case, qualitative factors must be considered. If Happy Daze finds a less expensive supplier of raw materials, the reliability of the supplier (shipments may be late, causing downtime) and the quality of the material (paper products are not as good, adhesive is not bonding) must be considered. Reducing labor costs also has both quantitative and qualitative implications. If less labor is involved in the production process, more machine time may be needed. Although this option certainly lowers variable costs, it may also raise fixed costs. Using lower skilled workers to save money could result in more defective products, owing to mistakes made by inexperienced workers. Another possible result of using fewer workers is that it can adversely affect employee morale. Being short staffed can cause stress on workers, owing to the likelihood that they will be overworked. Happy Daze decides to decrease variable costs by reducing the costs of direct labor. The operations manager assures the CEO that the change can be made by outsourcing some of the current production activities. This change reduces variable costs by 10 percent and, as shown in the following analysis, results in an overall increase in net operating income of $7,200: Impact of Reducing Variable Costs By 10 Percent 5 0 5 1 B U Sales Less: Variable costs Contribution margin Less: Fixed costs Net operating income (loss) Current Option 1 $100,000 $100,000 72,000 64,800 $ 28,000 $ 35,200 35,000 35,000 $ (7,000) $ 200 Option 2—Increase Sales Incentives (Commissions) The CEO of Happy Daze would also like to consider providing additional sales incentives to motivate the sales staff in an effort to increase sales volume. The Chapter 6: Cost–Volume–Profit Analysis 9781305323339, Managerial ACCT2, Second Edition, Sawyers/Jackson/Jenkins - © Cengage Learning. All rights reserved. No distribution allowed without express authorization. Impact of Increasing Sales Incentives (Sales Increase to $140,000) Current Sales Less: Variable costs Contribution margin Less: Fixed costs Net operating income (loss) $100,000 72,000 $ 28,000 35,000 $ (7,000) MAKING IT REAL A W I 2 Option L $140,000 S 104,800 $ 35,200 O 35,000 N $ , 200 J A M I E s consumer spending slowed during the recent recession, managers and owners of both 5 large and small companies 0 employed CVP analysis in an 5 effort to bolster income. For example, Drue Sanders, foun1 der of Drue Sanders Custom B Jewelers, created a new line U of jewelry using silver rather than more costly gold and platinum as the main component. This approach allowed the company to sell items for $150 to $200 rather than the normal $500 and up prices she normally charged. The result was increased volume In Option 1 and Option 2, the ultimate change in net income can be determined by focusing solely on the change in contribution margin. Fixed costs are not relevant in either analysis because they do not vary. However, as you will see in Option 3, that is not always the case. Option 3—Change Game Features and Increase Advertising Changes can be made to more than one variable at a time. In fact, changes in cost, price, and volume are never made in a vacuum and almost always affect one or both of the other variables. Happy Daze has decided to change some key features of its game. Although this change will add $0.25 to the variable cost per game, the marketing manager estimates that with additional advertising of $5,000, sales volume will increase by 40 percent, or 3,200 units. In order to offset some of these costs, the accounting manager proposes an increase of $0.75 per unit in the sales price. As shown next, this option increases the contribution margin per unit to $4.00 per unit. The new sales price per unit is $13.25, and variable costs increase from $9.00 to $9.25 per unit. The increase in contribution margin of $16,800 is more than enough to offset the $5,000 increase in fixed costs and results in an overall increase of $11,800 in net operating income. as consumers reacted to the lower pricing. In a similar fashion, in order to lure cost-conscious customers, PC makers such as Hewlett-Packard Co. and Dell shifted their product lines toward cheaper laptops and notebooks that sold for as little as $399. With consumers balking at spending thousands of dollars on a new computer, offering lower priced computers with fewer (and less expensive) features allowed the companies to continue making sales in a difficult economy. © Jana Birchum/Getty Images marketing manager estimates that if Happy Daze raises the sales commission by 10 percent on all sales above the present level, sales will increase by $40,000, or 3,200 games. (The additional sales commission will be $4,000.) Happy Daze can increase net operating income by $7,200 by increasing the sales commission by 10 percent on all sales of more than $100,000. The new variable costs are calculated by using a variable-cost percentage of 72 percent on sales up to $100,000 and 82 percent on all sales of more than $100,000. As you can see in the following income statement, if sales increase by $40,000, operating income will increase by $7,200, and Happy Daze will report net operating income of $200: Source: “Smart Ways to Cut Prices,” by Diana Ransom, and “Leaner Laptops, Lower Prices,” by Justin Scheck and Loretta Chao, The Wall Street Journal, April 22, 2009. Chapter 6: Cost–Volume–Profit Analysis 9781305323339, Managerial ACCT2, Second Edition, Sawyers/Jackson/Jenkins - © Cengage Learning. All rights reserved. No distribution allowed without express authorization. 125 Impact of Changes to Cost, Price, and Volume Sales Less: Variable costs Contribution margin Less: Fixed costs Net operating income (loss) Current (8,000 units) Option 3 (11,200 units) $100,000 ($8,000 × $12.50) $148,400 (11,200 × $13.25) 72,000 (8,000 × $9.00) 103,600 (11,200 × $9.25) $ 28,000 (8,000 × $3.50) $ 44,800 (11,200 × $4.00) 35,000 40,000 $ (7,000) $ 4,800 How well does each option meet the stated objectives of increasing net operating income while maintaining a high-quality product? The CEO of Happy Daze should W analyze each alternative solution in the same manner and choose the best course of action on the basis ofI both quantitative and qualitative factors. L From a quantitative perspective, Option 1 results S in an increase in net operating income of $7,200, Option 2 increases net operating income by the same $7,200, andO Option 3 increases net operating income by $11,800. TheN CEO must also assess the risk inherent in each option, including the sensitivity of a decision to make changes, in key assumptions. For example, although Option 1 appears to have little quantitative risk because the decreaseJ in costs is known with certainty and no increase in sales is projected, Happy Daze should consider whether reducingA labor costs in Option 1 will have a negative impact onM the quality of its product. If the reduction in labor costsI results from using lower paid but inadequately skilled E workers, quality may be adversely affected. 5 0 LO3 Break-Even Analysis 5 n addition to considering what-if analysis, it is useful1 for managers to know the number of units sold orB the dollar amount of sales that is necessary for a com-U I pany to break even. The break-even point is the level of sales at which the contribution margin just covers fixed costs and, consequently, income is equal to zero. Breakeven analysis is really just a variation of CVP analysis in Break-even point The level of sales at which the contribution margin just covers fixed costs and income is equal to zero. 126 which volume is increased or decreased in an effort to find the point at which income is equal to zero. Break-even analysis is facilitated through ...
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Running head: PRINCIPLES OF MANAGERIAL ACCOUNTING

Principles of Managerial Accounting

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PRINCIPLES OF MANAGERIAL ACCOUNTING

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Sunk costs comprise the costs which have been incurred already in the past whereby
anything that is done currently or in the future cannot affect them (Sawyers, R., Jackson, S...

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