20-1   Info often reported in a CVP income statement.   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. Cost-Volume-Profit (CVP) Review Basic Concepts

20-2 Detailed CVP Income Statement Cost-Volume-Profit (CVP) Review Basic Concepts

20-3 Ex: V Video’s CVP income statement shows: Total fixed costs = $200,000, *CM per unit is $200. *Contribution Margin … can also be expressed as a ratio which in the case of V Video is … 40% ($200 ÷ $500). Cost-Volume-Profit (CVP) Review Basic Computations – Break-Even Analysis

20-4 Basic Computations – Target Net Income Ex: Fixed costs: $200,000 … Target Net Income: $250,000. Required sales in units & dollars to achieve this are: Cost-Volume-Profit (CVP) Review

20-5  illustrates how far sales can drop before a “loss”.  can be expressed in dollars or as a ratio. Ex: Assume V Video’s sales are $800,000: Cost-Volume-Profit (CVP) Review Basic Computations – Margin of Safety

20-6

20-7 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 80:20.  Sales mix is important because different products often have very different contribution margins. Sales Mix

20-8 Can compute break-even sales for a mix of two or more products by determining the weighted-average unit contribution margin. Ex: “V” sells camcorders AND TV sets in these quantities: 1,500 camcorders and 500 TVs. Total Units Sold = _2,000_. Sales Mix … Break-Even Sales in Units Sales mix, expressed as a function of total units sold, is:

20-9 First, determine the weighted-average contribution margin. Sales Mix … Break-Even Sales in Units $200 X.75 = $150$500 X.25 = $125 $150 + $125 = $275 New Info

20-10 Second, use the weighted-average unit contribution margin to compute the break-even point in units Sales Mix … Break-Even Sales in Units New Info

20-11  With a break-even point of 1,000 units, V Video must sell: ► 750 Camcorders (1,000 units x 75%) ► 250 TVs (1,000 units x 25%)  At this level, total CM will equal the fixed costs of $275,000. Sales Mix … Break-Even Sales in Units Break-Even Sales in Units

20-12  Companies have limited resources: space, machine hrs, direct labor hrs, etc.  Management must decide which products to sell to maximize net income. Ex: V Video makes camcorders & TVs. Production Machine capacity is limited to 3,600 hours per month. Sales Mix Determining Sales Mix with Limited Resources Additional New Info

20-13 Calculate the contribution margin per unit of limited resource. Management should produce more camcorders if demand exists or else increase machine capacity. Sales Mix Determining Sales Mix with Limited Resources

20-14 Assume V Video can increase capacity from 3,600 hrs to 4,200 hrs. Should the 600 added hours be used to make camcorders or TVs. To maximize net income, all 600 hours should be used to produce and sell camcorders. Sales Mix Determining Sales Mix with Limited Resources

20-15

20-16 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. Cost Structure and Operating Leverage If a business has a lot of fixed vs variable cost then it has a high operating leverage. These firms use a lot of fixed costs in their business it is capital intensive.

20-17  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, high operating leverage can have devastating consequences. Cost Structure and Operating Leverage Operating Leverage

20-18 Ex: “V” Video has a competitor “NW” Inc. Both make camcorders. “V” uses a labor-intensive (many employees) manufacturing process. “NW” uses an automated system. (Employees only set-up, adjust, and maintain the machinery.) CVP income statements Cost Structure and Operating Leverage

20-19 Look at CM ratios. Cost Structure and Operating Leverage Effect on Contribution Margin Ratio

20-20   New Wave contributes 80 cents to net income for each dollar of increased sales while Vargo only contributes 40 cents.   New Wave’s cost structure which relies on fixed costs is more sensitive to changes in sales. Cost Structure and Operating Leverage Effect on Contribution Margin Ratio

20-21   New Wave needs to generate $150,000 more in sales than Vargo to break-even.   Because of the greater break-even sales required, New Wave is a riskier company than Vargo. Calculate the break-even point. Cost Structure and Operating Leverage Effect on Break-Even Point

20-22   The difference in ratios reflects the difference in risk between New Wave and Vargo.   Vargo can sustain a 38% decline in sales before operating at a loss versus only a 19% decline for New Wave. Computation of margin of safety ratio Cost Structure and Operating Leverage Effect on Margin of Safety

20-23 Ex: GM & FORD Capital intensive (high operating leverage). High fixed costs … machines, robots, buildings etc. When economy slows, fewer people buy new cars, but auto companies still have to pay their fixed costs. Economic slowdown hurts a capital intensive firm much more than a company not quite so capital intensive. Labor intensive (more workers = higher variable costs) has lower operating leverage. Hotel-Casino …. Labor or capital intensive ? Labor intensive typically have an easier time surviving than capital intensive firms.

20-24

20-25 Under Absorption Costing, product costs consist of: Direct Material Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead APPENDIX … ABSORPTION VS VARIABLE Costing All we have covered so far are variations of: Absorption Costing All manufacturing costs are added to the product during manufacture and are assets (as finished goods inv.) until sold – then recognized as the “Cost of Goods Sold.

20-26 Under variable costing, product costs consist of: Direct Materials Direct Labor Variable Manufacturing Overhead just like absorption … EXCEPT FOR: APPENDIX … ABSORPTION VS VARIABLE Costing FIXED Manufacturing Costs – not part of inventory (like absorption BUT “expensed” as a monthly “period cost”)

20-27 The difference between absorption and variable costing:   Under both costing methods, selling and administrative expenses (corporate) are treated as period costs … BUT absorption says FIXED MFG Cost is a period cost.   Companies may not use variable costing for external financial reports because GAAP requires that fixed manufacturing overhead be treated as a product cost. APPENDIX … ABSORPTION VS VARIABLE Costing

20-28 Ex: PCorp makes a sealant, called Fix-It. Relevant data for Fix-It in JAN 2013, the first month of production, are: Comparing Absorption with Variable Costing APPENDIX … ABSORPTION VS VARIABLE Costing

20-29 Per unit manufacturing cost under each approach. The mfg cost per unit is $4 ($13 -$9) higher for absorption costing because fixed mfg costs are treated as product costs. Comparing Absorption with Variable Costing APPENDIX … ABSORPTION VS VARIABLE Costing

20-30 Absorption Costing Example APPENDIX … ABSORPTION VS VARIABLE Costing P Corp

20-31 Variable Costing Example APPENDIX … ABSORPTION VS VARIABLE Costing

20-32 Decision-Making Concerns  GAAP 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. APPENDIX … ABSORPTION VS VARIABLE Costing

20-33  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. Decision-Making Concerns APPENDIX … ABSORPTION VS VARIABLE Costing

20-34 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. APPENDIX … ABSORPTION VS VARIABLE Costing

20-35 Unit Cost Direct Materials7.50 Direct Labor2.45 Variable Mfg Overhead5.80 Mfg Cost Per Unit15.75 (a)

20-36 Unit Cost Direct Materials7.50 Direct Labor2.45 Variable Mfg Overhead5.80 Mfg Cost Per Unit15.75 Income Statement - Variable Costing Sales (80,000 lures x $25) 2,000,000 Var Costs (80,000 x $15.75) 1,260,000 Var Selling – Admin Exp (80,000 x $3.90) 312,0001,572,000 Contribution Margin 428,000 Fixed Mfg Overhead225,000 Fixed Sell – Admin Exp240,100465,100 Net Income (Loss) (37,100) (b)

20-37 Unit Cost Direct Materials7.50 Direct Labor2.45 Variable Mfg Overhead5.80 Fixed Mfg Overhead2.50 Mfg Cost Per Unit18.25 (c)

20-38 Unit Cost Direct Materials7.50 Direct Labor2.45 Variable Mfg Overhead5.80 Fixed Mfg Overhead2.50 Mfg Cost Per Unit18.25 Income Statement - Absorption Costing Sales (80,000 lures x $25) 2,000,000 Cost of Goods Sold (80,000 x $18.75) 1,460,000 Gross Profit 40,000 Var Sell-Admin Exp (80,000 x $3.90) 312,000 Fixed Sell – Admin Exp240,100465,100 Net Income (Loss) (12,100)

20-39 (a) Variable Costing Labor (Crate builders)38,000 Material (Wood)54,000 Var Overhead (Utilities)2,400 Var Overhead (Nails)350 Total Mfg Costs$ 94,750 (b) Absorption Costing Labor (Crate builders)38,000 Material (Wood)54,000 Var Overhead (Utilities)2,400 Var Overhead (Nails)350 Fxd Overhead (Utilities)18,000 Fxd Overhead (Rent)21,400 Total Mfg Costs$ 134,150 (c) Difference is due to fixed overhead being included as part of manufacturing costs under absorption costing ONLY. This difference amounts to $39,400 ($18,000 + $21,400). (b) (c) (a)