CHAPTER 6 MORE CVP ANALYSIS

SALES MIX Understanding and managing sales mix is critical to company success

SALES MIX  Companies often sell more than one product  Critical decision: what mix of products to sell  Relative percentage in which each product is sold when more than one product is sold  Important because different products have substantially different contribution margins

SALES MIX Break-Even Sales In Units Steps for a mix of two or more products:  Compute the weighted-average unit contribution margin of all the products: Product 1 Unit Contribution Margin X Percentage of Sales + Product 2 Unit Contribution Margin X Percentage of Sales = Weighted Average Unit Contribution Margin  Compute the break-even point in units: Fixed Costs ) Weighted Average = Break-even Unit Contribution Point Margin in Units

SALES MIX Break-Even Sales In Units Example – Vargo Video Basic Data  Sells both DVD players and TVs  Fixed costs of $200,000

SALES MIX - Break-Even Sales In Units Example – Vargo Video Continued  Determine weighted-average unit contribution margin for the sales mix of 75 percent DVDs and 25 percent TVs:  Determine the break-even point in units:

SALES MIX - Break-Even Sales In Units Example – Vargo Video (Continued)  Verify the number of DVDs and TVs to be sold to break even with a sales mix of 75 % DVDs and 25 % TVs and with fixed costs of $200,000:

SALES MIX Break-Even Sales In Units At any level of units sold, net income will be greater if more high contribution margin units are sold than low contribution margin units.

SALES MIX Break-Even Sales In Dollars Steps for a mix of many products in two or more product lines or divisions:  Compute the weighted-average unit contribution margin ratio of all product lines or divisions: Division 1 Contribution Margin Ratio X Percentage of Sales + Division 2 Contribution Margin Ratio X Percentage of Sales = Weighted Average Contribution Margin Ratio  Compute the break-even point in dollars: Weighted Average Break-even Fixed Costs ÷ Contribution = Point Margin Ratio in Dollars

SALES MIX Break-Even Sales In Dollars Example – Kale Garden Supply Co. Basic Data  Total fixed costs $300,000  Two Product Divisions: Indoor Plants: Sales Mix Ratio 20% Contribution Margin Ratio 40% Outdoor Plants: Sales Mix Ratio 80% Contribution Margin Ratio 30%

SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued)  Determine weighted-average contribution margin ratio for all divisions:  Determine the break-even point in dollars:

SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued)  Using Kale’s sales mix of 20 percent and 80 percent, break-even sales from each division:  Indoor Plant Division: $187,500 (.20 X $937,500)  Outdoor Plant Division: $750,000 (.80 X $937,500)

SALES MIX - Break-Even Sales In Dollars Example – Kale Garden Supply (Continued)  Break-even point affected by a shift in sales from one division to another  Shift sales to the Indoor Plant Division:  Division’s higher contribution margin ratio increases weighted average contribution margin ratio  Results in a lower break-even point in sales dollars  Shift sales to the Outdoor Plant Division:  Opposite effect occurs due to Division’s lower contribution margin ratio

COST STRUCTURE AND OPERATING LEVERAGE Cost Structure  Relative proportion of fixed versus variable costs for a company  Can have a significant impact on profits

COST STRUCTURE AND OPERATING LEVERAGE Operating Leverage  Extent to which a company’s net income reacts to a given change in sales  Higher fixed cost structure increases sensitivity to changes in sales; thus, higher operating leverage  Profits increase rapidly when sales increase and plunge drastically when sales decrease  When used carefully, can add to company profitability

COST STRUCTURE AND OPERATING LEVERAGE Example – Makers of Croquet Mallets  Old English Mallet Company - Labor-intensive manufacturing approach  New Wave Mallet Company - Completely automated system  Same sales and same net income  Managed differently due to different cost structures

COST STRUCTURE AND OPERATING LEVERAGE

COST STRUCTURE AND OPERATING LEVERAGE Effect on Contribution Margin Ratio Example – Makers of Croquet Mallets (Continued)  Higher cost structure for New Wave  More sensitive to changes in sales  Higher operating leverage  Net income increases 60¢ for each additional sales dollar  Net income decreases 60¢ for each lost sales dollar

COST STRUCTURE AND OPERATING LEVERAGE Degree of Operating Leverage  Measures earnings volatility Example – Makers of Croquet Mallets (Continued)  Higher operating leverage for New Wave  Net income changes 4 times (6 ÷ 1.5) as much as Old English with an equal change in sales  Exposed to greater earnings volatility risk

COST STRUCTURE AND OPERATING LEVERAGE Effect on Break-Even Point Example – Makers of Croquet Mallets (Continued)  Higher break-even point for New Wave  Needs $150,000 more in sales than Old English to break even  Riskier than Old English  Cannot survive for very long unless it breaks even

COST STRUCTURE AND OPERATING LEVERAGE Effect on Margin of Safety Ratio Example – Makers of Croquet Mallets (Continued) Old English could sustain a 67 percent decline in sales before operating at a loss New Wave could only have a 17 percent decline in sales prior to being in “the red” Thus, New Wave is riskier than Old English

APPENDIX: ABSORPTION COSTING VERSUS VARIABLE COSTING  Full or Absorption Costing  Assigns all variable and fixed manufacturing costs to the product  Required for external reporting  Variable Costing  Assigns only variable manufacturing costs to the product  Direct material, direct labor, variable manufacturing overhead

ABSORPTION COSTING VERSUS VARIABLE COSTING COMPARISON Primary Difference Under variable costing, fixed manufacturing overhead is an expense in the current period. You will remember: Under absorption costing, fixed manufacturing overhead is part of the O/H pool allocated to inventory under Standard or ABC costing.

ABSORPTION COSTING VERSUS VARIABLE COSTING COMPARISON - Continued  Variable costing does not defer fixed manufacturing overhead to the future - i.e., they are not inventoried  Net income under absorption costing compared to net income under variable costing:  Higher when units produced exceed units sold  Lower when units produced are less than units sold  Equal when units produced and sold are the same: There is no added ending inventory so fixed costs are not deferred into the future

ABSORPTION COSTING VERSUS VARIABLE COSTING Example – Premium Products  Manufactures Fix-it, a sealant for car windows  Relevant data for the first month of production:

ABSORPTION COSTING VERSUS VARIABLE COSTING Example - Continued  Per unit manufacturing cost under each approach:  Manufacturing costs are $4 ($13 - $9) higher for absorption costing because fixed manufacturing costs are product costs.

ABSORPTION COSTING VERSUS VARIABLE COSTING Absorption Costing Income Statement

ABSORPTION COSTING VERSUS VARIABLE COSTING Variable Costing Income Statement

ABSORPTION vs VARIABLE COSTING 1.Last year, fixed manufacturing overhead was $30,000, variable production costs were $48,000, fixed selling and administration costs were $20,000, and variable selling administrative expenses were $9,600. There was no beginning inventory. During the year, 3,000 units were produced and 2,400 units were sold at a price of $40 per unit. Under variable costing, net income would be: a)a profit of $6,000. b)a profit of $4,000. c)a loss of $2,000. d)a loss of $4,400.

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $ Sales Units2,400 Mfg: Var.48,000 Fixed30,000 SG&A: Var.9,600 Fixed20,000 Total Cost:107,600 Net Inc:

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $ Sales Units2, Mfg: Var.48,000 Fixed30,000 SG&A: Var.9,600 Fixed20,000 Total Cost:107,600 Net Inc:

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $96,00096,00096,000 Sales Units2, Mfg: Var.48,000 Fixed30,000 SG&A: Var.9,600 Fixed20,000 Total Cost:107,600 Net Inc: 2,400 units x $40

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $96,00096,00096,000 Sales Units2,4002, , Mfg: Var.48,000 Fixed30,000 SG&A: Var.9,6009,6009,600 Fixed20,00020,00020,000 Total Cost:107,600 Net Inc:

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $96,00096,00096,000 Sales Units2,4002, , Mfg: Var.48,000 Fixed30,000 SG&A: Var.9,6009,6009,600 Fixed20,00020,00020,000 Total Cost:107,600 Net Inc: Product Cost Product CostPeriod Cost

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $96,00096,00096,000 Sales Units2,4002, , Mfg: Var.48,00038,4009,600 Fixed30,000 SG&A: Var.9,6009,6009,600 Fixed20,00020,00020,000 Total Cost:107,600 Net Inc:

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $96,00096,00096,000 Sales Units2,4002, , Mfg: Var.48,00038,4009,600 38,4009,600 Fixed30,000 SG&A: Var.9,6009,6009,600 Fixed20,00020,00020,000 Total Cost:107,600 Net Inc:

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $96,00096,00096,000 Sales Units2,4002, , Mfg: Var.48,00038,4009,600 38,4009,600 Fixed30,00024,0006,000 SG&A: Var.9,6009,6009,600 Fixed20,00020,00020,000 Total Cost:107,600 Net Inc:

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $96,00096,00096,000 Sales Units2,4002, , Mfg: Var.48,00038,4009,600 38,4009,600 Fixed30,00024,0006,00030,000 SG&A: Var.9,6009,6009,600 Fixed20,00020,00020,000 Total Cost:107,600 Net Inc:

ABSORPTION vs VARIABLE COSTING Given: Absorption Variable Inc StmtEnd InvInc StmtEnd Inv Sales $96,00096,00096,000 Sales Units2,4002, , Mfg: Var.48,00038,4009,600 38,4009,600 Fixed30,00024,0006,00030,000 SG&A: Var.9,6009,6009,600 Fixed20,00020,00020,000 Total Cost:107,60092,00015,60098,0009,600 Net Inc:4,000

ABSORPTION vs VARIABLE COSTING 1.Last year, fixed manufacturing overhead was $30,000, variable production costs were $48,000, fixed selling and administration costs were $20,000, and variable selling administrative expenses were $9,600. There was no beginning inventory. During the year, 3,000 units were produced and 2,400 units were sold at a price of $40 per unit. Under variable costing, net income would be: a)a profit of $6,000. b)a profit of $4,000. c)a loss of $2,000. d)a loss of $4,400.

ABSORPTION vs VARIABLE COSTING Summary of Income Effects

DECISION-MAKING CONCERNS  Generally Accepted Accounting Principles (GAAP)  Must be followed for external reporting  Requires absorption costing for inventory  Does not differentiate between fixed and variable costs  Poor business decisions may result  Thus, variable costing used for internal decision making

DECISION-MAKING CONCERNS Example - Basic Data for Lighting Division Decision: Produce 20,000 or 30,000 units?

DECISION-MAKING CONCERNS Example – Continued  At 20,000 units, net income is $85,000.  At 30,000 units, net income is $105,000 with 10,000 unit ending inventory.  Difference in income due to $20,000 fixed costs assigned to ending inventory. Comparative Absorption Costing Income Statements Based on these statements, should production be increased?

DECISION-MAKING CONCERNS Example – Continued  At both levels, net income is $85,000.  Fixed costs treated as a period expense.  10,000 units of ending inventory include only variable costs. Comparative Variable Costing Income Statements Based on these statements, should production be increased?

ADVANTAGES OF VARIABLE COSTING  Consistent with CVP and incremental analysis  Net income unaffected by changes in production levels  Net income closely tied to changes in sales levels – not production levels  Easier to identify fixed and variable costs and their effect on company

SERVICE COMPANY PERSPECTIVE  Distinction between fixed and variable costs very relevant  Shipping companies rely heavily on variable costing for pricing decisions  When operating below full capacity, absorption costing results in a high charge per shipment  Resulting in price too high compared to competitors  Creates further decline in operations

Quiz Question 1 Fixed manufacturing overhead costs are recognized as: a.Period costs under absorption costing b.Product costs under absorption costs c.Product costs under variable costing d.Part of ending inventory costs under both absorption and variable costing

Let’s Review Fixed manufacturing overhead costs are recognized as: a.Period costs under absorption costing b.Product costs under absorption costs c.Product costs under variable costing d.Part of ending inventory costs under both absorption and variable costing