ACCT 2302 Fundamentals of Accounting II Spring 2011 Lecture 6 Professor Jeff Yu

Review: Cost Behavior  True Variable Cost (a=0, b>0)  Total cost: Y=bX, increases with X  Unit cost: Y/X=b, constant  Fixed Cost ( a>0, b=0)  Total cost: Y=a, constant  Unit cost: Y/X=a/X, decreases with X  Mixed Cost ( a>0, b>0)  Total cost: Y=a+bX, increases with X  Unit cost: Y/X=a/X + b, decreases with activity level X.

(1) Select the highest- & the lowest- activity levels: X h, X l (2) Fit a line through the two data points: (X h, Y h ), (X l, Y l ) Y h =a + bX h b=(Y h - Y l )/(X h - X l ) Y l =a + bX l a= ? The slope of the line: b = Variable Cost per unit The intercept of the line: a = Total Fixed Cost Review: Cost Function & High-low Method Cost Function: Y = a + bX

Used primarily for external reporting Used primarily for Managerial Decision making The Contribution Format Income Statement

The contribution format emphasizes cost behavior. Contribution Margin (CM) covers fixed costs and then contributes to net operating income. The Contribution Format Income Statement

Q: Prepare a contribution margin format income statement for August. Example JulyAugust Sales in units11,00010,000 Sales$165,000$150,000 Cost of goods sold 72,600 66,000 Gross margin 92,400 84,000 Selling and administrative expenses: Rent12,000 Sales commissions13,20012,000 Maintenance expenses13,50013,000 Clerical expense 16,000 15,000 Total S&A expense 54,700 52,000 Net operating income$ 37,700$ 32,000 Comparative income statements for Boggs Co. for the last two months are presented below (assume all costs are either fixed, true variable or mixed):

The 2010 income statement for Janna Company is as follows: Sales$1,600,000 Less: Cost of goods sold $1,200,000 Gross Margin$ 400,000 Less: Selling expenses$ 196,000 Administrative expenses$ 98,000 Net Income$ 106,000 The price of the product is $50 per unit and CGS is entirely variable. Variable selling expenses are $5.5 per unit. The remaining selling expenses are fixed. Variable administrative expenses are 2% of CGS. The remaining administrative expenses are fixed. Q: (1) What is the contribution margin for year 2010? (2) Let X be the number of units sold, what is the cost function for total S&A expenses? Practice Problem

Break-even point is the amount of units needed to be sold to make the company’s revenues equal to expenses (NOI = 0). Chapter 6: CVP Analysis

Sales – Variable Expenses – Fixed Expenses = NOI Unit price Units sold × VC Per Unit Units Sold × At the break-even point, NOI=0. $$$ $0 or target Profit Break-even Point: The Equation Method

Contribution Margin = NOI + Fixed Expenses Once the Break-even Point has been reached, NOI will increase by contribution margin per unit for each additional unit sold. At the Break-even Point, NOI = 0, Contribution Margin = Fixed Expenses. Break-even Point: Contribution Margin Method

 Consider Razor Inc, a scooter manufacturer. For each additional scooter sold, Razor Inc. generates $200 in contribution margin. Example Q: calculate the break-even point in units for Razor Inc.

We can calculate the break-even point in sales dollars rather than in units using the Contribution-Margin (CM) ratio. Break Even Point in Sales Dollars What is the break-even point in Sales Dollars for Razor Inc.? CM = Fixed Expenses at the break-even point

Target Profit: CM Approach Original formula: Target profit modification: We can determine the number of scooters that Razor must sell to earn a target profit of $100,000 by slightly modifying the break-even point formula:

Sales revenue – Variable expenses – Fixed expenses = NOI ($500 × X)($300 × X)––$80,000 = $100,000 ($200X)= $180,000 X = 900 units Target Profit: Equation Approach

Asphalt is a gravel making firm. Gravel is made by crushing stones. The variable cost of making gravel is estimated to be $15 per ton. The fixed costs of operating the gravel making plant for the year are $100,000. The sales price of gravel is $25 per ton. Q: (1)How many tons of gravel must Asphalt sell to break even? (2)What is the break-even point in sales dollars for Asphalt? (3)How many units you have to sell if the target profit is $100,000? (4)What will the NOI be if 11,000 tons of gravel are sold? Practice Problem

For Next Class  Continue covering Chapter 6.  Complete assigned readings.  Attempt the assigned HW problems.

Homework Problem 1 Units SoldUnit Price VC per unit CM per unit Total CMTotal fixed costs NOI 120,000$30$720,000$640, ,000$6$4$320,000 80,000$9$160,000$40,000 Fill in the blanks of the following table:

In 2010, Voltar Co. sold 20,000 units of a special telephone at $60 each, variable expenses were $900,000 and fixed expenses were $240,000. Q:(1) Compute its CM ratio and variable expense ratio. (2) Compute its break-even point in units and sales dollars. (3) How many units have to be sold to earn a profit of $90,000 in 2011? Homework Problem 2

Air Safety Systems manufactures a component used in aircraft radar systems. The firm’s fixed costs are $4,000,000 per year. The variable cost per unit is $2,000 and the sales price is $3,000 per component. The company sold 5,000 components in Q: (1) What is the breakeven point in units? (2) What is the breakeven point in units if fixed costs increase 10%? (3) What if sales price and VC per unit both decrease 10%, while other things remain unchanged? The sales manager believes that reducing sales price to $2,500 per unit will increase the sales volume to 7,500 components. (4) What will the new break-even point in units be? Should the change be made? Homework Problem 3