1 INTRODUCTION TO MANAGERIAL ACCOUNTING Lecture 3 & 4

2 Learning Aims To be able to analyze the distribution format in the income statement. To be able to understand the basics of Cost Volume Profit Analysis. To be able to prepare CVP elements: Break-even Analysis, Target profit analysis and margin of safety.

3 Income Statement Presents the results of operations for a period of time. –Income – the sales revenue shows the income from goods/services sold in the year. –Expenses – in order to make revenues we must incur expenses: an outflow of money to pay for an item or service e.g. wages, rents, electricity e.t.c The income statement is split into two parts a) the Trading account which gives the gross profit and b) the Profit & Loss account which gives us the Net Profit.

4 RETAIL FIRM: Trading and Profit & Loss account Opening Stock of ready goods Add Purchases of ready goods Less Purchases Return Less Closing stock of ready goods € X X X X Gross Profit c/d Operating expenses Selling Expenses Administrative Expenses X X X X X Sales Less Sales Returns X € X X X Cost of Sales X X Gross Profit b/d Net Profit X X X X TRADITIONAL FORMAT

5 MANUFACTURING COMPANY: Trading and Profit & Loss account Opening Stock of finished goods Add Purchases of ready goods Add: Cost of Production (Cost of goods manufactured) Less Closing stock of finished goods € X X X X Gross Profit c/d X X X X X Sales Less Sales Returns X € X X X Cost of Sales X X Gross Profit b/d Net Profit X X X X Operating expenses Selling Expenses Administrative Expenses TRADITIONAL FORMAT

6 The Contribution Format of the Income Statement Is the format which distinguish the costs according to their behavior: variable or fixed. The reason we do this is to help internally the managers through the grouping of cost data into the format which will make easy the planning, controlling and decision making. This format is not available to people outside the business. A contribution margin income statement is an income statement in which all variable expenses are deducted from sales to arrive at a contribution margin, from which all fixed expenses are then deducted to arrive at the net profit or loss for the period. As sales increase, the contribution margin will increase in combination with sales, while fixed costs remain (approximately) the same.

7 MANUFACTURING COMPANY: Trading and Profit & Loss account VARIABLE EXPENSES: Variable manufacturing expenses € X X X Contribution Margin c/d X X X X X Sales Less Sales Returns X € X X X Variable Administrative Expenses X Contribution Margin b/d Net Profit X X X X CONTRIBUTION FORMAT Variable Selling Expenses X FIXED COSTS: Fixed manufacturing expenses Fixed Selling Expenses Fixed Administrative Expenses

8 In a traditional Format the ‘cost of goods sold’ contains both variable and fixed expenses and when we apply a contribution format the ‘cost of goods sold’ is divided between variable production costs and fixed production costs.

9 COST-VOLUME-PROFIT ANALYSIS CVP Cost – Volume – Profit (CVP) analysis is a powerful tool that helps managers understand the relationships among cost, volume and profit and then make decisions. CVP analysis focuses on how profits are affected by the following five factors: –Selling prices –Sales volume –Per Unit Variable Costs –Total Fixed Costs –Mix of Products sold

10 Some examples of decisions where Cost-Volume-Profit analysis can provide help are: What price(s) should we charge for our products or services ? How many units of a product should we produce ? Should we spend more on advertising ? Should we add or delete a product line ? Should we accept or decline a special order ? What sales mix (different products) should we strive for ? What is the effect of a change to a different raw material supplier ? Should we increase or decrease our work force ? How should we make our products ?

The contribution Margin Income Statement Sales - Variable Costs =Contribution Margin - Fixed Costs = Net Profit/Loss 11 The contribution income statement helps managers to be aware of the impact of changes in selling price, cost and volume.

The contribution Margin Income Statement: Income statement that groups cost by behavior – variable costs or fixed costs – and highlights the contribution margin. Contribution Margin: it is called the contribution margin because the excess of sales revenue over variable costs contributes to covering fixed costs and then to providing net profit (operating income). 12

13 Examples: The A company is selling one unit of its product for €250. It has variable expenses €150 per unit and total fixed expenses € ) If it sells only 1 product: Contribution Income Statement Total € Per Unit € Sales (1 unit) Less: Variable exps (150) (150) Contribution Margin Less: Fixed exps (35000) NET LOSS (34900) For each additional product that the company can sell €100 contribution margin will become available to cover the fixed costs

14 2) How many units the business must sell in order to reach at break even point? Break even point is the number of units sold at which the company has neither profit nor loss but it just covers all of its costs. This point in our example is realized when we sell 350 units: Contribution Income Statement Total € Per Unit € Sales (350*250) Less: Variable exps (52500) (150) (350*150) Contribution Margin Less: Fixed exps (35000) NET PROFIT / LOSS (0)

15 Once the break-even point has been reached the net income will increase for each additional unit sold. For e.g. if 352 units are sold (2 units above the break even point then the net profit will be €200 and so forth. An easy way to calculate the net profit is to multiply the contribution margin with the extra units, in this case is €100*2= €200

TWO RELATIONSHIPS IN THE CONTRIBUTION MARGIN INCOME STATEMENT CM RATIO and VARIABLE COSTS TO SALES RELATION 16

17 Contribution Margin Ratio ( CM Ratio) Contribution margin ratio can be used to calculate cost – volume – profit. The CM Ratio is the expression of contribution margin as percentage of total sales: CM RATIO = Total Contribution Margin Total Sales The CM Ratio is a useful tool because it shows how the contribution margin will be affected by a change in total sales. The relationship between profit and the CM ratio can be expressed using the following equation: Profit = CM Ratio X Sales – Fixed Expenses If fixed expenses do not change the net profit will be increased by the same amount as the contribution margin.

VARIABLE COSTS TO SALES RELATION = VARIABLE COSTS SALES 18

19 The Cost Volume Profit Analysis can help find out the most profitable combination of fixed costs, variable costs, selling price and sales volume. The examples following shows how. Some Applications of CVP Analysis

1. CHANGE IN FIXED COST AND SALES VOLUME Example: The A company sold 400 units of its product and fixed exps are € But the sales manager believes that if they increase by €10,000 the advertising cost the sales will be increased by €30,000, which means they will sell totally 520 units of product. Should the advertising be increased? Solution 1: Contribution Income Statement Current Sales with Per Unit € Sales € Incr. in Adv € Sales (400*250) (520*250) 250 Less:Variable exps (400*150) (60000) (78000) (520*150) (150) Contribution Margin Less: Fixed exps (35000) (45000) NET PROFIT Solution 2: CM Ratio= 40000=0.4=40% Increase in contribution margin *40%= Less Increase in F.Exps Increase in Net Profit 2000 Increase in Profit €2000

21 2. CHANGE IN VARIABLE COST AND SALES VOLUME Example: The management of the A company believes that if they use higher quality materials which will increase the variable costs by €10 per unit the sales will be increased to 480 from 400.Should the quality be improved? Solution 1: Contribution Income Statement Current Sales with Per Unit after Sales € in V.C € the change € Sales (400*250) (480*250) 250 Less:Variable exps (400*150) (60000) (76800) (480*160) (160) Contribution Margin Less: Fixed exps (35000) (35000) NET PROFIT Solution 2: The new Contribution Margin will be decreased by €10 since the variable cost will be increased by € *90= Less Initial C.M Increase in Total C.M 3200 Increase in Profit €3200 Increase in C.M €3200 THE NET PROFIT INCREASED AT THE SAME AMOUNT AS C.M (recall slide 14)

22 3. CHANGE IN FIXED COST,SALES PRICE AND SALES VOLUME Example: The sales manager of the A company believes that if they cut down the sales price by €20 and increase advertising by €15000 the sales will be increased to 600 from 400.Should they realize those thoughts? NO Solution 1: Contribution Income Statement Current Sales with Per Unit after Sales € in Price € the change € Sales (400*250) (600*230) 230 Less:Variable exps (400*150) (60000) (90000) (600*150) (150) Contribution Margin Less: Fixed exps (35000) (50000) NET PROFIT/LOSS 5000 (2000) Solution 2: The new Contribution Margin will be decreased by €20 since the Sale price will be reduce by € *80= Less previous C.M (40000) Increase in C.M 8000 Less increase in Fixed Costs (15000) Decrease in profit (7000) Reduce in Profit by (€7000)

23 4. CHANGE IN FIXED COST,VARIABLE COST AND SALES VOLUME Example: The sales manager of the A company believes that if they pay sales commissions of €15 per unit sold, rather than pay salespersons flat salary €6000 per month, the sales will be increased to 460 from 400.Should they realize those thoughts? Solution 1: Contribution Income Statement Current Sales with Per Unit after Sales € in V.C € the change € Sales (400*250) (460*250) 250 Less:Variable exps (400*150) (60000) (75900) (460*165) (165) Contribution Margin Less: Fixed exps (35000) (29000) NET PROFIT/LOSS Solution 2: The new Contribution Margin will be decreased by €15 since the Variable cost will be rise by € *85= Less previous C.M (40000) Increase in C.M (900) Add decrease in Fixed Costs 6000 Increase in profit 5100 Increase in Profit €5100

24 Important Elements of CVP Analysis Break-Even element Is the level of sales at which the company profit is zero. Is important to know this level so as to Estimate how far the sales could drop before the company begins to loose money. Two methods to compute Break-even-point: A) The equation method and B) The contribution margin method

25 A) The equation method: Profit= Sales – variable costs – fixed costs therefore Sales= Profits + variable costs +fixed costs Example: The A company is selling one unit of its product for €250. it has variable expenses €150 per unit and total fixed expenses € What is the level of sales at which it has break even? Q*250=Q* =>Q*250-Q*150=35000 =>100Q=35000 =>Q=350 total units So the break even in total euro sales is 350*250= €87500

26 B) The contribution margin method: Is based on the idea show at the beginning where:each unit sold gives a certain amount of contribution margin that goes toward covering fixed costs. Break-even-point = Fixed Expenses Contribution margin per unit Example 1 slide 11: BEP=35000=350 units 100 If we wish to find the BEP in total euro sales, which is useful for companies that have multiple product lines and they want to compute a single break even point for the company as a whole, we use the following Calculation: Break-even-point = Fixed Expenses CM Ratio

27 Target profit analysis The CVP formulas are used to estimate the volume of sales needed to achieve a target profit. We use the equation method of break-even to calculate this. Example: If our target is to reach the € and all other data are the same as example 1 how many units we must sell in order to gain € profits? Profit= Sales – variable costs – fixed costs => 40000=Q*250-Q* =>40000=100*Q =>Q=75000 =750 units must be sold 100

28 The Margin of Safety Is the excess of budgeted (or actual) sales euro over the break – even volume of sales euro. It is the amount by which sales can drop before losses are incurred. The higher the margin of safety, the lower the risk of not breaking even and incurring a loss. The formula for the margin of safety is: Margin of Safety in euro = Total Budgeted (or actual) sales – Break even sales

29 Example: If we sell at the present 400 units of €250 each and we found before that the BEP is at 350 units the margin of safety is: Actual sales 400* € 250= 100,000 Break-even-point at 350*250= (87,500) Margin of safety € 12,500 This means that the company can not drop its sales more than € 12,500 because then it will face losses.