1. 1 CHAPTER M5 Business Decisions Using Cost Behavior © 2007 Pearson Custom Publishing

2. 2 Learning Objective 1: Describe the differences between a functional income statement and a contribution income statement. © 2007 Pearson Custom Publishing

3. 3 Functional Income Statements All financial income statements are functional income statements. All financial income statements are functional income statements. Expenses are grouped together according to their function. More specifically, they are grouped as either product costs (COGS) or period costs (selling and administrative). Expenses are grouped together according to their function. More specifically, they are grouped as either product costs (COGS) or period costs (selling and administrative). © 2007 Pearson Custom Publishing

4. 4 Functional Format Review A CD Dealer buys and sells compact discs. A CD Dealer buys and sells compact discs. Each CD is purchased at a cost of $6 and sold for $15. Each CD is purchased at a cost of $6 and sold for $15. Selling expenses last month were $10,000, when 2,000 CDs were sold. Selling expenses last month were $10,000, when 2,000 CDs were sold. Administrative expenses last month were $6,000. Administrative expenses last month were $6,000. Make an income statement for last month. Make an income statement for last month. © 2007 Pearson Custom Publishing

5. 5 Functional Income Statement

6. 6 Discussion Questions Using the functional income statement on the previous slide, answer these questions: Using the functional income statement on the previous slide, answer these questions: How many units must they sell to break even? How many units must they sell to break even? If sales increased by 10%, by what percentage would income increase? If sales increased by 10%, by what percentage would income increase? If they were to sell 100 more units, how much additional profit would there be? If they were to sell 100 more units, how much additional profit would there be? These questions are difficult to answer without having more information. These questions are difficult to answer without having more information. © 2007 Pearson Custom Publishing

7. 7 Contribution Income Statement Managers find that the contribution income statement can be more helpful when making certain types of internal decisions. Managers find that the contribution income statement can be more helpful when making certain types of internal decisions. For the contribution format, expenses are grouped together according to their cost behavior. Variable expenses are reported separately from fixed expenses. For the contribution format, expenses are grouped together according to their cost behavior. Variable expenses are reported separately from fixed expenses. © 2007 Pearson Custom Publishing

8. 8 Purpose of the Contribution Format The contribution income statement enables the manager to answer questions like those just asked about the CD Dealer. The contribution income statement enables the manager to answer questions like those just asked about the CD Dealer. With expenses organized according to cost behavior, managers find it much easier to see the potential effect of changes they may initiate in managing the business. With expenses organized according to cost behavior, managers find it much easier to see the potential effect of changes they may initiate in managing the business. © 2007 Pearson Custom Publishing

9. 9 Contribution Margin Contribution Margin Sales revenue minus variable expenses equals the contribution margin. Sales revenue minus variable expenses equals the contribution margin. To break even, a company needs to generate a large enough contribution margin to cover all of the fixed expenses. To break even, a company needs to generate a large enough contribution margin to cover all of the fixed expenses. To make a profit, a company must generate more contribution margin than its fixed expenses. To make a profit, a company must generate more contribution margin than its fixed expenses. © 2007 Pearson Custom Publishing

10. 10 Learning Objective 2: Determine per unit amounts for sales, variable costs, and the contribution margin. © 2007 Pearson Custom Publishing

11. 11 Cost Behavior for CD Dealer Assume that the expenses for CD Dealer have the following behavior patterns: Assume that the expenses for CD Dealer have the following behavior patterns: Cost of goods sold.......all variable Cost of goods sold.......all variable Selling expenses…......$4,000 variable, $6,000 fixed Selling expenses…......$4,000 variable, $6,000 fixed Admin. Expenses...…$2,000 variable, $4,000 fixed Admin. Expenses...…$2,000 variable, $4,000 fixed Compute the per unit revenue and costs for CD Dealer. Compute the per unit revenue and costs for CD Dealer. © 2007 Pearson Custom Publishing

12. 12 © 2007 Pearson Custom Publishing Cost Behavior for CD Dealer

13. 13 Learning Objective 4: Prepare and analyze a contribution income statement for a merchandising firm. © 2007 Pearson Custom Publishing

14. 14 © 2007 Pearson Custom Publishing

15. 15 Discussion Questions The CD Dealer made a $2,000 profit on sales of 2,000 units. What profit would he earn on sales of 4,000 units? The CD Dealer made a $2,000 profit on sales of 2,000 units. What profit would he earn on sales of 4,000 units? If he does sell 4,000 units, would you expect the fixed expenses to increase? If he does sell 4,000 units, would you expect the fixed expenses to increase? If he does sell 4,000 units (double the current sales), which other numbers on the statement would you expect to double? If he does sell 4,000 units (double the current sales), which other numbers on the statement would you expect to double? © 2007 Pearson Custom Publishing

16. 16 The condensed contribution income statement shown above helps to answer the kind of questions posed earlier. The condensed contribution income statement shown above helps to answer the kind of questions posed earlier. © 2007 Pearson Custom Publishing Condensed Contribution Income Statement

17. 17 Using the Contribution Margin The condensed contribution income statement clearly shows two very useful pieces of information. The condensed contribution income statement clearly shows two very useful pieces of information. The unit contribution margin (UCM) is a key element in many management decisions. For the CD Dealer, the UCM equals $6.00. Thus, each additional unit sold adds $6.00 to the monthly profit. The unit contribution margin (UCM) is a key element in many management decisions. For the CD Dealer, the UCM equals $6.00. Thus, each additional unit sold adds $6.00 to the monthly profit. © 2007 Pearson Custom Publishing

18. 18 Discussion Questions At the start business on the first day of a month, is it fair to say that the CD Dealer has a net loss of $10,000 for the month? At the start business on the first day of a month, is it fair to say that the CD Dealer has a net loss of $10,000 for the month? What would be the net loss after the first CD of the month is sold? What about after the second? After the third? What would be the net loss after the first CD of the month is sold? What about after the second? After the third? © 2007 Pearson Custom Publishing

19. 19 Learning Objective 3: Determine the contribution margin ratio and explain its importance as a management tool. © 2007 Pearson Custom Publishing

20. 20 Using the Contribution Margin The second piece of useful information is the contribution margin ratio (CMR). The second piece of useful information is the contribution margin ratio (CMR). For the CD Dealer, the CMR is 40%. This means that for any dollar increase in sales, there should be an increase in income equal to 40% of the dollar increase in sales. For the CD Dealer, the CMR is 40%. This means that for any dollar increase in sales, there should be an increase in income equal to 40% of the dollar increase in sales. © 2007 Pearson Custom Publishing

21. 21 Learning Objective 5: Describe cost-volume- profit (CVP) analysis and explain its importance as a management tool. © 2007 Pearson Custom Publishing

22. 22 Cost-Volume-Profit Analysis Cost-volume-profit analysis (CVP) is the analysis of the relationship between cost and volume and the effect of these relationships on profit. Cost-volume-profit analysis (CVP) is the analysis of the relationship between cost and volume and the effect of these relationships on profit. CVP analysis can help determine the future profitability prospects, or lack thereof, for managers, owners, or potential owners of businesses. CVP analysis can help determine the future profitability prospects, or lack thereof, for managers, owners, or potential owners of businesses. © 2007 Pearson Custom Publishing

23. 23 Break-Even Point The most basic analysis in the CVP toolbox is break-even analysis. The break-even point is the sales volume required to generate neither a profit nor a loss. The most basic analysis in the CVP toolbox is break-even analysis. The break-even point is the sales volume required to generate neither a profit nor a loss. Using the contribution income statement, the total contribution margin will equal the total fixed expenses at the break-even point. Using the contribution income statement, the total contribution margin will equal the total fixed expenses at the break-even point. © 2007 Pearson Custom Publishing

24. 24 Break-even Points in Units Break-even Point (units) = Total Fixed Costs UCM For the CD Dealer =$10,000 $6.00 =1,667 Units © 2007 Pearson Custom Publishing

25. 25 Break-even Point in Sales Dollars Break-even Point ($) = Total Fixed Costs CMR Break-even Point ($) = Total Fixed Costs CMR For the CD Dealer = $10,000.40 For the CD Dealer = $10,000.40 =$25,000 of Sales =$25,000 of Sales © 2007 Pearson Custom Publishing

26. 26 Predicting Profits Using CVP Analysis A natural extension of break-even analysis is to calculate the amount of sales volume needed to earn a certain level of profit. A natural extension of break-even analysis is to calculate the amount of sales volume needed to earn a certain level of profit. In order to earn a desired level of profit, the total contribution margin must be equal to the total fixed costs plus the desired amount of profit. In order to earn a desired level of profit, the total contribution margin must be equal to the total fixed costs plus the desired amount of profit. © 2007 Pearson Custom Publishing

27. 27 Learning Objective 6: Use CVP analysis to determine the amount of sales required to break even or to earn a targeted profit. © 2007 Pearson Custom Publishing

28. 28 Required Sales in Units to Meet Target Profits Required Unit Sales = Fixed Costs + Target Profit UCM For the CD Dealer to earn $5,000 profit: = $10,000 + $5,000 $6.00 For the CD Dealer to earn $5,000 profit: = $10,000 + $5,000 $6.00 = 2,500 Units © 2007 Pearson Custom Publishing

29. 29 Required Sales ($) to Meet Target Profits Required Sales ($) = Fixed Costs + Target Profit CMR Required Sales ($) = Fixed Costs + Target Profit CMR For the CD Dealer to earn $5,000 profit: = $10,000 + $5,000.40 For the CD Dealer to earn $5,000 profit: = $10,000 + $5,000.40 = $37,500 Sales © 2007 Pearson Custom Publishing

30. 30 CVP Graphing A CVP graph would be drawn as follows: A CVP graph would be drawn as follows: The sales revenue line would start at the origin and slope upward at a rate equal to the selling price per unit. The sales revenue line would start at the origin and slope upward at a rate equal to the selling price per unit. The total cost line would start at the amount of fixed costs, and slope upward at a rate equal to the variable cost per unit. The total cost line would start at the amount of fixed costs, and slope upward at a rate equal to the variable cost per unit. The break-even point is that volume where the revenue and cost lines intersect. The break-even point is that volume where the revenue and cost lines intersect. © 2007 Pearson Custom Publishing

31. 31 © 2007 Pearson Custom Publishing

32. 32 Learning Objective 7: Use CVP to perform sensitivity analysis. © 2007 Pearson Custom Publishing

33. 33 Sensitivity Analysis Sensitivity analysis is applied to assess the changes in the CVP analysis when changes are made in the basic parameters (price, volume, etc.) Sensitivity analysis is applied to assess the changes in the CVP analysis when changes are made in the basic parameters (price, volume, etc.) It is also called what-if analysis. For example: “What if we increased our fixed costs by 10%, while lowering our variable costs by 20%?” It is also called what-if analysis. For example: “What if we increased our fixed costs by 10%, while lowering our variable costs by 20%?” © 2007 Pearson Custom Publishing

34. 34 Change in Selling Price If the only change is in the selling price, then the contribution margin also changes in the same direction by the same amount. If the only change is in the selling price, then the contribution margin also changes in the same direction by the same amount. You would expect the break-even point and target profit volumes to change in the opposite direction of the change in selling price. If the selling price decreases, the break-even point increases. You would expect the break-even point and target profit volumes to change in the opposite direction of the change in selling price. If the selling price decreases, the break-even point increases. © 2007 Pearson Custom Publishing

35. 35 Change in Price Example Lets assume that the CD Dealer decreases the price of CDs from $15 to $14. This results in a decrease in the UCM from $6 to $5, and a decrease in the CMR from 40% to 33.3%. Lets assume that the CD Dealer decreases the price of CDs from $15 to $14. This results in a decrease in the UCM from $6 to $5, and a decrease in the CMR from 40% to 33.3%. New break-even point in units: $10,000 / $5 = 2,000 units New break-even point in units: $10,000 / $5 = 2,000 units New breakeven in dollars: $10,000 /.333 = $30,000 New breakeven in dollars: $10,000 /.333 = $30,000 © 2007 Pearson Custom Publishing

36. 36 Change in Variable Cost If the only change is in the variable cost, the contribution margin also changes in the opposite direction by the same amount. If the only change is in the variable cost, the contribution margin also changes in the opposite direction by the same amount. You would expect a change in the break- even point and target profit volumes in the same direction as the change in the variable cost. If the variable cost increases, the break-even point also increases. You would expect a change in the break- even point and target profit volumes in the same direction as the change in the variable cost. If the variable cost increases, the break-even point also increases. © 2007 Pearson Custom Publishing

37. 37 Change in Variable Cost Example The CD Dealer experiences an increase in variable costs from $9 to $11. This results in a decrease in the UCM from $6 to $4, and a decrease in the CMR from 40% to 26.7%. The CD Dealer experiences an increase in variable costs from $9 to $11. This results in a decrease in the UCM from $6 to $4, and a decrease in the CMR from 40% to 26.7%. New break-even point in units: $10,000 / $4 = 2,500 units New break-even point in units: $10,000 / $4 = 2,500 units New breakeven in dollars: $10,000 / 26.7% = $37,500 New breakeven in dollars: $10,000 / 26.7% = $37,500 © 2007 Pearson Custom Publishing

38. 38 Change in Fixed Cost If the only change is in the fixed cost, then there is no change in the contribution margin. If the only change is in the fixed cost, then there is no change in the contribution margin. You would expect a change in the break- even point and target profit volumes in the same direction as the change in fixed cost. If the fixed cost decreases, then the break- even point also decreases. You would expect a change in the break- even point and target profit volumes in the same direction as the change in fixed cost. If the fixed cost decreases, then the break- even point also decreases. © 2007 Pearson Custom Publishing

39. 39 Change in Fixed Cost Example The CD Dealer experiences a decrease in fixed costs from $10,000 to $9,000. This change has no affect on the UCM or CMR. The CD Dealer experiences a decrease in fixed costs from $10,000 to $9,000. This change has no affect on the UCM or CMR. New break-even point in units: $9,000 / $6 = 1,500 units New break-even point in units: $9,000 / $6 = 1,500 units New breakeven in dollars: $9,000 /.40 = $22,500 New breakeven in dollars: $9,000 /.40 = $22,500 © 2007 Pearson Custom Publishing

40. 40 Change in Both Costs If there are changes in both the fixed cost and the variable cost, then there will be a change in the contribution margin. If there are changes in both the fixed cost and the variable cost, then there will be a change in the contribution margin. There will most likely be a change in the break-even point and target profit volumes, but the direction of that change depends on both the direction and relative magnitude of the changes in the variable and fixed costs. There will most likely be a change in the break-even point and target profit volumes, but the direction of that change depends on both the direction and relative magnitude of the changes in the variable and fixed costs. © 2007 Pearson Custom Publishing

41. 41 Change in Both Costs Example The CD Dealer lowers variable selling costs by $1 per unit while increasing fixed selling costs by $1,900. The new UCM is $7, the new CMR is 46.7%, and the new fixed cost is $11,900. The CD Dealer lowers variable selling costs by $1 per unit while increasing fixed selling costs by $1,900. The new UCM is $7, the new CMR is 46.7%, and the new fixed cost is $11,900. Breakeven in units = $11,900 / $7 = 1,700 Breakeven in units = $11,900 / $7 = 1,700 Breakeven in $ = $11,900 /.467 = $25,500 Breakeven in $ = $11,900 /.467 = $25,500 © 2007 Pearson Custom Publishing

42. 42 Multiple Products What would we do if the CD Dealer started selling cassette tapes in addition to CDs? What would we do if the CD Dealer started selling cassette tapes in addition to CDs? In a multiple product situation, we can still perform the basic CVP calculations if we use the total amounts, rather than the per unit amounts. In a multiple product situation, we can still perform the basic CVP calculations if we use the total amounts, rather than the per unit amounts. © 2007 Pearson Custom Publishing

43. 43 Multiple Products Example Assume that the CD Dealer has prepared a contribution income statement using his sales and costs expectations for the average month in the future. Assume that the CD Dealer has prepared a contribution income statement using his sales and costs expectations for the average month in the future. Included in the sales and costs are the amounts related to both the CDs and the tapes. The statement is shown on the next slide. Included in the sales and costs are the amounts related to both the CDs and the tapes. The statement is shown on the next slide. © 2007 Pearson Custom Publishing

44. 44 Notice that the average contribution margin is now 45%, compared to 40% previously. Also, fixed costs have increased from $10,000 to $14,000. © 2007 Pearson Custom Publishing

45. 45 Discussion Questions Can you give examples of why the CD Dealer might experience an increase in monthly fixed costs when DVDs are added to the inventory? Can you give examples of why the CD Dealer might experience an increase in monthly fixed costs when DVDs are added to the inventory? Since the income statement shows a doubling of profit from $2,000 to $4,000, should the owner add DVDs without question? Since the income statement shows a doubling of profit from $2,000 to $4,000, should the owner add DVDs without question? © 2007 Pearson Custom Publishing

46. 46 Multiple Product Break-Even Point For the CD and DVD Dealer, the break- even point can now be calculated as follows: For the CD and DVD Dealer, the break- even point can now be calculated as follows: Fixed cost = $14,000 =$31,111 Fixed cost = $14,000 =$31,111 Avg. CMR.45 Avg. CMR.45 © 2007 Pearson Custom Publishing

47. 47 Multiple Product Target Profit Prior to adding DVDs, the CD Dealer earned a monthly profit of $2,000 on sales of $30,000. What sales volume is now required to earn that same $2,000 profit? Prior to adding DVDs, the CD Dealer earned a monthly profit of $2,000 on sales of $30,000. What sales volume is now required to earn that same $2,000 profit? Fixed + Profit =$16,000 = $35,556 Fixed + Profit =$16,000 = $35,556 Avg. CMR.45 Avg. CMR.45 © 2007 Pearson Custom Publishing

48. 48 Discussion Questions The addition of DVDs caused the expected profit to increase, but also caused the break- even point to increase. Does this indicate a greater risk of loss for the business? The addition of DVDs caused the expected profit to increase, but also caused the break- even point to increase. Does this indicate a greater risk of loss for the business? The target profit analysis shows that sales will have to be $5,556 higher than the current level of $30,000 just to earn the same $2,000 income that is currently earned. Does that sound right? What would you do? The target profit analysis shows that sales will have to be $5,556 higher than the current level of $30,000 just to earn the same $2,000 income that is currently earned. Does that sound right? What would you do? © 2007 Pearson Custom Publishing

49. 49 Simplifying Assumptions The following five assumptions are made when performing CVP analysis as described in this chapter: The following five assumptions are made when performing CVP analysis as described in this chapter: 1. All costs are either fixed or variable. 2. Total fixed costs remain fixed throughout the relevant range. (continued on next slide) (continued on next slide) © 2007 Pearson Custom Publishing

50. 50 Simplifying Assumptions 3. Variable cost per unit remains stable throughout the relevant range. 4. Selling prices remain stable throughout the relevant range. 5. Average contribution margin ratio for multiple products remains stable throughout the relevant range. © 2007 Pearson Custom Publishing

51. 51 The End of Chapter M5 © 2007 Pearson Custom Publishing