# ch06

```Managerial Accounting
Eighth Edition
Weygandt Kimmel Kieso
Chapter 6
Issues
This slide deck contains animations. Please disable animations if they cause issues with your
device.
Chapter Outline
Learning Objectives
LO 1 Apply basic CVP concepts.
LO 2 Explain the term sales mix and its effects on breakeven sales.
LO 3 Determine sales mix when a company has limited
resources.
LO 4 Indicate how operating leverage affects profitability.
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
2
Basic CVP Concepts
LEARNING OBJECTIVE 1
Apply basic CVP concepts.
CVP analysis:
• Study of the effects of changes in costs and volume on a
company’s profit.
• Important to profit planning.
• Critical in management decisions such as:
o
o
o
LO 1
determining product mix,
maximizing use of production facilities,
setting selling prices.
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
3
Basic CVP Concepts
Basic Concepts
• Management often wants the information reported in a special format income
statement.
• CVP income statement is for internal use only:
o
o
LO 1
Costs and expenses classified as fixed or variable.
Reports contribution margin as a total amount and on a per unit basis.
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
4
Basic CVP Concepts
Basic CVP income statement
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
5
Basic CVP Concepts
Detailed CVP income statement
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
6
Break-Even Analysis
Break-even point in units
Vargo Electronic’s CVP income statement (Ill. 6.2) shows
that total contribution margin is \$320,000, and the
company’s contribution margin per unit is \$200.
Contribution margin can also be expressed as the
contribution margin ratio which is 40% (\$200 &divide; \$500).
Fixed Costs
&divide;
Unit Contribution
=
Break - Even
Margin
\$200, 000
LO 1
&divide;
\$200
Point in Units
=
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
1, 000 units
7
Break-Even Analysis
Break-even point in dollars
Vargo Electronic’s CVP income statement (Ill. 6.2) shows
that total contribution margin is \$320,000, and the
company’s contribution margin per unit is \$200.
Contribution margin can also be expressed as the
contribution margin ratio which is 40% (\$200 &divide; \$500).
Fixed Costs
&divide;
Unit Contribution
=
Break - Even
Ratio
\$200, 000
LO 1
&divide;
.40
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
Point in Dollars
=
\$500, 000
8
Target Net Income
Target net income in units
Once a company achieves break-even sales, a sales goal
can be set that will result in a target net income
Illustration: Assuming Vargo’s target net income is
\$250,000, compute required sales in units to achieve
target net income :
(Fixed Costs
&divide;
+ Target Net Income)
Unit Contribution
= Sales in Units
Margin
(\$200, 000 + \$250, 000)
&divide;
\$200
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
=
2, 250 units
9
Target Net Income
Target net income in dollars
Once a company achieves break-even sales, a sales goal
can be set that will result in a target net income
Illustration: The contribution margin ratio is used to
compute required sales in dollars.
(Fixed Costs
&divide;
+ Target Net Income)
Contribution
= Sales in Dollars
Margin Ratio
(\$200, 000 + \$250, 000)
&divide;
.40
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
=
\$1,125, 000
10
Margin of Safety
Margin of safety in dollars
• tells us how far sales can drop before the company will
operate at a loss.
• can be expressed in dollars or as a ratio.
Illustration: Assume Vargo’s sales are \$800,000:
Actual (Expected)
Sales
\$800, 000
LO 1

Break - Even
=
Sales

\$500, 000
Margin of Safety
in Dollars
=
\$300, 000
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
11
Margin of Safety
Margin of safety ratio
• tells us how far sales can drop before the company will
operate at a loss.
• can be expressed in dollars or as a ratio.
Illustration: Vargo’s sales could drop by \$300,000, or
37.5%, before the company would operate at a loss
Margin of Safety
&divide;
in Dollars
\$300, 000
LO 1
Actual
=
(Expected) Sales
&divide;
\$800, 000
Margin of Safety
Ratio
=
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
37.5%
12
CVP and Changes in the Bus. Environment
Illustration: Original cell phone sales and cost data
for Vargo Electronics is as shown.
LO 1
Unit selling price
Unit variable cost
Total fixed costs
\$500
\$300
\$200,000
Break-even sales
\$500,000 or 1,000 units
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
13
CVP and Changes in the Bus. Environment
Case I
A competitor is offering a 10% discount on the selling
price of its camcorders. What effect will a 10% discount
on selling price (\$500 &times; 10% = \$50) have on the
breakeven point?
Fixed Costs
&divide;
Unit Contribution
=
Break - Even
Margin
\$200, 000
&divide;
\$150
(\$450  \$300)
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
Sales
=
1, 333 units
(rounded)
14
CVP and Changes in the Bus. Environment
Case II
Management invests in new equipment that will lower the
amount of direct labor required to make cell phones. They
estimate that total fixed costs will increase 30% and
variable cost per unit will decrease 30%. What effect will
the new equipment have on the sales volume required to
break even?
Fixed Costs &divide; Unit Contribution
=
Margin
\$260, 000 &divide;
(\$500  \$210)
Break - Even
Sales
=
897 units
(rounded)
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
15
CVP and Changes in the Bus. Environment
Case III
Vargo’s principal supplier of raw materials has just
announced a price increase. The higher cost is expected
to increase the variable cost of cell phones by \$25 per
unit. Management plans a cost-cutting program that will
save \$17,500 in fixed costs per month. Vargo is currently
realizing monthly net income of \$80,000 on sales of
1,400 cell phones. What increase in units sold will be
needed to maintain the same level of net income?
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
16
CVP and Changes in the Bus. Environment
Case III continued
Variable cost per unit increases to \$325 (\$300 + \$25).
Fixed costs are reduced to \$182,500 (\$200,000 − \$17,500).
Contribution margin per unit becomes \$175 (\$500 − \$325).
(Fixed Cost +
&divide;
Target Net Income)
(\$182, 500 + \$80, 000) &divide;
LO 1
Unit Contribution =
Sales in
Margin
Units
\$175
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
=
1, 500
17
Basic CVP Concepts
Question
Croc Catchers calculates its contribution margin to be less
than zero. Which statement is true?
a. Its fixed costs are less than the variable cost per unit.
b. Its profits are greater than its total costs.
c. The company should sell more units.
d. Its selling price is less than its variable costs.
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
18
Basic CVP Concepts
Croc Catchers calculates its contribution margin to be less
than zero. Which statement is true?
a. Its fixed costs are less than the variable cost per unit.
b. Its profits are greater than its total costs.
c. The company should sell more units.
d. Answer: Its selling price is less than its variable costs.
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
19
Do It! 1: CVP Analysis
Krisanne Company reports the following for June.
Total
Sales (5,000 units)
Per Unit
\$300,000
\$60
Variable costs
180,000
36
Contribution margin
120,000
\$24
Fixed expenses
100,000
Net income
\$ 20,000
To increase net income, management is considering reducing
the selling price by 10%, with no changes to unit variable costs
or fixed costs. Management is confident that this change will
increase unit sales by 25%.
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
20
Do It! 1: CVP Analysis
Solution
Using the contribution margin technique, compute the breakeven point in units and dollars and margin of safety in dollars
assuming no changes to sales price or costs.
Break-even point in units = 4,167 units (rounded) (\$100,000 &divide; \$24)
Break-even point in sales dollars = \$250,000 (\$100,000 &divide; .40a )
Margin of safety in dollars = \$50,000 (\$300,000 − \$250,000)
a
\$24 &divide; \$60
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
21
Do It! 1: CVP Analysis
Solution continued
Using the contribution margin technique, compute the
break-even point in units and dollars and margin of safety
in dollars assuming changes to sales price and volume as
described.
Break-even point in units =
5,556 units (round) (\$100,000 &divide; \$18b )
Break-even point in sales dollars = \$300,000 (\$100,000 &divide; (\$18 &divide; \$54c ))
Margin of safety in dollars = \$37,500 (\$337,500d  \$300,000)
b
(\$60  (.10  \$60)  36 = \$18)
c
(\$60  (.10  \$60)
d
(5,000 + (.25 &times; 5,000) = 6,250 units, 6, 250 units &times; \$54 = \$337,500)
LO 1
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
22
Sales Mix and Break-Even Sales
LEARNING OBJECTIVE 2
Explain the term sales mix and its effects on break-even
sales.
• 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% to 20%.
• Sales mix is important because different products often
have very different contribution margins.
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
23
Break-Even Sales in Units
Sales mix as a percentage of units sold
Companies can compute break-even sales for a mix of two
or more products by determining the weighted-average
unit contribution margin of all the products.
Illustration: Vargo Electronics sells not only cell phones
but high-definition TVs. Vargo sells its products in the
following amounts: 1,500 cell phones and 500 TVs.
TVs
Cell Phones
1,500 units &divide; 2,000 units = 75% 500 units &divide; 2,000 units = 25%
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
24
Break-Even Sales in Units
Per unit data-sales mix
Additional information related to Vargo Electronics.
TVs
Cell Phones
1,500 units &divide; 2,000 units = 75% 500 units &divide; 2,000 units = 25%
Unit Data
Cell Phones TVs
Selling price
\$500
\$1,000
Variable costs
300
500
Contribution margin
\$200
\$ 500
Sales mix—units
75%
25%
Fixed costs = \$275,000
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
25
Break-Even Sales in Units
Weighted-average unit contribution margin
First, determine weighted-average contribution margin.
Unit Data
Cell Phones TVs
Selling price
\$500
\$1,000
Variable costs
300
500
Contribution margin
\$200
\$ 500
Sales mix—units
75%
25%
Fixed costs = \$275,000
Cell Phones
TVs
(Unit Contribution
Margin &times; Sales Mix
Percentage)
+
(Unit Contribution
Margin &times; Sales Mix
Percentage)
=
Weighted-Average Unit
Contribution Margin
(\$200 &times; .75)
+
(\$500 &times; .25)
=
\$275
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
26
Break-Even Sales in Units
For a given sales mix
First, determine weighted-average contribution margin.
Cell Phones
TVs
(Unit Contribution
Margin &times; Sales Mix
Percentage)
+
(Unit Contribution
Margin &times; Sales Mix
Percentage)
=
Weighted-Average Unit
Contribution Margin
(\$200 &times; .75)
+
(\$500 &times; .25)
=
\$275
Fixed Cost
&divide;
Weighted - Average Unit = Break - Even
Contribution Margin
\$275,000
LO 2
&divide;
\$275
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
Point in Units
=
1, 000 Units
27
Break-Even Sales in Units
Break-even proof – sales units
• With break-even point of 1,000 units, Vargo must sell:
o
o
750 cell phones (1,000 units &times; 75%)
250 TVs (1,000 units &times; 25%)
• At this level, the total contribution margin will equal the
fixed costs of \$275,000.
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
28
Break-Even Sales in Dollars
• Works well if company has many products.
• Calculates break-even point in terms of sales dollars for
o
o
o
LO 2
divisions or
product lines,
not individual products.
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
29
Break-Even Sales in Dollars
Cost-volume-profit data
Kale Garden Supply Company has two divisions.
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
30
Break-Even Sales in Dollars
Weighted aver. cont. margin and break-even point
Determine weighted-average contribution margin.
Indoor Plant
Division
Outdoor Plant
Division
(Contribution Margin
Ratio &times; Sales Mix
Percentage)
+
(Contribution Margin
Ratio &times; Sales Mix
Percentage)
=
Weighted-Average
Contribution Margin
Ratio
(.40 &times; .20)
+
(.30 &times; .80)
=
.32
Calculate break-even point in dollars.
Fixed Cost
&divide;
Weighted - Average
Contribution Margin Ratio
\$300, 000
LO 2
&divide;
.32
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
=
Break - Even
Point in Dollars
= \$937, 500
31
Break-Even Sales in Dollars
• With break-even sales of \$937,500 and a sales mix of
20% to 80%, Kale must sell:
o
o
\$187,500 from the Indoor Plant division
\$750,000 from the Outdoor Plant division
• If sales mix becomes 50% to 50%, the weighted average
contribution margin ratio changes to 35%, resulting in a
lower break-even point of \$857,143.
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
32
Break-Even Sales in Dollars
Question
Net income will be:
a. Greater if more higher-contribution margin units are
sold than lower-contribution margin units.
b. Greater is more lower-contribution margin units are
sold than higher-contribution margin units.
c. Equal as song as total sales remain equal, regardless of
which products are sold.
d. Unaffected by changes in the mix of products sold.
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
33
Break-Even Sales in Dollars
Net income will be:
a. Answer: Greater if more higher-contribution margin
units are sold than lower-contribution margin units.
b. Greater is more lower-contribution margin units are
sold than higher-contribution margin units.
c. Equal as song as total sales remain equal, regardless of
which products are sold.
d. Unaffected by changes in the mix of products sold.
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
34
Do It! 2: Sales Mix Break Even
Part (a)
Manzeck Bicycles International produces and sells three
different types of mountain bikes. Information regarding
the three models is shown below.
Pro
Intermediate
Standard
Total
Units sold
5,000
10,000
25,000
40,000
Selling price
\$800
\$500
\$350
Variable costs
\$500
\$300
\$250
The company’s total fixed costs are \$7,500,000.
(a) Determine the sales mix as a function of units sold for
the three products.
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
35
Do It! 2: Sales Mix Break Even
Solution for part (a)
(a) Determine the sales mix as a function of units sold for
the three products.
Pro
Intermediate Standard
Units sold
5,000
10,000
25,000
Selling price
\$800
\$500
\$350
\$500
\$300
\$250
Variable costs
Solution
Total
40,000
5,000
= 12.5%
40,000
10,000
Intermediate =
= 25%
40,000
25, 000
Standard =
= 62.5%
40, 000
Pro =
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
36
Do It! 2: Sales Mix Break Even
Part (b) with solution
(b) Determine the weighted-average unit contribution
margin.
Pro
Intermediate Standard
Units sold
5,000
10,000
25,000
Selling price
\$800
\$500
\$350
Variable costs
\$500
\$300
\$250
Total
40,000
Solution
[.125 &times; (\$800 - \$500)] +
[. 25 &times; (\$500 - \$300)] +
[ .625 &times; (\$350 - \$250)] = \$150
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
37
Do It! 2: Sales Mix Break Even
Part (c) with solution
(c) Determine the total number of units that the company
must sell to break even.
Pro
Intermediate Standard
Units sold
5,000
10,000
25,000
Selling price
\$800
\$500
\$350
Variable costs
\$500
\$300
\$250
Total
40,000
Solution
\$7,500,000 &divide; \$150 = 50,000 units
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
38
Do It! 2: Sales Mix Break Even
Part (d) with solution
(d) Determine the number of units of each model that the
company must sell to break even.
Pro
Intermediate Standard
Units sold
5,000
10,000
25,000
Selling price
\$800
\$500
\$350
Variable costs
\$500
\$300
\$250
Total
40,000
Solution
Pro:
50,000 units &times; 12.5%
=
6,250 units
Intermediate:
50,000 units &times; 25%
=
12,500 units
Standard:
50,000 units &times; 62.5%
=
31,250 units
50,000 units
LO 2
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
39
Sales Mix with Limited Resources
LEARNING OBJECTIVE 3
Determine sales mix when a company has limited
resources.
• All companies have limited resources whether it be
floor space, raw materials, direct labor hours, etc.
• Management must decide which products to sell to
maximize net income.
Illustration: Vargo manufactures cell phones and TVs.
Machine capacity is limited to 3,600 hours per month.
Unit contribution margin
Machine hours required per unit
LO 3
Cell Phones
TVs
\$200
\$500
.2
.625
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
40
Sales Mix with Limited Resources
• Approach used to identify and manage constraints so as
to achieve company goals.
• Company must continually
o
o
LO 3
identify its constraints and
find ways to reduce or eliminate them, where appropriate.
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
41
Sales Mix with Limited Resources
Contribution margin per unit of limited resource
Calculate the contribution margin per unit of limited
resource.
Cell Phones
Unit contribution margin
Machine hours required per unit
Contribution margin per unit of
Limited resource [(a) &divide; (b)]
TVs
\$200
\$500
.2
.625
\$1,000
\$800
Management should produce more cell phones if demand
exists or increase machine capacity.
LO 3
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
42
Sales Mix with Limited Resources
Question
If the contribution margin per unit is \$15 and it takes 3.0
machine hours to produce the unit, the contribution
margin per unit of limited resource is:
a. \$25.
b. \$5.
c. \$4.
d. No correct answer is given.
LO 3
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
43
Sales Mix with Limited Resources
If the contribution margin per unit is \$15 and it takes 3.0
machine hours to produce the unit, the contribution
margin per unit of limited resource is:
a. \$25.
c. \$4.
d. No correct answer is given.
LO 3
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
44
Do It! 3: Sales Mix with Limited Resources
Carolina Corporation manufactures and sells three
different types of high-quality sealed ball bearings for
mountain bike wheels. The bearings vary in terms of their
quality specifications—primarily with respect to their
smoothness and roundness. They are referred to as Fine,
Extra-Fine, and Super-Fine bearings. Machine time is
limited. More machine time is required to manufacture the
Extra-Fine and Super-Fine bearings.
LO 3
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
45
Do It! 3: Sales Mix with Limited Resources
Selling price
Variable costs and expenses
Contribution margin
Machine hours required
LO 3
Fine
Extra Fine
Super Fine
\$6.00
\$10.00
\$16.00
4.00
6.50
11.00
\$2.00
\$3.50
\$5.00
0.02
0.04
0.08
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
46
Do It! 3: Sales Mix with Limited Resources
Solution
Selling price
Variable costs and expenses
Contribution margin
Machine hours required
Fine
Extra Fine
Super Fine
\$6.00
\$10.00
\$16.00
4.00
6.50
11.00
\$2.00
\$3.50
\$5.00
0.02
0.04
0.08
What is the contribution margin per unit of limited
resource for each type of bearing?
Fine
Unit contribution margin
Limited resource consumed per unit
LO 3
\$2
 \$100
.02
Extra Fine
Super Fine
\$5
\$3.5
 \$62.50
 \$87.50
.08
.04
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
47
Operating Leverage and Profitability
LEARNING OBJECTIVE 4
Indicate how operating leverage affects profitability.
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.
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
48
Operating Leverage and Profitability
Vargo Electronics and one of its competitors, New Wave Company.
Both make cell phones. Vargo uses a traditional, labor-intensive
manufacturing process. New Wave has invested in a completely
automated system. The factory employees are involved only in
setting up, adjusting, and maintaining the machinery.
Vargo
Sales
New Wave
\$800,000
\$800,000
Variable costs
480,000
160,000
Contribution margin
320,000
640,000
Fixed costs
200,000
520,000
Net income
\$120,000
\$120,000
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
49
Operating Leverage and Profitability
CVP income statements for two companies
Vargo
New Wave
\$800,000
\$800,000
Variable costs
480,000
160,000
Contribution margin
320,000
640,000
Fixed costs
200,000
520,000
Net income
\$120,000
\$120,000
Sales
Contribution Margin  Sales = Contribution
Margin Ratio
\$320,000

\$800, 000

40%
New Wave \$640,000

\$800, 000

80%
Vargo
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
50
Operating Leverage and Profitability
Contribution margin ratio for two companies
Contribution Margin  Sales = Contribution
Margin Ratio
Vargo
\$320,000

\$800, 000

40%
New Wave
\$640,000

\$800, 000

80%
• 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.
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
51
Effect on Break-Even Point
Fixed Costs  Contribution Margin Ratio = Break - even
Point in Dollars
Vargo
\$200,000

.40

\$500, 000
New Wave
\$520,000

.80

\$650, 000
• 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.
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
52
Effect on Margin of Safety
(Actual sales – Break-Even
Sales)
&divide;
Actual
Sales
=
Margin of
Safety Ratio
Vargo
Electronics
(\$800,000 − \$500,000)
&divide;
\$800,000
=
38%
New Wave
(\$800,000 − \$650,000)
&divide;
\$800,000
=
19%
• 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.
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
53
Operating Leverage
• 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, too much operating
leverage can have devastating consequences.
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
54
Degree of Operating Leverage
• Provides a measure of a company’s earnings volatility.
• Computed by dividing total contribution margin by net
income.
Contribution Margin  Net Income = Degree of
Operating
Leverage
Vargo
\$320,000
&divide;
\$120,000
= 2.67
New Wave \$640,000
&divide;
\$120,000
= 5.33
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
55
Operating Leverage
Question
The degree of operating leverage:
a. Can be computed by dividing total contribution margin
by net income.
b. Provides a measure of the company’s earnings
volatility.
c. Affects a company’s break-even point.
d. All of the above.
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
56
Operating Leverage
The degree of operating leverage:
a. Can be computed by dividing total contribution margin
by net income.
b. Provides a measure of the company’s earnings
volatility.
c. Affects a company’s break-even point.
d. Answer: All of the above.
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
57
Do It! 4: Operating Leverage
Rexfield Corp., a company specializing in crime scene
investigations, is contemplating an investment in
automated mass-spectrometers. Its current process relies
on a high number of lab technicians. The new equipment
would employ a computerized expert system. The
company’s CEO has requested a comparison of the old
technology versus the new technology. The accounting
department has prepared the following CVP income
statements for use in your analysis.
LO 4
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
58
Do It! 4: Operating Leverage
Solution
Old
Sales
New
\$2,000,000
\$2,000,000
1,400,000
600,000
Contribution margin
600,000
1,400,000
Fixed costs
400,000
1,200,000
Net income
\$200,000
\$200,000
Variable costs
Compute the degree of operating leverage.
Contribution Margin  Net Income = Degree of
Operating
Leverage
Old \$600,000
LO 4
&divide;
\$200,000
=
3.00
New \$1,400,000 &divide;
\$200,000
=
7.00
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
59
Absorption Costing versus Variable Costing
Under variable costing, product costs consist of:
• Direct Materials
• Direct Labor
Difference between absorption and variable costing is:
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
60
Absorption Costing versus Variable Costing
Differences
The difference between absorption and variable costing:
• Under both costing methods, selling and administrative
expenses are treated as period costs.
• Companies may not use variable costing for external
financial reports because GAAP requires that fixed
manufacturing overhead be treated as a product cost.
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
61
Absorption versus Variable Costing
Illustration
Premium Products Corporation manufactures a sealant, called FixIt, for car windshields. Relevant data for Fix-It in January 2020, the
first month of production is shown.
Selling price
\$20 per unit.
Units Produced
30,000; sold 20,000; beginning inventory zero.
Variable unit costs
Manufacturing \$9 (direct materials \$5, direct
labor \$3, and variable overhead \$1).
Fixed costs
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
62
Absorption versus Variable Costing
Contribution of per unit manufacturing cost
Type of Cost
Absorption Variable
Direct materials
\$5
\$5
Direct labor
3
3
1
1
4
0
\$13
\$9
(\$120,000 &divide; 30,000 units produced)
Manufacturing cost per unit
Manufacturing cost per unit is \$4 (\$13 − \$9) higher for absorption
costing because fixed manufacturing costs are treated as product
costs.
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
63
Absorption Costing Example
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
64
Variable Costing Example
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
65
Absorption Costing versus Variable Costing
Question
Fixed manufacturing overhead costs are recognized as:
a. Period costs under absorption costing.
b. Product costs under absorption costing.
c. Product costs under variable costing.
d. Part of ending inventory costs under both absorption
and variable costing.
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
66
Absorption Costing versus Variable Costing
Fixed manufacturing overhead costs are recognized as:
a. Period costs under absorption costing.
b. Answer: Product costs under absorption costing.
c. Product costs under variable costing.
d. Part of ending inventory costs under both absorption
and variable costing.
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
67
Decision-Making Concerns
• Generally accepted accounting principles 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
o
o
o
LO 5
evaluate performance,
justify cost reductions, or
evaluate new projects.
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
68
Decision-Making Concerns
continued
• Net income calculated using GAAP does not highlight
differences between variable and fixed costs and may
• Some companies use variable costing for internal
reporting purposes.
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
69
1. Net income computed under variable costing is unaffected
by changes in production levels.
2. Variable costing readily supports cost-volume-profit
analysis.
3. Net income computed under variable costing is closely tied
to changes in sales levels and therefore provides a more
realistic assessment of a company’s success or failure.
4. The presentation of fixed and variable cost components on
the variable costing income statement makes it easier to
identify these costs.
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
70
Do It! 5: Variable Costing
Franklin Company produces and sells tennis balls. The following
costs are available for the year ended December 31, 2020. The
company has no beginning inventory. In 2020, 8,000,000 units were
produced, but only 7,500,000 units were sold. The unit selling price
was \$0.50 per ball. Costs and expenses were as follows.
Variable costs per unit
Direct materials
\$0.10
Direct labor
0.05
0.08
0.02
Annual fixed costs and expenses
\$500,000
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
100,000
71
Do It! 5: Variable Costing
Solution to part a.
Variable costs per unit
Direct materials
\$0.10
Direct labor
0.05
0.08
0.02
Annual fixed costs and expenses
\$500,000
100,000
a. Compute the cost of one unit using variable costing.
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
72
Do It! 5: Variable Costing
Solution to part b.
b. Prepare a 2020 income statement using variable costing.
LO 5
Copyright &copy;2018 John Wiley &amp; Sons, Inc.
73