Chapter
6-1

Chapter
6-2
6
Managerial Accounting, Fourth Edition

1.
Describe the essential features of a cost-volumeprofit income statement.
2.
Apply basic CVP concepts.
3.
Explain the term sales mix and its effects on break-even sales.
4.
Determine sales mix when a company has limited resources.
5.
Understand how operating leverage affects profitability.
Chapter
6-3

Chapter
6-4
The relationship between a company’s fixed and variable costs can have a huge impact on its profitability
The current trend is toward companies with cost structures dominated by fixed costs
This has significantly increased the volatility of many companies’ net income
Thus, the use of CVP analysis has additional uses in making sound business decisions

Chapter
6-5
Cost-Volume-
Profit (CVP)
Review
Sales Mix
Basic concepts
Basic computations
CVP and changes in the business environment
Break-even sales in units
Break-even in dollars
Sales mix with limited resources
Cost Structure and Operating
Leverage
Effect on contribution margin ration
Effect on break-even point
Effect on margin of safety ratio
Operating leverage

Chapter
6-6
As noted in Chapter 5, CVP analysis is: the study of the effects of changes in costs and volume on a company’s profit
CVP analysis is important to profit planning
CVP analysis is critical in management decisions such as: determining product mix, maximizing use of production facilities, setting selling prices
LO 1: Describe the essential features of a cost-volume-profit income statement.

Basic Concepts
Chapter
6-7
Because CVP is so important, management often wants the information reported in a special format income statement.
The CVP income statement is for internal use only, classifies costs and expenses as fixed or variable , reports a contribution margin in the body of the statement.
Contribution margin – amount of revenue remaining after deducting all variable costs
The contribution margin is often reported as a total amount and on a per unit basis.
LO 1: Describe the essential features of a cost-volume-profit income statement.

CVP Income Statement - Example
The CVP income statement for Vargo Video Company is illustrated below: (This illustration was also presented as Illustration 5-11 in Chapter 5)
Chapter
6-8
LO 1: Describe the essential features of a cost-volume-profit income statement.

CVP Income Statement – Example Cont’d
A detailed CVP income statement for Vargo Video Company is illustrated below: (This uses the same base information as the previous statement)
Chapter
6-9
LO 1: Describe the essential features of a cost-volume-profit income statement.

Chapter
6-10
Basic Computations – A Review
Break-Even Analysis
As noted in Chapter 5, Vargo Company’s contribution margin per unit is $200 (sales price
$500 - $300 variable costs)
It was also shown that Vargo Company’s contribution margin ratio was:
LO 2: Apply basic CVP concepts.

Basic Computations – A Review
Break-Even Analysis
Vargo Company’s break-even point in units or in dollars (using contribution margin ratio) is:
Chapter
6-11
In its early stages of operation, a company’s primary goal is to break-even.
Failure to break-even will eventually lead to financial failure
LO 2: Apply basic CVP concepts.

Chapter
6-12
Basic Computations – A Review
Target Net Income
Once a company achieves break-even sales, a sales goal can be set that will result in a target net income
Assuming Vargo’s target net income is $250,000, required sales in units and dollars to achieve this are:
LO 2: Apply basic CVP concepts.

Chapter
6-13
Basic Computations – A Review
Margin of Safety
Remember from Chapter 5, the margin of safety tells us how far sales can drop before the company will operate at a loss
The margin of safety can be expressed in dollars or as a ratio
Assuming Vargo’s sales are $800,000:
LO 2: Apply basic CVP concepts.

Chapter
6-14
Basic Computations – A Review
CVP and Changes in the Business Environment
To better understand CVP analysis, three independent cases involving Vargo company will be examined.
Each case will use the original data for Vargo
Company:
LO 2: Apply CVP concepts.

Basic Computations – A Review: Case I
Should Vargo Company match a competitor’s 10% discount and reduce selling price to $450 per unit?
With variable costs per unit unchanged, a 10% discount in selling price will decrease the contribution margin to $150 and increase break-even sales to 1,333 units
Chapter
6-15
Management must decide how likely it is that Vargo can achieve the increase in sales as well as the likelihood of lost sales if the discount is not matched
LO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case II
Use of new equipment is being considered that will increase fixed costs by 30% and lower variable costs by 30%. What effect will the new equipment have on the sales required to break-even?
Fixed costs will increase $60,000 and variable costs will decrease $90,000 (variable cost per unit =$210).
Chapter
6-16
The change appears positive as break-even point is reduced by approximately 10%
LO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case III
Chapter
6-17
Vargo’s supplier of raw materials has increased the cost of raw materials which will increase the variable cost per unit by $25.
Management will not change the selling price of the
DVDs.
Management intends to cut fixed costs by $17,500
Vargo currently has a net income of $80,000 on sales of 1,400 DVDs
How many more units will need to be sold to maintain the $80,000 net income?
LO 2: Apply basic CVP concepts.

Basic Computations – A Review: Case III
Variable cost per unit increases to $325 as a result of the $25 increase in raw materials cost
Fixed costs decrease to $182,500
Contribution margin per unit is now $175
Chapter
6-18
If Vargo cannot sell an additional 100 units, management must further reduce costs, increase the selling price of the DVDs, or accept a lower net income.
LO 2: Apply 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. Its selling price is less than its variable costs.
LO 1: Describe the essential features of a cost-volume-profit income statement.
LO 2: Apply basic CVP concepts.
Chapter
6-19

Chapter
6-20
Sales Mix
When a company sells more than one product
It is important to understand its sales mix
The 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 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Units
A company can compute break-even sales for a mix of two or more products by determining the
Weighted-average unit contribution margin of all products
The weighted-average unit contribution margin is the sum of the weighted contribution margin of each product
Chapter
6-21
LO 3: Explain the term sales mi and its effects on break-even sales.

Break-Even Sales in Units - Example
Assume that Vargo Company sells two products and has the following sales mix and related information:
Chapter
6-22
LO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Units - Example
First, determine the weighted-average contribution margin for Vargo’s two products:
Second, use the weighted-average unit contribution margin to compute the break-even point in units
Chapter
6-23
LO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Units - Example
With a break-even point of 1,000 units, Vargo must sell:
750 DVD Players (1,000 units x 75%)
250 TVs (1,000 units x 25%)
At this level, the total contribution margin will equal the fixed costs of $275,000
Chapter
6-24
LO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Dollars
The calculation of break-even point in units works well if the company has only a few products
Consider 3M which has over 30,000 different products:
3M would need to calculate 30,000 different unit contribution margins
When there are many products, calculate the breakeven point in terms of sales dollars for divisions or product lines, NOT individual products
Chapter
6-25
LO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Dollars - Example
Assume that Kale Garden Supply Company has two divisions: Indoor Plants and Outdoor Plants
Each division has hundreds of different plant types
Compute sales mix as a percentage of total dollar sales rather than units sold and
Compute the contribution margin ratio rather than the contribution margin per unit
Chapter
6-26
LO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Dollars - Example
The information necessary to perform costvolume-profit analysis is:
Chapter
6-27
LO 3: Explain the term sales mix and its effects on break-even sales.

Break-Even Sales in Dollars - Example
First, determine the weighted-average contribution margin ratio for each division:
Second, use the weighted-average unit contribution margin ratio to compute the break-even point in dollars:
Chapter
6-28
LO 3: Explain the term sales mix and its effects on break-even sales.

Chapter
6-29
Break-Even Sales in Dollars - Example
With break-even sales of $937,500 and a sales mix of 20% to 80%, Kale must sell:
$187,500 from the Indoor Plant division
$750,000 from the Outdoor Plant division
If the sales mix between the divisions changes, the weighted-average contribution margin ratio also changes, resulting in a new break-even point in dollars.
Example If the 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 3: Explain the term sales mix and its effects on break-even sales.

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.
Chapter
6-30
LO 3: Explain the term sales mix and its effects on break-even sales.

Sales Mix with Limited Resources
All companies have limited resources whether it be floor space, raw materials, direct labor hours, etc.
Limited resources force management to decide which products to sell to maximize net income.
Example: Vargo makes DVD players and TVs. The limiting resource is machine capacity – 3,600 hours per month. Relevant date is as follows:
Chapter
6-31
LO 4: Determine sales mix when a company has limited resources.

Sales Mix with Limited Resources - Example
The TVs seem to be more profitable since they have the higher contribution margin per unit, but they require more machine hours to produce than the DVD Players
To determine the appropriate sales mix, compute the contribution margin per unit of limited resource:
Since DVD players have higher contribution margin per machine hour, management should produce more DVD players if demand exists or else increase machine capacity.
Chapter
6-32
LO 4: Determine sales mix when a company has limited resources.

Sales Mix with Limited Resources - Example
Alternative : Increase machine capacity from
3,600 to 4,200 hours
Chapter
6-33
To maximize net income, all 600 hours should be used to produce and sell DVD players.

Theory of Constraints
Approach used to identify and manage constraints so as to achieve company goals
Requires identification of constraints
Continual attempts to reduce or eliminate constraints
Chapter
6-34
LO 4: Determine sales mix when a company has 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.
b. $5. c. $4.
d. No correct answer is given.
Chapter
6-35
LO 4: Determine the sales mix when a company has limited resources.

Chapter
6-36
Cost Structure and Operating Leverage
Cost Structure is the relative proportion of fixed versus variable costs that a company incurs
May have a significant effect on profitability
Thus, a company must carefully choose its cost structure.
LO 5: Understand how operating leverage affects profitability.

Comparison of Cost Structures
Vargo Video manufactures DVD players using a traditional, labor-intensive manufacturing process
New Wave Company also manufactures DVD players, but uses a completely automated system where factory employees only set up, adjust, and maintain the machinery.
Chapter
6-37
Both companies have the same sales and net income; however, each has different risks and rewards due to changes in sales as a result of their cost structures.
LO 5: Understand how operating leverage affects profitability.

Effect on Contribution Margin Ratio
The contribution margin ratio for each company is as follows:
Chapter
6-38
Thus, New Wave contributes 80 cents to net income for each dollar of increased sales while Vargo only contributes 40 cents.
However, New Wave loses 80 cents per dollar of sales decrease while Vargo only loses 40 cents.
New Wave’s cost structure which relies on fixed costs is more sensitive to changes in sales
LO 5: Understand how operating leverage affects profitability.

Effect on Break-even Point
The break-even point for each company is as follows:
Chapter
6-39
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 5: Understand how operating leverage affects profitability.

Effect on Margin of Safety Ratio
The margin of safety ratio of each company is as follows:
Chapter
6-40
The difference in the margin of safety ratio 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 before it would be operating “in the red.”
LO 5: Understand how operating leverage affects profitability.

Chapter
6-41
Operating Leverage
Operating leverage refers to the 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 – a good thing.
When sales revenues are declining, too much operating leverage can have devastating consequences.
LO 5: Understand how operating leverage affects profitability.

Operating Leverage
The degree of operating leverage provides a measure of a company’s earnings volatility.
The degree of operating leverage is computed by dividing total contribution margin by net income.
The computations for Vargo and New Wave are:
Chapter
6-42
New Wave’s earnings would go up (or down) by about two times (5.33 ÷ 2.67 = 1.99) as much as Vargo’s with an equal increase in sales.
LO 5: Understand how operating leverage affects profitability.

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.
Chapter
6-43
LO 5: Understand how operating leverage affects profitability.

All About You
Chapter
6-44
Big Decisions for Your Energy Future
The cost of wind powered electricity is as low as 3 or 4 cents per kilowatt hour (about the same as coal).
It costs about $77,500 to install a residential solarpowered system. It would take 50 years without subsidies to recover your cost or ten years with subsidies.
Industrial plants using solar power have a cost of 30 cents per kilowatt hour. A new approach could lower this to 9 – 12 cents.
EPA Energy Star designated products could save 30% in energy use as well as about $12 billion on utility bills.

Chapter
6-45
What Do You Think?
Do you think that it is possible to compare coal with alternative energy sources without considering environmental costs?
Should environmental costs be incorporated into decision formulas when evaluating new power plants?

Presto Candle Supply makes candles. The sales mix
(as a percent of total dollar sales) of its three product lines is as follows: birthday candles, 30%; standard tapered candles, 50%; and large scented candles, 20%. The contribution margin ratio of each candle type is shown below.
Candle Type
Birthday
Standard tapered
Large scented
Contribution Margin Ratio
10%
20%
45%
What is the weighted-average contribution margin ratio?
Chapter
6-46

Type of Candles
Birthday
Standard tapered
Large scented
CMR Sales Mix
10% X
20% X
45% X
30% =
50% =
03%
10%
20% = 09%
Weighted Average Contribution Margin Ratio 22%
If the company’s fixed costs are $440,000 per year, what is the dollar amount of each type of candle that must be sold to break even?
Step 1: Fixed Costs $440,000 ÷ WA CMR 22% = $ BEP
$2,000,000
Chapter
6-47
Step 2:
Birthday candles
Standard tapered
Large scented
$2,000,000 X 30% = $ 600,000
$2,000,000 X 50% = 1,000,000
$2,000,000 X 20% = 400,000

Appendix
Absorption Costing vs. Variable Costing
Under variable costing, product costs consist of:
Direct Materials
Direct Labor
Variable Mfg. Overhead

The difference between absorption and variable costing is:
Chapter
6-48
LO 6: Explain the difference between absorption costing and variable costing.

Chapter
6-49
Appendix
Absorption Costing vs. 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.
Fixed Mfg.
Overhead
LO 6: Explain the difference between absorption costing and variable costing.

Appendix
Absorption Costing vs. Variable Costing
Example – Premium Products
Manufactures Fix-it, a sealant for car windows.
Relevant data for January 2008, the first month of production are:
Chapter
6-50
LO 6: Explain the difference between absorption costing and variable costing.

Appendix
Absorption Costing vs. Variable Costing
Example – Continued
Per unit manufacturing cost under each approach.
Chapter
6-51
The manufacturing cost per unit is $4 ($13 -$9) higher for absorption costing because fixed manufacturing costs are treated as product costs.
LO 6: Explain the difference between absorption costing and variable costing.

Appendix
Absorption Costing Income Statement
Chapter
6-52
LO 6: Explain the difference between absorption costing and variable costing.

Appendix
Variable Costing Income Statement
Chapter
6-53
LO 6: Explain the difference between absorption costing and variable costing.

Appendix
Summary of Income Effects
Chapter
6-54
LO 7: Discuss net income effects under absorption costing versus variable costing.

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.
Chapter
6-55
LO 6: Explain the difference between absorption costing and variable costing.

Chapter
6-56
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