# Ppt Accounting Lecture for Manufacturing Income Statement - PowerPoint by bts14318

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```									     ACCT 102
Management Accounting
Lecture 3 & 4

Cost-Volume-Profit
(CVP) Analysis
2

CVP Analysis
• Decision making and planning do not involve only
the determination of relevant cost behavior
• They also involve a consideration of the combined
effect on both cost and revenue functions of
changes in the level of activity
• They are achieved by examining the relationship
of costs, volume and revenues which in turn gives
insight into the incremental impact on the
profitability of the various choices open to
management - CVP analysis.
3

CVP Assumptions
 All costs are classified as fixed or variable with
unit level activity cost drivers.
 The total cost function is linear within the relevant
range.
 The total revenue function is linear within the
relevant range.
 The analysis is for a single product, or the sales
mix of multiple products is constant.
 There is only one activity cost driver: unit or
dollar sales volume.
4

The Profit Formula

=R-Y
Where:
 = Profit
R = Total revenues
Y = Total costs
5

The Profit Formula
R = pX
Y = a + bX
Where:
p = Unit selling price
a = Fixed costs
b = Unit variable costs
X = Unit sales
6

Detailed Profit Formula

 = pX - (a + bX)
7

Break-even Point (BEP)
• Break-even Point
• =0
• Since  = pX - (a + bX) [Refer to previous slide]
0 = pX - (a + bX)
pX = (a + bX)
TR = TC
• Until break-even sales are reached, the object of
interest operates at a loss
• Beyond this point, increasing levels of profits are
achieved
8

BEP
Example: Ace Pte Ltd
• Selling price (per unit)           \$12
• Fixed costs per period             \$50,000
• Semi-variable
– Fixed component                 \$30,000
– Variable component (per unit)   \$2
• Variable costs (per unit)          \$5
• Relevant range of output (units)   6,000 – 50,000
9

BEP
Break even point (BEP) using TR = TC
• At BEP,  = 0 and TR = TC
• Substituting the data,
12x = 80,000 + 7x
5x = 80,000
x = 16,000 units
• Break even point in units = 16000 units
• Break even point in dollar sales
= 16000 x 12 = \$192,000
10

Contribution Margin (CM)
• BEP output level for Ace Pte Ltd is 16,000 units
• What happens if it were to sell only 15,999 units?
 = Px – (a + bx)
 = (12 * 15,999) – (80,000 + (7 * 15,999))
= (191,988) – (80,000 + 111,993)
= 191,988 – 191,993 = – 5
11

CM
• If 16,001 units were sold, what would be the profit ?
 = Px – (a + bx)
 = (12 X 16,001) – (80,000 + (7 X 16,001)
= 192,012 – (80,000 + 112,007)
= 192,012 – 192,007 = 5
• Significance of the \$5 loss and \$5 profit respectively?
• Each additional unit produced and sold generates an
incremental profit of \$5, which is given by the
difference between the selling price of \$12/unit and
the variable cost of \$7/unit
• Incremental profit termed “Contribution Margin” (CM)
12

CM
• Contribution margin focuses on sales in relation to all
variable costs
• Distinguish CM from Gross Margin (Sales – COGS)
• CM per unit = Selling price less variable costs per
unit
• CM ratio = CM per unit/Selling Price or
Total CM/Sales or
1 – VC-sales ratio
Note: CM ratio is the portion of each dollar of sales revenue
contributed towards covering fixed cost and earning a profit
13

BEP (using CM approach)
• Break-even Point Formulas (using CM approach)

Break-even
unit sales              Fixed costs
=
volume           Unit contribution margin

Break-even                Fixed costs
=
dollar sales       Contribution margin ratio
volume
14

BEP (using CM approach)
• CM per unit    = SP – VC per unit
= \$5
• BEP in units   = FC/CM per unit
= 16,000 units
• CM ratio = CM per unit/SP or Total CM/Sales
= 0.417
• BEP in \$ = FC / CM ratio
= \$192,000
15

Incremental Analysis
• Focuses on changes occurring in revenues, costs,
and/or volume. Looks at
• what if price per unit were to increase or decrease,
• what if variable cost per unit or fixed costs were to
increase or decrease, and
• what if sales volume were to increase decrease and
so on.
16

Incremental Analysis
Question
• Using the previous example, if Ace Pte Ltd current
sales is 25,000 units and it is confident that it can
increase its sales by another 10,000 units through a
promotion program that will cost \$30,000, should the
company carry out the promotion program?
17

Incremental Analysis
• Since every dollar of contribution margin after the
BEP is profit, Ace should carry out the promotion
program if the additional contribution margin from the
• Increase in contribution      \$50,000
• Increase in fixed cost        \$30,000
• Incremental profit            \$20,000
18

Incremental Analysis
Question
• Ace estimates that if the selling price is reduced by \$1,
it can generate additional sales of 5,000 units over its
current sales of 25,000 units. Should Ace proceed with
the price reduction?
19

Incremental Analysis
• If the sales price is reduced by \$1, total contribution
from the current sales will reduce by \$25,000.
• Contribution from the additional sales will amount to
\$20,000.
• Net loss as a result of reducing sales price by \$1 will
be \$5,000.
20

Contribution and Functional
Income Statements
• Contribution income statement: Costs are classified
according to behavior as variable or fixed
• Functional income statement: Costs are classified
according to function, e.g. COGS, selling expenses,
• Contribution income statements provides better
information to internal decision makers.
21

Contribution and Functional
Income Statements
Variable Costs per Carton
Manufacturing:
Direct materials                 \$1.00
Direct labor                      0.25
Total                                         \$3.00
Fixed Costs per Month

Total                                        \$15,000
22

Contribution Income Statement
Benchmark Paper Company
Contribution Income Statement
for a Monthly Volume of 5,400 Cartons
Sales (5,400 x \$8)                                   \$43,200
Less variable costs:
Direct materials (5,400 x \$1.00)           \$ 5,400
Direct labor (5,400 x \$0.25)                 1,350
Manufacturing overhead (5,400 x \$1.25)       6,750
Selling and administrative (5,400 x \$0.50)   2,700 -16,200
Contribution margin                                  \$27,000
Less fixed costs:
Manufacturing                              \$ 5,000
Profit                                               \$12,000
23

Functional Income Statement
Benchmark Paper Company
Functional Income Statement
for a Monthly Volume of 5,400 Cartons
Sales (5,400 x \$8)                                    \$43,200
Less cost of goods sold:
Direct materials (5,400 x \$1.00)            \$ 5,400
Direct labor (5,400 x \$0.25)                  1,350
Variable Mfg. overhead (5,400 x \$1.25)        6,750
Gross margin                                          \$24,700
Less other expenses:
Variable selling and admin. (5,400 x \$0.50) \$ 2,700
Profit                                                \$12,000
24

Contribution Income Statement
Ratio to
Total    Per Unit     Sales
Sales (5,400 units)       \$43,200      \$8         1.000
Variable costs            -16,200       -3       -0.375
Contribution margin       \$27,000      \$5         0.625
Fixed costs               -15,000
Contribution Margin
Profit                    \$12,000             Ratio
If sales increase by 100 cartons
per month, what will be the
increase in net income?        100 x \$5 = \$500
25

Contribution Income Statement
Break-even                 Fixed costs
unit sales   =    Selling price - Variable costs
volume              per unit        per unit
Break-even
unit sales               Fixed costs
=
volume            Unit contribution margin

Break-even
unit sales       \$15,000
=               = 3,000 units per month
volume             \$5
26

Profit Planning
Assume Benchmark’s management desires to
know the unit sales volume required to
achieve a monthly profit of \$18,000.
Target unit
sales volume         Fixed costs + Desired Profit
=
Unit contribution margin
Target unit
\$15,000 + \$18,000
sales volume    =                       = 6,600 units
\$5
27

Profit Planning
Benchmark desires a profit of \$12,000.

Target dollar sales       Fixed costs + Desired profit
=
volume                Contribution margin ratio

Target dollar sales           \$15,000 + \$12,000
volume           =
0.625

Target dollar sales
volume            = \$43,200
28

Margin of safety
• Margin of safety is the excess of a company’s
actual sales above its BEP point (in units or dollars)
•   It is the amount that sales can drop before it starts
to make a loss.
•   It can be expressed as:
• Units (actual units less break-even units)
• Dollars (actual sales in dollars less break-even
sales in dollars), or
• Percentage (excess of units/sales dollar over
breakeven units/sales dollar as a % of budgeted
or actual units/sales dollar).
29

Margin of safety
• Using data from Benchmark, assume that the sales
for Benchmark is projected to be 4000 units. The
margin of safety for Benchmark is:
• in units:     4,000 – 3,000 = 1,000 units
• in sales \$: 32,000 – 24,000 = \$8,000
• in %:         1000/4,000 = 25% or
8,000/32,000 = 25%
30

Graphs relating to CVP
\$60,000 -                                   Profit area
Total Revenues and Total Costs

\$50,000 -
Break-even point
\$40,000 -      3,000 units                           Total revenues
\$8 per unit
\$30,000 - Loss area
Fixed costs
\$20,000 -                            \$15,000
\$10,000 -                                         Variable costs
\$3X
\$0 -                |              |            |          |
0              2000           4000         6000       8000
Unit Sales
CVP Graph
31

Graphs relating to CVP
Total profit
\$20,000 -
or loss
\$15,000 - Break-even point
Total Profit or (Loss)

\$5,000 -     \$24,000                      Profit area

\$0 -             |              |                   |
Loss
(\$5,000) -
0          20,000         40,000          60,000
area
(\$10,000) -

(\$15,000) -
Total Revenues

Profit-Volume Graph
32

Operating Leverage
• Operating leverage provides information
concerning the relationship between a company’s
variable and fixed costs.
• Generally, companies that are highly labor
intensive tend to have higher variable costs and
lower fixed costs, and thus, low operating
leverage. The reverse is also true for capital
intensive companies.
33

Operating Leverage
• Characteristics of a highly leveraged company
– Generally have high contribution margin since their
variable costs tend to be lower. However, the higher fixed
costs would mean that the BEP would also be high.
– If selling price is relatively stable, the volume of sales
would have high impact on profit/loss. A small increase in
sales volume can have a major impact on profit/loss within
a given relevant range.
– It is important to reduce operational leverage during
periods of economic distress
34

Operating Leverage

Degree of          Total Contribution margin
=
operating leverage              Income

\$20,000
4 =
\$5,000

Degree of operating leverage measures how a percentage change
in sales from the current level will impact company profit/loss.

If Benchmark’s sales increase 12.5 percent,
how much should profits increase?
35

Operating Leverage

Increase in sales                    12.5%
Degree of operating leverage          x 4.0
Increase in profits                  50.0%

Current profit                       \$5,000
Increase in profits (\$5,000 x 50%)    2,500
New profit                           \$7,500
36

Multiple Product CVP
• Assumptions required:
• Sales mix is constant
• Fixed costs is not directly related to a particular
product. If fixed costs are directly related to a
particular product, then the fixed costs should
be regarded as fixed costs of the product and
included in the separate analysis related to it
=> 2 separate CVPs
37

Multiple Product CVP
• CM may be used to determine the break-even
units volume or the units required to achieve a
desired profit

Fixed costs
Break-even point (units) =
Weighted-average contribution
margin

Target sales (units)      Fixed costs + Desired profit
=
Weighted-average contribution
margin
38

Multiple Product CVP
• CM ratio may be used to determine the break-even
dollar sales volume or the dollar sales volume
required to achieve a desired profit

Fixed costs
Break-even point (\$) =
Weighted-average contribution
margin ratio

Target sales (\$)      Fixed costs + Desired profit
=
Weighted-average contribution
margin ratio
39

Multiple Product CVP
40

Multiple Product CVP
41

Multi-Level CVP
• Major limitation of traditional CVP
– Exclusive use of unit level activity cost drivers, i.e.
does not consider other categories of cost drivers
– High probability of significant errors in cost
estimation and prediction (Refer to Lecture 2
notes)
• Expansion of CVP to incorporate non-unit activity
cost drivers
– Difficult to develop graphical relationships
– Good way to begin is to make use of a contribution
statement that incorporates a hierarchy of cost
drivers
42

Multi-Level CVP
• Example: General Distribution
–   Sales (Multiple products)           \$3,000,000
–   Number of sales orders              3,200
–   Number of customers                 400
–   Cost hierarchy
• Unit level activities:
– COGS                         \$0.80 per sales dollar
• Order level activities
– Cost of processing order     \$20 per order
• Customer level activities
– Mail, phone, sales visits…   \$200 per customer per year
• Facility level costs
– Depreciation, insurance…     \$120,000 per year
43

Multi-Level CVP
General Distribution
Multi-Level Contribution Income Statement
for the Year 2002
Sales                                                  \$3,000,000
Less unit level costs:
Cost of goods sold (\$5,000,000 x 0.80)               -2,400,000
Unit level contribution margin                         \$ 600,000
Cost of processing order (3,200 orders x \$20)           - 64,000
Order level contribution margin                         \$ 536,000
Less customer level costs:
Mail, phone, sales visits, recordkeeping, and
so forth (400 customers x \$200)                        - 80,000
Customer level contribution margin                      \$456,000
44

Multi-Level CVP
General Distribution
Multi-Level Contribution Income Statement
for the Year 2002
Customer level contribution margin                     \$456,000
Less facility level costs:
Depreciation, manager salaries, insurance,
and so forth                                         -120,000
Profit                                                 \$336,000
45

Multi-Level CVP
Current      Current
Unit level break-  order- + customer- + Facility
even point in     level         level             level
dollars with no = costs         costs              costs
changes in other
costs (in \$)            Contribution margin ratio

= (\$64,000 + \$80,000 + \$120,000)/(1 - 0.80)

= \$1,320,000
46

Multi-Level CVP

Break-even order                 Cost of each order
size (in \$)   =
Contribution margin ratio
= (\$20)/(1 - 0.80)

= \$100

•   To break even, each order must have be for \$100 of goods.
•   Discourage smaller orders
47

Multi-Level CVP
Cost of each order x Average orders per customer
Break-even               + Cost of customer level activity
on an average    =
customer (in \$)                Contribution margin ratio
= (\$20 x 8 + \$200)/(1 - 0.80)

= \$1,800

•    To break even, each customer must purchase \$1,800 of goods
•    Discontinue relations with customers with annual purchases of
less than this amount or try to serve such customers in a less
costly manner

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