WEEK 8a
ADDITIONAL ISSUES IN CVP ANALYSIS
Study objectives:
1. Describe the essential features of a cost-volume-profit 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.
6. Explain the difference between absorption and variable costing.
7. Discuss net income effects under absorption costing versus variable costing.
8. Discuss the merits of absorption costing versus variable costing for management
decision-making.
Cost-Volume-Profit Income Statement
The Cost-Volume-Profit (CVP) income statement classifies costs as variable or fixed
and computes a contribution margin. Contribution margin is the amount of revenue
remaining after deducting variable costs. It is often stated both as a total amount and on
a per unit basis. Here is a sample CVP income statement:
Basic Computations
Desossa Music Players’ CVP income statement shows that total contribution margin
(sales minus variable expenses) is $175,000, and the company’s contribution margin per
unit is $50. The contribution margin ratio (contribution margin divided by sales) is
41.67% ($50 ÷ $120). Desossa’s break-even point in units (using contribution
margin per unit) or in dollars (using contribution margin ratio) are calculated as follows:
Assuming Desossa’s management has a target net income of $100,000, the
required sales in units and dollars to achieve its target net income are calculated as
follows:
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Desossa’s margin of safety in dollars or as a ration are calculated as follows:
CVP and Changes in the Business Environment
To better understand how CVP analysis works, let’s assume that shipping costs have
increased significantly causing the unit variable cost to increase by 10%, what effect will
this have on Desossa’s break-even point?
Answer: A 10% increase in variable costs increases the per unit variable cost to $77
[$70 + ($70 X 10%)]. The new contribution margin per unit is therefore $43 ($120 – $77).
Thus, the new break-even point in units is calculated as follows:
Sales Mix
Sales mix is the relative percentage in which a company sells its multiple products. For
example, if 60% of product A is sold for every 40% of product B, the sales mix of the
product is 60% to 40%.
Break-even sales can be computed for a mix of two or more products by determining the
weighted average unit contribution margin of all the products.
Assume that Seth Inc. sells tables and chairs in a ratio of four chairs for every one table.
The sales mix in percentages is 20% (1/5) for tables and 80% (4/5) for chairs. The
following is the per unit data for Seth Inc.:
To compute break-even for Seth, Inc., we use the weighted average contribution margin
as follows:
To break-even, Seth must sell 2,400 (12,000 X 20%) tables and 9,600 (12,000 X 80%)
chairs.
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At any level of units sold, net income will be greater if more high contribution margin
units are sold than low contribution margin units. An analysis of these relationships
generally shows that a shift from low-margin sales to high margin sales may increase net
income, even though there is a decline in total units sold.
The formula for computing the break-even point in dollars is fixed costs divided by the
weighted-average contribution margin ratio. To compute a company’s weighted-average
contribution ratio, multiply each division’s contribution margin ratio by its percentage of
total sales and then sum these amounts.
Seth Inc’s contribution margin ratio for sales of tables is .40 ($40/$100) and for chairs
is .50 ($10/$20). The weighted-average contribution margin ratio is calculated as follows:
Sales Mix with Limited Resources
When a company has limited resources (e.g., floor space, raw materials, direct labor
hours), management must decide which products to make and sell in order to maximize
net income. Assume that Seth Inc. has limited machine capacity which is 2,600 hours
per month. Relevant data consist of the following:
Tables Chairs
Contribution margin per unit $40 $10
Machine hours required per unit .8 .16
The contribution margin per unit of limited resource is calculated as follows:
Tables Chairs
Contribution margin per unit (a) $40 $10
Machine hours required (b) .8 .16
Contribution margin per unit of
limited resource [(a) (b)] $50 $62.50
If Seth Inc. increases machine capacity hours by 400 hours per month, it would be better
to use the hours to produce more chairs.
Tables Chairs
Machine hours (a) 400 400
Contribution margin per unit of limited resource (b) $50 $62.50
Contribution margin [(a) X (b)] $20,000 $25,000
Cost Structure and Operating Leverage
Cost structure refers to the relative proportion of fixed versus variable costs that a
company incurs. In most cases, increased reliance on fixed costs increases a company’s
risk. When sales are increasing, profits can increase at a high rate, but when sales
decline, losses can also increase at a high rate. Companies can change their cost
structure by using more sophisticated robotic equipment and reducing it later, or vice
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versa. The equipment would increase the fixed costs whereas labor increases variable
costs.
Variable Costing vs. Absorption Costing
There are two approaches to product costing.
a. Under full or absorption costing all manufacturing costs are charged to
the product. This is also the approach required under generally accepted
accounting principles.
a. Under variable costing only direct materials, direct labor, and variable
manufacturing overhead costs are treated as product costs; fixed manufacturing
overhead costs are recognized as period costs (expenses) when incurred.
The primary difference between variable and absorption costing is that under variable
costing the fixed manufacturing overhead is charged as an expense in the current
period. The result is that absorption costing will show a higher net income number than
variable costing whenever units produced exceed units sold. The reason: the cost of the
ending inventory is higher under absorption costing than under variable costing.
Assume Thibodeau Company manufactures candy bars and has the following
information:
Volume Information 2020
Candy bars in beginning inventory 20,000
Candy bars produced 40,000
Candy bars sold 30,000
Financial Information
Selling price per candy bar $1.00
Variable manufacturing cost per candy bar $0.40
Fixed manufacturing cost per year $ 12,000
Fixed manufacturing cost per candy bar $0.30
Variable selling and administrative expense per candy bar $0.05
Fixed selling and administrative expense $ 4,000
The absorption costing income statement and variable costing income statement are
shown below:
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The effects of the alternative costing methods on income from operations are:
Circumstance Effects on Net Income (NI) from
operations
Units produced > Units sold Absorption costing NI > Variable costing NI
Units produced < Units sold Absorption costing NI < Variable costing NI
Units produced = Units sold Absorption costing NI = Variable costing NI
One of the problems with absorption costing is that management may be tempted to
overproduce in a given period in order to increase net income. Therefore, to avoid this
overproduction, variable costing is often used internally to evaluate management
decision-making.
The following are potential advantages of variable costing:
a. Net income computed under variable costing is unaffected by changes in
production levels.
b. The use of variable costing is consistent with cost-volume-profit and incremental
analysis.
c. Net income computed under variable costing is closely tied to changes in sales
levels giving a more realistic assessment of a company’s success or failure.
d. The presentation of fixed and variable cost components on the face of the
variable costing income statement makes it easier to identify these costs and
understand their effect on the business.
Sources:
Cabrera & Cabrera / Management Accounting Concepts and Application, 2017 Edition
Hilton / Managerial Accounting, 9th Edition
IMA / Standards of Ethical Conduct for Management Accountants,
[Link]
Kieso & Waygandt / Managerial Accounting, 4th Edition
Roque, Rogelio S. / Reviewer in Management Advisory Services, 2016 Edition
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End of Week 8
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