ACCT 2302

Fundamentals of Accounting II

Spring 2011

Lecture 7

Professor Jeff Yu

Used primarily forexternal reporting

Used primarily for Managerial Decision making

Review: The Contribution Format Income Statement

Review: The Contribution Margin Method

per Unit CM

Expenses Fixedin UnitsPoint even -Break

Ratio CM

Expenses FixedDollars Salesin Point even -Break

Per Unit CM

ProfitTarget Expenses FixedProfitTarget attain tosales Units

Sales – Variable Expenses – Fixed Expenses = NOI

Price * X VC/unit * X $$$ $0

Review: The Equation Method

B.E.P in sales dollars = B.E.P. in Units * Price

Let B.E.P. in units = X

How can a company change its break-even point?

1. If fixed costs change by X%, then break-even point would also change by X% (assuming everything else remains constant)

2. An increase or decrease in CM per unit will also change break-even point.

CVP Analysis: Changes in Break-even Point

Expected profit (NOI) may change due to: a change in fixed expenses a change in CM per unit (=price - VC/unit) a change in sales volume:

once the break-even point has been reached, NOI will increase by CM per unit for each additional unit sold.

Two approaches to predict profit using CVP analysis:1)Income Statement approach2)Incremental approach

CVP Analysis: predicting profit

Razor Inc. is currently selling 500 scooters per month. The owner believes that an increase of $10,000 in the monthly advertising budget would increase sales of scooters to 540 per month.

Q: Should the increase in advertising be made?

Example

Margin of Safety in units = Budgeted or actual units sold – Break-even point in units

Margin of Safety in sales dollars = Budgeted or actual sales – Break-even point in sales dollars

Margin of Safety percentage = Margin of Safety in units / Budgeted or actual units sold

= Margin of Safety in sales dollars / Budgeted or actual sales

Margin of Safety

The amount by which sales can drop before losses are incurred.

Example

Coffee Klatch is an espresso stand in a downtown office building. The price of a cup of coffee is $1.5 and the variable expense per cup is $0.36. The fixed expense per month is $1,140. Each month 2,000 cups are sold.

Q: (1) What is the margin of safety in cups?

(2) Margin of safety in sales dollars?

(3) Margin of safety percentage?

Operating Leverage

A measure of how sensitive net operating income is to percentage changes in sales.

Contribution Margin

Net operating income

Degree ofOperating Leverage =

Thought Question: How will cost structure (relative proportion of fixed costs) or sales volume affect the degree of operating leverage?

Example

Actual sales 500 Bikes

Sales 250,000$ Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Net income 20,000$

Actual sales 500 Bikes

Sales 250,000$ Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Net income 20,000$

Q: (1) What is the degree of operating leverage?

(2) If sales increase by 10%, net operating income will increase by ___%?

The sales mix is the relative proportions in which a company’s multiple products are sold. Profits will often be greater if high-margin items make up a larger proportion of total sales.

For simplicity, we assume sales mix is always CONSTANT, that is, the relative proportions of each product as a percentage of total sales do not change as sales volume changes.

Sales Mix and Break-even Analysis

Okabee Co. makes two products: A100 & B900.

Q: Based on the current sales mix,

(1) What is its break-even point in total sales dollars?

(2) Prepare a contribution format income statement for Okabee.

(3) If sales increase by $50,000 per month, by how much would you expect net operating income to increase?

Example

A100 B900 Total

Sales $700,000 $300,000 $1,000,000

CM Ratio 60% 70% ?

Razor sells scooters and bicycles. Total fixed cost is $95,000.

Q: What is Razor’s breakeven point based on the current sales mix (for every 1 bicycle sold, 2 scooters are sold)?

Practice Problem

For Next Class

Review for Midterm Exam 1

Acoustic Concepts is currently selling 400 speakers per month; monthly sales are $100,000. Variable cost per speaker is 60% of the speaker price. The sales manager feels that a $10,000 increase in the monthly advertising budget would increase monthly sales by $30,000.

Q: Should the advertising budget be increased?

Homework Problem 1

In 2008, Voltar Co. sold 20,000 units of a special telephone at $60 each, variable expenses were $900,000 and fixed expenses were $240,000.

Q:(1) Sales are expected to increase by $400,000 in 2010. If cost behavior remain unchanged, by how much will NOI increase in 2010?

(2) Compute its margin of safety in dollars and percentages.

(3) Compute its degree of operating leverage at current sales volume.

(4) If sales increase by 8% in 2011, by what % will NOI increase?

(5) If a high-quality speaker is used, annual sales will increase by 20%, variable cost will increase by $3 per unit, but annual salary of $30,000 paid to one quality inspector can be eliminated. Should the change be made?

Homework Problem 2

Pittman Co. produces two products, A and B. Product A accounts for 20% of total sales, while B accounts for 80% of sales. Variable expense ratios are 75% for A and 50% for B. Pittman’s total fixed cost is $90,000.

Q: Based on the current sales mix,

(1) What is its break-even point in total sales?

(Hint: CM ratio = 1 – variable expense ratio)

(2) Assume the unit price of product B is $24, how many units of B should Pittman sell to break even?

Homework Problem 3