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11 CHAPTER DEVELOPING A BUSINESS PLAN FOR A MANUFACTURING COMPANY: COST-VOLUME-PROFIT PLANNING AND ANALYSIS 1 Chapter Overview How does the fact that a manufacturing company makes the products it sells affect its business plan? How does a manufacturing company determine the cost of the goods that it manufactures? Why are standard costs useful in controlling a company s operations? 2 Chapter Overview How do manufacturing costs affect costvolume-profit analysis? What is the effect of multiple products on cost-volume-profit analysis? How does a manufacturing company use cost-volume-profit analysis for its planning? 3 The Production Plan The production plan is part of a manufacturing company s overall business plan. It describes how the company plans to efficiently produce its goods while maintaining a desired level of product quality. It also describes the company s plan for achieving specific levels of productivity through the use of raw materials, labor, equipment, and facilities. 4 Manufacturing Costs A major difference between accounting of a manufacturing company and that of a retail company is the way in which inventories and cost of goods sold are measured. Unlike retail companies, a manufacturing company has no products to sell until they are manufactured. The manufacturing cost of goods includes three components: raw materials, direct labor, and factory overhead. 5 Direct materials are the raw materials that physically become part of a manufactured product Direct labor is the labor of the employees who work with the direct materials to convert or assemble Exhibit 11-3 them into finished products. Factory overhead includes all items, other than direct materials and direct labor, that are necessary to manufacture products. They usually cannot be traced to individual 6 products. Manufacturing Costs Standard Costs Standard costs are the costs that should be incurred in performing an activity or producing a product. Many factors influence the determination of standard costs, because assumptions must be made about the set of conditions under which the costs will be incurred. These cost assumptions are incorporated into the company s production plan and, ultimately, its financial plan. 7 Usefulness of Standard Costs Standards provide the benchmark to analyze why costs vary from what is planned. Standards simplify decision-making, providing a more reliable basis for estimating costs and to project costs Standards are very useful in developing a company s operating budget as part of its production plan. 8 Behavior of Manufacturing Costs: Using CVP Analysis To study manufacturing costs with CVP analysis, the cost behavior of each cost must be determined. Like other costs, manufacturing costs can ultimately be classified into fixed or variable costs. 9 Reflection What were the characteristics of variable and fixed costs that we learned in Chapter 3? 10 Fixed Cost Behavior Exhibit 3-3 Recall how Sweet Temptation s monthly rent remained constant at $1,000 per month as sales volume increased. Fixed costs are constant in total but change on a per unit basis. At a level of 500 boxes of chocolate, the monthly rent is $1,000 or $2 per box; at 1,000 boxes, it is still $1,000 in total but only $1 per box. Fixed manufacturing costs react in the same way. 11 Variable Cost Behavior Exhibit 3-4 Recall how Sweet Temptation s variable costs increased proportionately as sales volume increases. Variable costs change in total but are constant on a per unit basis. At a level of 500 boxes of chocolate, variable costs are $2,250, or $4.50 per box. At 1,000 boxes, the variable costs are $4,500 in total, but still $4.50 per box. Variable manufacturing costs react in the same way. 12 Classifying Manufacturing Costs The costs of direct materials and direct labor are variable manufacturing costs because these costs change as production varies. Factory overhead can be both fixed and variable, depending on the type of cost incurred. For example, indirect materials and labor would be variable factory overhead and depreciation would be fixed factory overhead. 13 Mixed Cost Behavior Exhibit 11-5 Total mixed cost = F + vX Some costs have a fixed and a variable component. These are called mixed costs. 14 High Low Method of Cost Estimation The high-low method is an accounting tool to calculate the cost of operating at a given level of activity. It assumes that any change in total costs from one operating level to another is due to an increase in variable costs. By determining the variable cost at any given level, total costs can then be computed. 15 High Low Method of Cost Estimation Variable cost per unit at any given level (defined as v ) may be calculated with the following equation: v= Cost change from lowest to highest volume Volume change from lowest to highest volume 16 High Low Method of Cost Estimation Assume Unlimited Decadence s power cost and related volume data for the last 6 years is as follows: H hvolu e ig m Lowvolu e m Ch n e ag V m (ca s) Tot l Pow r Cost olu e se e a 5 0 ,0 0 ,0 0 0 $ 9 ,0 0 22 0 2 0 ,0 0 ,8 0 0 12 0 8 ,0 0 2 0 ,0 0 ,2 0 0 $ 1 ,0 0 10 0 Variable cost per unit can be estimated at: v= $110,000 2,200,000 = $0.05 17 High Low Method of Cost Estimation By multiplying the variable cost per unit times the volume (at any level), the total variable costs at the given level can be calculated: 5,000,000 cases X $0.05 = $250,000 By subtracting total variable costs from the total cost, the total fixed costs can be calculated: Tot l Pow r Cost a e s ( t5 0 ,0 0ca s) a ,0 0 0 se Tot l V ria leCost aab s Tot l Fix d Cost ae s $2 2 0 9 ,0 0 $2 0 0 5 ,0 0 $ 4 ,0 0 20 18 High Low Method of Cost Estimation Now we can create a total cost formula for any given level of activity. Remember the total cost equation is expressed as follows: Total Costs = F + vX Thus, Unlimited Decadence s total power costs can be expressed in the following total cost equation: Total Power Costs = $42,000 + $0.05X Fixed costs Variable costs 19 Relevant Range Relevant range is the normal level of activity over which costs are predictable: Cost ($) Relevan t range 5,000 25,000 20 Activity level Using CVP Analysis with Product Sales Mix In Chapter 3, we learned how CVP analysis is used to calculate profit under alternative sales volumes, selling prices, and costs. Calculating contribution margin per unit was a key factor in performing CVP analysis. An implicit assumption used in Chapter 3, in computing contribution margin, was that the product equaled 100% of the sales mix. 21 Using CVP Analysis with Product Sales Mix In most cases, a company produces more than one product, so assuming that contribution margin of any one product is 100% of the sales mix is not valid. Product sales mix is the relative proportion of units of different products sold. Darkly Decadent accounts for 5/6th or 83% of N o. Prod ct u Unlimited Decadence s Prod ct u Ca s Sold Sa s M se le ix sales D rk D ca e t a ly e d n Pu D ca e ce re e d n Tot l Sa s a le 5 1 6 8% 3 1% 7 10 0% 22 Using CVP Analysis with Product Sales Mix When more than one product is sold, the total contribution margin is weighted to reflect that portion of contribution margin each product contributes. %Sa s Ca s le se Con rib t t u ion Tot l a Prod ct u M ix Sold M rg /Ca a in se CM D rk D ca e t a ly e d n 8% 3 5 X$ 5$ 2 5 Pu D ca e ce re e d n 1% 7 1 X$ 6$ 6 Wig t d Con rib t M rg e he t u ion a in $3 1 23 Calculating Break-Even Point Using the $31 weighted contribution margin per unit, Unlimited Decadence s break-even point in units can be calculated using the breakeven formula: Fixed costs Contribution margin per unit $24,800,000 $31 per unit = 800,000 units 24 Pre-tax net income can A company usually wants to project its be defined break-even point in pre-tax or after-tax as after-tax dollars. If a company earns $100,000 in net net income and pays 40% in income income/(1 taxes, its pre-tax and after tax income can tax rate), or $60,000/ (1 be expressed as: -.40),or After-tax net $100,000 income can be Prea n tin e $1 0 0 t x e com 0 ,0 0 defined as 1 rate (1 -.40), In et x@ 4 % $ 4 ,0 0 tax.60 (60%), or com a 0 00 or $60,000 A e a n tin e $ 6 ,0 0 ft r-t x e com 00 25 The Impact of Taxes on Break-Even Point Calculating Pre-Tax Break-Even Point in Units If we assume Unlimited Decadence is subject to a 40% tax rate and projects after tax income of $3,240,000, the pre-tax break-even point, in units, would be computed as follows: Fixed costs + Desired pretax income Contribution margin per unit $24,800,000 + 5,400,000* $31 per unit *$3,240,000/(1-0.40) = 974,194 units 26 Calculating Pre-Tax Sales Volume We can also project sales volume by using the contribution margin ratio of 31%* instead of the contribution margin per unit of $31. *Sales price $100 VC 69 Contribution margin ratio CM $ 31 $24,800,000 + 5,400,000** CMR = $97,419,355 31% 31% Fixed costs + Desired pretax income **$3,240,000/(1-0.40) 27 Calculating Break-Even of Adding a New Product Assume Unlimited Decadence is considering making a new chocolate bar, Empty Decadence. The new bar would require $1,188,000 in special processing equipment to be purchased, but is expected to yield a contribution margin per case of $5.50. How many cases of Empty Decadence bars would have to sold to break-even? 28 Calculating Break-Even of Adding a New Product CVP concepts can easily be applied to determine the break-even point for this new product: The numerator includes the additional fixed costs of the new product line (the special processing equipment) Additional Fixed costs Contribution margin per unit The denominator includes the contribution margin of the new product (projected sales price less variable costs) 29 Calculating Break-Even of Adding a New Product Unlimited Decadence would have to sell 216,000 cases of Empty Decadence to breakeven: Additional Fixed costs Contribution margin per unit $1,188,000 $5.50 = 216,000 cases Unlimited Decadence would have to evaluate the likelihood of achieving this unit sales target in deciding to go forward with the new product. 30

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