for Objectives today
Review two types of income statements
Absorption costing Variable costing When given one, how to compute the other
Using variable costing: Cost-volumeprofit (CVP) analysis
CVP model Breakeven model Assumptions underlying CVP analysis
ACC 333 (Farrell)
Fall 2011, Class 18
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Absorption costing income statement
On an absorption costing income statement:
Cost of good sold (COGS) = DM + DL + OH Gross profit (a.k.a. gross margin) = Sales COGS
Key subtotal that signals it's absorption costing
Costs are classified by functional area in the firm
Manufacturing vs. Non-manufacturing (SG&A)
All costs to manufacture products sold are in COGS Why use this methodology?
Required by GAAP Gross profit enables external users to evaluate all costs of production needed to generate a certain level of sales, including investments in fixed assets
ACC 333 (Farrell)
Fall 2011, Class 18
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Simple Absorption Costing Income Statement
Sales Less: Cost of goods sold * Gross margin Less operating expenses: Selling General & administrative Operating income Income taxes Net income * Cost of good sold = DM+DL+Variable OH+Fixed OH
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$2,000,000 1,300,000 $700,000
$300,000 150,000 $450,000 $250,000 $75,000 $175,000
ACC 333 (Farrell), Fall 2011, Class 18
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Variable costing income statement
On a variable costing income statement:
Contribution margin (CM) = Sales - variable costs
Key subtotal that signals it's variable costing
Costs are classified by behavior
Variable vs. Fixed
Why?
Variable costs are usually relevant in evaluating different decision alternatives Easier to understand the impact of changes in sales on profit Stresses the need to recoup (i.e., recover) fixed costs before profit is earned
ACC 333 (Farrell)
Fall 2011, Class 18
4
Simple Variable Costing Income Statement
Sales Less: Variable expenses * Contribution margin Less fixed expenses ** Operating income Income taxes Net income $2,000,000 1,000,000 $1,000,000 $750,000 $250,000 $75,000 $175,000
* Variable expenses = Variable manufacturing + variable selling + variable administrative ** Fixed expenses = Fixed manufacturing + fixed selling + fixed administrative
ACC 333 (Farrell) Fall 2011, Class 18 5
When given one, compute the other
When given gross margin, you can compute CM: gross margin (which is sales COGS) + fixed manufacturing costs - variable non-manufacturing costs contribution margin (which is sales VC) When given CM, you can compute gross margin: contribution margin (which is sales VC) - fixed manufacturing costs + variable non-manufacturing costs gross margin (which is sales COGS)
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In-class activity Should CableVision serve Miranda?
Part 1: Prepare simple absorption costing and variable costing income statements
ACC 333 (Farrell) Fall 2011, Class 18 7
Using variable costing: CVP analysis
Cost-Volume-Profit (CVP) analysis
Simple model for evaluating decision alternatives Incorporates relationships between price, volume, and costs Necessarily includes simplifying assumptions about those relationships
Breakeven Analysis
A special form of CVP analysis in which profit = $0
ACC 333 (Farrell)
Fall 2011, Class 18
8
CVP model
Profit = Revenues Variable costs (VC) Fixed costs (FC)
If we expand the components of the formula: Profit = (Sales price(SP)/unit x Units sold) (VC/unit x Units sold) FC
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Breakeven model
What if we want to know how many units we must sell to break even? The breakeven point is the point where profit = $0, so put that in the CVP model: $0 = (SP/unit x Units sold) - (VC/unit x Units sold) - FC
ACC 333 (Farrell)
Fall 2011, 18
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Breakeven Class model (continued)
Using algebra, we can go from this equation:
$0 = (SP/unit x Units sold) - (VC/unit x Units sold) - FC
To this equation:
Units sold = FC (SP/unit - VC/unit)
And recall that:
SP/unit - VC/unit = CM/unit
So the breakeven formula can be expressed as:
Units needed to break even (BEunits) = FC CM/unit
And can be expressed in revenue dollars as:
Breakeven revenue (BErev) = SP/unit x BEunits
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Takeaways: CVP analysis
CVP analysis can be used to analyze many decisions by simply plugging estimates into the model and solving for unknowns Examples:
Breakeven analysis is a special case of CVP Safety margin: The dollar amount OR number of units by which actual sales (expressed in either dollars or units) exceeds the amount required to break even Sensitivity analysis: Repeating CVP with different estimates and assumptions to see how results change
ACC 333 (Farrell)
Fall 2011, Class 18
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Assumptions underlying CVP
All models are abstractions of reality, and thus include simplifying assumptions Taken together, the assumptions of CVP imply that the firm has a certain scale of operations that is constant in the short run
This is fine for short-run decision-making, and we can use sensitivity analysis to address concerns that assumptions lead to poor estimates But if we need to expand beyond that, we may need a different kind of analysis
What are the assumptions underlying CVP?
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Assumptions underlying CVP
(continued)
The behavior of total revenue is linear
This implies that the selling price of the product/service won't change as sales volume changes
The behavior of costs is linear over the relevant range
This implies that:
Costs can be categorized as variable, fixed, etc. Total fixed costs don't change as activity changes Per-unit variable costs don't change as activity changes Efficiency and productivity of workers remains constant
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ACC 333 (Farrell)
Assumptions underlying CVP
(continued)
Selling prices and costs are known with certainty
This implies that:
We don't need to consider a distribution of prices and costs A change in one variable (e.g., costs) does not lead to a change in another (e.g., price)
The number of units produced during the period equals the number of units sold
This implies that inventory levels do not change (i.e., beginning inventory = ending inventory)
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Fall 2011, Class 18
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Assumptions underlying CVP
(continued)
If we do a multi-product CVP analysis, the sales mix remains constant
This implies that all products/services offered by a firm are sold in the same market and are substitutes for each other (i.e., when the price of one good increases, its demand decreases while the demand for another increases)
ACC 333 (Farrell)
Fall 2011, Class 18
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CVP Example
Assume that the Princess Theater has:
$48,000 in monthly FC $8 ticket price $2 VC per ticket
Compute breakeven units and revenues.
ACC 333 (Farrell)
Fall 2011, Class 18
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CVP Example (continued)
Suppose the theater's monthly capacity is 12,000 tickets, and the theater operated at 60% capacity in December. 1) Today is December 30. Has the theater made any money this month?
2)
Suppose the theater could capture 1000 customers by lowering the ticket price to $7 for New Year's Eve. Should they do it? Why/why not?
ACC 333 (Farrell)
Fall 2011, Class 18
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ACC 333 (Farrell), Fall 2011, Class 18
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In-class activity Should CableVision serve Miranda?
Part 2: Should CableVision serve the Miranda market?
ACC 333 (Farrell)
Fall 2011, Class 18
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