Chapter 7 & 8 Accounting Notes

REVIEW:
High month: look at machine hours
Low month: look at machine hours
o High Cost Low Cost = Difference
o High Volume Low Volume = Difference
Change in Cost / Change in Volume = Variable Cost (slope)
Total Cost Direct Cost per unit X Volume = Fixed Cost
Total Cost = Fixed Cost + Direct Cost per unit X Volume

Chapter 7
Cost-Volume-Profit Analysis

o Helps managers make important business decisions

Relationship of:
Costs, volume, and profit
How much a company must sell to break even
Decide how sales volume need to change
o Relies on interdependency of:
Sales price per unit
Volume sold
Variable costs per unit
Fixed costs
Operating income
o Assumptions:
No volume discounts
Costs are linear throughout relevant range
Revenues are linear in relevant range
Inventory levels will not change
Sales mix will not change
o Example:
Poster sells for $35
Variable cost of $21
Fixed cost of $7,000
550 posters
Sales
revenue
(550
posters)..................................... $ 19,250
Less:
Variable
expenses ............................................ (11,550)
Contribution
margin .................................................... 7,700

Less:
Fixed
expenses.................................................. (7,000)
Operating
income.......................................................$
700

o Contribution margin ratio:

o % of each sales $ covering fixed expenses and generating
profit

o Breakeven point:

o Sales level at which operating income is zero

Above= profit
Below= loss
o Fixed expenses = Total contribution margin
o Total sales = total expenses
Units Sold=
Fixed expenses + Operating income
Contribution margin per unit

Sales in $ =

Fixed expenses + Target operating income

Contribution margin ratio

Graphing the CVP Relationship

o Choose a sales volume (Units x $Price)
Plot point for total sales revenue
Draw sales revenue line from origin through the plotted
point
o Draw the fixed cost line
o Draw the total cost line
o Identify the breakeven point and the areas of operating
income and loss
o Mark operating income and operating loss areas on graph

o Sensitivity Analysis

o Managers need to be prepared for increasing costs, pricing

pressure from competitors, and other changing business
conditions.

o What If Analysis
o If sales price changes
Contribution margin will change
Breakeven point will change
o If variable costs change:
Contribution margin changes
Breakeven point changes
o If fixed costs change:
Will not affect contribution margin
Though, it will change the breakeven point
Total expected contribution margin:
Regular posters (500 x $14) ...............................
Large posters (300 x $30) ..................................
Total expected contribution margin .................
Divided by total expected sales revenue:
Regular posters (500 x $35) ...............................
Large posters (300 x $70) ..................................
Total expected sales .........................................
Contribution margin ratio.............................
=

$ 7,000
$ 9,000
$16,000
$17,500
21,000
$38,500
41.558%

o Margin of Safety
o Drop in sales that the company can absorb before incurring
a loss
o Used to evaluate risk of current operation and the risk of
new plans
Excess of expected sales
Breakeven sales
Margin of safety as a percentage: Margin of safety in units
Expected sales in units

o Operating Leverage
o Relative amount of fixed and variable costs that make up a
companys total costs
o How responsive a companys operating income is to
changes in volume
Lowest possible value for this factor is 1, if the
company has no fixed costs
o Higher operating leverage companies have:

Higher levels of fixed costs and lower levels of

variable costs
Higher contribution margin ratios
Higher risk
Higher potential for reward
o Lower operating leverage companies have:
Higher levels of variable costs and lower levels of
fixed costs
Lower contribution margin ratios
Change in volume do NOT have a significant effect
on operating income
Lower risk
Lower potential for reward
EX: merchandising companies

Operating leverage factor = Contribution margin

Operating income

Chapter 8
Relevant Information: Change in $
Expected future (cost and revenue) data
Differs among alternative courses of action
Is both quantitative and qualitative

Irrelevant Information: No change in $

Costs that do not differ between alternatives
Sunk costs incurred in past and cannot be changed

Relevant Nonfinancial Information:

Nonfinancial, qualitative factors, that play into a managers
decisions
Laying off, outsourcing, discounted prices to certain
customers
Ignoring qualitative factors leads to serious mistakes

6 Short-Term Special Decisions:

o Special sales orders
o Pricing
o Discontinuing products, departments, and stores
o Product mix
o Outsourcing (make or buy)
o Selling as is or processing further

Two keys in analyzing short-term business decisions:

o Focus on relevant revenues, costs, and profits
o Contribution margin approach
Separate variable and fixed costs

Special Order Considerations:

o A customer requests a one-time order at a reduced
sale price
Often for a large quantity

If revenues are GREATER than expected cost

increase
o Accept offer
If revenues are LESS than expected cost increase
o Reject offer

Regular Pricing Considerations

o What is our target profit?

o How much will customers pay?
o Are we a price-taker or a price-setter for this product?

Price-Takers

Price-Setters

Product lacks
uniqueness

Product is more unique

Heavy competition
Pricing approach
emphasizes target costing

Less competition
Pricing approach
emphasizes cost-plus pricing

Target Costing:

o Market price Desired Profit = Target Cost

o Includes:
Development cost
Marketing cost
Design cost
Delivery cost
Production cost
Service cost

Other Strategies:
o Increase sales
o Change or add to its product mix
Offer levels of the same product

 Offer new items to the product mix with high CM

Remove items with the lowest CM
o Differentiate its products
Branding, quality, service packs
Cost-Plus Pricing:
o The opposite of the target-pricing approach
Starts with companys full costs
Adds desired profit to determine cost-plus price
o If company is price taker:
Emphasize target costing approach
o If the company is a price setter:
Emphasize cost-plus pricing approach

Discontinuing Products:
o If lost revenues may occur
Do not discontinue
o If total cost savings exceed the lost revenues
Discontinue
Which product to emphasize?
o Product with the highest contribution margin per unit of
constraint

Outsourcing
o To buy a product or service or produce it in-house
o How best to use available resource
If incremental costs of making exceed incremental costs
of outsourcing
OUTSOURCE
If incremental costs of making are less than the
incremental costs of outsourcing
DONT OUTSOURCE

Sell As-Is or Process Further Considerations

o Revenue generated as-is?
o Revenue generated after processing further?
o Costs for processing the product further?