Accounting Information for Management Decisions

Week 4 Class Notes

The areas that are important for you to understand in chapter 20 are listed below.

• Explore the critical relationship of costs, volume, and the impact on profit.
CVP (cost, volume, profit)
• Understanding how costs behave vs the classifications of product/period
costs
• Explore a new format for the Income Statement (CVP) and compare to a
multiple step Income Statement(product vs period)
• Break even and targeted profit calculations
• How to use CVP analysis to determine whether to add a new product line,
change the current sales mix to make a company more profitable and
evaluating new promotions/purchases to calculate the impact to profit
• Evaluate multiple product lines within a company

Explore the critical relationship of costs, volume, and the impact on profit. CVP (cost, volume,
profit)

How does a company set a price for their product or services? How do they determine their
profit if certain costs or volume changes? A new product line- is it a good idea or bad? How
many units must be sold to reach break-even or a targeted profit?
These decisions are important and can be answered from understanding the concepts in this
chapter. A business needs to understand types of costs and the impact of volume changes on
profit if they are going to be successful.
We will explore some new terms and concepts before we can answer questions like those listed
above. This area is critical to all types of companies in various industries.

Understanding how costs behave vs the classifications of product/period costs

In the prior chapters, we classified costs as product or period. These same costs can also be
classified as Variable, Fixed or Mixed (semi variable). These classifications are two separate
methods to identify costs. Each one is used for specific reasons and produces different reports.

Before we talk about the types of costs, you need to understand that each cost can have a
different activity base. What is an activity base? It is the activity that changes the cost.
Depending on the cost and the company, each activity base can be unique to the company. For
example, if we were looking at the cost of a copying machine, the activity base would probably
be the number of copies which would have a direct relationship to changes in the cost for the
machine. Activity bases can be anything that has a relationship to a cost. Some other
examples of activity bases could be sales in units or dollars, machine hours, numbers of miles
driven, number of purchase orders and number of direct labor hours. This concept of an activity
base should sound familiar as we talked about it in chapter 17. Please look at the problem
below.

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PROBLEM 1(see answers at the back of the notes)
You have been hired as a consultant to assist the following companies with cost-volume-profit
analysis:

• Freeman's Retail Floral Shop

• Susquehanna Trails Bus Service
• Wilson Pump Manufacturers
• McCauley & Pratt, Attorneys-at-Law

Suggest an appropriate activity base for each of these clients. Please note that these are
suggested bases as there is no one right answer. I want you to get a feel, however, for
identifying some options for activity bases.

Variable costs are costs that change in total based on a certain activity base. The per unit cost,
however, stays the same. For example, a variable cost could be direct materials which are
based on units sold. So if DMs cost $5 per unit and you sold 2,000 units, your total variable
cost will be $10,000. If the units sold were only 1,000, your total variable cost would be less at
$5,000. Another example of variable costs would be sales commissions where the activity base
could be sales $. Please note that in both examples, if we were classifying product vs. period,
DM would be product and the sales commissions would be period.

Fixed costs are costs that do not change in total based on an activity. The per unit for fixed
costs, however, do change. Some examples of fixed costs are depreciation expense, rent,
salaries and advertising. Let’s say your rent is $6,000 monthly. The total dollars will not be
impacted if you make only one unit or 1000 units. Correct? How does the volume change per
unit, though? If we only produced one unit for the month, the per unit cost would be $6,000 but
when we produce 1,000 units, the per unit cost goes down to $6. The higher the volume, fixed
costs will decrease on a per unit basis.

Mixed costs (Semi variable costs) have both a fixed portion and a variable portion. For
example, repairs and maintenance on machines could have a monthly amount always spent on
maintaining the machines (fixed portion). As the machine hours increase, there could be a cost
associated with the increased use. For example, maybe the cost is $1 per machine hour. Other
examples of mixed costs could be utility costs and renting a copier or truck (base charge with a
per unit charge).

All companies will have a different mix of costs which is called a cost structure. It is important
for each company to understand their cost structure. For example, many companies will have a
larger % of fixed costs. There are pros and cons to this type of structure. If most costs are
fixed, the company can produce more for less. However, if a sudden drop in production occurs,
the company must still pay its fixed costs. Think of the rent example from above…..

One last piece to understand for this area is the concept of relevant range. Costs only behave
as we discussed within a certain range. For example, if a company generally produces between
8,000 and 10,000 units a month, the costs will act as we expect but outside the range may
cause different behavior. Let’s say that the company wants to double their production, which
would definitely be outside the range. Fixed costs like rent would have to change as the facility
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space will have to increase so the total fixed cost of rent will change. Unless told otherwise, we
will assume the company is operating within the relevant range.

Problem 2

Explain whether you regard each of the following costs or categories of costs as fixed, variable,
or semi-variable(mixed). Briefly explain your reasoning. If you do not believe that a cost fits into
any of these classifications, explain.

a. The cost of goods sold (in relation to units sold)

b. Salaries to salespeople (these salaries include a monthly minimum amount, plus a
commission on all sales).
c. Income taxes expense.
d. Property taxes expense.
e. Depreciation expense on a sales showroom, based on the straight-line method of
depreciation.
f. Advertising expense.
g. Hourly Labor employees.

Explore a new format for the Income Statement (CVP) and compare to a multiple step Income
Statement (product vs period)

In Financial Accounting, a traditional multiple step Income Statement is used. An example is

listed below. This format would be used for external users.

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We need to use a different format to accommodate the cost classifications of variable, fixed and
mixed costs. It is called a CVP or Contribution Income Statement (see example below). This
format is only used for internal users.
Per unit

Sales 100% 80,000 $15.38

Variable Costs 65% 52,000 $10.00
Contribution
Margin 35% 28,000 $5.38
Fixed Costs 14,933
Operating
Income $13,067

Looking at this example, can you tell me how many units we have sold?
If you calculated 5,200 you would be correct. The volume is calculated by taking the dollars and
dividing by per unit sale price. If I had given you the 5,200 units, you would be able to calculate
per unit cost. This Income Statement looks very different from the traditional Income Statement
(listed on page 3) which is classified on product vs period costs. Also, note that we are not
including income taxes or any non-operating items. Please note there are no mixed costs. A
mixed cost would be broken down into its fixed and variable portion. The two examples of
Income Statements are independent of each other. If they were the same company, the
operating income would equal under both formats.

Why do we need a new Income Statement format? This format will help us to analyze changes
in costs and volume to predict changes to the profit (operating income). For example, what
happens if volume increases or decreases? What is the impact to the bottom line? What if the
variable cost per unit increases but the volume stays the same? When is break even reached?
Break even means the company has no profit or fixed costs = contribution margin.

How to use CVP analysis to determine whether to add a new product line, change the current
sales mix to make a company more profitable and evaluating new promotions/purchases to
calculate the impact to profit

Please recalculate the Income Statement above with two independent scenarios. First,
calculate the profit if you sold 10% less units. Problem 3 (see answers at end of the notes) A
couple things to note that sales price per unit is not changing and assume all costs will behave
normally (within the relevant range). Remember how the costs behave…..
Check your answer at the end before trying the next scenario.
For the next independent scenario, assume that some of the materials to make the product are
changing. The marketing department predicts that an increase of .50 per unit for higher-end
materials will allow the company to sell 5% more than the current volume of 5,200. A small
price increase of .60 is also expected. In addition, a new machine must be purchased which
will cause the depreciation to increase by $2,000. Make all these changes in one new CVP
Income Statement. Should these changes be made? A lot to change here….. My
recommendation to understand this problem is to always start with the per unit amounts. I
would recalculate per unit sale price and variable cost. Next, I would determine the new volume
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and then use per unit amounts to calculate the total sales $ and variable $. Don’t forget for this
problem there is a change to fixed costs. Problem 4(answers at end of notes)
Looking at the changes, the operating income is less than the original scenario. Should we
make these changes? The answer might be yes! Why??? Let’s talk about the contribution
margin. This is calculated by taking the sales price – variable cost. In the revised scenario, the
contribution margin has increased which means at some point an increased volume will allow
the company to increase the bottom line as the fixed costs will remain the same. Looking at this
problem, I would say any volume increase over the 5% will increase the profit. Increase the
volume by 10% and the profit will be larger than the original scenario. If the company thinks
they can sell more units, changes should be made.

Break even and targeted profit calculations

There are many formulas used in this chapter. Companies need to understand how many units
or sales $ they need to break even or to have a targeted profit. This concept is especially
important when adding a new product line, entering new markets, or making changes to a
current product. The formulas are listed below with some explanations as needed.

Contribution Margin(CM) Ratio

Contribution margin per unit(or total)
Unit sales price(or total)
This ratio helps us to understand how much of the fixed costs will be covered
from each unit sold. Once the fixed costs are covered, this is the amount that will be
added to the bottom line for each unit sold. For example, if a company’s CM=$100 per
unit and 5 units are sold over break even, the profit will increase by $500. You can see
the CM ratio on the earlier income statement. It was 35%. Keep in mind that sales are
100% which means the variable costs are 65%.

Break even(BE) or Targeted Profit(TP) in units and sales $

BE or TP Units sold = Fixed costs + targeted profit(0 if BE)

Unit Contribution margin
BE or TP Sales $= Fixed costs + targeted profit(0 if BE)
Contribution ratio
Change in Operating income from a change in sales
$ or % change in sales X CM Ratio = Change in $ or % to operating income
For example, if sales increase by $100 and the company’s cm ratio is 30%, operating income
will increase by $30.

Margin of Safety(MOS)(excess of budgeted or actual sales over break even sales)

MOS $ = total budget or actual sales – break even sales
MOS % = MOS $
Total budget or actual sales

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 MOS is important to understand as companies need to understand where the current or
budgeted sales are in relation to break-even sales. The higher the MOS translates to less risk
that the company will have an operating loss.

See the next few problems to practice these formulas.

Problem 5
City Ambulance Service estimates the monthly cost of responding to emergency calls to be
$15,000, plus $200 per call.

1. In a month in which the company responds to 150 emergency calls, determine the
estimated:
a. Total cost of responding to emergency calls.
b. Average cost of responding to emergency calls.

2. Assume that in a given month, the number of emergency calls was unusually low. Would
you expect the average cost of responding to emergency calls during this month to be
higher or lower than in other months? Explain.

PROBLEM 6
Firebird Mfg. Co. has a contribution margin ratio of 30 percent and must sell 75,000 units at a
price of $60 each in order to break even.
a. Compute total fixed costs. Do not forget that Fixed costs=CM
b. Compute variable cost per unit.
c. Develop the company's cost formula.

PROBLEM 7

Chaps & Saddles, a retailer of tack and Western apparel, earns an average contribution margin
of 40 percent on its sales volume. Recently, the advertising manager of a local “country” radio
station offered to run numerous radio advertisements for Chaps & Saddles at a monthly cost of
$2,400.

Compute the amount by which the proposed radio advertising campaign must increase Chaps &
Saddles's monthly sales volume to:

A. Pay for itself.

B. Increase operating income by $1,200 per month.

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Evaluate multiple product lines within a company

The discussion so far is focusing on companies with one product/service which is unreasonable
to assume for most companies. When companies sell more than one product, sales mix is
important to understand. Sales mix is the % of sales for each product line. Also, keep in mind
that each product line will have its own contribution margin and %. We will have to use a
weighted average for a company’s total contribution margin. For example, a company has two
product lines, pencils and pens with sales of $100,000 and $400,000 respectively. The sales
mix would be 20% pencils and 80% pens. If the CM% for the pencils is 40% and the pens are
20%. The company’s total weighted average contribution margin would be????

Pencils 20% X 40% = 8%

Pens 80% X 20% = 16%

Weighted Avg CM 24%

What is the impact to the profit if we switched the sales mix? If we sold more of the pencils with
a higher CM, the profit would increase. Keep in mind that it is important for companies to
understand their sales mix and which products are contributing more profit to the company’s
overall profit.

Try problem 8 to practice with a company that has two product lines.

PROBLEM 8

Glow Worm Corporation makes flashlights and batteries. Its monthly fixed costs average
$1,600,000. The company has provided the following information about its two product lines:

Contribution Margin Percentage of Total

Ratio Sales
Flashlights . . . . . . . . . . . . . . . . . . . . . . . 60% 20%
Batteries . . . . . . . . . . . . . . . . . . . . . . . . 25 80
.

A. Determine the company's monthly break-even point in sales dollars.

B. How much revenue must the company generate in the upcoming month for a monthly
operating income of $3,000,000?

The first calculation that you should complete is the total company’s weighted average
contribution margin so you can calculate the break even in sales dollars.

To summarize, companies have many tools to help them understand how profit changes in
relation to volume and costs. When you start the homework, you will be able to practice more of
the concepts that we have discussed. Keep in mind that sometimes there are different
approaches that can be used for the same problem.

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ANSWERS

PROBLEM 1

The following activity bases could be suggested to each of

your clients:
Client Possible Activity Bases
Freeman’s Retail Sales dollars; # of
Floral Shop customers
Susquehanna Trails Passenger miles driven; #
Bus Service of customers
Wilson Pump Manufacturers Number of pumps
produced
Sales dollars
Machine hours
Direct labor hours
McCauley & Pratt, Attorneys Billable client hours
at Law
Number of cases

PROBLEM 2

a. Variable. The cost of goods sold normally rises and falls in almost direct
proportion to changes in net sales.
b. As described in this exercise, the salaries to salespeople are semi-variable with
respect to net sales. The monthly minimum amount represents a fixed cost that
does not vary with fluctuations in net sales. However, the commissions on sales
transactions represent a variable element of sales salaries that does fluctuate in
approximate proportion to fluctuations in net sales.

c. Income taxes are not a fixed, variable, or semi-variable cost with respect to net
sales. Income taxes may be viewed as a variable cost, but the relevant activity
base is taxable income, not net sales. (Different tax brackets complicate the
analysis of income taxes expense, even given taxable income as the activity base.
Therefore, cost-volume-profit analysis usually focuses upon operating
income—that is, income before income tax expense and other items that resist
classification as costs that are fixed, variable, or semi-variable with respect to net sales).
d. Fixed.
e. Fixed.
f. Fixed.
g. Variable.

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Problem 3
New Volume = 4680
per unit
Sales $71,978 $15.38
Variable Costs 46,800 $10.00
Contribution
25,178
Margin $5.38
Fixed Costs 14,933
Operating Income $10,245

Please note that per unit does not change in this problem– just the volume. No changes occur
in fixed cost due to volume changes.

Problem 4

Per
Volume 5,460 unit
Sales 87,250 $15.98
Variable Costs 57,330 $10.50
Contribution
Margin 29,920 $5.48
Fixed Costs 16,933
Net Income $12,987

Problem 5

1. (a) Estimated cost of responding to 150 emergency calls

in one month:
Fixed element of monthly emergency response
cost
……………………………………………….. $15,000
Variable cost of responding to 150 calls
(150 calls × $200 per call) ……………………… 30,000
Estimated total cost of responding to emergency
calls ………………………………………………..
$45,000

(b) Average cost per call (150 calls per month):

Estimated total cost of responding to 150
emergency calls per month [part a (1)] ……… $45,000
Number of calls …………………………………… 150
Average cost per call ($45,000 ÷ 150 calls) ……. $300

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2. The overall cost of responding to emergency calls is
semivariable—that is, it includes both fixed and variable
elements. Therefore, when the volume of emergency calls is
unusually low, the average cost of responding to each call will
rise, because the fixed cost elements must be spread over fewer
calls.

PROBLEM 6

a. CM% is 30% x $60 sales price =$18 per unit for the
contribution margin. Fixed costs must equal contribution
margin at break-even so $18 x 75,000 units = $1,350,000. Or
use the calculation below…..

Break-even sales volume ($60 × 75,000 units) … $4,500,000

Contribution margin ratio ………………………………. 30%
Fixed costs ($4,500,000 × 30%) ……………………………. $1,350,000

b. Break-even sales volume ($60 × 75,000 units) …………… $4,500,000

Less: Fixed costs (part a) ………………………………… 1,350,000
Variable cost at 75,000 units ……………………………… $3,150,000
Variable cost per unit ($3,150,000 ÷ 75,000 units) ……… $ 42

Alternatively, if the contribution margin ratio is 30%, variable costs must amount
to 70% of the unit sales price. Thus, $60 sales price × 70% = $42. I would use
this calculation as it seems easier.
c. Total costs = fixed costs + (variable cost per unit × number of units)
= $1,350,000 + ($42 × number of units)

PROBLEM 7

a. $6,000 ($2,400 additional monthly fixed cost, divided by 40%

contribution margin)
b. $9,000 [($2,400 additional cost + $1,200 target
operating income) ÷ 40%]

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PROBLEM 8

a. Contribution Percentage of Average

× Total
Margin Ratio Sales = Contribution
Flashlights 60% 20% 12%
Batteries 25% 80% 20%
Average contribution margin ratio 32%

Break-Even
Fixed Costs/Average Contribution Margin Ratio =
Sales Revenue

$1,600,000 ÷ 32% = $5,000,000

b. Fixed Costs + Target Operating Income
= Target Revenue
Average Contribution Margin Ratio

($1,600,000 + $3,000,000) ÷ 32% = $14,375,000

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