Test bank Accounting Management 11e Chapter 03 COST- Volume- Profit Analysis PDF

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CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS LEARNING OBJECTIVES 1. Understand the assumptions underlying cost-volume-profit (CVP) analysis 2. Explain the features of CVP analysis 3. Determine the breakeven point and output level needed to achieve a target operating income using the equation, contribution ...

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CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS LEARNING OBJECTIVES 1. Understand the assumptions underlying cost-volume-profit (CVP) analysis 2. Explain the features of CVP analysis 3. Determine the breakeven point and output level needed to achieve a target operating income using the equation, contribution margin, and graph methods 4. Understand how income taxes affect CVP analysis 5. Explain CVP analysis in decision making and how sensitivity analysis helps managers cope with uncertainty 6. Use CVP analysis to plan fixed and variable costs 7. Apply CVP analysis to a company producing different products 8. Adapt CVP analysis to situations in which a product has more than one cost driver 9. Distinguish between contribution margin and gross margin

CHAPTER OVERVIEW Chapter 3 presents the cost-volume-profit (CVP) analysis model. Much “what-if” knowledge may be derived from the use of a model, certainly the case with CVP analysis. Models are developed from known relationships and used for forecasting. CVP uses one cost driver, volume of units produced and sold, and uses the behavior of costs, variable or fixed, in relation to that cost driver. As with all models, a complex situation is simplified. The assumptions of CVP analysis identify the simplifications made. Throughout the chapter, reference is made to changes in the CVP model to allow for more complexity. The complexities do not render the model useless, they generally require additional factors be considered for producing better predictions. Relevant information for strategic and planning decisions can be made readily available. The text focuses on accountants providing value for decision makers. CVP analysis is a useful tool for providing cost/beneficial information on a timely basis. The basic CVP model deserves careful study. The last section of the appendix is noteworthy. With the emphasis on decision making in the text, the point made about distinguishing between a good decision and a good outcome and/or a good decision and a bad outcome seems especially relevant. TEACHING TIP: An excellent article on the value of models is “Going Forward in Reverse” by Einhorn & Hogarth, Harvard Business Review, Jan./Feb. 1987, pp. 66-70.

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CHAPTER OUTLINE I. I

Basic Cost-Volume-Profit (CVP) model A. Definition of CVP analysis: examines the behavior of total revenues, total costs, and operating income as changes occur in output level, selling price, variable cost per unit, and/or fixed costs

Learning Objective 1: Understand the assumptions underlying cost-volume-profit (CVP) analysis B. Assumptions 1. Simplifications of complex relationships a. Number of output units only revenue driver and only cost driver b. Total costs can be separated into the primary categories of variable costs and fixed costs c. Total revenues and total costs are linear within the relevant range (and time period) d. Unit selling price, unit variable costs, and fixed costs known and constant e. Single product or constant sales mix f.

Time value of money effects ignored

2. Complexities noted in chapter that affect basic model a. Multiple revenue and multiple cost drivers b. Lack of linearity Do multiple choice 1.

Assign Exercise 3-16.

Learning Objective 2: Explain the features of CVP analysis C. Features and terminology 1. Income model: Revenues – Expenses = Income 2. Contribution margin: Total revenues – Total variable costs a. Calculated per unit: Selling price/unit – Variable cost/unit [Exhibit 3-1] b. Calculated as a percent of sales or ratio: Contribution Margin/Sales c. Calculated as a total: Sales (Revenues) – Variable costs 3. Multiple-step-type income statement: Rev – VC = CM – FC = OI

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Chapter 3

4. Operating income versus Net income a. OI + Nonoperating Rev. – Nonoperating Costs – Income Tax = NI b. Chapter 3 assumes zero for nonoperating revenues and expenses Do multiple choice 2.

Assign Exercises 3-17 and 3-20.

II. Breakeven concept A. Definition of breakeven point: quantity of output sold at which total revenues equal total costs Learning Objective 3: Determine the breakeven point and output level needed to achieve a target operating income using the equation, contribution margin, and graph methods B. Contribution margin approach to calculation 1. Equation method: (USP x Q) – (UVC x Q) – FC = OI 2. Contribution margin method a. Per unit approach that calculates breakeven in units of output [Use algebraic equation UCM x Q = FC + OI —>UCM x Q = Total CM to calculate Q , units, as FC + OI = CM] b. Ratio or percentage approach that calculates breakeven in dollars of revenue [Use equation CM% x Revenues = FC + OI—>CM% x Revenues = Total CM to calculate Revenues by dividing both sides by CM%: CM% = CM/Revenues] 3. Graph method: x-axis output units, y-axis dollars; total revenue and total cost lines intersect at breakeven output quantity [Exhibits 3-2 and 3-3] Do multiple choice 3.

Assign Exercises 3-21 and 3-23 and Problem 3-34.

TEACHING TIP: Exercise 3-23 is a good example to use before studying sales mix. This exercise uses an average revenue amount for the calculations. When studying sales mix, referencing an “average sales check per customer” provides an illustration of differing products, from a cup of coffee to a full dinner. More sales checks for cups of coffee than for full dinners would change the “average” downward. C. Useful for target income 1. Operating income: FC + Target OI can be divided by UCM for units of output or divided by CM% for dollars of revenue (sales) Learning Objective 4: Understand how income taxes affect CVP analysis 2. Net income: Target OI must be adjusted by incorporating income tax Target net income/(1 – Tax rate) = Target operating income

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TEACHING TIP: The use of the income statement format may be helpful to some students, Target Operating Income 100%TOI { $40,000} Tax (Tax Rate x TOI) 35% -35%TOI {.35x40,000 14,000} Target Net Income 65%TOI = $26,000 —> TOI = $26,000 / 0.65 = $40,000 3. Any of the three approaches for calculating breakeven may be used for target income TEACHING TIP: A caution for students when calculating target income, especially if using total rather than unit costs: variable costs in total are variable with respect to volume and will change if output units change or are expected to change. Use of an equation with contribution margin is helpful. To calculate revenues use the equation, CM% x Revenues = CM in total dollars, or to calculate output units, UCM x Q = CM in total dollars. [CM in total dollars in equal to FC + target OI.] Do multiple choice 4.

Assign Problem 3-36.

D. Effect of income taxes: BEP unaffected by income taxes because no tax is no operating income Do multiple choice 5.

Assign Problem 3-39.

Learning Objective 5: Explain CVP analysis in decision making and how sensitivity analysis helps managers cope with uncertainty E. Useful for decision making 1. Can incorporate changes in total fixed costs, selling price per unit (changes CM per unit), unit variable cost, and units sold 2. Helps managers by estimating long-term profitability of choices 3. Evaluates risk to operating income if original predicted data not achieved III. Sensitivity analysis [Exhibit 3-4] A. Definitions 1. Sensitivity analysis: “what-if” technique managers use to examine how a result will change if original predicted data not achieved or if an underlying assumption changes 2. Uncertainty: possibility that an actual amount will deviate from an expected amount B. Used before committing costs 1. Analysis of changes in operating income for changes underlying assumptions 2. Systematic and efficient approach 3. Allows for calculation of margin of safety: amount of budgeted revenues over and above breakeven revenues

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Chapter 3

4. [Appendix] Probability and expected value incorporated Do multiple choice 6.

Assign Problems 3-38, 3-40 and 3-41.

Learning Objective 6: Use CVP analysis to plan fixed and variable costs II C. Highlights risks and returns 1. Highlights risks and returns as fixed costs are substituted for variable costs in cost structure TEACHING TIP: A section in the chapter appendix references a manager’s attitude toward risk (each decision has its own attitude as well as each manager has such an attitude). Following are descriptive phrases for discussing risk attitudes: (1) risk neutral: decision maker weighs each dollar as a full dollar, no more, no less; (2) risk averse: decision maker weighs loss of dollar as greater than gain of dollar; (3) risk seeking: decision maker weighs gain of dollar as greater than loss of dollar. 2. Demand for product or service is variable [Exhibit 3-5] 3. Use of operating leverage: effect fixed costs have on changes in operating income as changes occur in units sold (contribution margin)—degree of operating leverage equals contribution margin divided by operating income [Concepts in Action] Do multiple choice 7.

Assign Exercise 3-26.

TEACHING TIP: Operating leverage is obviously named for the “lever” effect that comes from the use of fixed costs to generate more profit. Costs are incurred to generate revenues. If the choice exists to incur fixed or variable cost, and fixed is chosen, then variable cost would be less, yielding a larger contribution margin and the possibility of larger profit. Once the fixed costs are recovered, the contribution margin is profit. This effect can be seen on a breakeven graph. The intersecting revenue and total cost lines create equal and opposite angles at the intersection point. One can note that the risk (downside) is equal to the reward (upside). The larger the fixed cost, the wider the intersection angles usually: the greater the opportunity for reward, the greater the possibility of loss. 4. Cost labels as fixed or variable a. Time frame affects costs: shorter the time frame, more costs fixed b. Relevant range assumes limits for constancy of total fixed costs or unit variable costs c. Specific question/decision affects relevancy of cost classification IV. Products and CVP: A complexity Learning Objective 7: Apply CVP analysis to company producing different products A. Sales mix: CVP assumption for one product or a constant mix of different products

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1. No unique breakeven point when selling a mix of multiple products: each new mix, a new BEP 2. Profit varies even though same total quantity of units sold: Mix with more units of larger dollar amount of contribution margin per unit yields greater profit{affects BEP} 3. Profit varies even though same total dollars of revenue: Mix with more units of larger contribution margin ratio sold yields greater profit Do multiple choice 8.

Assign Exercise 3-28 and Problems 3-44 and 3-46.

B. Service as a product 1. Define “product” or output unit for measurement 2. Use CVP model for relationship between revenues, variable costs and fixed costs 3. Use CVP analysis for prediction and consideration for adjusting operations Learning Objective 8: Adapt CVP analysis to situations in which a product has more than one cost driver C. Multiple cost drivers 1. No unique breakeven point 2. CVP model can be adapted by changes to the variable cost for situation but simple formula cannot be used Do multiple choice 9.

Assign Exercise 3-30 and Problem 3-43.

Learning Objective 9: Distinguish between contribution margin and gross margin D. CVP uses contribution margin as opposed to gross margin* on financial accounting income statements 1. Service-sector companies a. Costs primarily classified as either variable or fixed for calculating contribution margin b. Do not have cost of goods sold so cannot use gross margin emphasis 2. Merchandising-sector companies a. Costs are primarily classified as either variable or fixed for calculating contribution margin b. Costs are primarily classified as either cost of goods sold or operating costs for gross margin emphasis

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Chapter 3

c. If any fixed costs were included in cost of goods sold, they would be reclassified as operating costs for contribution margin emphasis 3. Manufacturing-sector companies a. Costs primarily classified as variable or fixed for calculating contribution margin b. Costs primarily classified as manufacturing or nonmanufacturing in calculating gross margin c. Variable nonmanufacturing costs above the “margin line” for contribution margin calculation but below for gross margin d. Fixed manufacturing costs above the “margin line” for gross margin calculation but below for contribution margin e. Fixed manufacturing costs used as per unit cost for cost of goods sold (gross margin) but as total cost for contribution margin 4. For statement comparison purposes costs should be classified with both classifications a. Variable manufacturing and variable nonmanufacturing b. Fixed manufacturing and fixed nonmanufacturing * Gross margin can be expressed as a total, as an amount per unit, or as a percentage. If gross margin is expressed as a percentage the basis could be revenue or cost of goods sold. Conversion is simple from one base to the other, but the base must be noted for one to know to convert. See TEACHING TIP for conversion.

TEACHING TIP: Quick conversion calculation for GM as a percentage of CGS or revenue: Revenue 125% 100% Revenue 100% 150% CGS 100% 80% CGS 66.7% 100% Gross margin 25% 20% Gross margin 33.3% 50% Conversion: Divide GM (as a percentage of CGS) by revenue (when CGS is 100%) to convert GM to a percentage of revenue: 25%/125% = 20%; a markup of 25% with a margin of 20% or for GM as a percentage of CGS when originally given as percentage of revenue: 33.3% /66.7% = 50%; a margin of 33.3% with a markup of 50%. Do multiple choice 10.

Assign Exercise 3-31.

V. Appendix: Decision models and uncertainty [Exhibit 3-6] A. Use of a decision model B. Identify events (differentiated from actions) C. Consider past experience to project probabilities D. Incorporate risk attitude E. Distinguish between good decision and good outcome

CHAPTER QUIZ SOLUTIONS: 1.a

2.c 3.b 4.a 5.c 6.d 7.b 8.c 9.b 10.d

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CHAPTER QUIZ 1.

Which of the following is not an assumption of cost-volume-profit analysis? a. b. c. d.

2.

The time value of money is incorporated in the analysis. Costs can be classified into variable and fixed components. The behavior of revenues and expenses is accurately portrayed as linear over the relevant range. The number of output units is the only driver.

Contribution margin is calculated as a. b. c. d.

total revenue – total fixed costs. total revenue – total manufacturing costs (CGS). total revenue – total variable costs. operating income + total variable costs.

Questions 3–5 are based on the following data: Tee Times, Inc., produces and sells the finest quality golf clubs in all of Clay County. The company expects the following revenues and costs in 2003 for its Elite Quality golf club sets: Revenues (400 sets sold @ $600 per set) Variable costs Fixed costs 3.

How many sets of clubs must be sold for Tee Times, Inc., to reach their breakeven point? a. 400

4.

d. 150

b. 500

c. 400

d. 300

b. $429,000

c. $420,000

d. $300,000

One way for managers to cope with uncertainty in profit planning is to a. b. c. d.

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c. 200

What amount of sales must Tee Times, Inc., have to earn a target net income of $63,000 if they have a tax rate of 30%? a. $489,000

6.

b. 250

How many sets of clubs must be sold to earn a target operating income of $90,000? a. 700

5.

$240,000 160,000 50,000

use CVP analysis because it assumes certainty. recommend management hire a futurist whose work it is to predict business trends. wait to see what does happen and prepare a report based on actual amounts. use sensitivity analysis to explore various what-if scenarios in order to analyze changes in revenues or costs or quantities.

Chapter 3

7.

The Beta Mu Omega Chi (BMOC) fraternity is looking to contract with a local band to perform at its annual mixer. If BMOC expects to sell 250 tickets to the mixer at $10 each, which of the following arrangements with the band will be in the best interest of the fraternity? a. b. c. d.

8.

Twin Products Company produces and sells two products. Product M sells for $12 and has variable costs of $6. Product W sells for $15 and has variable costs of $10. Twin predicted sales of 25,000 units of M and 20,000 of W. Fixed costs are $60,000 per month. Assume that Twin achieved its sales goal of $600,000 for September, but fell short of its expected operating income of $190,000. Which of the following descriptions best describes the actual results reported of revenue of $600,000 and operating income of less than $190,000? a. b. c. d.

9.

$2500 fixed fee $1000 fixed fee plus $5 per person attending $10 per person attending $25 per couple attending

Twin sold 50,000 of M and no product W. Twin sold more of both products M and W than expected. Twin sold more of product W and less of product M than expected. Twin sold more of product M and less of product W than expected.

In the situation of multiple cost drivers, CVP analysis can be a. modified so that the various simple formulas can be used by applying them separately to each cost driver. b. used with the same formulas as used with a single cost driver. c. changed by incorporating all of the cost drivers into the breakeven formula to calculate the unique point of output at which the company would break even. d. adapted by incorporating the cost drivers into the calculation of the variable costs.

10. Which of the following statements is true? a. “Gross margin” can be used only in financial accounting income statements. b. “Gross margin” implies a different cost classification usage than the term “contribution margin” when used in income statements. c. “Contribution margin” can be used in place of “gross margin” if management prefers that terminology in their financial statements. d. Only manufacturing-sector companies use the term “gross margin” in their income statements.

Cost-Volume-Profit Analysis

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WRITING/DISCUSSION EXERCISES 1. Understand the assumptions underlying cost-volume-profit (CVP) analysis

How helpful is a model, such as CVP analysis, if the assumptions on which it is based seem too simplistic? Even the simplest models can be helpful. Models describe known relationships and their use can prevent errors of omission by focusing on basic concepts and interactions as well as enable learning. From a simple checklist to the most sophisticated artificial intelligence program, models force one to take certain steps and combine factors in particular ways. Airline pilots, even the most experienced, use a checklist before take-off to insure that they did not forget a key item. Models or simulations are also helpful in teaching a person to perform a task. The CVP analysis model is a cost-effective tool that managers can use for gathering relevant information in the process of making decisions. The simple CVP relationships are helpful in strategic and long-range planning decisions, for example. Knowing the assumptions of the basic model, one can incorporate changes to refine or particularize for a given situation. The need for a more complex model is recognized after using the basic ideas of the CVP analysis. The choice of incurring additional costs is supported for gaining significant benefit of improved decisions with a more complicated and expensive...