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Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 11th Edition Chapter 6 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter Six Cost-Volume-Profit Relationships This is one of the most important chapters in the text. It integrates much of what we have learned so far. We will learn the relationships among product costs, sales volumes and resulting profits. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Basics of Cost-Volume-Profit Analysis Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted. Contribution margin is defined as sales less variable expenses. In the case of Racing Bicycle Company, contribution margin is one hundred thousand dollars. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Basics of Cost-Volume-Profit Analysis CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income. Contribution margin is used first to cover fixed expenses. Any remaining contribution margin contributes to net operating income. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. If Racing sells an additional bicycle, $200 additional CM will be generated to cover fixed expenses and profit. Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. For each additional unit Racing Bicycle Company sells, $200 more in contribution margin will help to cover fixed expenses and provide a profit. Each month Racing Bicycle must generate at least $80,000 in total contribution margin to break-even (which is the level of sales at which profit is zero). If Racing sells 400 units a month, it will be operating at the break-even point. If Racing sells one more bike (401 bikes), net operating income will increase by $200. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach Each month Racing must generate at least $80,000 in total CM to break even. Each month Racing Bicycle must generate at least $80,000 in total contribution margin to break-even (which is the level of sales at which profit is zero). Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach If Racing sells 400 units in a month, it will be operating at the break-even point. If Racing sells 400 units a month, it will be operating at the break-even point. If Racing sells one more bike (401 bikes), net operating income will increase by $200. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach If Racing sells one more bike (401 bikes), net operating income will increase by $200. You can see that the sale of one unit above the break-even point yields net income of two hundred dollars for Racing Bicycle ...

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Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 11th Edition Chapter 6 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter Six Cost-Volume-Profit Relationships This is one of the most important chapters in the text. It integrates much of what we have learned so far. We will learn the relationships among product costs, sales volumes and resulting profits. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Basics of Cost-Volume-Profit Analysis Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted. Contribution margin is defined as sales less variable expenses.
In the case of Racing Bicycle Company, contribution margin is one hundred thousand dollars. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Basics of Cost-Volume-Profit Analysis CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income. Contribution margin is used first to cover fixed expenses. Any remaining contribution margin contributes to net operating income. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. If Racing sells an additional bicycle, $200 additional CM will be generated to cover fixed expenses and profit. Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. For each additional unit Racing Bicycle Company sells, $200 more in contribution margin will help to cover fixed expenses and provide a profit. Each month Racing Bicycle must generate at least $80,000 in
total contribution margin to break-even (which is the level of sales at which profit is zero). If Racing sells 400 units a month, it will be operating at the break-even point. If Racing sells one more bike (401 bikes), net operating income will increase by $200. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach Each month Racing must generate at least $80,000 in total CM to break even. Each month Racing Bicycle must generate at least $80,000 in total contribution margin to break-even (which is the level of sales at which profit is zero). Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach If Racing sells 400 units in a month, it will be operating at the break-even point. If Racing sells 400 units a month, it will be operating at the break-even point. If Racing sells one more bike (401 bikes), net operating income will increase by $200. Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin The Contribution Approach If Racing sells one more bike (401 bikes), net operating income will increase by $200. You can see that the sale of one unit above the break-even point yields net income of two hundred dollars for Racing Bicycle. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach We do not need to prepare an income statement to estimate profits at a particular sales volume. Simply multiply the number of units sold above break-even by the contribution margin per unit. If Racing sells 430 bikes, its net income will be $6,000. If we develop equations to calculate break-even and net income, we will not have to prepare an income statement to determine what net income will be at any level of sales. For example, we know that if Racing Bicycle sells four hundred thirty bikes, net income will be six thousand dollars. The company will sell thirty bikes above the break-even unit sales and the contribution margin is two hundred dollars per bike. So, we multiply thirty bikes times two hundred dollars per bike and get net income of six thousand dollars.. Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin CVP Relationships in Graphic Form The relationship among revenue, cost, profit and volume can be expressed graphically by preparing a CVP graph. Racing developed contribution margin income statements at 300, 400, and 500 units sold. We will use this information to prepare the CVP graph. The relationship among revenue, cost, profit and volume can be expressed graphically by preparing a cost-volume-profit (CVP) graph. To illustrate, we will use contribution income statements for Racing Bicycle Company at three hundred, four hundred, and five hundred units sold. Sheet1Income 300 unitsIncome 400 unitsIncome 500 unitsSales$ 150,000$ 200,000$ 250,000Less: variable expenses90,000120,000150,000Contribution margin$ 60,000$ 80,000$ 100,000Less: fixed expenses80,00080,00080,000Net operating income$ (20,000)$ - 0$ 20,000 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Units Dollars In a CVP graph, unit volume is usually represented on the horizontal (X) axis and dollars on the vertical (Y) axis.
In a CVP graph, unit volume is usually represented on the horizontal (X) axis and dollars on the vertical (Y) axis. Once we have settled on this convention we will plot the fixed cost. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P
Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Units Dollars Fixed Expenses
The first step begins by drawing a line parallel to the volume axis to represent total fixed expenses of eighty thousand dollars. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P Sheet9 &A
Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Dollars Units Fixed Expenses Total Expenses
Next, choose some sales volume (for example, five hundred units) and plot the point representing total expenses (e.g., fixed and variable) at that sales volume. Draw a line through the data point back to where the fixed expenses line intersects the dollar axis. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A
Page &P Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Dollars Units Fixed Expenses
Total Expenses Total Sales Finally, choose some sales volume (for example, five hundred units) and plot the point representing total sales dol lars at the chosen activity level. Draw a line through the data point back to the origin. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7
&A Page &P Sheet8 &A Page &P Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Dollars
Units Profit Area Loss Area Break-even point (400 units or $200,000 in sales) The break-even point is where the total revenue and total expenses lines intersect. In the case of Racing Bicycle, break- even is four hundred bikes sold, or sales revenue of two hundred thousand dollars. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P
Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin Contribution Margin Ratio The contribution margin ratio is: For Racing Bicycle Company the ratio is: Each $1.00 increase in sales results in a total contribution margin increase of 40¢. Total CM Total sales CM Ratio = $80,000 $200,000 = 40% We can calculate the contribution margin ratio of Racing Bicycle by dividing total contribution by total sales. In the case of Racing Bicycle, the contribution margin ratio is forty percent. This means that for each dollar increase in sales the company will produce forty cents in contribution margin. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Contribution Margin Ratio Or, in terms of units, the contribution margin ratio is:
For Racing Bicycle Company the ratio is: $200 $500 = 40% Unit CM Unit selling price CM Ratio = We may also calculate the contribution margin ratio using per unit amounts. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Contribution Margin Ratio A $50,000 increase in sales revenue results in a $20,000 increase in CM. ($50,000 × 40% = $20,000) Let’s see how we can use the contribution margin ratio to look at the contribution margin income statement of Racing Bicycle in a little different way. If Racing is able to increase its sales by fifty thousand dollars, it will increase contribution margin by twenty thousand dollars, that is, fifty thousand dollars times forty percent. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution
margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000400 Bikes500 BikesSales$ 200,000$ 250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net operating income$ - 0$ 20,000 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A
Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the CM Ratio for Coffee Klatch? a. 1.319 b. 0.758 c. 0.242 d. 4.139 Can you calculate the contribution margin ratio for Coffee Klatch? The calculation may take a minute or so to complete.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the CM Ratio for Coffee Klatch? a. 1.319 b. 0.758 c. 0.242 d. 4.139 Unit contribution margin Unit selling price CM Ratio = = ($1.49-$0.36) $1.49 = $1.13 $1.49 = 0.758 How did you do? The CM ratio is seventy-five point eight percent. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Changes in Fixed Costs and Sales Volume What is the profit impact if Racing can increase unit sales from 500 to 540 by increasing the monthly advertising budget by $10,000? Let’s assume that the management of Racing Bicycle believes it can increase unit sales from five hundred to five hundred forty if it spends ten thousand dollars on advertising. Would you recommend that the advertising campaign be undertaken? See if you can solve this problem before going to the next screen. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Changes in Fixed Costs and Sales Volume Sales increased by $20,000, but net operating income decreased by $2,000. $80,000 + $10,000 advertising = $90,000 As you can see, even if sales revenue increases to two hundred seventy thousand dollars, Racing will experience a twelve thousand dollar increase in variable costs and a ten thousand dollar increase in fixed costs (the new advertising campaign). As a result net income will actually drop by two thousand dollars. The advertising campaign would certainly not be a good idea. We can help management see the problem before any additional monies are spent. Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin Changes in Fixed Costs and Sales Volume The Shortcut Solution Here is a shortcut approach to looking at the problem. You can see that an increase in contribution margin is more than offset by the increased advertising costs. Sheet1Increase in CM (40 units X $200)$ 8,000Increase in advertising expenses10,000Decrease in net operating income$ (2,000) Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Variable Costs and Sales Volume
What is the profit impact if Racing can use higher quality raw materials, thus increasing variable costs per unit by $10, to generate an increase in unit sales from 500 to 580? Management at Racing Bicycle believes that using higher quality raw materials will result in an increase in sales from five hundred to five hundred eighty. The higher quality raw materials will lead to a ten dollar increase in variable costs per unit. Would you recommend the use of the higher quality raw materials? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Variable Costs and Sales Volume Sales increase by $40,000, and net operating income increases by $10,200. 580 units × $310 variable cost/unit = $179,800 As you can see, revenues will increase by forty thousand dollars (eighty bikes times five hundred dollars per bike), and variable
costs will increase by twenty-nine thousand eight hundred dollars. Contribution margin will increase by ten thousand two hundred dollars. With no change in fixed costs, net income will also increase by ten thousand two hundred dollars. The use of higher quality raw materials appears to be a profitable idea. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Fixed Cost, Sales Price and Volume What is the profit impact if Racing (1) cuts its selling price $20 per unit, (2) increases its advertising budget by $15,000 per month, and (3) increases unit sales from 500 to 650 units per month? Here is a more complex situation because we will experience a change in selling price, advertising expense, and unit sales. Would you support this plan?
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Fixed Cost, Sales Price and Volume Sales increase by $62,000, fixed costs increase by $15,000, and net operating income increases by $2,000. This appears to be a good plan because net income will increase by two thousand dollars. Take a few minutes and analyze the change in sales revenue, variable expenses and fixed expenses. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Variable Cost, Fixed Cost and Sales Volume What is the profit impact if Racing (1) pays a $15 sales commission per bike sold instead of paying salespersons flat salaries that currently total $6,000 per month, and (2) increases unit sales from 500 to 575 bikes? Here is another complex question involving cost-volume-profit relationships. In this question we eliminate a fixed cost and
substitute a variable cost while increasing the units sold. Be careful with your calculation of the profit impact of these changes. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Variable Cost, Fixed Cost and Sales Volume Sales increase by $37,500, variable costs increase by $31,125, but fixed expenses decrease by $6,000. Net income increases by twelve thousand three hundred seventy-five dollars. Notice that sales revenue and variable expenses increased as well. Fixed expenses were decreased as a result of making sales commissions variable in nature. How did you do? We hope you are beginning to see the potential power of CVP analysis. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Change in Regular Sales Price If Racing has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers or fixed expenses, what price would it quote to the wholesaler if it wants to increase monthly profits by $3,000? Suppose Racing Bicycle has a one-time opportunity to sell one hundred fifty bikes to a wholesaler. There would be no change in the cost structure as a result of this sale. Racing wants the one-time sale to produce a profit of three thousand dollars. What selling price should Racing quote to the wholesaler? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Regular Sales Price If we desire a profit of three thousand dollars on the sale of one hundred fifty bikes, we must have a profit of twenty dollars per bike. The variable expenses associated with each bike are three hundred dollars, so we would quote a selling price of three
hundred twenty dollars. You can see the proof of the quote in the blue schedule. Sheet1$ 3,000÷150 bikes=$ 20per bikeVariable cost per bike=300per bikeSelling price required=$ 320per bi ke Sheet2 Sheet3 Sheet1150 bikes×$320 per bike=$ 48,000Total variable costs=45,000Increase in net income=$ 3,000 Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Break-Even Analysis Break-even analysis can be approached in two ways: Equation method Contribution margin method
We can accomplish break-even analysis in one of two ways. We can use the equation method or the contribution margin method. We get the same results regardless of the method selected. You may prefer one method over the other. It’s a personal choice, but be aware there are some problems associated with either method. Some are easier to solve using the equation method, while others can be quickly solved using the contribution margin method. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Equation Method Profits = (Sales – Variable expenses) – Fixed expenses Sales = Variable expenses + Fixed expenses + Profits OR At the break-even point profits equal zero The equation method is based on the contribution approach income statement. The equation can be stated in one of two ways:
Profits equal Sales less Variable expenses, less Fixed Expenses, or Sales equal Variable expenses plus Fixed expenses plus Profits Remember that at the break-even point profits are equal to zero. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Break-Even Analysis Here is the information from Racing Bicycle Company: Here is some information provided by Racing Bicycle that we will use to solve some problems. We have the contribution margin income statement, the selling price and variable expenses per unit, and the contribution margin ratio. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net operating income$ 20,000
&A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P Sheet9 &A
Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin Equation Method We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 Where: Q = Number of bikes sold $500 = Unit selling price $300 = Unit variable expense $80,000 = Total fixed expense The break-even point in units is determined by creating the equation as shown, where Q is the number of bikes sold, five hundred dollars is the unit selling price, three hundred dollars is the unit variable expense, and eighty thousand dollars is the total fixed expense. We need to solve for Q. Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin Equation Method We calculate the break-even point as follows: $500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = $80,000 ÷ $200 per bike Q = 400 bikes Sales = Variable expenses + Fixed expenses + Profits Solving this equation shows that the break-even point in units is 400 bikes. We want to be careful with the algebra when we group terms. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Equation Method The equation can be modified to calculate the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + $80,000 + $0
Where: X = Total sales dollars 0.60 = Variable expenses as a % of sales $80,000 = Total fixed expenses The equation can be modified as shown to calculate the break- even point in sales dollars. In this equation, X is total sales dollars, point six zero (or sixty percent) is the variable expense as a percentage of sales, and eighty thousand dollars is the total fixed expense. We need to solve for X. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Equation Method X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $80,000 ÷ 0.40 X = $200,000 Sales = Variable expenses + Fixed expenses + Profits
The equation can be modified to calculate the break-even point in sales dollars. Solving this equation shows that the break-even point is sales dollars is two hundred thousand dollars. Once again, be careful when you combine the X values in the equation. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Contribution Margin Method The contribution margin method has two key equations. Fixed expenses Unit contribution margin = Break-even point in units sold Fixed expenses CM ratio = Break-even point in total sales dollars
The contribution margin method has two key equations: Break-even point in units sold equals Fixed expenses divided by CM per unit, and Break-even point in sales dollars equals Fixed expenses divided by CM ratio. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Contribution Margin Method Let’s use the contribution margin method to calculate the break- even point in total sales dollars at Racing. Fixed expenses CM ratio = Break-even point in total sales dollars
$80,000 40% = $200,000 break-even sales Part I Let’s use the contribution margin method to calculate break- even in total sales dollars. Part II The break-even sales revenue is two hundred thousand dollars. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average
fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in units? 872 cups b. 3,611 cups c. 1,200 cups d. 1,150 cups Now use the contribution margin approach to calculate the break-even point in cups of coffee sold. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in units? a. 872 cups b. 3,611 cups c. 1,200 cups d. 1,150 cups
Fixed expenses Unit CM Break-even = $1,300 $1.49/cup - $0.36/cup = $1,300 $1.13/cup = 1,150 cups = The contribution margin per cup of coffee is one dollar and thirteen cents. The number of cups to sell to reach break-even is one thousand one hundred fifty. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in dollars? a. $1,300 b. $1,715 c. $1,788 d. $3,129 Let’s calculate the break-even in sales dollars for Coffee Klatch. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in dollars? a. $1,300
b. $1,715 c. $1,788 d. $3,129 Fixed expenses CM Ratio Break-even sales $1,300 0.758 = $1,715 = = With a contribution margin ratio of seventy-five point eight percent rounded, break-even sales revenue is one thousand seven hundred fifteen dollars. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Target Profit Analysis The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit. Suppose Racing Bicycle Company wants to know how many bikes must be sold to earn a profit of $100,000. We can use either method to determine the revenue or units needed to achieve a target level of profits. Suppose Racing Bicycle wants to earn net income of one hundred thousand dollars. How many bikes must the company sell to achieve this profit level? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The CVP Equation Method Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $100,000
$200Q = $180,000 Q = 900 bikes Instead of setting profit to zero like we do in a break-even analysis, we set the profit level to one hundred thousand dollars. Solving for Q, we see that the company will have to sell nine hundred bikes to achieve the desired profit level. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Margin Approach The contribution margin method can be used to determine that 900 bikes must be sold to earn the target profit of $100,000. Fixed expenses + Target profit Unit contribution margin = Unit sales to attain the target profit $80,000 + $100,000 $200/bike
= 900 bikes A quicker way to solve this problem is to add the desired profits to the fixed cost and divide the total by the contribution margin per unit. Notice we get the same result of nine hundred bikes. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. How many cups of coffee would have to be sold to attain target profits of $2,500 per month? a. 3,363 cups b. 2,212 cups c. 1,150 cups d. 4,200 cups
The Coffee Klatch wants to earn a monthly profit of two thousand five hundred dollars. How many cups of coffee must the company sell to reach this profit goal? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. How many cups of coffee would have to be sold to attain target profits of $2,500 per month? a. 3,363 cups b. 2,212 cups c. 1,150 cups d. 4,200 cups = $3,800 $1.13 $1,300 + $2,500 $1.49 - $0.36
= Fixed expenses + Target profit Unit CM Unit sales to attain target profit = 3,363 cups = We add the desired profit to the fixed cost and divide by the unit contribution of one dollar thirteen cents. The company must sell three thousand three hundred and sixty-three cups of coffee to reach its profit goal. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. Margin of safety = Total sales - Break-even sales Let’s look at Racing Bicycle Company and determine the margin of safety.
The margin of safety helps management assess how far above or below the break-even point the company is currently operating. To calculate the margin of safety we take total current sales and subtract break-even sales. Let’s calculate the margin of safety for Racing Bicycle. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Margin of Safety If we assume that Racing Bicycle Company has actual sales of $250,000, given that we have already determined the break-even sales to be $200,000, the margin of safety is $50,000 as shown Racing Bicycle is currently selling five hundred bikes and
producing total sales revenue of two hundred fifty thousand dollars. Sales at the break-even point are two hundred thousand dollars, so the company’s margin of safety is fifty thousand dollars. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000Break-even sales 400 unitsActual sales 500 unitsSales$ 200,000$ 250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net operating income$ - 0$ 20,000 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Margin of Safety The margin of safety can be expressed as 20% of sales. ($50,000 ÷ $250,000)
We can express the margin of safety as a percent of sales. In the case of Racing Bicycle, the margin of safety is twenty percent (fifty thousand dollars divided by two hundred fifty thousand dollars). Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000Break-even sales 400 unitsActual sales 500 unitsSales$ 200,000$ 250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net operating income$ - 0$ 20,000 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Margin of Safety The margin of safety can be expressed in terms of the number of units sold. The margin of safety at Racing is $50,000, and each bike sells for $500.
$50,000 $500 Margin of Safety in units = = 100 bikes We can express the margin of safety as a percent of sales. In the case of Racing Bicycle, the margin of safety is twenty percent (fifty thousand dollars divided by two hundred fifty thousand dollars). Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average
fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the margin of safety? a. 3,250 cups b. 950 cups c. 1,150 cups d. 2,100 cups Let’s see if you can calculate the margin of safety in cups of coffee for the Coffee Klatch. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the margin of safety? a. 3,250 cups b. 950 cups c. 1,150 cups d. 2,100 cups
Margin of safety = Total sales – Break-even sales = 950 cups = 2,100 cups – 1,150 cups or 950 cups 2,100 cups Margin of safety percentage = = 45% The margin of safety is nine hundred fifty cups, or we can calculate the margin of safety as forty five percent. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Cost Structure and Profit Stability Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization’s cost structure.
A company’s cost structure refers to the relative proportion of fixed and variable expenses. Some companies have high fixed expenses relative to variable expenses. Do you remember our discussion of utility companies? Because of the heavy investment in property, plant and equipment, many utility companies have a high proportion of fixed costs. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Cost Structure and Profit Stability There are advantages and disadvantages to high fixed cost (or low variable cost) and low fixed cost (or high variable cost) structures. An advantage of a high fixed cost structure is that income will be higher in good years compared to companies with lower proportion of
fixed costs. A disadvantage of a high fixed cost structure is that income will be lower in bad years compared to companies with lower proportion of fixed costs. Generally, companies with a high fixed cost structure will show higher net income in good years than companies with lower fixed cost structures. Just the opposite is true in bad years. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Operating LeverageA measure of how sensitive net operating income is to percentage changes in sales.
Contribution margin Net operating income Degree of operating leverage = The degree of operating leverage is a measure, at any given level of sales, of how a percentage change in sales volume will affect profits. It is computed by dividing contribution margin by net operating income. Let’s look at Racing Bicycle. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Operating Leverage
At Racing, the degree of operating leverage is 5. $100,000 $20,000 = 5 Recall that Racing is currently selling five hundred bikes and producing net income of twenty thousand dollars. Contribution margin is one hundred thousand dollars. Operating leverage is five. We determine this by dividing the one hundred thousand contribution by net income of twenty thousand dollars. Now that we calculated the degree of operating leverage for Racing, let’s see exactly what this means to management. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000Actual sales 500 BikesActual sales 500 unitsSales$ 250,000$ 250,000Less: variable expenses150,000150,000Contribution margin100,000100,000Less: fixed expenses80,00080,000Net income$ 20,000$ 20,000
&A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Operating Leverage With an operating leverage of 5, if Racing increases its sales by 10%, net operating income would increase by 50%. Here’s the verification! If Racing is able to increase sales by ten percent, net income will increase by fifty percent. We multiply the percentage increase in sales by the degree of operating leverage. Let’s verify the fifty percent increase in profit. Sheet1Percent increase in sales10%Degree of operating leverage×5Percent increase in profits50% &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc.
McGraw-Hill/Irwin Operating Leverage 10% increase in sales from $250,000 to $275,000 . . . . . . results in a 50% increase in income from $20,000 to $30,000. A ten percent increase in sales would increase bike sales from the current level of five hundred to five hundred fifty. Look at the contribution margin income statement and notice that income increased from twenty thousand to thirty thousand dollars. That ten thousand dollar increase in net income is a fifty percent increase. So it is true that a ten percent increase in sales results in a fifty percent increase in net income. This is powerful information for a manager to have. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000Actual sales (500)Increased sales (550)Sales$
250,000$ 275,000Less variable expenses150,000165,000Contribution margin100,000110,000Less fixed expenses80,00080,000Net operating income$ 20,000$ 30,000 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quic Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the operating leverage? a. 2.21 b. 0.45 c. 0.34 d. 2.92 See if you can calculate the degree of operating leverage for the Coffee Klatch.
Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the operating leverage? a. 2.21 b. 0.45 c. 0.34 d. 2.92 Contribution margin Net operating income Operating leverage = $2,373 $1,073 =
= 2.21 The computations took a while to complete, didn’t they. You can see that operating leverage is two point two one. Sheet1Actual sales2,100 cupsSales$ 3,129Less: Variable expenses756Contribution margin2,373Less: Fixed expenses1,300Net operating income$ 1,073 Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Chec At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, and the average fixed expense per month is $1,300. 2,100 cups are sold each month on average. If sales increase by 20%, by how much should net operating income increase? a. 30.0%
b. 20.0% c. 22.1% d. 44.2% If the Coffee Klatch is able to increase sales by twenty percent, what will be the increase in net income? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Qu At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, and the average fixed expense per month is $1,300. 2,100 cups are sold each month on average. If sales increase by 20%, by how much should net operating income increase? a. 30.0% b. 20.0% c. 22.1% d. 44.2%
You are right. The increase in net income is forty-four point two percent. Sheet1Actual salesIncreased sales2,100 cups2,520 cupsSales$ 3,1293755Less: Variable expenses756907Contribution margin2,3732,848Less: Fixed expenses1,3001,300Net operating income$ 1,073$ 1,548% change in sales20.0%%change in net operating income44.3%Percent increase in sales20.0%×Degree of operating leverage2.21Percent increase in profit44.20% Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Verify Increase in Profit Here is our verification of the increase in net income. Take a few minutes and make sure you understand how we calculated all the numbers. Sheet1Actual salesIncreased sales2,100 cups2,520 cupsSales$
3,129$ 3,755Less: Variable expenses756907Contribution margin2,3732,848Less: Fixed expenses1,3001,300Net operating income$ 1,073$ 1,548% change in sales20.0%% change in net operating income44.2% Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Structuring Sales Commissions Companies generally compensate salespeople by paying them either a commission based on sales or a salary plus a sales commission. Commissions based on sales dollars can lead to lower profits in a company. Let’s look at an example. You have probably heard that salespersons can be compensated on a commission basis. The commission is usually based on sales revenue generated. Some salespersons work on a salary plus commission.
When salespersons are paid a commission based on sales dollars generated, the income statement impact may not be fully understood. Let’s look at an example. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Structuring Sales Commissions Pipeline Unlimited produces two types of surfboards, the XR7 and the Turbo. The XR7 sells for $100 and generates a contribution margin per unit of $25. The Turbo sells for $150 and earns a contribution margin per unit of $18. The sales force at Pipeline Unlimited is compensated based on sales commissions. This company produces two surfboards. The XR7 model sells for one hundred dollars and has a contribution margin per unit
of twenty-five dollars. The second surfboard, the Turbo model, sells for one hundred fifty dollars and has a contribution margin of eighteen dollars per unit sold. The sales force at Pipeline is paid on sales commissions. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Structuring Sales Commissions If you were on the sales force at Pipeline, you would push hard to sell the Turbo even though the XR7 earns a higher contribution margin per unit. To eliminate this type of conflict, commissions can be based on contribution margin rather than on selling price alone. If you were on the sales force, you would try to sell all the Turbo models you could because it has a higher selling price per unit. The problem is that the XR7 model produces a higher contribution margin to the company.
It might be a good idea for Pipeline to base its sales commissions on contribution margin rather than selling price alone. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Concept of Sales MixSales mix is the relative proportion in which a company’s products are sold.Different products have different selling prices, cost structures, and contribution margins. Let’s assume Racing Bicycle Company sells bikes and carts and that the sales mix between the two products remains the same. When a company sells more than one product, break-even analyses become more complex because of the relative mix of the products sold. Different products will have different selling prices, cost structures and contribution margins. Let’s expand the product line at Racing Bicycle and see what
impact this has on break-even. We are going to assume that the sales mix between the products remains the same in our example. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Multi-product break-even analysis Racing Bicycle Co. provides the following information: $265,000 $550,000 = 48.2% (rounded) Racing Bicycle sells both bikes and carts. Look at the contribution margin for each product. Notice that we subtract fixed expenses from the total contribution margin. We do not allocate the fixed costs to each product. The sales mix shows that forty-five percent of the company’s sales revenue comes from the sale of bikes and fifty-five percent comes from the sale of carts.
The combined contribution margin ratio is forty-eight point two percent (rounded). Let’s look at break-even. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Multi-product break-even analysis Fixed expenses CM Ratio Break-even sales $170,000 48.2% = $352,697 = =
Part I Break-even in sales dollars is three hundred fifty-two thousand six hundred ninety-seven dollars. We calculate this amount in the normal way. We divide total fixed expenses of one hundred seventy thousand dollars by the combined contribution margin ratio. Part II We begin by allocating total break-even sales revenue to the two products. Forty-five percent of the total is assigned to the bikes and fifty-five percent to the carts. The variable costs-by-product are determined by multiplying the variable expense percent times the assigned revenue. The contribution margin is the difference between the assigned revenue and the variable expenses. Once again we subtract fixed expenses from the combined total contribution margin for the two products. Because we used a rounded contribution margin percent, we have a rounding error of one hundred seventy-six dollars.
Obviously, the more products a company has, the more complex the break-even analysis becomes. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Key Assumptions of CVP Analysis Selling price is constant. Costs are linear. In multi-product companies, the sales mix is constant. In manufacturing companies, inventories do not change (units produced = units sold). Here are the four key assumptions of cost-volume-profit analysis. You are probably familiar with the first three by now. The forth assumption tells us that there can be no change in inventory levels. That is, all units produced are sold in the current period. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
End of Chapter 6 This chapter covered a number of important concepts for business managers. If you wish to become an effective manager after leaving college, it is important that you understand CVP analysis and how to apply it. Income 300 units Income 400 units Income 500 units Sales150,000$ 200,000$ 250,000$ Less: variable expenses90,000 120,000 150,000 Contribution margin60,000$ 80,000$ 100,000$ Less: fixed expenses80,000 80,000 80,000 Net operating income(20,000)$ -$ 20,000$ - 50,000 100,000 150,000 200,000 250,000
300,000 350,000 400,000 450,000 -100200300400500600700800 Increase in CM (40 units X $200)8,000$ Increase in advertising expenses10,000 Decrease in net operating income(2,000)$ TotalPer UnitPercent Sales (500 bikes)250,000$ 500$ 100% Less: variable expenses150,000 300 60% Contribution margin100,000$ 200$ 40% Less: fixed expenses80,000 Net operating income20,000$ Actual sales 2,100 cups Sales3,129$ Less: Variable expenses756 Contribution margin2,373 Less: Fixed expenses1,300 Net operating income1,073$ Break-even sales 400 units Actual sales
500 units Sales200,000$ 250,000$ Less: variable expenses120,000 150,000 Contribution margin80,000 100,000 Less: fixed expenses80,000 80,000 Net operating income-$ 20,000$ Actual sales 500 Bikes Sales250,000$ Less: variable expenses150,000 Contribution margin100,000 Less: fixed expenses80,000 Net income20,000$ Percent increase in sales 10% Degree of operating leverage × 5 Percent increase in profits 50% Actual sales (500) Increased sales (550) Sales250,000$ 275,000$ Less variable expenses150,000 165,000
Contribution margin100,000 110,000 Less fixed expenses80,000 80,000 Net operating income20,000$ 30,000$ Percent increase in sales20.0% × Degree of operating leverage2.21 Percent increase in profit44.20% Actual sales Increased sales 2,100 cups2,520 cups Sales3,129$ 3,755$ Less: Variable expenses756 907 Contribution margin2,373 2,848 Less: Fixed expenses1,300 1,300 Net operating income1,073$ 1,548$ % change in sales20.0% % change in net operating income44.2% - 50,000 100,000 150,000 200,000 250,000
300,000 350,000 400,000 450,000 -100200300400500600700800 - 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 -100200300400500600700800 - 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000
450,000 -100200300400500600700800 150 bikes×$320 per bike=48,000$ Total variable costs=45,000 Increase in net income=3,000$ 3,000$ ÷150 bikes=20$ per bike Variable cost per bike=300 per bike Selling price required=320$ per bike 400 Bikes500 Bikes Sales200,000$ 250,000$ Less: variable expenses120,000 150,000 Contribution margin80,000 100,000 Less: fixed expenses80,000 80,000 Net operating income-$ 20,000$ SIXTH EDITION ACCOUNTING MANAGERIAL TOOLS FOR BUSINESS DECISION MAKING
BMPhotoCredits.indd Page 2 7/25/11 7:55 PM user- F392BMPhotoCredits.indd Page 2 7/25/11 7:55 PM user-F392 /Users/user-F392/Desktop/Users/user-F392/Desktop This page intentionally left blank Jerry J. Weygandt PhD, CPA University of Wisconsin—Madison Madison, Wisconsin Paul D. Kimmel PhD, CPA University of Wisconsin—Milwaukee Milwaukee, Wisconsin Donald E. Kieso PhD, CPA Northern Illinois University DeKalb, Illinois John Wiley & Sons, Inc.
FMTOC.qxd 8/12/11 2:14 PM Page i Dedicated to the Wiley sales representatives who sell our books and service our adopters in a professional and ethical manner, and to Enid, Merlynn, and Donna Vice President & Executive Publisher George Hoffman Associate Publisher Christopher DeJohn Senior Acquisitions Editor Michael McDonald Operations Manager Yana Mermel Senior Content Editor Brian Kamins Senior Content Editor Ed Brislin Development Editor Terry Ann Tatro Project Manager Aaron Riccio Content Manager Dorothy Sinclair Senior Production Editor Valerie Vargas
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or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc. 222 Rosewood Drive, Danvers, MA 01923, website www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748- 6008, website http://www.wiley.com/go/permissions. To order books or for customer service, please call 1-800-CALL WILEY (225-5945). Jerry J. Weygandt, PhD, CPA; Paul D. Kimmel, PhD, CPA; and Donald E. Kieso, PhD, CPA Managerial Accounting, Sixth Edition ISBN-13 978-1-118-09689-5 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 FMTOC.qxd 8/22/11 8:49 AM Page ii
http://www.copyright.com http://www.wiley.com/go/permissions From the Authors Dear Student, Why This Course? Remember your biology course in high school? Did you have one of those “invisible man” models (or maybe something more high-tech than that) that gave you the opportunity to look “inside” the human body? This accounting course offers something similar: To understand a business, you have to understand the financial insides of a business organization. A managerial accounting course will help you understand the essential financial components of businesses. Whether you are looking at a large multinational company like Microsoft or Starbucks or a single- owner software consulting business or coffee shop, knowing the fundamentals of
managerial accounting will help you understand what is happening. As an employee, a manager, an investor, a business owner, or a director of your own personal finances—any of which roles you will have at some point in your life—you will make better decisions for having taken this course. Why This Book? Hundreds of thousands of students have used this textbook. Your instructor has chosen it for you because of its trusted reputation. The authors have worked hard to keep the book fresh, timely, and accurate. This textbook contains features to help you learn best, whatever your learning style. To understand what your learning style is, spend about 10 minutes to take the learning style quiz at the book’s companion website. Then, look at page xi for how you can apply an understanding of your learning style to this course. When you know more about your own learning style, browse through pages xii–xiii. These pages describe the main features you will find in this textbook and explain their purpose. How To Succeed? We’ve asked many students and many
instructors whether there is a secret for success in this course. The nearly unanimous answer turns out to be not much of a secret: “Do the homework.” This is one course where doing is learning, and the more time you spend on the homework assignments—using the various tools that this textbook provides—the more likely you are to learn the essential concepts, techniques, and methods of accounting. Besides the textbook itself, the textbook companion website offers various support resources. Good luck in this course. We hope you enjoy the experience and that you put to good use throughout a lifetime of success the knowledge you obtain in this course. We are sure you will not be disappointed. Jerry J. Weygandt Paul D. Kimmel Donald E. Kieso iii
“Whether you are looking at a large multinational company like Microsoft or Starbucks or a single-owner software consulting business or coffee shop, knowing the fundamentals of managerial accounting will help you understand what is happening.” FMTOC.qxd 8/16/11 9:52 AM Page iii Your Team for Success in Accounting Wiley Accounting is your partner in accounting education. We want to be the first publisher you think of when it comes to quality content, reliable technology, innovative resources, professional training, and unparalleled support for your accounting classroom. Your Wiley Accounting Team for Success is comprised of three distinctive advantages that you won’t find with any other publisher:
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www.wileyteamforsuccess.com FMTOC.qxd 8/12/11 2:14 PM Page v Author Commitment Collaboration. Innovation. Experience. After decades of success as authors of textbooks like this one, Jerry Weygandt, Paul Kimmel, and Don Kieso understand that teaching accounting goes beyond simply presenting data. The authors are truly effective because they know that teaching is about telling compelling stories in ways that make each concept come to life. TTeeaacchheerr // AAuutthhoorr // PPrrooffeessssiioonnaall Through their textbooks, supplements, online learning tools, and classrooms, these authors have developed a comprehensive pedagogy that engages students in learning and faculty with teaching. These authors collaborate throughout the entire process. The end result is a true collaboration where each author brings his
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FMTOC.qxd 8/12/11 2:14 PM Page vi Jerry Weygandt Jerry J. Weygandt, PhD, CPA, is Arthur Andersen Alumni Emeritus Professor of Accounting at the University of Wisconsin— Madison. He holds a Ph.D. in accounting from the University of Illinois. Articles by Professor Weygandt have appeared in the Accounting Review, Journal of Accounting Research, Accounting Horizons, Journal of Accountancy, and other academic and professional journals. These articles have examined such financial reporting issues as accounting for price-level adjustments, pensions, convertible securities, stock option contracts, and interim reports. Professor Weygandt is author of other accounting and financial reporting books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Wisconsin Society of
Certified Public Accountants. He has served on numerous committees of the American Accounting Association and as a member of the editorial board of the Accounting Review; he also has served as President and Secretary-Treasurer of the American Accounting Association. In addition, he has been actively involved with the American Institute of Certified Public Accountants and has been a member of the Accounting Standards Executive Committee (AcSEC) of that organization. He has served on the FASB task force that examined the reporting issues related to accounting for income taxes and served as a trustee of the Financial Accounting Foundation. Professor Weygandt has received the Chancellor’s Award for Excellence in Teaching and the Beta Gamma Sigma Dean’s Teaching Award. He is on the board of directors of M & I Bank of Southern Wisconsin. He is the recipient of the Wisconsin Institute of CPA’s Outstanding Educator’s Award and the Lifetime Achievement Award. In 2001 he received the American Accounting Association’s
Outstanding Educator Award. Paul Kimmel Paul D. Kimmel, PhD, CPA, received his bachelor’s degree from the University of Minnesota and his doctorate in accounting from the University of Wisconsin. He is an Associate Professor at the University of Wisconsin—Milwaukee, and has public accounting experience with Deloitte & Touche (Minneapolis). He was the recipient of the UWM School of Business Advisory Council Teaching Award, the Reggie Taite Excellence in Teaching Award and a three-time winner of the Outstanding Teaching Assistant Award at the University of Wisconsin. He is also a recipient of the Elijah Watts Sells Award for Honorary Distinction for his results on the CPA exam. He is a member of the American Accounting Association and the Institute of Management Accountants and has published articles in Accounting Review, Accounting Horizons, Advances in Management Accounting, Managerial Finance, Issues in Accounting
Education, Journal of Accounting Education, as well as other journals. His research interests include accounting for financial instruments and innovation in accounting education. He has published papers and given numerous talks on incorporating critical thinking into accounting education, and helped prepare a catalog of critical thinking resources for the Federated Schools of Accountancy. Don Kieso Donald E. Kieso, PhD, CPA, received his bachelor’s degree from Aurora University and his doctorate in accounting from the University of Illinois. He has served as chairman of the Department of Accountancy and is currently the KPMG Emeritus Professor of Accountancy at Northern Illinois University. He has public accounting experience with Price Waterhouse & Co. (San Francisco and Chicago) and Arthur Andersen & Co. (Chicago) and research experience with the Research Division of the American Institute of Certified Public Accountants (New York). He
has done post doctorate work as a Visiting Scholar at the University of California at Berkeley and is a recipient of NIU’s Teaching Excellence Award and four Golden Apple Teaching Awards. Professor Kieso is the author of other accounting and business books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Illinois CPA Society. He has served as a member of the Board of Directors of the Illinois CPA Society, then AACSB’s Accounting Accreditation Committees, the State of Illinois Comptroller’s Commission, as Secretary-Treasurer of the Federation of Schools of Accountancy, and as Secretary-Treasurer of the American Accounting Association. Professor Kieso is currently serving on the Board of Trustees and Executive Committee of Aurora University, as a member of the Board of Directors of Kishwaukee Community Hospital, and as Treasurer and Director of Valley West Community Hospital. From 1989 to 1993 he served as a charter member of
the national Accounting Education Change Commission. He is the recipient of the Outstanding Accounting Educator Award from the Illinois CPA Society, the FSA’s Joseph A. Silvoso Award of Merit, the NIU Foundation’s Humanitarian Award for Service to Higher Education, a Distinguished Service Award from the Illinois CPA Society, and in 2003 an honorary doctorate from Aurora University. Author Commitment FMTOC.qxd 8/12/11 2:14 PM Page vii WileyPLUS WileyPLUS is an innovative, research-based, online environment for effective teaching and learning. What do STUDENTS receive with WileyPLUS? WileyPLUS increases confidence through an innovative design
that allows greater engagement, which leads to improved learning outcomes. Design The WileyPLUS design integrates relevant resources, including the entire digital textbook, in an easy-to-navigate framework that helps students study more effectively and ensures student engagement. Innovative features, such as calendars and visual progress tracking, as well as a variety of self-evaluation tools, are all designed to improve time-management and increase student confidence. Engagement WileyPLUS organizes the textbook content into smaller, more man- ageable learning units with demonstrable study objectives and out- comes. Related media, examples, and sample practice items are integrated within each section to reinforce the study objectives. Throughout each study session, students can assess progress and gain immediate feedback on strengths and weaknesses in order
to ensure they are spending their time most effectively. Outcomes Throughout each study session, WileyPLUS provides precise report- ing of strengths and weaknesses, as well as individualized quizzes. As a result, students can be confident they are spending their time on the right things. With WileyPLUS, students always know the exact outcome of their efforts. With increased confidence, motivation is sustained so students stay on task longer, leading to success. for Students FMTOC.qxd 8/12/11 2:14 PM Page viii for Instructors
What do INSTRUCTORS receive with WileyPLUS? Support and Insight into Student Progress WileyPLUS provides reliable, customizable resources that reinforce course goals inside and outside of the classroom, as well as visibility into individual student progress. Pre-created materials and activities help instructors optimize their time. For class preparation and classroom use: • Interactive Tutorials • Problem Walkthrough Videos • Managerial Accounting Videos For assignments and testing: • Gradable Reading Assignment Questions (embedded with online text) • Question Assignments: all end-of-chapter problems coded algorithmically with hints, links to text For course planning: WileyPLUS comes with a pre-created
Course Plan designed by a subject matter expert uniquely for this course. Simple drag-and-drop tools make it easy to assign the course plan as-is or modify it to reflect your course syllabus. For progress monitoring: WileyPLUS provides instant access to reports on trends in class performance, student use of course materials, and progress toward learning objectives, helping inform decisions and drive classroom discussions. Experience WileyPLUS for effective teaching and learning at www.wileyplus.com. Powered by proven technology and built on a foundation of cognitive research, WileyPLUS has enriched the education of millions of students in numerous countries around the world. FMTOC.qxd 8/12/11 2:14 PM Page ix http://www.wileyplus.com The Place Where Faculty Connect ... The Wiley Faculty Network is a global community
of faculty connected by a passion for teaching and a drive to learn and share. Connect with the Wiley Faculty Network to collaborate with your colleagues, find a mentor, attend virtual and live events, and view a wealth of resources all designed to help you grow as an educator. Embrace the art of teaching—great things happen where faculty connect! Discover innovative ideas and gain knowledge you can use. • Training • Virtual Guest Lectures • Live Events Explore your resources and development opportunities. • Teaching Resources • Archived Guest Lectures • Recorded Presentations • Professional Development Modules Connect with colleagues—
your greatest resource. • Find a Mentor • Interest Groups • Blog Find out more at www.WHEREFACULTYCONNECT.com The Wiley Faculty Network Virtual Guest Lectures Connect with recognized leaders across disciplines and collaborate with your peers on timely topics and discipline specific issues, many of which offer CPE credit. Live and Virtual Events These invitation-only, discipline-specific events are organized through a close partnership between the WFN, Wiley, and the academic community near the event location.
Technology Training Discover a wealth of topic- and technology-specific training presented by subject matter experts, authors, and faculty where and when you need it. Teaching Resources Propel your teaching and student learning to the next level with quality peer-reviewed case studies, testimonials, classroom tools, and checklists. Connect with Colleagues Achieve goals and tackle challenges more easily by enlisting the help of your peers. Connecting with colleagues through the WFN can help you improve your teaching experience. FMTOC.qxd 8/12/11 2:14 PM Page x What TYPE of learner are you? Understanding each of these basic learning styles enables the authors to engage students’ minds and motivate them to do their best work, ultimately improving the
experience for both students and faculty. V IS U A L A U R A L R E A D IN G
/ W R IT IN G K IN E S T H E T IC • Pay close attention to charts, drawings, and handouts
your instructors use. • Underline. • Use different colors. • Use symbols, flow charts, graphs, different arrangements on the page, white spaces. Convert your lecture notes into “page pictures.” Therefore: • Use the “Intake” strategies. • Reconstruct images in different ways. • Redraw pages from memory. • Replace words with symbols and initials. • Look at your pages.
The Navigator/Feature Story/Preview Infographics/Illustrations Accounting Equation Analyses Highlighted words Questions/Exercises/Problems Real-World Focus Decision-Making at Current Designs Managerial Analysis Problem • Recall your “page pictures.” • Draw diagrams where appropriate. • Practice turning your visuals back into words. • Attend lectures and tutorials. • Discuss topics with students and instructors.
• Explain new ideas to other people. • Use a tape recorder. • Leave spaces in your lecture notes for later recall. • Describe overheads, pictures, and visuals to somebody who was not in class. You may take poor notes because you prefer to listen. Therefore: • Expand your notes by talking with others and with information from your textbook. • Tape-record summarized notes and listen. • Read summarized notes
out loud. • Explain your notes to another “aural” person. Preview Insight Boxes DO IT!/Action Plan Summary of Learning Objectives Glossary Self-Test Questions Questions/Exercises/Problems Real-World Focus Decision-Making at Current Designs Managerial Analysis Problem Decision-Making Across the Organization Communication Activity Ethics Case • Talk with the instructor. • Spend time in quiet places
recalling the ideas. • Practice writing answers to old exam questions. • Say your answers out loud. • Use lists and headings. • Use dictionaries, glossaries, and definitions. • Read handouts, textbooks, and supplementary library readings. • Use lecture notes. • Write out words again and again. • Reread notes silently. • Rewrite ideas and principles into other words.
• Turn charts, diagrams, and other illustrations into statements. The Navigator/Feature Story/Study Objectives/Preview DO IT!/Action Plan Summary of Learning Objectives Glossary/Self-Test Questions Questions/Exercises/Problems Writing Problems Real-World Focus Decision-Making at Current Designs Considering Your Costs and Benefits Managerial Analysis Problem Decision-Making Across the
Organization Communication Activity • Write exam answers. • Practice with multiple-choice questions. • Write paragraphs, beginnings, and endings. • Write your lists in outline form. • Arrange your words into hierarchies and points. • Use all your senses. • Go to labs, take field trips. • Listen to real-life examples. • Pay attention to applications. • Use hands-on approaches. • Use trial-and-error methods.
You may take poor notes because topics do not seem concrete or relevant. Therefore: • Put examples in your summaries. • Use case studies and applications to help with principles and abstract concepts. • Talk about your notes with another “kinesthetic” person. • Use pictures and photographs that illustrate an idea. The Navigator/Feature Story/Preview Infographics/Illustrations DO IT!/Action Plan Summary of Learning Objectives
Self-Test Questions Questions/Exercises/Problems Real-World Focus Decision-Making at Current Designs Managerial Analysis Problem Decision-Making Across the Organization Ethics Case Considering Your Costs and Benefits • Write practice answers. • Role-play the exam situation. Intake: To take in the information To make a study package Text features that may help you the most Output:
To do well on exams xi FMTOC.qxd 8/12/11 2:14 PM Page xi Integrated Company Coverage Beginning in Chapter 1, we introduce Current Designs, a kayak- making company based in Winona, Minnesota. We then follow-up with a new decision- making problem in every chapter based on this real-world company. Each problem presents realistic managerial accounting situa- tions that students must analyze to determine the best course of action. In addition, many of these end-of-chapter activities also have an accompanying video. People, Planet, and Profit Today’s companies are evaluating not just their profitability but also their corporate social responsibility. In this edition, we have profiled some of
these companies, such as Starbucks, to highlight their sustainable business practices. We also have added a new Broadening Your Perspective prob- lem, “Considering People, Planet, and Profit,” which requires students to assess and determine how best to balance a company’s profitability with its corporate social responsibility. New Feature Stories Students will be more willing to commit time and energy to a topic when they believe it is relevant to their future careers. There is no better way to demonstrate relevance than to ground discussions in the real world. To that end, we have written new Feature Stories about such companies as Starbucks, Amazon.com, and Zappos.com. Managerial Accounting Video Series Through the use of real-world, cutting-edge companies, these videos engage students with a dynamic overview of managerial accounting
topics and motivate them through the detailed tools, examples, and discussions presented in their textbook, WileyPLUS course, and classroom lectures. Continued Focus on Decision-Making In the Sixth Edition, we continue to demonstrate how invaluable management accounting infor- mation is to business decision-making. New to this edition is another new Broadening Your Perspective problem, “Considering Your Costs and Benefits,” which presents a realistic situation in which students must weigh the pros and cons of two alternatives. What’s New? Features of the Sixth Edition The Sixth Edition expands our emphasis on student learning and improves upon a teach- ing and learning package that instructors and students have rated the highest in cus- tomer satisfaction.
xii FMTOC.qxd 8/16/11 10:03 AM Page xii This edition was also subject to an overall, comprehensive revision to ensure that it is technically accurate, relevant, and up-to-date. We have continued and enhanced many of the features of the Fifth Edition of Managerial Accounting, including the following: Real-World Emphasis One of the goals of the managerial accounting course is to orient students to the application of accounting principles and techniques in practice. Accordingly, we have continued our practice of using numerous examples from real companies throughout the textbook. The names of these real companies are highlighted in red. Also, throughout the chapters, IInnssiigghhtt and
AAccccoouunnttiinngg AAccrroossss tthhee OOrrggaanniizzaattiioonn boxes show how people, often in non-accounting functions, in actual companies make decisions using accounting information. Guideline Answers to the critical thinking questions are provided at the end of each chapter. Finally, examples, exercises, and problems that focus on accounting situations faced by sseerrvviiccee ccoommppaanniieess are identified by the icon shown here. Decision Toolkit The DDeecciissiioonn TToooollkkiittss highlight the important analytical tools inte- grated throughout the textbook, designed to assist students in evaluation and using the information at hand. A UUssiinngg tthhee DDeecciissiioonn TToooollkkiitt exercise, just before the chapter summary, asks students to use the decision tools presented in the chapter and takes them through the problem-solving steps. Exercises Brief exercises ask students to apply their newly acquired knowledge. The exer-
cises include an Action Plan, which reviews the necessary steps to complete the exercise, as well as a

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Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hi

  • 1. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin 11th Edition Chapter 6 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter Six Cost-Volume-Profit Relationships This is one of the most important chapters in the text. It integrates much of what we have learned so far. We will learn the relationships among product costs, sales volumes and resulting profits. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Basics of Cost-Volume-Profit Analysis Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted. Contribution margin is defined as sales less variable expenses.
  • 2. In the case of Racing Bicycle Company, contribution margin is one hundred thousand dollars. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Basics of Cost-Volume-Profit Analysis CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income. Contribution margin is used first to cover fixed expenses. Any remaining contribution margin contributes to net operating income. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. If Racing sells an additional bicycle, $200 additional CM will be generated to cover fixed expenses and profit. Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. For each additional unit Racing Bicycle Company sells, $200 more in contribution margin will help to cover fixed expenses and provide a profit. Each month Racing Bicycle must generate at least $80,000 in
  • 3. total contribution margin to break-even (which is the level of sales at which profit is zero). If Racing sells 400 units a month, it will be operating at the break-even point. If Racing sells one more bike (401 bikes), net operating income will increase by $200. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach Each month Racing must generate at least $80,000 in total CM to break even. Each month Racing Bicycle must generate at least $80,000 in total contribution margin to break-even (which is the level of sales at which profit is zero). Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach If Racing sells 400 units in a month, it will be operating at the break-even point. If Racing sells 400 units a month, it will be operating at the break-even point. If Racing sells one more bike (401 bikes), net operating income will increase by $200. Copyright © 2006, The McGraw-Hill Companies, Inc.
  • 4. McGraw-Hill/Irwin The Contribution Approach If Racing sells one more bike (401 bikes), net operating income will increase by $200. You can see that the sale of one unit above the break-even point yields net income of two hundred dollars for Racing Bicycle. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Approach We do not need to prepare an income statement to estimate profits at a particular sales volume. Simply multiply the number of units sold above break-even by the contribution margin per unit. If Racing sells 430 bikes, its net income will be $6,000. If we develop equations to calculate break-even and net income, we will not have to prepare an income statement to determine what net income will be at any level of sales. For example, we know that if Racing Bicycle sells four hundred thirty bikes, net income will be six thousand dollars. The company will sell thirty bikes above the break-even unit sales and the contribution margin is two hundred dollars per bike. So, we multiply thirty bikes times two hundred dollars per bike and get net income of six thousand dollars.. Copyright © 2006, The McGraw-Hill Companies, Inc.
  • 5. McGraw-Hill/Irwin CVP Relationships in Graphic Form The relationship among revenue, cost, profit and volume can be expressed graphically by preparing a CVP graph. Racing developed contribution margin income statements at 300, 400, and 500 units sold. We will use this information to prepare the CVP graph. The relationship among revenue, cost, profit and volume can be expressed graphically by preparing a cost-volume-profit (CVP) graph. To illustrate, we will use contribution income statements for Racing Bicycle Company at three hundred, four hundred, and five hundred units sold. Sheet1Income 300 unitsIncome 400 unitsIncome 500 unitsSales$ 150,000$ 200,000$ 250,000Less: variable expenses90,000120,000150,000Contribution margin$ 60,000$ 80,000$ 100,000Less: fixed expenses80,00080,00080,000Net operating income$ (20,000)$ - 0$ 20,000 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Units Dollars In a CVP graph, unit volume is usually represented on the horizontal (X) axis and dollars on the vertical (Y) axis.
  • 6. In a CVP graph, unit volume is usually represented on the horizontal (X) axis and dollars on the vertical (Y) axis. Once we have settled on this convention we will plot the fixed cost. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P
  • 7. Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Units Dollars Fixed Expenses
  • 8. The first step begins by drawing a line parallel to the volume axis to represent total fixed expenses of eighty thousand dollars. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P Sheet9 &A
  • 9. Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Dollars Units Fixed Expenses Total Expenses
  • 10. Next, choose some sales volume (for example, five hundred units) and plot the point representing total expenses (e.g., fixed and variable) at that sales volume. Draw a line through the data point back to where the fixed expenses line intersects the dollar axis. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A
  • 11. Page &P Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Dollars Units Fixed Expenses
  • 12. Total Expenses Total Sales Finally, choose some sales volume (for example, five hundred units) and plot the point representing total sales dol lars at the chosen activity level. Draw a line through the data point back to the origin. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7
  • 13. &A Page &P Sheet8 &A Page &P Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin CVP Graph Dollars
  • 14. Units Profit Area Loss Area Break-even point (400 units or $200,000 in sales) The break-even point is where the total revenue and total expenses lines intersect. In the case of Racing Bicycle, break- even is four hundred bikes sold, or sales revenue of two hundred thousand dollars. Sheet1FCTCTR- 080,00080,000- 010080,000110,00050,00020080,000140,000100,00030080,0001 70,000150,00040080,000200,000200,00050080,000230,000250, 00060080,000260,000300,00070080,000290,000350,00080080,0 00320,000400,000 &A Page &P Sheet1 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P
  • 15. Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc.
  • 16. McGraw-Hill/Irwin Contribution Margin Ratio The contribution margin ratio is: For Racing Bicycle Company the ratio is: Each $1.00 increase in sales results in a total contribution margin increase of 40¢. Total CM Total sales CM Ratio = $80,000 $200,000 = 40% We can calculate the contribution margin ratio of Racing Bicycle by dividing total contribution by total sales. In the case of Racing Bicycle, the contribution margin ratio is forty percent. This means that for each dollar increase in sales the company will produce forty cents in contribution margin. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Contribution Margin Ratio Or, in terms of units, the contribution margin ratio is:
  • 17. For Racing Bicycle Company the ratio is: $200 $500 = 40% Unit CM Unit selling price CM Ratio = We may also calculate the contribution margin ratio using per unit amounts. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Contribution Margin Ratio A $50,000 increase in sales revenue results in a $20,000 increase in CM. ($50,000 × 40% = $20,000) Let’s see how we can use the contribution margin ratio to look at the contribution margin income statement of Racing Bicycle in a little different way. If Racing is able to increase its sales by fifty thousand dollars, it will increase contribution margin by twenty thousand dollars, that is, fifty thousand dollars times forty percent. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution
  • 18. margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000400 Bikes500 BikesSales$ 200,000$ 250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net operating income$ - 0$ 20,000 &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P Sheet9 &A Page &P Sheet10 &A Page &P Sheet11 &A
  • 19. Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the CM Ratio for Coffee Klatch? a. 1.319 b. 0.758 c. 0.242 d. 4.139 Can you calculate the contribution margin ratio for Coffee Klatch? The calculation may take a minute or so to complete.
  • 20. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the CM Ratio for Coffee Klatch? a. 1.319 b. 0.758 c. 0.242 d. 4.139 Unit contribution margin Unit selling price CM Ratio = = ($1.49-$0.36) $1.49 = $1.13 $1.49 = 0.758 How did you do? The CM ratio is seventy-five point eight percent. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
  • 21. Changes in Fixed Costs and Sales Volume What is the profit impact if Racing can increase unit sales from 500 to 540 by increasing the monthly advertising budget by $10,000? Let’s assume that the management of Racing Bicycle believes it can increase unit sales from five hundred to five hundred forty if it spends ten thousand dollars on advertising. Would you recommend that the advertising campaign be undertaken? See if you can solve this problem before going to the next screen. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Changes in Fixed Costs and Sales Volume Sales increased by $20,000, but net operating income decreased by $2,000. $80,000 + $10,000 advertising = $90,000 As you can see, even if sales revenue increases to two hundred seventy thousand dollars, Racing will experience a twelve thousand dollar increase in variable costs and a ten thousand dollar increase in fixed costs (the new advertising campaign). As a result net income will actually drop by two thousand dollars. The advertising campaign would certainly not be a good idea. We can help management see the problem before any additional monies are spent. Copyright © 2006, The McGraw-Hill Companies, Inc.
  • 22. McGraw-Hill/Irwin Changes in Fixed Costs and Sales Volume The Shortcut Solution Here is a shortcut approach to looking at the problem. You can see that an increase in contribution margin is more than offset by the increased advertising costs. Sheet1Increase in CM (40 units X $200)$ 8,000Increase in advertising expenses10,000Decrease in net operating income$ (2,000) Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Variable Costs and Sales Volume
  • 23. What is the profit impact if Racing can use higher quality raw materials, thus increasing variable costs per unit by $10, to generate an increase in unit sales from 500 to 580? Management at Racing Bicycle believes that using higher quality raw materials will result in an increase in sales from five hundred to five hundred eighty. The higher quality raw materials will lead to a ten dollar increase in variable costs per unit. Would you recommend the use of the higher quality raw materials? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Variable Costs and Sales Volume Sales increase by $40,000, and net operating income increases by $10,200. 580 units × $310 variable cost/unit = $179,800 As you can see, revenues will increase by forty thousand dollars (eighty bikes times five hundred dollars per bike), and variable
  • 24. costs will increase by twenty-nine thousand eight hundred dollars. Contribution margin will increase by ten thousand two hundred dollars. With no change in fixed costs, net income will also increase by ten thousand two hundred dollars. The use of higher quality raw materials appears to be a profitable idea. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Fixed Cost, Sales Price and Volume What is the profit impact if Racing (1) cuts its selling price $20 per unit, (2) increases its advertising budget by $15,000 per month, and (3) increases unit sales from 500 to 650 units per month? Here is a more complex situation because we will experience a change in selling price, advertising expense, and unit sales. Would you support this plan?
  • 25. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Fixed Cost, Sales Price and Volume Sales increase by $62,000, fixed costs increase by $15,000, and net operating income increases by $2,000. This appears to be a good plan because net income will increase by two thousand dollars. Take a few minutes and analyze the change in sales revenue, variable expenses and fixed expenses. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Variable Cost, Fixed Cost and Sales Volume What is the profit impact if Racing (1) pays a $15 sales commission per bike sold instead of paying salespersons flat salaries that currently total $6,000 per month, and (2) increases unit sales from 500 to 575 bikes? Here is another complex question involving cost-volume-profit relationships. In this question we eliminate a fixed cost and
  • 26. substitute a variable cost while increasing the units sold. Be careful with your calculation of the profit impact of these changes. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Variable Cost, Fixed Cost and Sales Volume Sales increase by $37,500, variable costs increase by $31,125, but fixed expenses decrease by $6,000. Net income increases by twelve thousand three hundred seventy-five dollars. Notice that sales revenue and variable expenses increased as well. Fixed expenses were decreased as a result of making sales commissions variable in nature. How did you do? We hope you are beginning to see the potential power of CVP analysis. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
  • 27. Change in Regular Sales Price If Racing has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers or fixed expenses, what price would it quote to the wholesaler if it wants to increase monthly profits by $3,000? Suppose Racing Bicycle has a one-time opportunity to sell one hundred fifty bikes to a wholesaler. There would be no change in the cost structure as a result of this sale. Racing wants the one-time sale to produce a profit of three thousand dollars. What selling price should Racing quote to the wholesaler? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Change in Regular Sales Price If we desire a profit of three thousand dollars on the sale of one hundred fifty bikes, we must have a profit of twenty dollars per bike. The variable expenses associated with each bike are three hundred dollars, so we would quote a selling price of three
  • 28. hundred twenty dollars. You can see the proof of the quote in the blue schedule. Sheet1$ 3,000÷150 bikes=$ 20per bikeVariable cost per bike=300per bikeSelling price required=$ 320per bi ke Sheet2 Sheet3 Sheet1150 bikes×$320 per bike=$ 48,000Total variable costs=45,000Increase in net income=$ 3,000 Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Break-Even Analysis Break-even analysis can be approached in two ways: Equation method Contribution margin method
  • 29. We can accomplish break-even analysis in one of two ways. We can use the equation method or the contribution margin method. We get the same results regardless of the method selected. You may prefer one method over the other. It’s a personal choice, but be aware there are some problems associated with either method. Some are easier to solve using the equation method, while others can be quickly solved using the contribution margin method. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Equation Method Profits = (Sales – Variable expenses) – Fixed expenses Sales = Variable expenses + Fixed expenses + Profits OR At the break-even point profits equal zero The equation method is based on the contribution approach income statement. The equation can be stated in one of two ways:
  • 30. Profits equal Sales less Variable expenses, less Fixed Expenses, or Sales equal Variable expenses plus Fixed expenses plus Profits Remember that at the break-even point profits are equal to zero. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Break-Even Analysis Here is the information from Racing Bicycle Company: Here is some information provided by Racing Bicycle that we will use to solve some problems. We have the contribution margin income statement, the selling price and variable expenses per unit, and the contribution margin ratio. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net operating income$ 20,000
  • 31. &A Page &P Sheet2 &A Page &P Sheet3 &A Page &P Sheet4 &A Page &P Sheet5 &A Page &P Sheet6 &A Page &P Sheet7 &A Page &P Sheet8 &A Page &P Sheet9 &A
  • 32. Page &P Sheet10 &A Page &P Sheet11 &A Page &P Sheet12 &A Page &P Sheet13 &A Page &P Sheet14 &A Page &P Sheet15 &A Page &P Sheet16 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc.
  • 33. McGraw-Hill/Irwin Equation Method We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 Where: Q = Number of bikes sold $500 = Unit selling price $300 = Unit variable expense $80,000 = Total fixed expense The break-even point in units is determined by creating the equation as shown, where Q is the number of bikes sold, five hundred dollars is the unit selling price, three hundred dollars is the unit variable expense, and eighty thousand dollars is the total fixed expense. We need to solve for Q. Copyright © 2006, The McGraw-Hill Companies, Inc.
  • 34. McGraw-Hill/Irwin Equation Method We calculate the break-even point as follows: $500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = $80,000 ÷ $200 per bike Q = 400 bikes Sales = Variable expenses + Fixed expenses + Profits Solving this equation shows that the break-even point in units is 400 bikes. We want to be careful with the algebra when we group terms. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Equation Method The equation can be modified to calculate the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + $80,000 + $0
  • 35. Where: X = Total sales dollars 0.60 = Variable expenses as a % of sales $80,000 = Total fixed expenses The equation can be modified as shown to calculate the break- even point in sales dollars. In this equation, X is total sales dollars, point six zero (or sixty percent) is the variable expense as a percentage of sales, and eighty thousand dollars is the total fixed expense. We need to solve for X. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Equation Method X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $80,000 ÷ 0.40 X = $200,000 Sales = Variable expenses + Fixed expenses + Profits
  • 36. The equation can be modified to calculate the break-even point in sales dollars. Solving this equation shows that the break-even point is sales dollars is two hundred thousand dollars. Once again, be careful when you combine the X values in the equation. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Contribution Margin Method The contribution margin method has two key equations. Fixed expenses Unit contribution margin = Break-even point in units sold Fixed expenses CM ratio = Break-even point in total sales dollars
  • 37. The contribution margin method has two key equations: Break-even point in units sold equals Fixed expenses divided by CM per unit, and Break-even point in sales dollars equals Fixed expenses divided by CM ratio. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Contribution Margin Method Let’s use the contribution margin method to calculate the break- even point in total sales dollars at Racing. Fixed expenses CM ratio = Break-even point in total sales dollars
  • 38. $80,000 40% = $200,000 break-even sales Part I Let’s use the contribution margin method to calculate break- even in total sales dollars. Part II The break-even sales revenue is two hundred thousand dollars. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average
  • 39. fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in units? 872 cups b. 3,611 cups c. 1,200 cups d. 1,150 cups Now use the contribution margin approach to calculate the break-even point in cups of coffee sold. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in units? a. 872 cups b. 3,611 cups c. 1,200 cups d. 1,150 cups
  • 40. Fixed expenses Unit CM Break-even = $1,300 $1.49/cup - $0.36/cup = $1,300 $1.13/cup = 1,150 cups = The contribution margin per cup of coffee is one dollar and thirteen cents. The number of cups to sell to reach break-even is one thousand one hundred fifty. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
  • 41. Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in dollars? a. $1,300 b. $1,715 c. $1,788 d. $3,129 Let’s calculate the break-even in sales dollars for Coffee Klatch. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in dollars? a. $1,300
  • 42. b. $1,715 c. $1,788 d. $3,129 Fixed expenses CM Ratio Break-even sales $1,300 0.758 = $1,715 = = With a contribution margin ratio of seventy-five point eight percent rounded, break-even sales revenue is one thousand seven hundred fifteen dollars. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
  • 43. Target Profit Analysis The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit. Suppose Racing Bicycle Company wants to know how many bikes must be sold to earn a profit of $100,000. We can use either method to determine the revenue or units needed to achieve a target level of profits. Suppose Racing Bicycle wants to earn net income of one hundred thousand dollars. How many bikes must the company sell to achieve this profit level? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The CVP Equation Method Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $100,000
  • 44. $200Q = $180,000 Q = 900 bikes Instead of setting profit to zero like we do in a break-even analysis, we set the profit level to one hundred thousand dollars. Solving for Q, we see that the company will have to sell nine hundred bikes to achieve the desired profit level. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Contribution Margin Approach The contribution margin method can be used to determine that 900 bikes must be sold to earn the target profit of $100,000. Fixed expenses + Target profit Unit contribution margin = Unit sales to attain the target profit $80,000 + $100,000 $200/bike
  • 45. = 900 bikes A quicker way to solve this problem is to add the desired profits to the fixed cost and divide the total by the contribution margin per unit. Notice we get the same result of nine hundred bikes. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. How many cups of coffee would have to be sold to attain target profits of $2,500 per month? a. 3,363 cups b. 2,212 cups c. 1,150 cups d. 4,200 cups
  • 46. The Coffee Klatch wants to earn a monthly profit of two thousand five hundred dollars. How many cups of coffee must the company sell to reach this profit goal? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. How many cups of coffee would have to be sold to attain target profits of $2,500 per month? a. 3,363 cups b. 2,212 cups c. 1,150 cups d. 4,200 cups = $3,800 $1.13 $1,300 + $2,500 $1.49 - $0.36
  • 47. = Fixed expenses + Target profit Unit CM Unit sales to attain target profit = 3,363 cups = We add the desired profit to the fixed cost and divide by the unit contribution of one dollar thirteen cents. The company must sell three thousand three hundred and sixty-three cups of coffee to reach its profit goal. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Margin of Safety
  • 48. The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. Margin of safety = Total sales - Break-even sales Let’s look at Racing Bicycle Company and determine the margin of safety.
  • 49. The margin of safety helps management assess how far above or below the break-even point the company is currently operating. To calculate the margin of safety we take total current sales and subtract break-even sales. Let’s calculate the margin of safety for Racing Bicycle. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Margin of Safety If we assume that Racing Bicycle Company has actual sales of $250,000, given that we have already determined the break-even sales to be $200,000, the margin of safety is $50,000 as shown Racing Bicycle is currently selling five hundred bikes and
  • 50. producing total sales revenue of two hundred fifty thousand dollars. Sales at the break-even point are two hundred thousand dollars, so the company’s margin of safety is fifty thousand dollars. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000Break-even sales 400 unitsActual sales 500 unitsSales$ 200,000$ 250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net operating income$ - 0$ 20,000 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Margin of Safety The margin of safety can be expressed as 20% of sales. ($50,000 ÷ $250,000)
  • 51. We can express the margin of safety as a percent of sales. In the case of Racing Bicycle, the margin of safety is twenty percent (fifty thousand dollars divided by two hundred fifty thousand dollars). Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000Break-even sales 400 unitsActual sales 500 unitsSales$ 200,000$ 250,000Less: variable expenses120,000150,000Contribution margin80,000100,000Less: fixed expenses80,00080,000Net operating income$ - 0$ 20,000 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Margin of Safety The margin of safety can be expressed in terms of the number of units sold. The margin of safety at Racing is $50,000, and each bike sells for $500.
  • 52. $50,000 $500 Margin of Safety in units = = 100 bikes We can express the margin of safety as a percent of sales. In the case of Racing Bicycle, the margin of safety is twenty percent (fifty thousand dollars divided by two hundred fifty thousand dollars). Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average
  • 53. fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the margin of safety? a. 3,250 cups b. 950 cups c. 1,150 cups d. 2,100 cups Let’s see if you can calculate the margin of safety in cups of coffee for the Coffee Klatch. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the margin of safety? a. 3,250 cups b. 950 cups c. 1,150 cups d. 2,100 cups
  • 54. Margin of safety = Total sales – Break-even sales = 950 cups = 2,100 cups – 1,150 cups or 950 cups 2,100 cups Margin of safety percentage = = 45% The margin of safety is nine hundred fifty cups, or we can calculate the margin of safety as forty five percent. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Cost Structure and Profit Stability Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization’s cost structure.
  • 55. A company’s cost structure refers to the relative proportion of fixed and variable expenses. Some companies have high fixed expenses relative to variable expenses. Do you remember our discussion of utility companies? Because of the heavy investment in property, plant and equipment, many utility companies have a high proportion of fixed costs. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Cost Structure and Profit Stability There are advantages and disadvantages to high fixed cost (or low variable cost) and low fixed cost (or high variable cost) structures. An advantage of a high fixed cost structure is that income will be higher in good years compared to companies with lower proportion of
  • 56. fixed costs. A disadvantage of a high fixed cost structure is that income will be lower in bad years compared to companies with lower proportion of fixed costs. Generally, companies with a high fixed cost structure will show higher net income in good years than companies with lower fixed cost structures. Just the opposite is true in bad years. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Operating LeverageA measure of how sensitive net operating income is to percentage changes in sales.
  • 57. Contribution margin Net operating income Degree of operating leverage = The degree of operating leverage is a measure, at any given level of sales, of how a percentage change in sales volume will affect profits. It is computed by dividing contribution margin by net operating income. Let’s look at Racing Bicycle. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Operating Leverage
  • 58. At Racing, the degree of operating leverage is 5. $100,000 $20,000 = 5 Recall that Racing is currently selling five hundred bikes and producing net income of twenty thousand dollars. Contribution margin is one hundred thousand dollars. Operating leverage is five. We determine this by dividing the one hundred thousand contribution by net income of twenty thousand dollars. Now that we calculated the degree of operating leverage for Racing, let’s see exactly what this means to management. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000Actual sales 500 BikesActual sales 500 unitsSales$ 250,000$ 250,000Less: variable expenses150,000150,000Contribution margin100,000100,000Less: fixed expenses80,00080,000Net income$ 20,000$ 20,000
  • 59. &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Operating Leverage With an operating leverage of 5, if Racing increases its sales by 10%, net operating income would increase by 50%. Here’s the verification! If Racing is able to increase sales by ten percent, net income will increase by fifty percent. We multiply the percentage increase in sales by the degree of operating leverage. Let’s verify the fifty percent increase in profit. Sheet1Percent increase in sales10%Degree of operating leverage×5Percent increase in profits50% &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc.
  • 60. McGraw-Hill/Irwin Operating Leverage 10% increase in sales from $250,000 to $275,000 . . . . . . results in a 50% increase in income from $20,000 to $30,000. A ten percent increase in sales would increase bike sales from the current level of five hundred to five hundred fifty. Look at the contribution margin income statement and notice that income increased from twenty thousand to thirty thousand dollars. That ten thousand dollar increase in net income is a fifty percent increase. So it is true that a ten percent increase in sales results in a fifty percent increase in net income. This is powerful information for a manager to have. Sheet1TotalPer UnitPercentSales (500 bikes)$ 250,000$ 500100%Less: variable expenses150,00030060%Contribution margin$ 100,000$ 20040%Less: fixed expenses80,000Net income$ 20,000Actual sales (500)Increased sales (550)Sales$
  • 61. 250,000$ 275,000Less variable expenses150,000165,000Contribution margin100,000110,000Less fixed expenses80,00080,000Net operating income$ 20,000$ 30,000 &A Page &P Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quic Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the operating leverage? a. 2.21 b. 0.45 c. 0.34 d. 2.92 See if you can calculate the degree of operating leverage for the Coffee Klatch.
  • 62. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the operating leverage? a. 2.21 b. 0.45 c. 0.34 d. 2.92 Contribution margin Net operating income Operating leverage = $2,373 $1,073 =
  • 63. = 2.21 The computations took a while to complete, didn’t they. You can see that operating leverage is two point two one. Sheet1Actual sales2,100 cupsSales$ 3,129Less: Variable expenses756Contribution margin2,373Less: Fixed expenses1,300Net operating income$ 1,073 Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Quick Chec At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, and the average fixed expense per month is $1,300. 2,100 cups are sold each month on average. If sales increase by 20%, by how much should net operating income increase? a. 30.0%
  • 64. b. 20.0% c. 22.1% d. 44.2% If the Coffee Klatch is able to increase sales by twenty percent, what will be the increase in net income? Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Qu At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, and the average fixed expense per month is $1,300. 2,100 cups are sold each month on average. If sales increase by 20%, by how much should net operating income increase? a. 30.0% b. 20.0% c. 22.1% d. 44.2%
  • 65. You are right. The increase in net income is forty-four point two percent. Sheet1Actual salesIncreased sales2,100 cups2,520 cupsSales$ 3,1293755Less: Variable expenses756907Contribution margin2,3732,848Less: Fixed expenses1,3001,300Net operating income$ 1,073$ 1,548% change in sales20.0%%change in net operating income44.3%Percent increase in sales20.0%×Degree of operating leverage2.21Percent increase in profit44.20% Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Verify Increase in Profit Here is our verification of the increase in net income. Take a few minutes and make sure you understand how we calculated all the numbers. Sheet1Actual salesIncreased sales2,100 cups2,520 cupsSales$
  • 66. 3,129$ 3,755Less: Variable expenses756907Contribution margin2,3732,848Less: Fixed expenses1,3001,300Net operating income$ 1,073$ 1,548% change in sales20.0%% change in net operating income44.2% Sheet2 Sheet3 Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Structuring Sales Commissions Companies generally compensate salespeople by paying them either a commission based on sales or a salary plus a sales commission. Commissions based on sales dollars can lead to lower profits in a company. Let’s look at an example. You have probably heard that salespersons can be compensated on a commission basis. The commission is usually based on sales revenue generated. Some salespersons work on a salary plus commission.
  • 67. When salespersons are paid a commission based on sales dollars generated, the income statement impact may not be fully understood. Let’s look at an example. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Structuring Sales Commissions Pipeline Unlimited produces two types of surfboards, the XR7 and the Turbo. The XR7 sells for $100 and generates a contribution margin per unit of $25. The Turbo sells for $150 and earns a contribution margin per unit of $18. The sales force at Pipeline Unlimited is compensated based on sales commissions. This company produces two surfboards. The XR7 model sells for one hundred dollars and has a contribution margin per unit
  • 68. of twenty-five dollars. The second surfboard, the Turbo model, sells for one hundred fifty dollars and has a contribution margin of eighteen dollars per unit sold. The sales force at Pipeline is paid on sales commissions. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Structuring Sales Commissions If you were on the sales force at Pipeline, you would push hard to sell the Turbo even though the XR7 earns a higher contribution margin per unit. To eliminate this type of conflict, commissions can be based on contribution margin rather than on selling price alone. If you were on the sales force, you would try to sell all the Turbo models you could because it has a higher selling price per unit. The problem is that the XR7 model produces a higher contribution margin to the company.
  • 69. It might be a good idea for Pipeline to base its sales commissions on contribution margin rather than selling price alone. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin The Concept of Sales MixSales mix is the relative proportion in which a company’s products are sold.Different products have different selling prices, cost structures, and contribution margins. Let’s assume Racing Bicycle Company sells bikes and carts and that the sales mix between the two products remains the same. When a company sells more than one product, break-even analyses become more complex because of the relative mix of the products sold. Different products will have different selling prices, cost structures and contribution margins. Let’s expand the product line at Racing Bicycle and see what
  • 70. impact this has on break-even. We are going to assume that the sales mix between the products remains the same in our example. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Multi-product break-even analysis Racing Bicycle Co. provides the following information: $265,000 $550,000 = 48.2% (rounded) Racing Bicycle sells both bikes and carts. Look at the contribution margin for each product. Notice that we subtract fixed expenses from the total contribution margin. We do not allocate the fixed costs to each product. The sales mix shows that forty-five percent of the company’s sales revenue comes from the sale of bikes and fifty-five percent comes from the sale of carts.
  • 71. The combined contribution margin ratio is forty-eight point two percent (rounded). Let’s look at break-even. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Multi-product break-even analysis Fixed expenses CM Ratio Break-even sales $170,000 48.2% = $352,697 = =
  • 72. Part I Break-even in sales dollars is three hundred fifty-two thousand six hundred ninety-seven dollars. We calculate this amount in the normal way. We divide total fixed expenses of one hundred seventy thousand dollars by the combined contribution margin ratio. Part II We begin by allocating total break-even sales revenue to the two products. Forty-five percent of the total is assigned to the bikes and fifty-five percent to the carts. The variable costs-by-product are determined by multiplying the variable expense percent times the assigned revenue. The contribution margin is the difference between the assigned revenue and the variable expenses. Once again we subtract fixed expenses from the combined total contribution margin for the two products. Because we used a rounded contribution margin percent, we have a rounding error of one hundred seventy-six dollars.
  • 73. Obviously, the more products a company has, the more complex the break-even analysis becomes. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Key Assumptions of CVP Analysis Selling price is constant. Costs are linear. In multi-product companies, the sales mix is constant. In manufacturing companies, inventories do not change (units produced = units sold). Here are the four key assumptions of cost-volume-profit analysis. You are probably familiar with the first three by now. The forth assumption tells us that there can be no change in inventory levels. That is, all units produced are sold in the current period. Copyright © 2006, The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
  • 74. End of Chapter 6 This chapter covered a number of important concepts for business managers. If you wish to become an effective manager after leaving college, it is important that you understand CVP analysis and how to apply it. Income 300 units Income 400 units Income 500 units Sales150,000$ 200,000$ 250,000$ Less: variable expenses90,000 120,000 150,000 Contribution margin60,000$ 80,000$ 100,000$ Less: fixed expenses80,000 80,000 80,000 Net operating income(20,000)$ -$ 20,000$ - 50,000 100,000 150,000 200,000 250,000
  • 75. 300,000 350,000 400,000 450,000 -100200300400500600700800 Increase in CM (40 units X $200)8,000$ Increase in advertising expenses10,000 Decrease in net operating income(2,000)$ TotalPer UnitPercent Sales (500 bikes)250,000$ 500$ 100% Less: variable expenses150,000 300 60% Contribution margin100,000$ 200$ 40% Less: fixed expenses80,000 Net operating income20,000$ Actual sales 2,100 cups Sales3,129$ Less: Variable expenses756 Contribution margin2,373 Less: Fixed expenses1,300 Net operating income1,073$ Break-even sales 400 units Actual sales
  • 76. 500 units Sales200,000$ 250,000$ Less: variable expenses120,000 150,000 Contribution margin80,000 100,000 Less: fixed expenses80,000 80,000 Net operating income-$ 20,000$ Actual sales 500 Bikes Sales250,000$ Less: variable expenses150,000 Contribution margin100,000 Less: fixed expenses80,000 Net income20,000$ Percent increase in sales 10% Degree of operating leverage × 5 Percent increase in profits 50% Actual sales (500) Increased sales (550) Sales250,000$ 275,000$ Less variable expenses150,000 165,000
  • 77. Contribution margin100,000 110,000 Less fixed expenses80,000 80,000 Net operating income20,000$ 30,000$ Percent increase in sales20.0% × Degree of operating leverage2.21 Percent increase in profit44.20% Actual sales Increased sales 2,100 cups2,520 cups Sales3,129$ 3,755$ Less: Variable expenses756 907 Contribution margin2,373 2,848 Less: Fixed expenses1,300 1,300 Net operating income1,073$ 1,548$ % change in sales20.0% % change in net operating income44.2% - 50,000 100,000 150,000 200,000 250,000
  • 79. 450,000 -100200300400500600700800 150 bikes×$320 per bike=48,000$ Total variable costs=45,000 Increase in net income=3,000$ 3,000$ ÷150 bikes=20$ per bike Variable cost per bike=300 per bike Selling price required=320$ per bike 400 Bikes500 Bikes Sales200,000$ 250,000$ Less: variable expenses120,000 150,000 Contribution margin80,000 100,000 Less: fixed expenses80,000 80,000 Net operating income-$ 20,000$ SIXTH EDITION ACCOUNTING MANAGERIAL TOOLS FOR BUSINESS DECISION MAKING
  • 80. BMPhotoCredits.indd Page 2 7/25/11 7:55 PM user- F392BMPhotoCredits.indd Page 2 7/25/11 7:55 PM user-F392 /Users/user-F392/Desktop/Users/user-F392/Desktop This page intentionally left blank Jerry J. Weygandt PhD, CPA University of Wisconsin—Madison Madison, Wisconsin Paul D. Kimmel PhD, CPA University of Wisconsin—Milwaukee Milwaukee, Wisconsin Donald E. Kieso PhD, CPA Northern Illinois University DeKalb, Illinois John Wiley & Sons, Inc.
  • 81. FMTOC.qxd 8/12/11 2:14 PM Page i Dedicated to the Wiley sales representatives who sell our books and service our adopters in a professional and ethical manner, and to Enid, Merlynn, and Donna Vice President & Executive Publisher George Hoffman Associate Publisher Christopher DeJohn Senior Acquisitions Editor Michael McDonald Operations Manager Yana Mermel Senior Content Editor Brian Kamins Senior Content Editor Ed Brislin Development Editor Terry Ann Tatro Project Manager Aaron Riccio Content Manager Dorothy Sinclair Senior Production Editor Valerie Vargas
  • 82. Associate Director of Marketing Amy Scholz Marketing Manager Karolina Zarychta Honsa Lead Product Designer Allison Morris Product Designer Greg Chaput Interactive Product Designer Daniela DiMaggio Design Director Harry Nolan Senior Designer Maureen Eide Designer Kristine Carney Production Management Services Ingrao Associates Senior Illustration Editor Anna Melhorn Senior Photo Editor Mary Ann Price Senior Editorial Assistant Jacqueline Kepping Senior Marketing Assistant Courtney Luzzi Cover Design Maureen Eide Cover Photo Robert Zaleski/Aurora Photos This book was set in New Aster by Aptara®, Inc. and printed and bound by RR Donnelley. The cover was printed by RR Donnelley. Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107
  • 83. or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc. 222 Rosewood Drive, Danvers, MA 01923, website www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748- 6008, website http://www.wiley.com/go/permissions. To order books or for customer service, please call 1-800-CALL WILEY (225-5945). Jerry J. Weygandt, PhD, CPA; Paul D. Kimmel, PhD, CPA; and Donald E. Kieso, PhD, CPA Managerial Accounting, Sixth Edition ISBN-13 978-1-118-09689-5 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 FMTOC.qxd 8/22/11 8:49 AM Page ii
  • 84. http://www.copyright.com http://www.wiley.com/go/permissions From the Authors Dear Student, Why This Course? Remember your biology course in high school? Did you have one of those “invisible man” models (or maybe something more high-tech than that) that gave you the opportunity to look “inside” the human body? This accounting course offers something similar: To understand a business, you have to understand the financial insides of a business organization. A managerial accounting course will help you understand the essential financial components of businesses. Whether you are looking at a large multinational company like Microsoft or Starbucks or a single- owner software consulting business or coffee shop, knowing the fundamentals of
  • 85. managerial accounting will help you understand what is happening. As an employee, a manager, an investor, a business owner, or a director of your own personal finances—any of which roles you will have at some point in your life—you will make better decisions for having taken this course. Why This Book? Hundreds of thousands of students have used this textbook. Your instructor has chosen it for you because of its trusted reputation. The authors have worked hard to keep the book fresh, timely, and accurate. This textbook contains features to help you learn best, whatever your learning style. To understand what your learning style is, spend about 10 minutes to take the learning style quiz at the book’s companion website. Then, look at page xi for how you can apply an understanding of your learning style to this course. When you know more about your own learning style, browse through pages xii–xiii. These pages describe the main features you will find in this textbook and explain their purpose. How To Succeed? We’ve asked many students and many
  • 86. instructors whether there is a secret for success in this course. The nearly unanimous answer turns out to be not much of a secret: “Do the homework.” This is one course where doing is learning, and the more time you spend on the homework assignments—using the various tools that this textbook provides—the more likely you are to learn the essential concepts, techniques, and methods of accounting. Besides the textbook itself, the textbook companion website offers various support resources. Good luck in this course. We hope you enjoy the experience and that you put to good use throughout a lifetime of success the knowledge you obtain in this course. We are sure you will not be disappointed. Jerry J. Weygandt Paul D. Kimmel Donald E. Kieso iii
  • 87. “Whether you are looking at a large multinational company like Microsoft or Starbucks or a single-owner software consulting business or coffee shop, knowing the fundamentals of managerial accounting will help you understand what is happening.” FMTOC.qxd 8/16/11 9:52 AM Page iii Your Team for Success in Accounting Wiley Accounting is your partner in accounting education. We want to be the first publisher you think of when it comes to quality content, reliable technology, innovative resources, professional training, and unparalleled support for your accounting classroom. Your Wiley Accounting Team for Success is comprised of three distinctive advantages that you won’t find with any other publisher:
  • 88. • Author Commitment • Wiley Faculty Network • WileyPLUS Author Commitment: A Proven Author Team of Inspired Teachers The Team for Success authors bring years of industry and academic experience to the development of each textbook that relates accounting concepts to real-world experiences. This cohesive team brings continuity of writing style, pedagogy, and problem material to each course from Principles to Intermediate so you and your students can seamlessly progress from introductory through advanced courses in accounting. The authors understand the mindset and time limitations of today’s students. They demonstrate an intangible ability to effectively deliver complex information so it is clear and understandable while
  • 89. staying one step ahead of emerging global trends in business. FMTOC.qxd 8/12/11 2:14 PM Page iv Wiley Faculty Network: A Team of Educators Dedicated to Your Professional Development The Wiley Faculty Network (WFN) is a global group of seasoned accounting professionals who share best practices in teaching with their peers. Our Virtual Guest Lecture Series provides the opportunity you need for professional development in an online environment that is relevant, convenient, and collaborative. The quality of these seminars and workshops meets the strictest standards, so we are proud to be able to offer valuable CPE credits to attendees. With 24 faculty mentors in accounting, it’s easy
  • 90. to find help with your most challenging curriculum questions—just ask our experts! WileyPLUS: An Experienced Team of Support Professionals The WileyPLUS Account Managers understand the time constraints of busy instructors who want to provide the best resources available to their students with minimal headaches and planning time. They know how intimidating new software can be, so they are sure to make the transition easy and painless. Account Managers act as your personal contact and expert resource for training, course set-up, and shortcuts throughout the WileyPLUS experience. Your success as an educator directly correlates to student success, and that’s our goal. The Wiley Accounting Team for Success truly strives for YOUR success! Partner with us today!
  • 91. www.wileyteamforsuccess.com FMTOC.qxd 8/12/11 2:14 PM Page v Author Commitment Collaboration. Innovation. Experience. After decades of success as authors of textbooks like this one, Jerry Weygandt, Paul Kimmel, and Don Kieso understand that teaching accounting goes beyond simply presenting data. The authors are truly effective because they know that teaching is about telling compelling stories in ways that make each concept come to life. TTeeaacchheerr // AAuutthhoorr // PPrrooffeessssiioonnaall Through their textbooks, supplements, online learning tools, and classrooms, these authors have developed a comprehensive pedagogy that engages students in learning and faculty with teaching. These authors collaborate throughout the entire process. The end result is a true collaboration where each author brings his
  • 92. individual experience and talent to the development of every paragraph, page, and chapter, thus creating a truly well- rounded, thorough view on any given accounting topic. MMaannyy WWaayyss iinn OOnnee DDiirreeccttiioonn Our Team for Success has developed a teaching system that addresses every learning style. Each year brings new insights, feedback, ideas, and improvements on how to deliver the material to every student with a passion for the subject in a format that gives them the best chance to succeed. The key to the team’s approach is in understanding that, just as there are many different ways to learn, there are also many different ways to teach. IInn TThheeiirr OOwwnn WWoorrddss Visit the Wiley Team for Success website to hear from the authors first-hand as they discuss their teaching styles, collaboration, and the future of accounting. wwwwww..wwiilleeyytteeaammffoorrssuucccceessss..ccoomm
  • 93. FMTOC.qxd 8/12/11 2:14 PM Page vi Jerry Weygandt Jerry J. Weygandt, PhD, CPA, is Arthur Andersen Alumni Emeritus Professor of Accounting at the University of Wisconsin— Madison. He holds a Ph.D. in accounting from the University of Illinois. Articles by Professor Weygandt have appeared in the Accounting Review, Journal of Accounting Research, Accounting Horizons, Journal of Accountancy, and other academic and professional journals. These articles have examined such financial reporting issues as accounting for price-level adjustments, pensions, convertible securities, stock option contracts, and interim reports. Professor Weygandt is author of other accounting and financial reporting books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Wisconsin Society of
  • 94. Certified Public Accountants. He has served on numerous committees of the American Accounting Association and as a member of the editorial board of the Accounting Review; he also has served as President and Secretary-Treasurer of the American Accounting Association. In addition, he has been actively involved with the American Institute of Certified Public Accountants and has been a member of the Accounting Standards Executive Committee (AcSEC) of that organization. He has served on the FASB task force that examined the reporting issues related to accounting for income taxes and served as a trustee of the Financial Accounting Foundation. Professor Weygandt has received the Chancellor’s Award for Excellence in Teaching and the Beta Gamma Sigma Dean’s Teaching Award. He is on the board of directors of M & I Bank of Southern Wisconsin. He is the recipient of the Wisconsin Institute of CPA’s Outstanding Educator’s Award and the Lifetime Achievement Award. In 2001 he received the American Accounting Association’s
  • 95. Outstanding Educator Award. Paul Kimmel Paul D. Kimmel, PhD, CPA, received his bachelor’s degree from the University of Minnesota and his doctorate in accounting from the University of Wisconsin. He is an Associate Professor at the University of Wisconsin—Milwaukee, and has public accounting experience with Deloitte & Touche (Minneapolis). He was the recipient of the UWM School of Business Advisory Council Teaching Award, the Reggie Taite Excellence in Teaching Award and a three-time winner of the Outstanding Teaching Assistant Award at the University of Wisconsin. He is also a recipient of the Elijah Watts Sells Award for Honorary Distinction for his results on the CPA exam. He is a member of the American Accounting Association and the Institute of Management Accountants and has published articles in Accounting Review, Accounting Horizons, Advances in Management Accounting, Managerial Finance, Issues in Accounting
  • 96. Education, Journal of Accounting Education, as well as other journals. His research interests include accounting for financial instruments and innovation in accounting education. He has published papers and given numerous talks on incorporating critical thinking into accounting education, and helped prepare a catalog of critical thinking resources for the Federated Schools of Accountancy. Don Kieso Donald E. Kieso, PhD, CPA, received his bachelor’s degree from Aurora University and his doctorate in accounting from the University of Illinois. He has served as chairman of the Department of Accountancy and is currently the KPMG Emeritus Professor of Accountancy at Northern Illinois University. He has public accounting experience with Price Waterhouse & Co. (San Francisco and Chicago) and Arthur Andersen & Co. (Chicago) and research experience with the Research Division of the American Institute of Certified Public Accountants (New York). He
  • 97. has done post doctorate work as a Visiting Scholar at the University of California at Berkeley and is a recipient of NIU’s Teaching Excellence Award and four Golden Apple Teaching Awards. Professor Kieso is the author of other accounting and business books and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Illinois CPA Society. He has served as a member of the Board of Directors of the Illinois CPA Society, then AACSB’s Accounting Accreditation Committees, the State of Illinois Comptroller’s Commission, as Secretary-Treasurer of the Federation of Schools of Accountancy, and as Secretary-Treasurer of the American Accounting Association. Professor Kieso is currently serving on the Board of Trustees and Executive Committee of Aurora University, as a member of the Board of Directors of Kishwaukee Community Hospital, and as Treasurer and Director of Valley West Community Hospital. From 1989 to 1993 he served as a charter member of
  • 98. the national Accounting Education Change Commission. He is the recipient of the Outstanding Accounting Educator Award from the Illinois CPA Society, the FSA’s Joseph A. Silvoso Award of Merit, the NIU Foundation’s Humanitarian Award for Service to Higher Education, a Distinguished Service Award from the Illinois CPA Society, and in 2003 an honorary doctorate from Aurora University. Author Commitment FMTOC.qxd 8/12/11 2:14 PM Page vii WileyPLUS WileyPLUS is an innovative, research-based, online environment for effective teaching and learning. What do STUDENTS receive with WileyPLUS? WileyPLUS increases confidence through an innovative design
  • 99. that allows greater engagement, which leads to improved learning outcomes. Design The WileyPLUS design integrates relevant resources, including the entire digital textbook, in an easy-to-navigate framework that helps students study more effectively and ensures student engagement. Innovative features, such as calendars and visual progress tracking, as well as a variety of self-evaluation tools, are all designed to improve time-management and increase student confidence. Engagement WileyPLUS organizes the textbook content into smaller, more man- ageable learning units with demonstrable study objectives and out- comes. Related media, examples, and sample practice items are integrated within each section to reinforce the study objectives. Throughout each study session, students can assess progress and gain immediate feedback on strengths and weaknesses in order
  • 100. to ensure they are spending their time most effectively. Outcomes Throughout each study session, WileyPLUS provides precise report- ing of strengths and weaknesses, as well as individualized quizzes. As a result, students can be confident they are spending their time on the right things. With WileyPLUS, students always know the exact outcome of their efforts. With increased confidence, motivation is sustained so students stay on task longer, leading to success. for Students FMTOC.qxd 8/12/11 2:14 PM Page viii for Instructors
  • 101. What do INSTRUCTORS receive with WileyPLUS? Support and Insight into Student Progress WileyPLUS provides reliable, customizable resources that reinforce course goals inside and outside of the classroom, as well as visibility into individual student progress. Pre-created materials and activities help instructors optimize their time. For class preparation and classroom use: • Interactive Tutorials • Problem Walkthrough Videos • Managerial Accounting Videos For assignments and testing: • Gradable Reading Assignment Questions (embedded with online text) • Question Assignments: all end-of-chapter problems coded algorithmically with hints, links to text For course planning: WileyPLUS comes with a pre-created
  • 102. Course Plan designed by a subject matter expert uniquely for this course. Simple drag-and-drop tools make it easy to assign the course plan as-is or modify it to reflect your course syllabus. For progress monitoring: WileyPLUS provides instant access to reports on trends in class performance, student use of course materials, and progress toward learning objectives, helping inform decisions and drive classroom discussions. Experience WileyPLUS for effective teaching and learning at www.wileyplus.com. Powered by proven technology and built on a foundation of cognitive research, WileyPLUS has enriched the education of millions of students in numerous countries around the world. FMTOC.qxd 8/12/11 2:14 PM Page ix http://www.wileyplus.com The Place Where Faculty Connect ... The Wiley Faculty Network is a global community
  • 103. of faculty connected by a passion for teaching and a drive to learn and share. Connect with the Wiley Faculty Network to collaborate with your colleagues, find a mentor, attend virtual and live events, and view a wealth of resources all designed to help you grow as an educator. Embrace the art of teaching—great things happen where faculty connect! Discover innovative ideas and gain knowledge you can use. • Training • Virtual Guest Lectures • Live Events Explore your resources and development opportunities. • Teaching Resources • Archived Guest Lectures • Recorded Presentations • Professional Development Modules Connect with colleagues—
  • 104. your greatest resource. • Find a Mentor • Interest Groups • Blog Find out more at www.WHEREFACULTYCONNECT.com The Wiley Faculty Network Virtual Guest Lectures Connect with recognized leaders across disciplines and collaborate with your peers on timely topics and discipline specific issues, many of which offer CPE credit. Live and Virtual Events These invitation-only, discipline-specific events are organized through a close partnership between the WFN, Wiley, and the academic community near the event location.
  • 105. Technology Training Discover a wealth of topic- and technology-specific training presented by subject matter experts, authors, and faculty where and when you need it. Teaching Resources Propel your teaching and student learning to the next level with quality peer-reviewed case studies, testimonials, classroom tools, and checklists. Connect with Colleagues Achieve goals and tackle challenges more easily by enlisting the help of your peers. Connecting with colleagues through the WFN can help you improve your teaching experience. FMTOC.qxd 8/12/11 2:14 PM Page x What TYPE of learner are you? Understanding each of these basic learning styles enables the authors to engage students’ minds and motivate them to do their best work, ultimately improving the
  • 106. experience for both students and faculty. V IS U A L A U R A L R E A D IN G
  • 107. / W R IT IN G K IN E S T H E T IC • Pay close attention to charts, drawings, and handouts
  • 108. your instructors use. • Underline. • Use different colors. • Use symbols, flow charts, graphs, different arrangements on the page, white spaces. Convert your lecture notes into “page pictures.” Therefore: • Use the “Intake” strategies. • Reconstruct images in different ways. • Redraw pages from memory. • Replace words with symbols and initials. • Look at your pages.
  • 109. The Navigator/Feature Story/Preview Infographics/Illustrations Accounting Equation Analyses Highlighted words Questions/Exercises/Problems Real-World Focus Decision-Making at Current Designs Managerial Analysis Problem • Recall your “page pictures.” • Draw diagrams where appropriate. • Practice turning your visuals back into words. • Attend lectures and tutorials. • Discuss topics with students and instructors.
  • 110. • Explain new ideas to other people. • Use a tape recorder. • Leave spaces in your lecture notes for later recall. • Describe overheads, pictures, and visuals to somebody who was not in class. You may take poor notes because you prefer to listen. Therefore: • Expand your notes by talking with others and with information from your textbook. • Tape-record summarized notes and listen. • Read summarized notes
  • 111. out loud. • Explain your notes to another “aural” person. Preview Insight Boxes DO IT!/Action Plan Summary of Learning Objectives Glossary Self-Test Questions Questions/Exercises/Problems Real-World Focus Decision-Making at Current Designs Managerial Analysis Problem Decision-Making Across the Organization Communication Activity Ethics Case • Talk with the instructor. • Spend time in quiet places
  • 112. recalling the ideas. • Practice writing answers to old exam questions. • Say your answers out loud. • Use lists and headings. • Use dictionaries, glossaries, and definitions. • Read handouts, textbooks, and supplementary library readings. • Use lecture notes. • Write out words again and again. • Reread notes silently. • Rewrite ideas and principles into other words.
  • 113. • Turn charts, diagrams, and other illustrations into statements. The Navigator/Feature Story/Study Objectives/Preview DO IT!/Action Plan Summary of Learning Objectives Glossary/Self-Test Questions Questions/Exercises/Problems Writing Problems Real-World Focus Decision-Making at Current Designs Considering Your Costs and Benefits Managerial Analysis Problem Decision-Making Across the
  • 114. Organization Communication Activity • Write exam answers. • Practice with multiple-choice questions. • Write paragraphs, beginnings, and endings. • Write your lists in outline form. • Arrange your words into hierarchies and points. • Use all your senses. • Go to labs, take field trips. • Listen to real-life examples. • Pay attention to applications. • Use hands-on approaches. • Use trial-and-error methods.
  • 115. You may take poor notes because topics do not seem concrete or relevant. Therefore: • Put examples in your summaries. • Use case studies and applications to help with principles and abstract concepts. • Talk about your notes with another “kinesthetic” person. • Use pictures and photographs that illustrate an idea. The Navigator/Feature Story/Preview Infographics/Illustrations DO IT!/Action Plan Summary of Learning Objectives
  • 116. Self-Test Questions Questions/Exercises/Problems Real-World Focus Decision-Making at Current Designs Managerial Analysis Problem Decision-Making Across the Organization Ethics Case Considering Your Costs and Benefits • Write practice answers. • Role-play the exam situation. Intake: To take in the information To make a study package Text features that may help you the most Output:
  • 117. To do well on exams xi FMTOC.qxd 8/12/11 2:14 PM Page xi Integrated Company Coverage Beginning in Chapter 1, we introduce Current Designs, a kayak- making company based in Winona, Minnesota. We then follow-up with a new decision- making problem in every chapter based on this real-world company. Each problem presents realistic managerial accounting situa- tions that students must analyze to determine the best course of action. In addition, many of these end-of-chapter activities also have an accompanying video. People, Planet, and Profit Today’s companies are evaluating not just their profitability but also their corporate social responsibility. In this edition, we have profiled some of
  • 118. these companies, such as Starbucks, to highlight their sustainable business practices. We also have added a new Broadening Your Perspective prob- lem, “Considering People, Planet, and Profit,” which requires students to assess and determine how best to balance a company’s profitability with its corporate social responsibility. New Feature Stories Students will be more willing to commit time and energy to a topic when they believe it is relevant to their future careers. There is no better way to demonstrate relevance than to ground discussions in the real world. To that end, we have written new Feature Stories about such companies as Starbucks, Amazon.com, and Zappos.com. Managerial Accounting Video Series Through the use of real-world, cutting-edge companies, these videos engage students with a dynamic overview of managerial accounting
  • 119. topics and motivate them through the detailed tools, examples, and discussions presented in their textbook, WileyPLUS course, and classroom lectures. Continued Focus on Decision-Making In the Sixth Edition, we continue to demonstrate how invaluable management accounting infor- mation is to business decision-making. New to this edition is another new Broadening Your Perspective problem, “Considering Your Costs and Benefits,” which presents a realistic situation in which students must weigh the pros and cons of two alternatives. What’s New? Features of the Sixth Edition The Sixth Edition expands our emphasis on student learning and improves upon a teach- ing and learning package that instructors and students have rated the highest in cus- tomer satisfaction.
  • 120. xii FMTOC.qxd 8/16/11 10:03 AM Page xii This edition was also subject to an overall, comprehensive revision to ensure that it is technically accurate, relevant, and up-to-date. We have continued and enhanced many of the features of the Fifth Edition of Managerial Accounting, including the following: Real-World Emphasis One of the goals of the managerial accounting course is to orient students to the application of accounting principles and techniques in practice. Accordingly, we have continued our practice of using numerous examples from real companies throughout the textbook. The names of these real companies are highlighted in red. Also, throughout the chapters, IInnssiigghhtt and
  • 121. AAccccoouunnttiinngg AAccrroossss tthhee OOrrggaanniizzaattiioonn boxes show how people, often in non-accounting functions, in actual companies make decisions using accounting information. Guideline Answers to the critical thinking questions are provided at the end of each chapter. Finally, examples, exercises, and problems that focus on accounting situations faced by sseerrvviiccee ccoommppaanniieess are identified by the icon shown here. Decision Toolkit The DDeecciissiioonn TToooollkkiittss highlight the important analytical tools inte- grated throughout the textbook, designed to assist students in evaluation and using the information at hand. A UUssiinngg tthhee DDeecciissiioonn TToooollkkiitt exercise, just before the chapter summary, asks students to use the decision tools presented in the chapter and takes them through the problem-solving steps. Exercises Brief exercises ask students to apply their newly acquired knowledge. The exer-
  • 122. cises include an Action Plan, which reviews the necessary steps to complete the exercise, as well as a