The cvp income statements shown below are available for armstrong company and contador company.

19

Cost‐Volume‐Profit Analysis: Additional Issues

 CHAPTER PREVIEW 

As the Feature Story about Whole Foods Market suggests, the relationship between a company's fixed and variable costs can have a huge impact on its profitability. In particular, the trend toward cost structures dominated by fixed costs has significantly increased the volatility of many companies' net income. The purpose of this chapter is to demonstrate additional uses of cost‐volume‐profit analysis in making sound business decisions.

A chart lists learning objectives and do it practices in this chapter. Learning objective 1: apply basic CVP concepts, covers basic concepts, basic computations, and business environment. Do it practice 1: CVP analysis. Learning objective 2: explain the term sales mix and its effects on break-even sales, covers break-even in units and break-even in dollars. Do it practice 2: sales mix break-even. Learning objective 3: determine sales mix when a company has limited resources. Do it practice 3: sales mix with limited resources. Learning objective 4: indicate how operating leverage affects profitability, covers contribution margin ratio, break-even point, margin of safety ratio, and operating leverage. Do it practice 4: operating leverage. Go to the review and practice section at the end of the chapter for a targeted summary and exercises with solutions. Visit WileyPlus for additional tutorials and practice opportunities.

Not Even a Flood Could Stop It

America has a reputation as a country populated with people who won't buy a restaurant meal unless it can be ordered from the driver's seat of a car. Customers want to receive said “meal” 30 seconds later from a drive‐up window and then consume the bagged product while driving one‐handed down an 8‐lane freeway. This is actually a fairly accurate depiction of the restaurant preferences (and eating habits) of one of the authors of this textbook. However, given the success of Whole Foods Market, this certainly cannot be true of all Americans.

Whole Foods Market began humbly in 1978 as a natural‐foods store called SaferWay. (Get it? A play on SafeWay grocery stores.) It was founded in Austin, Texas, by 25 year‐old John Mackey (a self‐described college dropout) and 21 year‐old Renee Lawson Hardy. They financed the first store by borrowing $45,000 from family and friends. The early days were “interesting.” First, John and Renee got kicked out of their apartment for storing grocery products there. No problem—they just moved into the store. They bathed in the store's dishwasher with an attached hose. They did whatever it took to keep their costs down and the store going.

Two years later, John and Renee merged SaferWay with another store to form the first Whole Foods Market. The store's first year was very successful. Well, that is until everything in the store was completely destroyed by Austin's biggest flood in more than 70 years. They lost $400,000 in goods—and they had no insurance. But within 28 days, with tons of volunteer work and understanding creditors and vendors, the store reopened.

Today, Whole Foods operates approximately 270 stores. The size of the average store has actually declined in recent years. While huge stores (up to 80,000 square feet) were successful in a few cities, in most locations the fixed costs of such a large facility made it hard to achieve profit targets. Then, when sales became sluggish during the recession, the company determined that it could reduce its fixed costs, such as rent and utility costs, by reducing its average store size by about 20%. However, with fewer square feet, managers must keep a close eye on the sales mix. They need to be aware of the relative contribution margins of each product line to maximize the profit per square foot while still providing the products its customers want.

Why is a company as successful as Whole Foods so concerned about controlling costs? The answer is that the grocery business runs on very thin margins. So while we doubt that anybody is bathing in the store's dishwashers anymore, Whole Foods is as vigilant about its costs today as it was during its first year of operations.

LEARNING OBJECTIVE 1

Apply basic CVP concepts.

As indicated in Chapter 18, cost‐volume‐profit (CVP) analysis is the study of the effects of changes in costs and volume on a company's profit. CVP analysis is important to profit planning. It is also a critical factor in determining product mix, maximizing use of production facilities, and setting selling prices.

BASIC CONCEPTS

Because CVP is so important for decision‐making, management often wants this information reported in a CVP income statement format for internal use. The CVP income statement classifies costs as variable or fixed, and computes a contribution margin. Contribution margin is the amount of revenue remaining after deducting variable costs. It is often stated both as a total amount and on a per unit basis.

Illustration 19-1 presents the CVP income statement for Vargo Video (which was shown in Illustration 18-12 on page 893). Note that Vargo sold 1,600 camcorders at $500 per unit.

VARGO VIDEO COMPANY CVP Income Statement For the Month Ended June 30, 2017

 

 

Total

 

Per Unit

 

 

Sales (1,600 camcorders)

 

$ 800,000

 

$ 500 

 

 

Variable costs

 

  480,000

 

 300 

 

 

Contribution margin

 

320,000

 

$200 

 

 

Fixed costs

 

  200,000

 

 

Net income

 

$120,000

 

ILLUSTRATION 19-1 Basic CVP income statement

Companies often prepare detailed CVP income statements. The CVP income statement in Illustration 19-2 uses the same base information as that presented in Illustration 19-1 but provides more detailed information (using assumed data) about the composition of expenses.

VARGO VIDEO COMPANY CVP Income Statement For the Month Ended June 30, 2017

 

Total

 

Per Unit

 

Sales

 

 

$ 800,000

 

$500

 

Variable expenses

 

 

 

 

 Cost of goods sold

 

$400,000

 

 

 

 Selling expenses

 

60,000

 

 

 

 Administrative expenses

 

  20,000

 

 

 

 Total variable expenses

 

 

 480,000

 

  300

 

Contribution margin

 

 

320,000

 

$200

 

Fixed expenses

 

 

 

 

 Cost of goods sold

 

120,000

 

 

 

 Selling expenses

 

40,000

 

 

 

 Administrative expenses

 

  40,000

 

 

 

 Total fixed expenses

 

 

 200,000

 

 

Net income

 

 

$120,000

 

 

ILLUSTRATION 19-2 Detailed CVP income statement

▼ HELPFUL HINT

The appendix to this chapter provides additional discussion of income statements used for decision‐making.

In the applications of CVP analysis that follow, we assume that the term “cost” includes all costs and expenses related to production and sale of the product. That is, cost includes manufacturing costs plus selling and administrative expenses.

BASIC COMPUTATIONS

Before we introduce additional issues of CVP analysis, let's review some of the basic concepts that you learned in Chapter 18, specifically break‐even analysis, target net income, and margin of safety.

Break‐Even Analysis

Vargo Video's CVP income statement (Illustration 19-2) shows that total contribution margin (sales minus variable expenses) is $320,000, and the company's unit contribution margin is $200. Recall that contribution margin can also be expressed in the form of the contribution margin ratio(contribution margin divided by sales), which in the case of Vargo is 40% ($200÷$500)40% ($200÷$500).

Illustration 19-3 demonstrates how to compute Vargo's break‐even point in units (using unit contribution margin).

Fixed Costs÷Unit Contribution Margin=Break-Even Point in Units$200,000÷$200=1,000 unitsFixed Costs÷Unit Contribution Margin=Break-Even Point in Units$200,000÷$200=1,000 units ILLUSTRATION 19-3 Break‐even point in units

Illustration 19-4 shows the computation for the break‐even point in dollars (using contribution margin ratio).

Fixed Costs÷Contribution Margin Ratio=Break-Even Point in Dollars$200,000÷.40=$500,000Fixed Costs÷Contribution Margin Ratio=Break-Even Point in Dollars$200,000÷.40=$500,000 ILLUSTRATION 19-4 Break‐even point in dollars

When a company is in its early stages of operation, its primary goal is to break even. Failure to break even will lead eventually to financial failure.

Target Net Income

Once a company achieves break‐even, it then sets a sales goal that will generate a target net income. For example, assume that Vargo's management has a target net income of $250,000. Illustration 19-5 shows the required sales in units to achieve its target net income.

(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units($200,000+$250,000)÷$200=2,250 units(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units($200,000+$250,000)÷$200=2,250 units ILLUSTRATION 19-5 Target net income in units

Illustration 19-6 uses the contribution margin ratio to compute the required sales in dollars.

(Fixed Costs+Target Net Income)÷Contribution Margin Ratio=Required Sales in Dollars($200,000+$250,000)÷.40=$1,125,000(Fixed Costs+Target Net Income)÷Contribution Margin Ratio=Required Sales in Dollars($200,000+$250,000)÷.40=$1,125,000 ILLUSTRATION 19-6 Target net income in dollars

In order to achieve net income of $250,000, Vargo has to sell 2,250 camcorders, for a total price of $1,125,000.

Margin of Safety

Another measure managers use to assess profitability is the margin of safety. The margin of safety tells us how far sales can drop before the company will be operating at a loss. Managers like to have a sense of how much cushion they have between their current situation and operating at a loss. This can be expressed in dollars or as a ratio. In Illustration 19-2 (page 924), for example, Vargo reported sales of $800,000. At that sales level, its margin of safety in dollars and as a ratio are as follows.

Actual (Expected) Sales−Break-Even Sales=Margin of Safety in Dollars$800,000−$500,000=$300,000Actual (Expected) Sales−Break-Even Sales=Margin of Safety in Dollars$800,000−$500,000=$300,000ILLUSTRATION 19-7 Margin of safety in dollars

As shown in Illustration 19-8, Vargo's sales could drop by $300,000, or 37.5%, before the company would operate at a loss.

Margin of Safety in Dollars÷Actual (Expected) Sales=Margin of Safety Ratio$300,000÷$800,000=37.5%Margin of Safety in Dollars÷Actual (Expected) Sales=Margin of Safety Ratio$300,000÷$800,000=37.5% ILLUSTRATION 19-8 Margin of safety ratio

CVP AND CHANGES IN THE BUSINESS ENVIRONMENT

To better understand how CVP analysis works, let's look at three independent situations that might occur at Vargo Video. Each case uses the original camcorder sales and cost data, which were as follows.

Unit selling price

 

$500

Unit variable cost

 

$300

Total fixed costs

 

$200,000

Break-even sales

 

$500,000 or 1,000 units

ILLUSTRATION 19-9 Original camcorder sales and cost data

Case I

A competitor is offering a 10% discount on the selling price of its camcorders. Management must decide whether to offer a similar discount.

Question: What effect will a 10% discount on selling price have on the break‐even point for camcorders?

Answer: A 10% discount on selling price reduces the selling price per unit to $450 [$500 − ($500 × 10%)]. Variable costs per unit remain unchanged at $300. Thus, the unit contribution margin is $150. Assuming no change in fi xed costs, break-even sales are 1,333 units, computed as follows.

Fixed Costs÷Unit Contribution Margin=Break-Even Sales$200,000÷$150=1,333 units (rounded)Fixed Costs÷Unit Contribution Margin=Break-Even Sales$200,000÷$150=1,333 units (rounded)ILLUSTRATION 19-10 Computation of break‐even sales in units

For Vargo, this change requires monthly sales to increase by 333 units, or 33⅓%, in order to break even. In reaching a conclusion about offering a 10% discount to customers, management must determine how likely it is to achieve the increased sales. Also, management should estimate the possible loss of sales if the competitor's discount price is not matched.

Case II

To meet the threat of foreign competition, management invests in new robotic equipment that will lower the amount of direct labor required to make camcorders. The company estimates that total fixed costs will increase 30% and that variable cost per unit will decrease 30%.

Question: What effect will the new equipment have on the sales volume required to break even?

Answer: Total fixed costs become $260,000 [$200,000 + (30% × $200,000)]. The variable cost per unit becomes $210 [$300 − (30% × $300)]. The new break-even point is approximately 897 units, computed as shown in Illustration 19-11.

Fixed Costs÷Unit Contribution Margin=Break-Even Sales$260,000÷($500−$210)=897 units (rounded)Fixed Costs÷Unit Contribution Margin=Break-Even Sales$260,000÷($500−$210)=897 units (rounded) ILLUSTRATION 19-11 Computation of break‐even sales in units

These changes appear to be advantageous for Vargo. The break‐even point is reduced by approximately 10%, or 100 units.

Case III

Vargo's principal supplier of raw materials has just announced a price increase. The higher cost is expected to increase the variable cost of camcorders by $25 per unit. Management decides to hold the line on the selling price of the camcorders. It plans a cost‐cutting program that will save $17,500 in fixed costs per month. Vargo is currently realizing monthly net income of $80,000 on sales of 1,400 camcorders.

Question: What increase in units sold will be needed to maintain the same level of net income?

Answer: The variable cost per unit increases to $325 ($300 + $25). Fixed costs are reduced to $182,500 ($200,000 − $17,500). Because of the change in variable cost, the unit contribution margin becomes $175 ($500 − $325). The required number of units sold to achieve the target net income is computed as follows.

(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units($182,500+$80,000)÷$175=1,500(Fixed Costs+Target Net Income)÷Unit Contribution Margin=Required Sales in Units($182,500+$80,000)÷$175=1,500ILLUSTRATION 19-12 Computation of required sales

To achieve the required sales, Vargo Video will have to sell 1,500 camcorders, an increase of 100 units. If this does not seem to be a reasonable expectation, management will either have to make further cost reductions or accept less net income if the selling price remains unchanged.

We hope that the concepts reviewed in this section are now familiar to you. We are now ready to examine additional ways that companies use CVP analysis to assess profitability and to help in making effective business decisions.

MANAGEMENT INSIGHT

Amazon.com

Don't Just Look—Buy Something

The screenshot is a snippet with a one-line title Management Insight, illustrating Amazo.’s conversion rate schemes. I.’s described that the more the conversion rate, the lower the cost to the company per purchase. The Conversion rate is represented as the percentage of visitors to the site who actually buys anything to the rest. Average conversion rate is said to be between 3 and 5%, whereas 2% is said to be poor and 10% said to be great.

When analyzing an Internet business such as Amazon.com, analysts closely watch the so‐called “conversion rate.” This rate is calculated by dividing the number of people who actually take action at an Internet site (buy something) by the total number of people who visit the site. Average conversion rates are from 3% to 5%. A rate below 2% is poor, while a rate above 10% is great.

Conversion rates have an obvious effect on the break‐even point. Suppose you spend $10,000 on your site, which then attracts 5,000 visitors. If you get a 2% conversion rate (100 purchases), your site costs $100 per purchase ($10,000÷100)($10,000÷100). A 4% conversion rate lowers your cost to $50 per transaction, and an 8% conversion rate gets you down to $25. Studies show that conversion rates increase if the site has an easy‐to‐use interface, fast‐performing screens, a convenient ordering process, and advertising that is both clever and clear.

Sources: J. William Gurley, “The One Internet Metric That Really Counts,” Fortune (March 6, 2000), p. 392; and Milind Mody, “Chief Mentor: How Startups Can Win Customers Online,” Wall Street Journal Online (May 11, 2011).

Besides increasing their conversion rates, what steps can online merchants use to lower their break‐even points? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 1

CVP Analysis

Krisanne Company reports the following operating results for the month of June.

KRISANNE COMPANY CVP Income Statement For the Month Ended June 30, 2017

 

 

Total

 

Per Unit

 

 

Sales (5,000 units)

 

$300,000

 

$60

 

 

Variable costs

 

 180,000

 

 36

 

 

Contribution margin

 

 120,000

 

$24

 

 

Fixed expenses

 

 100,000

 

 

 

Net income

 

$ 20,000

 

 

To increase net income, management is considering reducing the selling price by 10%, with no changes to unit variable costs or fixed costs. Management is confident that this change will increase unit sales by 25%.

Using the contribution margin technique, compute the break‐even point in units and dollars and margin of safety in dollars (a) assuming no changes to sales price or costs, and (b) assuming changes to sales price and volume as described above. (c) Comment on your findings.

Action Plan

✓ Apply the formula for the break‐even point in units.

✓ Apply the formula for the break‐even point in dollars.

✓ Apply the formula for the margin of safety in dollars.

SOLUTION

a. Assuming no changes to sales price or costs:

Break-even point in units = 4,167 units (rounded) ($100,000 ÷ $24)

Break-even point in sales dollars = $250,000 ($100,000 ÷ .40a)

Margin of safety in dollars = $50,000 ($300,000 − $250,000)

a$24 ÷ $60

b. Assuming changes to sales price and volume:

Break-even point in units = 5,556 units (rounded) ($100,000 ÷ $18b)

Break-even point in sales dollars = $300,000 ($100,000 ÷ ($18 ÷ $54c))

Margin of safety in dollars = $37,500 ($337,500d − $300,000)

b$60 − (.10 × $60) − 36 = $18

c$60 − (.10 × $60)

d5,000 + (.25 × 5,000) = 6,250 units; 6,250 units × $54 = $337,500

c. The increase in the break‐even point and the decrease in the margin of safety indicate that management should not implement the proposed change. The increase in sales volume will result in a contribution margin of $112,500 (6,250×$18)$112,500 (6,250×$18), which is $7,500 less than the current amount.

Related exercise material: BE19-3, BE19-4, BE19-5, BE19-6, E19-1, E19-2, E19-3, E19-4, E19-5, and DO IT! 19-1.

LEARNING OBJECTIVE 2

Explain the term sales mix and its effects on break‐even sales.

To this point, our discussion of CVP analysis has assumed that a company sells only one product. However, most companies sell multiple products. When a company sells many products, it is important that management understand its sales mix.

Sales mix is the relative percentage in which a company sells its multiple products. For example, if 80% of Hewlett Packard's unit sales are printers and the other 20% are PCs, its sales mix is 80% printers to 20% PCs.

Sales mix is important to managers because different products often have substantially different contribution margins. For example, Ford's SUVs and F150 pickup trucks have higher contribution margins compared to its economy cars. Similarly, first‐class tickets sold by United Airlines provide substantially higher contribution margins than coach‐class tickets. Intel's sales of computer chips for netbook computers have increased, but the contribution margin on these chips is lower than for notebook and desktop PCs.

BREAK‐EVEN SALES IN UNITS

Companies can compute break‐even sales for a mix of two or more products by determining the weighted‐average unit contribution margin of all the products. To illustrate, assume that Vargo Video sells not only camcorders but high‐definition TVs as well. Vargo sells its two products in the following amounts: 1,500 camcorders and 500 TVs. The sales mix, expressed as a percentage of the 2,000 total units sold, is as follows.

Camcorders

 

TVs

1,500 units ÷ 2,000 units = 75%

 

500 units ÷ 2,000 units = 25%

ILLUSTRATION 19-13 Sales mix as a percentage of units sold

That is, 75% of the 2,000 units sold are camcorders, and 25% of the 2,000 units sold are TVs.

Illustration 19-14 shows additional information related to Vargo. The unit contribution margin for camcorders is $200, and for TVs it is $500. Vargo’s fixed costs total $275,000.

Unit Data

 

Camcorders

 

TVs

Selling price

 

$500

 

$1,000

Variable costs

 

 300

 

  500

Contribution margin

 

$200

 

 $500

Sales mix—units

 

75%

 

 25%

Fixed costs = $275,000

 

 

ILLUSTRATION 19-14 Per unit data—sales mix

To compute break‐even for Vargo, we must determine the weighted‐average unit contribution margin for the two products. We use the weighted‐average contribution margin because Vargo sells three times as many camcorders as TVs. As a result, in determining an average unit contribution margin, three times as much weight should be placed on the contribution margin of the camcorders as on the TVs. Therefore, the camcorders must be counted three times for every TV sold. The weighted‐average contribution margin for a sales mix of 75% camcorders and 25% TVs is $275, which is computed as follows.

Camcorders¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯TVs¯¯¯¯¯¯¯¯⎛⎜⎝UnitContributionMargin×Sales MixPercentage⎞⎟⎠+⎛⎜⎝UnitContributionMargin×Sales MixPercentage⎞⎟⎠=Weighted-AverageUnit ContributionMargin($200×.75)+($500×.25)=$275Camcorders¯TVs¯(UnitContributionMargin×Sales MixPercentage)+(UnitContributionMargin×Sales MixPercentage)=Weighted-AverageUnit ContributionMargin($200×.75)+($500×.25)=$275

ILLUSTRATION 19-15 Weighted‐average unit contribution margin

Similar to our calculation in the single‐product setting, we can compute the break‐even point in units by dividing the fixed costs by the weighted‐average unit contribution margin of $275. The computation of break‐even sales in units for Vargo Video, assuming $275,000 of fixed costs, is as follows.

DECISION TOOLS Decision Tools

The break‐even point in units helps managers determine how many units of each product need to be sold to avoid a loss.

Illustration 19-16 shows the break‐even point for Vargo is 1,000 units—camcorders and TVs combined. Management needs to know how many of the 1,000 units sold are camcorders and how many are TVs. Applying the sales mix percentages that we computed previously of 75% for camcorders and 25% for TVs, these 1,000 units would be comprised of 750 camcorders (.75×1,000 units)(.75×1,000 units) and 250 TVs (.25×1,000)(.25×1,000). This can be verified by the computations in Illustration 19-17, which shows that the total contribution margin is $275,000 when 1,000 units are sold, which equals the fixed costs of $275,000.

Fixed Costs÷Weighted-Average Unit Contribution Margin=Break-Even Point in Units$275,000÷$275=1,000 unitsFixed Costs÷Weighted-Average Unit Contribution Margin=Break-Even Point in Units$275,000÷$275=1,000 units ILLUSTRATION 19-16 Break‐even point in units

Product

 

Unit Sales

 

×

 

Unit Contribution Margin

 

=

 

Total Contribution Margin

Camcorders

 

  750

 

×

 

$200

 

=

 

$ 150,000

TVs

 

  250

 

×

 

 500

 

=

 

  125,000

 

1,000

 

 

 

 

$275,000

ILLUSTRATION 19-17 Break‐even proof—sales units

Management should continually review the company's sales mix. At any level of units sold, net income will be greater if higher contribution margin units are sold rather than lower contribution margin units. For Vargo, the TVs produce the higher contribution margin. Consequently, if Vargo sells 300 TVs and 700 camcorders, net income would be higher than in the current sales mix even though total units sold are the same.

An analysis of these relationships shows that a shift from low‐margin sales to high‐margin sales may increase net income even though there is a decline in total units sold. Likewise, a shift from high‐ to low‐margin sales may result in a decrease in net income even though there is an increase in total units sold.

BREAK‐EVEN SALES IN DOLLARS

The calculation of the break‐even point presented for Vargo Video in the previous section works well if a company has only a small number of products. In contrast, consider 3M, the maker of Post‐it Notes, which has more than 30,000 products. In order to calculate the break‐even point for 3M using a weighted‐average unit contribution margin, we would need to calculate 30,000 different unit contribution margins. That is not realistic.

Therefore, for a company with many products, we calculate the break‐even point in terms of sales dollars (rather than units sold), using sales information for divisions or product lines (rather than individual products). This requires that we compute both sales mix as a percentage of total dollar sales (rather than units sold) and the contribution margin ratio (rather than unit contribution margin).

To illustrate, suppose that Kale Garden Supply Company has two divisions—Indoor Plants and Outdoor Plants. Each division has hundreds of different types of plants and plant‐care products. Illustration 19-18 provides information necessary for determining the sales mix percentages for the two divisions of Kale Garden Supply.

 

 

Indoor Plant Division

 

 

Outdoor Plant Division

 

 

Company Total

Sales

 

$  200,000

 

 

$  800,000

 

 

$1,000,000

Variable costs

 

   120,000

 

 

   560,000

 

 

   680,000

Contribution margin

 

$   80,000

 

 

$  240,000

 

 

$  320,000

Sales mix percentage

 

$  200,000

=.20

 

$  800,000

=.80

 

 

 (Division sales ÷ Total sales)

 

$1,000,000

 

$1,000,000

 

 

ILLUSTRATION 19-18 Cost‐volume‐profit data for Kale Garden Supply

As shown in Illustration 19-19, the contribution margin ratio for the combined company is 32%, which is computed by dividing the total contribution margin by total sales.

 

Indoor Plant Division

 

Outdoor Plant Division

 

Company Total

Contribution margin ratio   (Contribution margin ÷ Sales)

 

$ 80,000$200,000=.40$ 80,000$200,000=.40

 

$240,000$800,000=.30$240,000$800,000=.30

 

$ 320,000$1,000,000=.32$ 320,000$1,000,000=.32

ILLUSTRATION 19-19 Contribution margin ratio for each division

It is useful to note that the contribution margin ratio of 32% for the total company is a weighted average of the individual contribution margin ratios of the two divisions (40% and 30%). To illustrate, in Illustration 19-20 we multiply each division's contribution margin ratio by its sales mix percentage, based on dollar sales, and then total these amounts. The calculation in Illustration 19-20 is useful because it enables us to determine how the break‐even point changes when the sales mix changes.

Indoor Plant Division

Outdoor Plant Division

(ContributionMargin Ratio(ContributionMargin Ratio

×

Sales MixPercentage)Sales MixPercentage)

+

(ContributionMargin Ratio(ContributionMargin Ratio

×

Sales MixPercentage)Sales MixPercentage)

=

Weighted-AverageContributionMargin RatioWeighted-AverageContributionMargin Ratio

(.40

×

.20)

+

(.30

×

.80)

=

.32

ILLUSTRATION 19-20 Calculation of weighted‐average contribution margin

Kale Garden Supply's break‐even point in dollars is then computed by dividing its fixed costs of $300,000 by the weighted‐average contribution margin ratio of 32%, as shown in Illustration 19-21 (page 932).

Fixed Costs÷Weighted-Average Contribution Margin Ratio=Break-Even Point in Dollars$300,000÷.32=$937,500Fixed Costs÷Weighted-Average Contribution Margin Ratio=Break-Even Point in Dollars$300,000÷.32=$937,500 ILLUSTRATION 19-21 Calculation of break‐even point in dollars

The break‐even point is based on the sales mix of 20% to 80%. We can determine the amount of sales contributed by each division by multiplying the sales mix percentage of each division by the total sales figure. Of the company's total break‐even sales of $937,500, a total of $187,500 (.20×$937,500)$187,500 (.20×$937,500) will come from the Indoor Plant Division, and $750,000 (.80×$937,500)$750,000 (.80×$937,500) will come from the Outdoor Plant Division.

DECISION TOOLS Decision Tools

The break‐even point in dollars helps managers determine the sales dollars required from each division to avoid a loss.

What would be the impact on the break‐even point if a higher percentage of Kale Garden Supply's sales were to come from the Indoor Plant Division? Because the Indoor Plant Division enjoys a higher contribution margin ratio, this change in the sales mix would result in a higher weighted‐average contribution margin ratio and consequently a lower break‐even point in dollars. For example, if the sales mix changes to 50% for the Indoor Plant Division and 50% for the Outdoor Plant Division, the weighted‐average contribution margin ratio would be 35% [(.40×.50)+(.30×.50)]35% [(.40×.50)+(.30×.50)]. The new, lower, break‐even point is $857,143 ($300,000÷.35)$857,143 ($300,000÷.35). The opposite would occur if a higher percentage of sales were expected from the Outdoor Plant Division. As you can see, the information provided using CVP analysis can help managers better understand the impact of sales mix on profitability.

SERVICE COMPANY INSIGHT

Zoom Kitchen

Healthy for You, and Great for the Bottom Line

The screenshot is a snippet with a one-line title Service Company Insight, illustrating Zoom kitche.’s strategy after considering the Contribution Margin. With a deep dive into Contribution Margin the company found that Salads show higher margin than meat and thus began to offer many interesting assortment of salad ingredients thereby encouraging people to eat healthy.

Zoom Kitchen, a chain of restaurants in the Chicago area, was known for serving sizable portions of meat and potatoes. But the company's management was quite pleased when salad sales increased from 18% of its sales mix to 40%. Why were they pleased? Because the contribution margin on salads was much higher than on meat. The restaurant made a conscious effort to encourage people to buy more salads by offering an interesting assortment of salad ingredients including jicama, beets, marinated mushrooms, grilled tuna, and carved turkey. Management had to be very sensitive to contribution margin as opening up a new Zoom Kitchen restaurant was very costly.

Source: Amy Zuber, “Salad Sales ‘Zoom’ at Meat‐and‐Potatoes Specialist,” Nation's Restaurant News (November 12, 2001), p. 26.

Why do you suppose restaurants are so eager to sell beverages and desserts? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 2

Sales Mix Break‐Even

Manzeck Bicycles International produces and sells three different types of mountain bikes. Information regarding the three models is shown below.

 

Pro

 

Intermediate

 

Standard

 

Total

Units sold

 

5,000

 

10,000

 

25,000

 

40,000

Selling price

 

 $800

 

  $500

 

  $350

 

Variable costs

 

 $500

 

  $300

 

  $250

 

The company's total fixed costs to produce the bicycles are $7,500,000.

(a) Determine the sales mix as a function of units sold for the three products.

(b) Determine the weighted‐average unit contribution margin.

(c) Determine the total number of units that the company must sell to break even.

(d) Determine the number of units of each model that the company must sell to break even.

Action Plan

✓ The sales mix is the relative percentage of each product sold in units.

✓ The weighted‐average unit contribution margin is the sum of the unit contribution margins multiplied by the respective sales mix percentage.

✓ Determine the break‐even point in units by dividing the fixed costs by the weighted‐average unit contribution margin.

✓ Determine the number of units of each model to sell by multiplying the total break‐even units by the respective sales mix percentage for each product.

SOLUTION

(a) The sales mix percentages as a function of units sold are:

Pro

 

Intermediate

 

Standard

5,000/40,000 = 12.5%

 

10,000/40,000 = 25%

 

25,000/40,000 = 62.5%

(b) The weighted‐average unit contribution margin is:

[.125×($800−$500)]+[.25×($500−$300)]+[.625×($350−$250)]=$150[.125×($800−$500)]+[.25×($500−$300)]+[.625×($350−$250)]=$150

(c) The break‐even point in units is:

$7,500,000÷$150=50,000 units$7,500,000÷$150=50,000 units

(d) The break‐even units to sell for each product are:

Pro:

50,000 units × 12.5%

=

 6,250 units

Intermediate:

50,000 units × 25%

=

12,500 units

Standard:

50,000 units × 62.5%

=

31,250 units

50,000 units

Related exercise material: BE19-7, BE19-8, BE19-9, BE19-10, E19-6, E19-7, E19-8, E19-9, E19-10, and DO IT! 19-2.

LEARNING OBJECTIVE 3

Determine sales mix when a company has limited resources.

In the previous discussion, we assumed a certain sales mix and then determined the break‐even point given that sales mix. We now discuss how limited resources influence the sales‐mix decision.

All companies have resource limitations. The limited resource may be floor space in a retail department store, or raw materials, direct labor hours, or machine capacity in a manufacturing company. When a company has limited resources, management must decide which products to make and sell in order to maximize net income.

DECISION TOOLS Decision Tools

Determining the contribution margin per unit of limited resource helps managers decide which product should receive any additional capacity of the limited resource.

To illustrate, recall that Vargo Video manufactures camcorders and TVs. The limiting resource is machine capacity, which is 3,600 hours per month. Relevant data consist of the following.

 

Camcorders

 

TVs

Unit contribution margin

 

$200

 

$500

Machine hours required per unit

 

.2

 

 .625

ILLUSTRATION 19-22 Contribution margin and machine hours

The TVs may appear to be more profitable since they have a higher unit contribution margin ($500) than the camcorders ($200). However, the camcorders take fewer machine hours to produce than the TVs. Therefore, it is necessary to find the contribution margin per unit of limited resource—in this case, contribution margin per machine hour. This is obtained by dividing the unit contribution margin of each product by the number of units of the limited resource required for each product, as shown in Illustration 19-23.

▼ HELPFUL HINT

CM alone is not enough to make this decision. The key factor is CM per unit of limited resource.

 

Camcorders

 

TVs

Unit contribution margin (a)

 

$200

 

$500

Machine hours required (b)

 

0.2

 

0.625

Contribution margin per unit of limited   resource [(a) ÷ (b)]

 

$1,000

 

$800

ILLUSTRATION 19-23 Contribution margin per unit of limited resource

The computation shows that the camcorders have a higher contribution margin per unit of limited resource. This would suggest that, given sufficient demand for camcorders, Vargo should shift the sales mix to produce more camcorders or increase machine capacity.

As indicated in Illustration 19-23, the constraint for the production of the TVs is the larger number of machine hours needed to produce them. In addressing this problem, we have taken the limited number of machine hours as a given and have attempted to maximize the contribution margin given the constraint. One question that Vargo should ask, however, is whether this constraint can be reduced or eliminated. If Vargo is able to increase machine capacity from 3,600 hours to 4,200 hours, the additional 600 hours could be used to produce either the camcorders or TVs. The total contribution margin under each alternative is found by multiplying the machine hours by the contribution margin per unit of limited resource, as shown below.

 

Camcorders

 

TVs

Machine hours (a)

 

600

 

600

Contribution margin per unit of limited resource (b)

 

$    1,000

 

$    800

Contribution margin [(a) × (b)]

 

$600,000

 

$480,000

ILLUSTRATION 19-24 Incremental analysis—computation of total contribution margin

From this analysis, we can see that to maximize net income, all of the increased capacity should be used to make and sell the camcorders.

Vargo's manufacturing constraint might be due to a bottleneck in production or to poorly trained machine operators. In addition to finding ways to solve those problems, the company should consider other possible solutions, such as outsourcing part of the production, acquiring additional new equipment (discussed in Chapter 24), or striving to eliminate any non–value‐added activities (see Chapter 17). As discussed in Chapter 14, this approach to evaluating constraints is referred to as the theory of constraints. The theory of constraints is a specific approach used to identify and manage constraints in order to achieve the company's goals. According to this theory, a company must continually identify its constraints and find ways to reduce or eliminate them, where appropriate.

MANAGEMENT INSIGHT

Macy's

Something Smells

The illustration is a snippet with a one-line title Management Insight, illustrating Mac.’s strategy to reduce floor space for fragrance manufacturers. Manufacturers had to fight for the high-demand floor space and the winner does.’t really need the highest contribution margin but needs the highest contribution margin per square foot.

When fragrance sales went flat, retailers such as Macy's turned up the heat on fragrance manufacturers. They reduced the amount of floor space devoted to fragrances, leaving fragrance manufacturers fighting each other for the smaller space. The retailer doesn't just choose the fragrance with the highest contribution margin. Instead, it chooses the fragrance with the highest contribution margin per square foot for a given period of time. In this game, a product with a lower contribution margin, but a higher turnover, could well be the winner.

What is the limited resource for a retailer, and what implications does this have for sales mix? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 3

Sales Mix with Limited Resources

Carolina Corporation manufactures and sells three different types of high‐quality sealed ball bearings for mountain bike wheels. The bearings vary in terms of their quality specifications—primarily with respect to their smoothness and roundness. They are referred to as Fine, Extra‐Fine, and Super‐Fine bearings. Machine time is limited. More machine time is required to manufacture the Extra‐Fine and Super‐Fine bearings. Additional information is provided below.

 

Product

 

Fine

 

Extra-Fine

 

Super-Fine

Selling price

 

$6.00

 

$10.00

 

$16.00

Variable costs and expenses

 

 4.00

 

  6.50

 

 11.00

Contribution margin

 

$2.00

 

$ 3.50

 

$ 5.00

Machine hours required

 

 0.02

 

  0.04

 

  0.08

(a) Ignoring the machine time constraint, what strategy would appear optimal?

(b) What is the contribution margin per unit of limited resource for each type of bearing?

(c) If additional machine time could be obtained, how should the additional capacity be used?

Action Plan

✓ Calculate the contribution margin per unit of limited resource for each product.

✓ Apply the formula for the contribution margin per unit of limited resource.

✓ To maximize net income, shift sales mix to the product with the highest contribution margin per unit of limited resource.

SOLUTION

(a) The Super‐Fine bearings have the highest unit contribution margin. Thus, ignoring any manufacturing constraints, it would appear that the company should shift toward production of more Super‐Fine units.

(b) The contribution margin per unit of limited resource (machine hours) is calculated as:

 

Fine

 

Extra-Fine

 

Super-Fine

Unit contribution marginLimited resource consumed per unitUnit contribution marginLimited resource consumed per unit

 

$2.02=$100$2.02=$100

 

$3.5.04=$87.50$3.5.04=$87.50

 

$5.08=$62.50$5.08=$62.50

(c) The Fine bearings have the highest contribution margin per unit of limited resource even though they have the lowest unit contribution margin. Given the resource constraint, any additional capacity should be used to make Fine bearings.

Related exercise material: BE19-11, BE19-12, E19-11, E19-12, E19-13, and DO IT! 19-3.

LEARNING OBJECTIVE 4

Indicate how operating leverage affects profitability.

Cost structure refers to the relative proportion of fixed versus variable costs that a company incurs. Cost structure can have a significant effect on profitability. For example, computer equipment manufacturer Cisco Systems has substantially reduced its fixed costs by choosing to outsource much of its production. By minimizing its fixed costs, Cisco is now less susceptible to economic swings. However, as the following discussion shows, its reduced reliance on fixed costs has also reduced its ability to experience the incredible profitability that it used to have during economic booms.

The choice of cost structure should be carefully considered. There are many ways that companies can influence their cost structure. For example, by acquiring sophisticated robotic equipment, many companies have reduced their use of manual labor. Similarly, some brokerage firms, such as E*Trade, have reduced their reliance on human brokers and have instead invested heavily in computers and online technology. In so doing, they have increased their reliance on fixed costs (through depreciation on the robotic equipment or computer equipment) and reduced their reliance on variable costs (the variable employee labor cost). Alternatively, some companies have reduced their fixed costs and increased their variable costs by outsourcing their production. Nike, for example, does very little manufacturing but instead outsources the manufacture of nearly all of its shoes. It has consequently converted many of its fixed costs into variable costs and therefore changed its cost structure.

Consider the following example of Vargo Video and one of its competitors, New Wave Company. Both make camcorders. Vargo uses a traditional, labor‐intensive manufacturing process. New Wave has invested in a completely automated system. The factory employees are involved only in setting up, adjusting, and maintaining the machinery. Illustration 19-25 shows CVP income statements for each company.

 

Vargo Video

 

New Wave Company

Sales

 

$800,000

 

$800,000

Variable costs

 

 480,000

 

 160,000

Contribution margin

 

 320,000

 

 640,000

Fixed costs

 

 200,000

 

 520,000

Net income

 

$120,000

 

$120,000

ILLUSTRATION 19-25 CVP income statements for two companies

Both companies have the same sales and the same net income. However, because of the differences in their cost structures, they differ greatly in the risks and rewards related to increasing or decreasing sales. Let's evaluate the impact of cost structure on the profitability of the two companies.

EFFECT ON CONTRIBUTION MARGIN RATIO

First let's look at the contribution margin ratio. Illustration 19-26 shows the computation of the contribution margin ratio for each company.

Contribution Margin÷Sales=Contribution Margin RatioVargo Video$320,000÷$800,000=.40New Wave$640,000÷$800,000=.80Contribution Margin÷Sales=Contribution Margin RatioVargo Video$320,000÷$800,000=.40New Wave$640,000÷$800,000=.80 ILLUSTRATION 19-26 Contribution margin ratio for two companies

Because of its lower variable costs, New Wave has a contribution margin ratio of 80% versus only 40% for Vargo Video. That means that with every dollar of sales, New Wave generates 80 cents of contribution margin (and thus an 80‐cent increase in net income), versus only 40 cents for Vargo. However, it also means that for every dollar that sales decline, New Wave loses 80 cents in net income, whereas Vargo will lose only 40 cents. New Wave's cost structure, which relies more heavily on fixed costs, makes it more sensitive to changes in sales revenue.

EFFECT ON BREAK‐EVEN POINT

The difference in cost structure also affects the break‐even point. The break‐even point for each company is calculated in Illustration 19-27.

Fixed Costs÷Contribution Margin Ratio=Break-Even Point in DollarsVargo Video$200,000÷.40=$500,000New Wave$520,000÷.80=$650,000Fixed Costs÷Contribution Margin Ratio=Break-Even Point in DollarsVargo Video$200,000÷.40=$500,000New Wave$520,000÷.80=$650,000 ILLUSTRATION 19-27 Computation of break‐even point for two companies

New Wave needs to generate $150,000 ($650,000−$500,000)$150,000 ($650,000−$500,000) more in sales than Vargo Video before it breaks even. This makes New Wave riskier than Vargo because a company cannot survive for very long unless it at least breaks even.

EFFECT ON MARGIN OF SAFETY RATIO

We can also evaluate the relative impact that changes in sales would have on the two companies by computing the margin of safety ratio. Illustration 19-28 shows the computation of the margin of safety ratio for the two companies.

(Actual Sales−Break-Even Sales)÷Actual Sales=Margin of Safety RatioVargo Video($800,000−$500,000)÷$800,000=.38New Wave($800,000−$650,000)÷$800,000=.19(Actual Sales−Break-Even Sales)÷Actual Sales=Margin of Safety RatioVargo Video($800,000−$500,000)÷$800,000=.38New Wave($800,000−$650,000)÷$800,000=.19 ILLUSTRATION 19-28 Computation of margin of safety ratio for two companies

The difference in the margin of safety ratio also reflects the difference in risk between the two companies. Vargo Video could sustain a 38% decline in sales before it would be operating at a loss. New Wave could sustain only a 19% decline in sales before it would be “in the red.”

OPERATING LEVERAGE

Operating leverage refers to the extent to which a company's net income reacts to a given change in sales. Companies that have higher fixed costs relative to variable costs have higher operating leverage. When a company's sales revenue is increasing, high operating leverage is a good thing because it means that profits will increase rapidly. But when sales are declining, too much operating leverage can have devastating consequences.

DECISION TOOLS Decision Tools

Calculating the degree of operating leverage helps managers determine how sensitive the company's net income is to changes in sales.

Degree of Operating Leverage

How can we compare operating leverage between two companies? The degree of operating leverage provides a measure of a company's earnings volatility and can be used to compare companies. Degree of operating leverage is computed by dividing contribution margin by net income. This formula is presented in Illustration 19-29 and applied to our two manufacturers of camcorders.

Contribution Margin÷Net Income=Degree of Operating LeverageVargo Video$320,000÷$120,000=2.67New Wave$640,000÷$120,000=5.33Contribution Margin÷Net Income=Degree of Operating LeverageVargo Video$320,000÷$120,000=2.67New Wave$640,000÷$120,000=5.33 ILLUSTRATION 19-29 Computation of degree of operating leverage

New Wave's earnings would go up (or down) by about two times (5.33÷2.67=2.00)(5.33÷2.67=2.00) as much as Vargo Video's with an equal increase (or decrease) in sales. For example, suppose both companies experience a 10% decrease in sales. Vargo's net income will decrease by 26.7% (2.67×10%)26.7% (2.67×10%), while New Wave's will decrease by 53.3% (5.33×10%)53.3% (5.33×10%). Thus, New Wave's higher operating leverage exposes it to greater earnings volatility risk.

You should be careful not to conclude from this analysis that a cost structure that relies on higher fixed costs, and consequently has higher operating leverage, is necessarily bad. Some have suggested that Internet radio company Pandora has limited potential for growth in its profitability because it has very little operating leverage. When its revenues grow, its variable costs (fees it pays for the right to use music) grow proportionally. When used carefully, operating leverage can add considerably to a company's profitability. For example, computer equipment manufacturer Komag enjoyed a 66% increase in net income when its sales increased by only 8%. As one commentator noted, “Komag's fourth quarter illustrates the company's significant operating leverage; a small increase in sales leads to a big profit rise.” However, as our illustration demonstrates, increased reliance on fixed costs increases a company's risk.

SERVICE COMPANY INSIGHT

Burlington Northern Railroad

There Is Something About a Train

The image is a snippet with a one-line title Service Company Insight, illustrating Warren Buffet.’s strategy of investing $44 billion on Burlington Northern Railroad. Most prompt reason behind this purchase is the 50-60% fixed costs of railroad and the efficient nature.

A few years ago, Warren Buffett, arguably the most successful investor in history, bought a new train set—for $44 billion. The sage from Omaha bought Burlington Northern Railroad for a price that exceeded its fair value by 31%. At a time when the rest of the investing public was obsessed with technology companies like Facebook and Twitter, what could Buffett possibly see in a railroad? What he sees is a business whose costs are between 50–60% fixed. With such high fixed costs, railways have huge operating leverage. And because he bought the railroad at the bottom of a recession, when the economy turns around, Burlington could take off as well. Add to that the fact that railroad transport is very energy‐efficient, and it has high barriers to entry. So, as energy prices increase, more people will turn to the rails, but there are a limited number of railways. Makes sense to me.

Source: Liam Denning, “Buffett's Unusual Train of Thought,” Wall Street Journal (November 4, 2009).

Why did Warren Buffett think that this was a good time to invest in railroad stocks? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 4

Operating Leverage

Rexfield Corp., a company specializing in crime scene investigations, is contemplating an investment in automated mass‐spectrometers. Its current process relies on a high number of lab technicians. The new equipment would employ a computerized expert system. The company's CEO has requested a comparison of the old technology versus the new technology. The accounting department has prepared the following CVP income statements for use in your analysis.

 

CSI Equipment

 

Old

 

New

Sales

 

$2,000,000

 

$2,000,000

Variable costs

 

 1,400,000

 

   600,000

Contribution margin

 

600,000

 

1,400,000

Fixed costs

 

   400,000

 

  1,200,000

Net income

 

$  200,000

 

$  200,000

Use the information provided above to do the following.

(a) Compute the degree of operating leverage for the company under each scenario.

(b) Discuss your results.

Action Plan

✓ Divide contribution margin by net income to determine degree of operating leverage.

✓ A higher degree of operating leverage will result in a higher change in net income with a given change in sales.

SOLUTION

(a)

 

Contribution Margin

 

÷

 

Net Income

 

=

 

Degree of Operating Leverage

Old

 

  $600,000

 

÷

 

$200,000

 

=

 

3

New

 

$1,400,000

 

÷

 

$200,000

 

=

 

7

(b) The degree of operating leverage measures the company's sensitivity to changes in sales. By switching to a cost structure dominated by fixed costs, the company would significantly increase its operating leverage. As a result, with a percentage change in sales, its percentage change in net income would be 2.33 (7÷3)2.33 (7÷3) times as much with the new technology as it would under the old.

Related exercise material: BE19-13, BE19-14, BE19-15, E19-14, E19-15, E19-16, and DO IT! 19-4.

USING DECISION TOOLS—WHOLE FOODS MARKET

Whole Foods Market faces many decisions where it needs to apply the decision tools learned in this chapter, such as determining its cost structure. For example, suppose that Whole Foods Market has been approached by a robotics company with a proposal to significantly automate one of its stores. All stocking of shelves and bagging of groceries would be done by robots. Customers would check out through self‐service scanners and point‐of‐sale terminals. Any assistance would be provided by robots. Management has compiled the following comparative data for one average‐sized store.

 

Old

 

New

Sales

 

$3,600,000

 

$3,600,000

Variable costs

 

 2,800,000

 

 2,000,000

Contribution margin

 

800,000

 

1,600,000

Fixed costs

 

   480,000

 

 1,280,000

Net income

 

$  320,000

 

$  320,000

INSTRUCTIONS

Use the information provided above to do the following.

a. Compute the degree of operating leverage for the company under each scenario, and discuss your results.

b. Compute the break‐even point in dollars and margin of safety ratio for the company under each scenario, and discuss your results.

SOLUTION

a.

b.

 

Contribution Margin

 

÷

 

Net Income

 

=

 

Degree of Operating Leverage

Old

 

  $800,000

 

÷

 

$320,000

 

=

 

2.5

New

 

$1,600,000

 

÷

 

$320,000

 

=

 

5.0

c. The degree of operating leverage measures the company's sensitivity to changes in sales. By switching to a cost structure with higher fixed costs, Whole Foods would significantly increase its operating leverage. As a result, with a percentage change in sales, its percentage change in net income would be 2 times as much (5÷2.5)(5÷2.5) under the new structure as it would under the old.

d. To compute the break‐even point in sales dollars, we first need to compute the contribution margin ratio under each scenario. Under the old structure, the contribution margin ratio would be .22 ($800,000÷$3,600,000).22 ($800,000÷$3,600,000), and under the new it would be .44 ($1,600,000÷$3,600,000).44 ($1,600,000÷$3,600,000).

 

Fixed Costs

 

÷

 

Contribution Margin Ratio

 

=

 

Break‐Even Point in Dollars

Old

 

  $480,000

 

÷

 

.22

 

=

 

$2,181,818

New

 

$1,280,000

 

÷

 

.44

 

=

 

$2,909,090

e. Because Whole Foods' fixed costs would be substantially higher under the new cost structure, its break‐even point would increase significantly, from $2,181,818 to $2,909,090. A higher break‐even point is riskier because it means that the company must generate higher sales to be profitable.

f. The margin of safety ratio tells how far sales can fall before Whole Foods is operating at a loss.

 

(Actual Sales

 

−

 

Break-Even Sales)

 

÷

 

Actual Sales

 

=

 

Margin of Safety Ratio

Old

 

($3,600,000

 

−

 

$2,181,818)

 

÷

 

$3,600,000

 

=

 

.39

New

 

($3,600,000

 

−

 

$2,909,090)

 

÷

 

$3,600,000

 

=

 

.19

g. Under the old structure, sales could fall by 39% before the company would be operating at a loss. Under the new structure, sales could fall by only 19%.

h. On the one hand, grocery store sales are more stable than most products. Sales are less inclined to fluctuate with changes in the economy. However, Whole Foods sells many organic and unique products that have higher selling prices. It may be that during a recession, its customers might choose to switch to lower cost (e.g., non‐organic) substitutes at traditional, high‐volume grocery stores. If Whole Foods' sales are subject to significant swings, then changes in its cost structure could significantly affect its risk profile.

LEARNING OBJECTIVE *5

APPENDIX 19A: Explain the differences between absorption costing and variable costing.

In the earlier chapters, we classified both variable and fixed manufacturing costs as product costs. In job order costing, for example, a job is assigned the costs of direct materials, direct labor, and both variable and fixed manufacturing overhead. This costing approach is referred to as full or absorption costing . It is so named because all manufacturing costs are charged to, or absorbed by, the product. Absorption costing is the approach used for external reporting under generally accepted accounting principles.

An alternative approach is to use variable costing . Under variable costing, only direct materials, direct labor, and variable manufacturing overhead costs are considered product costs. Companies recognize fixed manufacturing overhead costs as period costs (expenses) when incurred. The difference between absorption costing and variable costing is shown graphically as follows.

A flow chart of the differences between absorption costing and variable costing shows two panes: Absorption costing to the left and variable costing to the right. The Fixed manufacturing overhead is depicted in the center and product cost to its left and period cost to its right. Two red arrows are shown to flow from middle to either sides. ILLUSTRATION 19A-1 Difference between absorption costing and variable costing

Under both absorption and variable costing, selling and administrative expenses are period costs.

Companies may not use variable costing for external financial reports because generally accepted accounting principles require that fixed manufacturing overhead be accounted for as a product cost.

EXAMPLE COMPARING ABSORPTION COSTING WITH VARIABLE COSTING

To illustrate absorption and variable costing, assume that Premium Products Corporation manufactures a polyurethane sealant, called Fix‐It, for car windshields. Relevant data for Fix‐It in January 2017, the first month of production, are shown in Illustration 19A-2.

Selling price

$20 per unit.

Units

Produced 30,000; sold 20,000; beginning inventory zero.

Variable unit costs

Manufacturing $9 (direct materials $5, direct labor $3, and variable overhead $1).

Selling and administrative expenses $2.

Fixed costs

Manufacturing overhead $120,000.

Selling and administrative expenses $15,000.

ILLUSTRATION 19A-2 Sealant sales and cost data for Premium Products Corporation

The per unit manufacturing cost under each costing approach is computed in Illustration 19A-3.

Type of Cost

 

Absorption Costing

 

Variable Costing

Direct materials

 

$  5

 

$5

Direct labor

 

   3

 

 3

Variable manufacturing overhead

 

   1

 

 1

Fixed manufacturing overhead   ($120,000 ÷ 30,000 units produced)

 

   4

 

 0

Manufacturing cost per unit

 

$13

 

$9

ILLUSTRATION 19A-3 Computation of per unit manufacturing cost

The manufacturing cost per unit is $4 higher ($13−$9)($13−$9) for absorption costing. This occurs because fixed manufacturing overhead costs are a product cost under absorption costing. Under variable costing, they are, instead, a period cost, and so they are expensed. Based on these data, each unit sold and each unit remaining in inventory is costed under absorption costing at $13 and under variable costing at $9.

Absorption Costing Example

Illustration 19A-4 shows the income statement for Premium Products using absorption costing. It shows that cost of goods manufactured is $390,000, computed by multiplying the 30,000 units produced times the manufacturing cost per unit of $13 (see Illustration 19A-3). Cost of goods sold is $260,000, after subtracting ending inventory of $130,000. Under absorption costing, $40,000 of the fixed overhead (10,000 units×$4)(10,000 units×$4) is deferred to a future period as part of the cost of ending inventory.

PREMIUM PRODUCTS CORPORATION Income Statement For the Month Ended January 31, 2017 Absorption Costing

Sales (20,000 units × $20)

$400,000

Cost of goods sold

 Inventory, January 1

$  –0–   

 Cost of goods manufactured (30,000 units × $13)

 390,000

 Cost of goods available for sale

390,000

 Less: Inventory, January 31 (10,000 units × $13)

 130,000

 Cost of goods sold (20,000 units × $13)

 260,000

Gross profit

140,000

Variable selling and administrative expenses   (20,000 × $2)

40,000

Fixed selling and administrative expenses

  15,000

  55,000

Net income

$ 85,000

ILLUSTRATION 19A-4 Absorption costing income statement

▼ HELPFUL HINT

The income statement format in Illustration 19A-4 is the same as that used under generally accepted accounting principles.

Variable Costing Example

As Illustration 19A-5 (page 942) shows, companies use the cost‐volume‐profit format in preparing a variable costing income statement. The variable manufacturing cost of $270,000 is computed by multiplying the 30,000 units produced times variable manufacturing cost of $9 per unit (see Illustration 19A-3). As in absorption costing, both variable and fixed selling and administrative expenses are treated as period costs.

PREMIUM PRODUCTS CORPORATION Income Statement For the Month Ended January 31, 2017 Variable Costing

Sales (20,000 units × $20)

$400,000

Variable cost of goods sold

 Inventory, January 1

$  –0–   

 Variable cost of goods manufactured (30,000 units × $9)

 270,000

 Variable cost of goods available for sale

270,000

 Less: Inventory, January 31 (10,000 units × $9)

  90,000

 Variable cost of goods sold

180,000

 Variable selling and administrative expenses (20,000 units × $2)

  40,000

 220,000

Contribution margin

180,000

Fixed manufacturing overhead

120,000

Fixed selling and administrative expenses

  15,000

 135,000

Net income

$ 45,000

ILLUSTRATION 19A-5 Variable costing income statement

▼ HELPFUL HINT

Note the difference in the computation of the ending inventory: $9 per unit here, $13 per unit in Illustration 19A-4.

There is one primary difference between variable and absorption costing: Under variable costing, companies charge the fixed manufacturing overhead as an expense in the current period. Fixed manufacturing overhead costs of the current period, therefore, are not deferred to future periods through the ending inventory. As a result, absorption costing will show a higher net income number than variable costing whenever units produced exceed units sold. This difference can be seen in the income statements in Illustrations 19A-4 and 19A-5. There is a $40,000 difference in the ending inventories ($130,000 under absorption costing versus $90,000 under variable costing). Under absorption costing, $40,000 of the fixed overhead costs (10,000 units×$4)(10,000 units×$4) has been deferred to a future period as part of inventory. In contrast, under variable costing, all fixed manufacturing costs are expensed in the current period.

As shown, when units produced exceed units sold, income under absorption costing is higher. When units produced are less than units sold, income under absorption costing is lower. When units produced and sold are the same, net income will be equal under the two costing approaches. In this case, there is no increase in ending inventory. So fixed overhead costs of the current period are not deferred to future periods through the ending inventory.

NET INCOME EFFECTS

To further illustrate the concepts underlying absorption and variable costing, we will look at an extended example using Overbay Inc., a manufacturer of small airplane drones. We assume that production volume stays the same each year over the 3‐year period, but the number of units sold varies each year.

2016 Results

As indicated in Illustration 19A-6, the variable manufacturing cost per drone is $240,000, and the fixed manufacturing overhead cost per drone is $60,000 (assuming 10 drones). Total manufacturing cost per drone under absorption costing is therefore $300,000 ($240,000+$60,000)$300,000 ($240,000+$60,000). Overbay also has variable selling and administrative expenses of $5,000 per drone. The fixed selling and administrative expenses are $80,000.

 

2016

 

2017

 

2018

Volume information

 

 

 

Drones in beginning inventory

 

     0

 

 0

 

 2

Drones produced

 

    10

 

10

 

10

Drones sold

 

    10

 

 8

 

12

Drones in ending inventory

 

     0

 

 2

 

 0

Financial information

 

 

 

Selling price per drone

 

$400,000

 

 

Variable manufacturing cost per drone

 

$240,000

 

 

Fixed manufacturing overhead for the year

 

$600,000

 

 

Fixed manufacturing overhead per drone

 

$ 60,000 ($600,000 ÷ 10)

 

Variable selling and administrative expenses per drone

 

$   5,000

 

 

Fixed selling and administrative expenses

 

$  80,000

 

 

ILLUSTRATION 19A-6 Information for Overbay Inc.

An absorption costing income statement for 2016 for Overbay Inc. is shown in Illustration 19A-7.

OVERBAY INC. Income Statement For the Year Ended December 31, 2016 Absorption Costing

Sales (10 drones × $400,000)

$4,000,000

Cost of goods sold (10 drones × $300,000)

 3,000,000

Gross profit

1,000,000

Variable selling and administrative expenses (10 drones × $5,000)

$50,000

Fixed selling and administrative expenses

 80,000

   130,000

Net income

$  870,000

ILLUSTRATION 19A-7 Absorption costing income statement—2016

Overbay reports net income of $870,000 under absorption costing.

Under a variable costing system, the income statement follows a cost‐volume‐profit (CVP) format. In this case, the manufacturing cost is comprised solely of the variable manufacturing costs of $240,000 per drone. The fixed manufacturing overhead costs of $600,000 for the year are expensed in 2016. As in absorption costing, the fixed and variable selling and administrative expenses are period costs expensed in 2016. A variable costing income statement for Overbay Inc. for 2016 is shown in Illustration 19A-8.

OVERBAY INC. Income Statement For the Year Ended December 31, 2016 Variable Costing

Sales (10 drones × $400,000)

$4,000,000

Variable cost of goods sold (10 drones × $240,000)

$2,400,000

Variable selling and administrative expenses (10 drones × $5,000)

   50,000

 2,450,000

Contribution margin

1,550,000

Fixed manufacturing overhead

600,000

Fixed selling and administrative expenses

   80,000

  680,000

Net income

$ 870,000

ILLUSTRATION 19A-8 Variable costing income statement—2016

As shown in Illustration 19A-8 (page 943), the variable costing net income of $870,000 is the same as the absorption costing net income computed in Illustration 19A-7 (page 943). When the numbers of units produced and sold are the same, net income is equal under the two costing approaches. Because no increase in ending inventory occurs, no fixed manufacturing overhead costs incurred in 2016 are deferred to future periods using absorption costing.

2017 Results

In 2017, Overbay produced 10 drones but sold only eight drones. As a result, there are two drones in ending inventory. The absorption costing income statement for 2017 is shown in Illustration 19A-9.

OVERBAY INC. Income Statement For the Year Ended December 31, 2017 Absorption Costing

Sales (8 drones × $400,000)

$3,200,000

Cost of goods sold (8 drones × $300,000)

 2,400,000

Gross profit

800,000

Variable selling and administrative expenses (8 drones × $5,000)

 $40,000

Fixed selling and administrative expenses

  80,000

  120,000

Net income

$ 680,000

ILLUSTRATION 19A-9 Absorption costing income statement—2017

Under absorption costing, the ending inventory of two drones is $600,000 ($300,000×2)$600,000 ($300,000×2). Each unit of ending inventory includes $60,000 of fixed manufacturing overhead. Therefore, fixed manufacturing overhead costs of $120,000 ($60,000×2 drones)$120,000 ($60,000×2 drones) are deferred until a future period.

The variable costing income statement for 2017 is shown in Illustration 19A-10.

OVERBAY INC. Income Statement For the Year Ended December 31, 2017 Variable Costing

Sales (8 drones × $400,000)

$3,200,000

Variable cost of goods sold (8 drones × $240,000)

$1,920,000

Variable selling and administrative expenses (8 drones × $5,000)

   40,000

 1,960,000

Contribution margin

1,240,000

Fixed manufacturing overhead

600,000

Fixed selling and administrative expenses

   80,000

   680,000

Net income

$  560,000

ILLUSTRATION 19A-10 Variable costing income statement—2017

As shown, when units produced (10) exceeds units sold (8), net income under absorption costing ($680,000) is higher than net income under variable costing ($560,000). The reason: The cost of the ending inventory is higher under absorption costing than under variable costing. In 2017, under absorption costing, fixed manufacturing overhead of $120,000 is deferred and carried to future periods as part of inventory. Under variable costing, the $120,000 is expensed in the current period and, therefore the difference in the two net income numbers is $120,000 ($680,000−$560,000)$120,000 ($680,000−$560,000).

2018 Results

In 2018, Overbay produced 10 drones and sold 12 (10 drones from the current year's production and 2 drones from the beginning inventory). As a result, there are no drones in ending inventory. The absorption costing income statement for 2018 is shown in Illustration 19A-11.