1 Managerial Accounting

Learning Objectives
Identify the features of managerial accounting and the
1 functions of management.

Describe the classes of manufacturing costs and the

2
differences between product and period costs.
Demonstrate how to compute cost of goods
3 manufactured and prepare financial statements for a
manufacturer.

1-1
 Comparing Managerial and Financial
Accounting

ILLUSTRATION 1-1
Differences between financial
and managerial accounting
1-2 LO 1
 Organizational Structure

Organization charts show

the interrelationships of
activities and the delegation
of authority and
responsibility within the
company.

Illustration 1-2
A typical corporate
organization chart

1-3 LO 1
 Describe the classes of manufacturing costs
LEARNING
OBJECTIVE
2 and the differences between product and
period costs.

Managers should ask questions such as the following.

1. What costs are involved in making a product or

providing a service?

2. If we decrease production volume, will costs decrease?

3. What impact will automation have on total costs?

4. How can we best control costs?

1-4
 Firms according to Cost Structure

Firms categorized to three according to their cost

structure :
1. Manufacturing : Produce and sell goods
 Brisa, Ereğli Demir Çelik, Tat Konserve, Arçelik
2. Merchandising : Buy and sell goods
 BİM, Migros, CarrefourSA
3. Service : Produce and sell services
 THY, Turkcell, Türk Telekom

1-5 LO 2
 Product Versus Period Costs

1-6 LO 2
 Manufacturing Costs

Manufacturing consists of activities and processes that

convert raw materials into finished goods.

1-7 LO 2
 Manufacturing Costs

Raw Materials
Basic materials, parts and components used in the manufacturing
process.
Based on where they are used, they are categorized into two:

1. Direct Materials
2. Indirect Materials

1-8 LO 2
 Manufacturing Costs
1. Direct Materials
Raw materials that can be physically and directly
associated with the finished product during the
manufacturing process.
2. Indirect Materials
• Not physically part of the finished product or

• Their physical association with the finished product is

too small in terms of cost.

Considered part of manufacturing overhead.

1-9 LO 2
 Manufacturing Costs
Labor
Similar to Raw Materials, Labour costs are also categorized into
two, based on where employees work:

1. Direct Labor
2. Indirect Labor

1-10 LO 2
 Manufacturing Costs

1. Direct Labor
Work of factory employees that can be physically and directly
associated with converting raw materials into finished goods.
Mainly assembly line workers, construction workers

2. Indirect Labor
Work of factory employees that has no physical association
with the finished product.
• Factory management, supervisors
• Cleaning Staff, Maintenance staff

1-11 LO 2
 Manufacturing Costs

Manufacturing Overhead
 Costs that are indirectly associated with manufacturing
the finished product.

 Includes all manufacturing costs except direct materials

and direct labor.

 Main Components:
• Indirect Labor
• Indirect Materials
• Depreciation

1-12 LO 2
 Product Versus Period Costs

Product Costs
 Direct materials
 Components:  Direct labor
 Manufacturing overhead

 Costs that are an integral part of producing the

product.

 Recorded in “inventory” account.

 Not an expense (COGS) until the goods are sold.

1-13 LO 2
 Product Versus Period Costs

Period Costs
 Charged to expense as incurred.

 Costs not related to the manufacturing process

 Mainly selling and administrative expenses.

1-14 LO 2
 Product Versus Period Costs
Illustration 1-3
Product versus period costs

1-15 LO 2
 Product Versus Period Costs

Illustration: Suppose you started your own snowboard

factory, KRT Boards. Here are some of the costs that your
snowboard factory would incur. Assign the following costs:

Illustration 1-4

1-16 LO 2
 Product Versus Period Costs
Illustration 1-4

1-17 LO 2
 Product Versus Period Costs

If KRT Boards produces 10,000 snowboards the first year,

what would be the total manufacturing costs?

Illustration 1-5
Computation of total
manufacturing costs

1-18 LO 2
 2 Managerial Cost Concepts

A bicycle company has these costs: tires, salaries of employees who

put tires on the wheels, factory depreciation, advertising expenditures,
lubricants, spokes, salary of factory manager, salary of accountant,
handlebars, and salaries of factory maintenance employees. Classify
each cost as direct materials, direct labor, overhead, or a period cost.

Direct Materials Direct Labor Overhead

 Tires.  Salaries of  Factory depreciation.

 Spokes. employees who put  Lubricants
tires on the wheels.
 Handlebars.  Factory manager
salary.
Advertising expenditures and salary  Factory maintenance
of accountant are period costs. employees salary.
1-19 LO 2
 Demonstrate how to compute cost of goods
LEARNING
OBJECTIVE
3 manufactured and prepare financial statements for a
manufacturer.

Income Statement
Under a periodic inventory system, the income statements
of a merchandiser and a manufacturer differ in the cost of
goods sold section.

“COGS”
1-20
 Income Statement

Illustration 1-6
Cost of goods sold components
1-21 LO 3
 Income Statement

Cost of goods sold sections of merchandising and manufacturing

income statements

Illustration 1-7
Cost of goods sold sections of
merchandising and manufacturing
Income statements

1-22 LO 3
 Balance Sheet

Inventory accounts for a manufacturer Illustration 1-10

The balance sheet for a merchandising company shows just

one category of inventory.

1-23 LO 3
 Brisa Balance Sheet as of Dec. 31,2020
Partial: Inventory Account

1-24
 Cost of Goods Manufactured

Total Manufacturing Costs – sum of direct material costs,

direct labor costs, and manufacturing overhead in the current
year.
Total Work in Process – (1) cost of beginning work in process
and (2) total manufacturing costs for the current period.

Illustration 1-8
1-25 Cost of goods manufactured formula LO 3
 Illustration 1-9
Cost of goods
manufactured schedule

1-26 LO 3
 3 Cost of Goods Manufactured

1-27 LO 3
 3 Cost of Goods Manufactured

1-28 LO 3
 Balance Sheet

Inventory accounts for a manufacturer Illustration 1-10

The balance sheet for a merchandising company shows just

one category of inventory.

1-29 LO 3
 Balance Sheet

Current assets sections of merchandising and manufacturing

balance sheets

Illustration 1-11
Current assets sections of
merchandising and manufacturing
balance sheets

1-30 LO 3
 LEARNING
OBJECTIVE
4 Discuss trends in managerial accounting.

Service Industries
 Much of the U.S. economy has shifted toward an
emphasis on providing services rather than goods.

 Over 50% of U.S. workers are now employed by service

companies.

 Most of the techniques learned for manufacturing firms

are applicable to service companies.

1-31
 Focus on the Value Chain

Refers to all business processes associated with providing

a product or service.
For a manufacturing firm these include the following:

Illustration 1-12
A manufacturer’s value chain

1-32 LO 4
 Focus on the Value Chain

Theory of Constraints
 Constraints (“bottlenecks” ) limit the company’s
potential profitability.

 A specific approach to identify and manage these

constraints in order to achieve company goals.

Enterprise Resource Planning (ERP)

 Software programs designed to manage all major
business processes.

1-33 LO 4
 Focus on the Value Chain

Activity-Based Costing (ABC)

 Allocates overhead based on use of activities.

 Results in more accurate product costing and scrutiny

of all activities in the value chain.

1-34 LO 4
 Balanced Scorecard

 Evaluates operations in an integrated fashion.

 Uses both financial and non-financial measures.

 Links performance to overall company objectives.

1-35 LO 4
 Business Ethics

 All employees are expected to act ethically.

 Many organizations have codes of business ethics.

 Past financial frauds:

► Enron,

► Global Crossing,

► WorldCom

1-36 LO 4
 Corporate Social Responsibility

 Considers a company’s efforts to employ sustainable

business practices with regard to its employees,
society, and the environment.

 Is sometimes referred to as the triple bottom line

because it evaluates a company’s performance with
regard to people, planet, and profit.

 Recent reports indicate that over 50% of the 500

largest U.S. companies provide sustainability reports.

1-37 LO 4
 Copyright

Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
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programs or from the use of the information contained herein.

1-38
 2 Job Order Costing

Learning Objectives
Describe cost systems and the flow of costs in a job order
1 system.

2 Use a job cost sheet to assign costs to work in process.

Demonstrate how to determine and use the predetermined

3 overhead rate.

Prepare entries for manufacturing and service jobs completed

4 and sold.

Distinguish between under- and overapplied manufacturing

5 overhead.
2-1
 LEARNING Describe cost systems and the flow of
1
OBJECTIVE costs in a job order system.

Cost Accounting involves Measuring, Recording, and

Reporting product costs.

 Accounts are fully integrated into the general ledger.

 Perpetual inventory system provides immediate, up-to-date

information on the cost of a product.

 Two basic types:

(1) a process cost system ( Safha Maliyetleme)

(2) a job order cost system ( Sipariş Maliyetleme)

2-2 LO 1
 Process Cost System

 Used when a large volume of similar products are

manufactured - (cereal, refining of petroleum,
production of ice cream).

 Costs are accumulated for a time period – (week or

month).

 Costs are assigned to departments or processes for

a specified period of time.

2-3 LO 1
 Process Cost System

Illustration 2-1
Process cost system

2-4 LO 1
 Job Order Cost System

 Costs are assigned to each job or batch.

 Important feature: Each job or batch has its own

distinguishing characteristics.

 Objective is to compute the cost per job.

 Measures costs for each job completed – not for set time
periods.

2-5 LO 1
 Job Order Cost System

Illustration 2-2 shows the recording of costs in a job order cost

system for Disney as it produced two different films.

Illustration 2-2
2-6 Job order cost system for Disney LO 1
 Job Order Cost Flow

The flow of costs parallels the physical flow of the materials

as they are converted into finished goods

1. Manufacturing costs are assigned to the Work in

Process (WIP) Inventory account.

2. Cost of completed jobs is transferred to the Finished

Goods Inventory account.

3. When units are sold, the cost is transferred to the Cost

of Goods Sold account.

2-7 LO 1
 Job Order Cost Flow

Illustration 2-3
Flow of costs in job Basic overview of the flow of costs in a manufacturing
order costing
setting for production of a fire truck.

2-8 LO 1
 Accumulating Manufacturing Costs

1. Raw Material Costs

Illustration: Wallace Company purchases 2,000 lithium
batteries (Stock No. AA2746) at $5 per unit ($10,000) and 800
electronic modules (Stock No. AA2850) at $40 per unit
($32,000) for a total cost of $42,000 ($10,000 + $32,000). The
entry to record this purchase on January 4 is:

Jan. 4 Raw Materials Inventory 42,000

Accounts Payable 42,000

2-9 LO 1
 Accumulating Manufacturing Costs

2. Factory Labor Costs

Consists of three costs:
1. Gross earnings of factory workers,

2. Employer payroll taxes on these earnings, and

3. Fringe benefits (such as sick pay, pensions, and vacation

pay) incurred by the employer.

2-10 LO 1
 Accumulating Manufacturing Costs

Factory Labor Costs

Illustration: Wallace incurs $32,000 of factory labor costs. Of
that amount, $27,000 relates to wages payable and $5,000
relates to payroll taxes payable in February. The entry to record
factory labor for the month is:

Jan. 31 Factory Labor 32,000

Factory Wages Payable 27,000
Employer Payroll Taxes Payable 5,000

2-11 LO 1
 Accumulating Manufacturing Costs

3. Manufacturing Overhead Costs

 Many types of overhead costs
► For example, property taxes, depreciation, insurance,
and repairs related to the manufacturing process.

 Costs unrelated to manufacturing process are expensed.

 Costs related to manufacturing process are accumulated

in Manufacturing Overhead account.
► Manufacturing overhead subsequently assigned to
work in process.

2-12 LO 1
 Accumulating Manufacturing Costs

Manufacturing Overhead Costs

Illustration: Using assumed data, the summary entry for
manufacturing overhead in Wallace Manufacturing Company is:

Jan. 31 Manufacturing Overhead 13,800

Utilities Payable 4,800
Prepaid Insurance 2,000
Accounts Payable (for repairs) 2,600
Accumulated Depreciation 3,000
Property Taxes Payable 1,400

2-13 LO 1
 LEARNING Use a job cost sheet to assign costs to work
2
OBJECTIVE in process.

Assigning manufacturing costs to work in process results

in the following entries.

1. Debits made to Work in Process Inventory

2. Credits made to
► Raw Materials Inventory

► Factory Labor

► Manufacturing Overhead

2-14 LO 2
 LEARNING Use a job cost sheet to assign costs to work
2
OBJECTIVE in process.

Job Cost Sheet (Sipariş Maliyet Kartı)

 Used to record costs chargeable to specific jobs.

 Constitutes the subsidiary ledger for the work in process

account.

 Each entry to Work in Process

Inventory must be accompanied
by a corresponding posting to
one or more job cost sheets.

2-15 LO 2
 Illustration 2-4
Job cost sheet

2-16 LO 2
 Raw Material Costs

 Assigned to a job when materials are issued in

response to requests.

 Materials requisition slip (Malzeme Talep Fişi)

► Written authorization for issuing raw materials.

► May be directly issued to use on a job - direct

materials (charged to Work in Process Inventory).

► May be considered indirect materials – charged to

Manufacturing Overhead.

2-17 LO 2
 Illustration 2-5
Materials requisition slip

2-18 LO 2
 Raw Material Costs

Illustration: Wallace uses $24,000 of direct materials and $6,000

of indirect materials in January, the entry is:

Jan. 31 Work in Process Inventory 24,000

Manufacturing Overhead 6,000
Raw Materials Inventory 30,000

2-19 LO 2
 Raw Material Costs Illustration 2-6
Job cost sheets–posting
of direct materials

Illustration 15-6
The sum of the direct
materials columns of
the job cost sheets
should equal the
direct materials
debited to Work in
Process Inventory
account.

2-20 LO 2
 Factory Labor Costs

 Assigned to jobs on the basis of time tickets.

(Zaman Kartı)

 Time tickets are prepared when the work is performed.

 Time tickets indicate:

► Employee

► Hours worked

► Account and job charged

► Total labor cost

2-21 LO 2
 Factory Labor Costs

Illustration 2-7
Time ticket

2-22 LO 2
 Factory Labor Costs

Illustration: The time tickets are later sent to the payroll

department, which applies the employee’s hourly wage rate and
computes the total labor cost. If the $32,000 total factory labor
cost consists of $28,000 of direct labor and $4,000 of indirect
labor, the entry is:

Jan. 31 Work in Process Inventory 28,000

Manufacturing Overhead 4,000
Factory Labor 32,000

2-23 LO 2
 Factory Labor Costs

Jan. 31 Work in Process Inventory 28,000

Manufacturing Overhead 4,000
Factory Labor 32,000

2-24 LO 2
 Factory Labor Costs

The sum of the

direct labor
columns of the job
cost sheets should
equal the direct
labor debited to
Work in Process
Inventory.

Illustration 2-8
Job cost sheets–
direct labor

2-25 LO 2
 LEARNING Demonstrate how to determine and use the
3
OBJECTIVE predetermined overhead rate.

Manufacturing Overhead Costs

 Relates to production operations as a whole.

 Cannot be assigned to specific jobs based on actual

costs incurred.

 Companies assign to work in process and to specific jobs

on an estimated basis through the use of a …

Predetermined Overhead Rate

2-26 LO 3
 Predetermined Overhead Rate

 Based on the relationship between estimated annual

overhead costs and expected annual operating activity.

 Expressed in terms of an activity base such as:

► Direct labor costs

► Direct labor hours

► Machine hours

► Any other measure that will provide an equitable

basis for applying overhead costs to jobs.

2-27 LO 3
 Predetermined Overhead Rate

 Established at the beginning of the year.

 Small companies often use a single, company-wide

predetermined rate.

 Large companies often use a different rate for each

department and each department may have a different
activity base.

 Formula for computing the predetermined rate

overhead rate is: Illustration 2-9

2-28 LO 3
 Predetermined Overhead Rate

Manufacturing overhead costs are assigned to Work in

Process during the period to get timely information about the
cost of a completed job.

Illustration 2-10
Using predetermined
overhead rates

2-29 LO 3
 Predetermined Overhead Rate

Illustration: Wallace Company uses direct labor cost as the

activity base. Assuming that the company expects annual overhead
costs to be $280,000 and direct labor costs for the year to be
$350,000, compute the overhead rate.

This means that for every dollar of direct labor, Wallace will
80 cents of manufacturing overhead to a job.
assign _________

2-30 LO 3
 Predetermined Overhead Rate

Illustration: Wallace applies manufacturing overhead to work in

process when it assigns direct labor costs. Calculate the amount of
applied overhead assuming direct labor costs were $28,000.

$28,000 x 80% = $22,400

The following entry records this application.

Jan. 31 Work in Process Inventory 22,400

Manufacturing Overhead 22,400

2-31 LO 3
 Predetermined Overhead Rate

The sum of the

manufacturing
overhead columns
of the job cost
sheets should
equal the
manufacturing
overhead debited
(i.e., applied) to
Work in Process
Inventory.

Illustration 2-12
Job cost sheets–
manufacturing
overhead applied
2-32
 Predetermined Overhead Rate

At the End of Each Month:

The balance in the Work in Process Inventory should equal
the sum of the costs shown on the job cost sheets of unfinished
jobs.

Illustration 2-13
Proof of job cost sheets to
work in process inventory

2-33 LO 3
 3 Predetermined Overhead Rate

Stanley Company produces specialized safety devices. For the

year, manufacturing overhead costs are expected to be
$160,000. Expected machine usage is 40,000 hours. The
company assigns overhead based on machine hours. Job No.
302 used 2,000 machine hours. Compute the predetermined
overhead rate.

Solution

$160,000 ÷ 40,000 hours = $4.00 per machine hour

2-34 LO 3
 3 Predetermined Overhead Rate

Stanley Company produces specialized safety devices. For the

year, manufacturing overhead costs are expected to be
$160,000. Expected machine usage is 40,000 hours. The
company assigns overhead based on machine hours. Job No.
302 used 2,000 machine hours. Determine the amount of
overhead to allocate to Job No. 302.

Solution

2,000 hours x $4.00 = $8,000

2-35 LO 3
 3 Predetermined Overhead Rate

Stanley Company produces specialized safety devices. For the

year, manufacturing overhead costs are expected to be
$160,000. Expected machine usage is 40,000 hours. The
company assigns overhead based on machine hours. Job No.
302 used 2,000 machine hours. Prepare the entry to assign
overhead to Job No. 302 on March 31.

Solution

Work in Process Inventory 8,000

Manufacturing Overhead 8,000

2-36 LO 3
 LEARNING Prepare entries for manufacturing and
4
OBJECTIVE service jobs completed and sold.

Assigning Costs to Finished Goods

When a job is
completed,
Wallace
Company
summarizes the
costs and
completes the
lower portion of
the applicable
job cost sheet.
Illustration 2-14
Completed job
cost sheet
2-37
 Assigning Costs to Finished Goods

Illustration: When a job is completed, Wallace makes an

entry to transfer its total cost to finished goods inventory.

Jan. 31 Finished Goods Inventory 39,000

Work in Process Inventory 39,000

2-38 LO 4
 Assigning Costs to Finished Goods

Illustration: On January 31 Wallace Manufacturing sells on

account Job 101. The job cost $39,000, and it sold for $50,000.
Entries to record the sale and recognize cost of goods sold are:

Jan. 31 Accounts Receivable 50,000

Sales revenue 50,000
Cost of Goods Sold 39,000
Finished Goods Inventory 39,000

2-39 LO 4
 Summary of Job Order Cost Flows

Illustration 2-15
Flow of costs in a job
order cost system

2-40 LO 4
 Summary of Job Order Cost Flows

Illustration 2-16
Flow of documents in a
job order cost system

2-41 LO 4
 Job Order Costing for Service Companies

While service companies do not have inventory, the

techniques of job order costing are still quite useful in many
service-industry environments.

Consider, for example, the Mayo Clinic (health care),

PricewaterhouseCoopers (accounting), and Goldman
Sachs (investment banking).

These companies need to keep track of the cost of jobs

performed for specific customers to evaluate the profitability
of medical treatments, audits, or investment banking
engagements.

2-42 LO 4
2-43 LO 4
 Job Order Costing

Advantages
 More precise in assignment of costs to projects than
process costing.

 Provides more useful information for determining the

profitability of particular projects and for estimating costs
when preparing bids on future jobs.

Disadvantage
 Requires a significant amount of data entry.

2-44 LO 4
 LEARNING Distinguish between under- and overapplied
5
OBJECTIVE manufacturing overhead.

Illustration 2-17
Cost of goods
manufactured
schedule

 Shows manufacturing overhead applied rather than actual

overhead costs.
 Applied overhead is added to direct materials and direct labor to
determine total manufacturing costs
2-45 LO 5
 Cost of Goods Manufactured

Partial Income Statement

Illustration 2-18

2-46 LO 5
 Under- or Overapplied Overhead

 A debit balance in manufacturing overhead means

that overhead is underapplied.
 A credit balance in manufacturing overhead means
that overhead is overapplied.
Illustration 2-19
Under- and overapplied
overhead

2-47 LO 5
 Under- or Overapplied Overhead

Any Year-End Balance in manufacturing overhead is

eliminated by adjusting cost of goods sold.
 Underapplied overhead is debited to COGS

 Overapplied overhead is credited to COGS

Illustration: Wallace has a $2,500 credit balance in Manufacturing

Overhead at December 31. The adjusting entry for the over-applied
overhead is:

Dec. 31 Manufacturing Overhead 2,500

Cost of Good Sold 2,500

2-48 LO 5
 5 Applied Manufacturing Overhead

For Karr Company, the predetermined overhead rate is 140% of

direct labor cost. During the month, Karr incurred $90,000 of factory
labor costs, of which $80,000 is direct labor and $10,000 is indirect
labor. Actual overhead incurred was $119,000. Compute the
amount of manufacturing overhead applied during the month.
Determine the amount of under- or overapplied manufacturing
overhead.

Manufacturing overhead
(140% x $80,000) = $112,000
applied

Underapplied
($119,000 - $112,000) = $7,000
manufacturing overhead

2-49 LO 5
 5 Cost-Volume-Profit

Learning Objectives
1 Explain variable, fixed, and mixed costs and the relevant range.

Apply the high-low method to determine the components of

2 mixed costs.

Prepare a CVP income statement to determine contribution

3 margin.

4 Compute the break-even point using three approaches.

Determine the sales required to earn target net income and

5 determine margin of safety.
5-1
LEARNING Explain variable, fixed, and mixed costs and the
OBJECTIVE
1 relevant range.

Cost Behavior Analysis is the study of how specific costs

respond to changes in the level of business activity.

 Some costs change; others remain the same.

 Helps management plan operations and decide between

alternative courses of action.

 Applies to all types of businesses and entities.

 Starting point is measuring key business activities.

5-2 LO 1
 Cost Behavior Analysis

Cost Behavior Analysis is the study of how specific costs

respond to changes in the level of business activity.

 Activity levels may be expressed in terms of:

► Sales dollars (in a retail company)
► Number of goods produced (in a manufacturing company.)
► Miles driven (in a trucking company)
► Passenger km flown ( in an airline)
► Room occupancy (in a hotel)

 Many companies use more than one measurement base.

5-3 LO 1
 Cost Behavior Analysis

Cost Behavior Analysis is the study of how specific costs

respond to changes in the level of business activity.

 Changes in the level or volume of activity should be

correlated with changes in costs.

 Activity Level Selected: :

► Allows costs to be classified as variable, fixed, or mixed.

5-4 LO 1
 Variable Costs

 Costs that vary in total directly and proportionately with

changes in the activity level.

► Example: If the activity level increases 10 percent, total

variable costs increase 10 percent.

► Example: If the activity level decreases by 25 percent,

total variable costs decrease by 25 percent.

 Variable costs remain the same per unit at every level of

activity.

5-5 LO 1
 Variable Costs

Illustration: Damon Company

manufactures tablet computers that
contain a $10 camera. The activity Illustration 5-1
level selected is the number of
tablets produced.
As Damon
manufactures
each tablet, the
total cost of the
cameras used
increases by
$10.

5-6 LO 1
 Variable Costs

Illustration: Damon Company manufactures tablet

computers that contain a $10 camera.
As part (b) of
Illustration 5-1
Illustration 5-1 shows,
the unit cost of $10 for
the camera is the
same whether Damon
produces 2,000 or
10,000 tablets.

5-7 LO 1
 Variable Costs

Illustration 5-1
Behavior of total and
unit variable costs

5-8 LO 1
 Fixed Costs

 Costs that remain the same in total regardless of

changes in the activity level within a relevant range.

 Fixed cost per unit cost varies inversely with activity:

As volume increases, unit cost declines, and vice versa

 Examples:
► Property taxes
► Insurance
► Rent
► Depreciation on buildings and equipment

5-9 LO 1
 Fixed Costs

Illustration: Damon Company leases its Illustration 5-2

productive facilities at a cost of $10,000

per month. Total fixed costs of the
facilities will remain constant at every
level of activity.

5-10 LO 1
 Fixed Costs

Illustration: Damon Company leases its

productive facilities at a cost of $10,000
Illustration 5-2
per month. Total fixed costs of the
facilities will remain constant
at every level of activity. But,
on a per unit basis, the cost
of rent will decline as
activity increases, as part
(b) of Illustration 5-2 shows.

5-11 LO 1
 Fixed Costs

Illustration 5-2
Behavior of total and
unit fixed costs

5-12 LO 1
 Relevant Range

 Throughout the range of possible levels of activity, a

straight-line relationship usually does not exist for either
variable costs or fixed costs.

 Relationship between variable costs and changes in

activity level is often curvilinear.

 For fixed costs, the

relationship is also nonlinear –
some fixed costs will not change
over the entire range of activities,
while other fixed costs may
change.

5-13 LO 1
 Relevant Range

Illustration 5-3
Nonlinear behavior of
variable and fixed costs

5-14 LO 1
 Relevant Range

Range of activity over which a company expects to

operate during a year. Illustration 5-4
Linear behavior within
relevant range

5-15 LO 1
 Mixed Costs

 Costs that have both a variable element and a fixed element.

 Change in total but not proportionately with changes in activity

level.

Illustration 5-5
Behavior of a
mixed cost

5-16 LO 1
 1 Types of Costs

Helena Company, reports the following total costs at two levels

of production.

Classify each cost as variable, fixed, or mixed.

Variable
Fixed
Mixed

5-17 LO 1
 LEARNING Apply the high-low method to determine the
OBJECTIVE
2 components of mixed costs.

High-Low Method
 High-Low Method uses the total costs incurred at the high
and the low levels of activity to classify mixed costs into
fixed and variable components.

 The difference in costs between the high and low levels

represents variable costs, since only variable-cost element
can change as activity levels change.

5-18 LO 2
 High-Low Method

STEP 1: Determine variable cost per unit using the following

formula:

Illustration 5-6
Formula for variable cost per
unit using high-low method

5-19 LO 2
 High-Low Method

Illustration: Metro Transit Company has the

following maintenance costs and mileage data for
its fleet of buses over a 6-month period. Illustration 5-7
Assumed maintenance
costs and mileage data

Change in Costs (63,000 - 30,000) $33,000 $1.10

= cost per
High minus Low (50,000 - 20,000) 30,000
unit

5-20 LO 2
 High-Low Method

STEP 2: Determine the fixed cost by subtracting

the total variable cost at either the high or the low Illustration 5-8
High-low method
activity level from the total cost at that activity level. computation of
fixed costs

5-21 LO 2
 High-Low Method

Maintenance costs are therefore $8,000 per month of fixed

costs plus $1.10 per mile of variable costs. This is
represented by the following formula:

Maintenance costs = $8,000 + ($1.10 x Miles driven)

Example: At 45,000 miles, estimated maintenance costs would

be:
Fixed $ 8,000
Variable ($1.10 x 45,000) 49,500
$57,500

5-22 LO 2
 High-Low Method

Illustration 5-9
Scatter plot for Metro
Transit Company
5-23 LO 2
 LEARNING Prepare a CVP income statement to determine
OBJECTIVE
3 contribution margin.

Cost-volume-profit (CVP) analysis is the study of the

effects of changes in costs and volume on a company’s profits.

 Important in profit planning.

 Critical factor in management decisions as

► Setting selling prices,

► Determining product mix, and

► Maximizing use of production facilities.

5-24 LO 3
 Cost-Volume-Profit Analysis

Basic Components

Illustration 5-10
Components of CVP analysis

5-25 LO 3
 Basic Components

Assumptions
 Behavior of both costs and revenues is linear throughout
the relevant range of the activity index.

 Costs can be classified accurately as either variable or

fixed.

 Changes in activity are the only factors that affect costs.

 All units produced are sold.

 When more than one type of product is sold, the sales mix
will remain constant.

5-26 LO 3
 Cost-Volume-Profit Analysis

CVP Income Statement

 A statement for internal use.

 Classifies costs and expenses as fixed or variable.

 Reports contribution margin in the body of the

statement.
► Contribution margin – amount of revenue remaining
after deducting variable costs.

 Reports the same net income as a traditional income

statement.

5-27 LO 3
 CVP Income Statement

Example: Vargo Video Company produces a high-definition

digital camcorder. Relevant data for the camcorders sold by
this company in June 2014 are as follows.

5-28 LO 3
 CVP Income Statement

Illustration: The CVP income statement for Vargo Video

therefore would be reported as follows.

Illustration 5-12
5-29 LO 3
 CVP Income Statement

UNIT CONTRIBUTION MARGIN

 Contribution margin is available to cover fixed costs
and to contribute to income.

 Formula for contribution margin per unit and the

computation for Vargo Video are:

Illustration 5-13
Formula for unit contribution margin

5-30 LO 3
 CVP Income Statement

UNIT CONTRIBUTION MARGIN

Vargo’s CVP income statement assuming a zero net income.

Illustration 5-14
5-31 LO 3
 CVP Income Statement

UNIT CONTRIBUTION MARGIN

Assume that Vargo sold one more camcorder, for a total of 1,001
camcorders sold.
Illustration 5-15

5-32 LO 3
 CVP Income Statement

CONTRIBUTION MARGIN RATIO

 Shows the percentage of each sales dollar available to
apply toward fixed costs and profits.

 Formula for contribution margin ratio and the

computation for Vargo Video are:

Illustration 5-17
Formula for contribution
margin ratio

5-33 LO 3
 CVP Income Statement

CONTRIBUTION MARGIN RATIO

Illustration 5-16
CVP income statement, with
net income and percent of sales data

5-34 LO 3
 CVP Income Statement

CONTRIBUTION MARGIN RATIO

Assume Vargo Video’s current sales are $500,000 and it wants to
know the effect of a $100,000 (200-unit) increase in sales.

Illustration 5-18

5-35 LO 3
 LEARNING Compute the break-even point using three
OBJECTIVE
4 approaches.

Break-Even Analysis ( «Başabaş»)

 Process of finding the break-even point level of activity at
which total revenues equal total costs (both fixed and
variable).

 Can be computed or derived

► from a mathematical equation,

► by using contribution margin, or

► from a cost-volume profit (CVP) graph.

 Expressed either in sales units or in sales dollars.

5-36 LO 4
 Mathematical Equation

Break-even occurs where total sales equal variable costs plus

fixed costs; i.e., net income is zero

Computation
of break-
even point in
units.

Illustration 5-20

5-37 LO 4
 Contribution Margin Technique

 At the break-even point, contribution margin must equal total

fixed costs

(CM = total revenues – variable costs)

 Break-even point can be computed using either contribution

margin per unit or contribution margin ratio.

5-38 LO 4
 Break-Even Analysis

CONTRIBUTION MARGIN IN UNITS

 When the break-even-point in units is desired,
contribution margin per unit is used in the following
formula which shows the computation for Vargo Video:

Illustration 5-21
Formula for break-even point
in units using unit contribution
margin

5-39 LO 4
 Break-Even Analysis

CONTRIBUTION MARGIN RATIO

 When the break-even-point in dollars is desired,
contribution margin ratio is used in the following formula
which shows the computation for Vargo Video:

Illustration 5-22
Formula for break-even point
in dollars using contribution
Margin ratio

5-40 LO 4
 Graphic Presentation

Because this
graph also shows
costs, volume, and
profits, it is
referred to as a
cost-volume-
profit (CVP)
graph.

Illustration 5-23
CVP graph

5-41 LO 4
 4 Break-Even Analysis

Lombardi Company has a unit selling price of $400, variable

costs per unit of $240, and fixed costs of $180,000. Compute
the break-even point in units using (a) a mathematical
equation and (b) contribution margin per unit.
Illustration 5-19

Variable Fixed Net

Sales - - =
Costs Costs Income

$400Q - $240Q - $180,000 = 0

$160Q = $180,000
Q = 1,125 units

5-42 LO 4
 4 Break-Even Analysis

Lombardi Company has a unit selling price of $400, variable

costs per unit of $240, and fixed costs of $180,000. Compute
the break-even point in units using (a) a mathematical
equation and (b) contribution margin per unit.
Illustration 5-21

Fixed Contribution Break-Even

÷ =
Costs Margin per Unit Point in Units

$180,000 ÷ $160 = 1,125 units

5-43 LO 4
 LEARNING Determine the sales required to earn target net
OBJECTIVE
5 income and determine margin of safety.

Target Net Income

 Level of sales necessary to achieve a specified income.

 Can be determined from each of the approaches used to

determine break-even sales/units:
► from a mathematical equation,

► by using contribution margin technique, or

► from a cost-volume profit (CVP) graph.

 Expressed either in sales units or in sales dollars.

5-44 LO 5
 Target Net Income

MATHEMATICAL EQUATION
Formula for required sales to meet target net income.

Illustration 5-24

5-45 LO 5
 Target Net Income

MATHEMATICAL EQUATION
Using the formula for the break-even point, simply include the
desired net income as a factor.
Illustration 5-25

5-46 LO 5
 Target Net Income

CONTRIBUTION MARGIN TECHNIQUE

To determine the required sales in units for Vargo Video:

Illustration 5-26
Formula for required sales in
units using unit contribution
margin

5-47 LO 5
 Target Net Income

CONTRIBUTION MARGIN TECHNIQUE

To determine the required sales in dollars for Vargo Video:

Illustration 5-27
Formula for required sales
in dollars using contribution
margin ratio

5-48 LO 5
 Target Net Income

GRAPHIC
PRESENTATION
Suppose Vargo Video
sells 1,400 camcorders.
Illustration 5-23 shows
that a vertical line drawn
at 1,400 units intersects
the sales line at $700,000
and the total cost line at
$620,000. The difference
between the two amounts
represents the net
income (profit) of
$80,000.
Illustration 5-23

5-49 LO 5
 Margin of Safety

 Difference between actual or expected sales and sales

at the break-even point.
 Measures the “cushion” that a particular level of sales
provides.
 May be expressed in dollars or as a ratio.
 Assuming actual/expected sales are $750,000:

Illustration 5-28
Formula for margin of safety
in dollars

5-50 LO 5
 Margin of Safety Ratio

 Computed by dividing the margin of safety in dollars by

the actual (or expected) sales.
 Assuming actual/expected sales are $750,000:
Illustration 5-29

 The higher the dollars or percentage, the greater the

margin of safety.

5-51 LO 5
 Margin of Safety

Question
Marshall Company had actual sales of $600,000 when break-
even sales were $420,000. What is the margin of safety ratio?
a. 25%.
b. 30%.
c. 33 1/3%.
d. 45%.

5-52 LO 5
 5 Break-Even, Margin of Safety, and Target Net
Comprehensive
Income

Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
following:

a) break-even point in dollars using the contribution margin

(CM) ratio;

b) the margin of safety and margin of safety ratio assuming

actual sales are $1,382,400; and

c) the sales dollars required to earn net income of

$410,000.

5-53 LO 5
 5 Break-Even, Margin of Safety, and Target Net
Comprehensive
Income

Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute
break-even point in dollars using the contribution margin
(CM) ratio.

Contribution margin ratio = [($56 - $42) ÷ $56] = 25%

Break-even sales in dollars = $320,000 ÷ 25% = $1,280,000

5-54 LO 5
 5 Break-Even, Margin of Safety, and Target Net
Comprehensive
Income

Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
margin of safety and margin of safety ratio assuming
actual sales are $1,382,400.

Margin of safety = $1,382,400 - $1,280,000 = $102,400

Margin of safety ratio = $102,400 ÷ $1,382,400 = 7.4%

5-55 LO 5
 5 Break-Even, Margin of Safety, and Target Net
Comprehensive
Income

Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
sales dollars required to earn net income of $410,000.

Required sales in dollars =

($320,000 + $410,000) ÷ 25% = $2,920,000

5-56 LO 5
 Copyright

“Copyright © 2015 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted in
Section 117 of the 1976 United States Copyright Act without the
express written permission of the copyright owner is unlawful. Request
for further information should be addressed to the Permissions
Department, John Wiley & Sons, Inc. The purchaser may make back-
up copies for his/her own use only and not for distribution or resale.
The Publisher assumes no responsibility for errors, omissions, or
damages, caused by the use of these programs or from the use of the
information contained herein.”

5-57
 6 Cost-Volume-Profit
Analysis: Additional Issues

Learning Objectives

1 Review : Apply basic CVP concepts.

Explain the term sales mix and its effects on break-

2 even sales.

Determine sales mix when a

3 company has limited resources.

4 Indicate how operating leverage affects profitability.

6-1
 Cost-Volume-Profit (CVP) Review

CVP analysis is:

 The study of the effects of changes in costs and volume
on a company’s profit.

 Important to profit planning.

 Critical in management decisions such as:

► determining product mix,

► maximizing use of production facilities,

► setting selling prices.

6-2 LO 1 Describe the essential features of a cost-volume-profit income statement.

 Cost-Volume-Profit (CVP) Review

Basic Concepts
 Management often wants the information reported in a
special format income statement.

 CVP income statement is for internal use only:

► Costs and expenses classified as fixed or variable.

► Reports contribution margin as a total amount and

on a per unit basis.

6-3
 Cost-Volume-Profit (CVP) Review

Basic Concepts Illustration 6-1

Basic CVP income
statement

6-4
 Cost-Volume-Profit (CVP) Review

Basic Concepts Illustration 6-2

Detailed CVP
income
statement

6-5
 Cost-Volume-Profit (CVP) Review

Basic Computations – Break-Even Analysis

Illustration: Vargo Video’s CVP income statement (Ill. 6-2)
shows that total contribution margin is $320,000, and the
company’s contribution margin per unit is $200. Contribution
margin can also be expressed in the form of the contribution
margin ratio which in the case of Vargo is 40% ($200 ÷ $500).
Illustration 6-3 and 6-4

6-6
 Cost-Volume-Profit (CVP) Review

Basic Computations – Target Net Income

Once a company achieves break-even sales, a sales goal can be
set that will result in a target net income
Illustration: Assuming Vargo’s target net income is $250,000,
required sales in units and dollars to achieve this are:
Illustration 6-5 and 6-6

6-7 LO 2 Apply basic CVP concepts.

 Cost-Volume-Profit (CVP) Review

Basic Computations – Margin of Safety

Margin of safety
 cells us how far sales can drop before the company will
operate at a loss.
 can be expressed in dollars or as a ratio.

Illustration: Assume Vargo’s sales are $800,000:

Illustration 6-7 and 6-8

6-8 LO 2 Apply basic CVP concepts.

 Blue Diamond, Inc. sold 20,000 units and recorded sales of $800,000
for the first quarter of 2014. In making the sales, the company
incurred the following costs and expenses.

(a) Prepare a CVP income statement for the quarter ended March 31,
2014.
(b) Compute the contribution margin per unit.
(c) Compute the contribution margin ratio.

6-9 LO 1 Describe the essential features of a cost-volume-profit income statement.

 (a) Prepare a CVP income statement for the quarter ended
March 31, 2014.

6-10 LO 1
 (b) Compute the contribution margin per unit.

÷ 20,000 = $40.00

÷ 20,000 = $21.60
$18.40
Per unit

6-11 LO 1
 (c) Compute the contribution margin ratio.

÷ 800,000 = 46%

or,
$18.40 ÷ $40 = 46%

6-12 LO 1
 Cost-Volume-Profit (CVP) Review

CVP and Changes in the Business Environment

Illustration: Original camcorder sales and cost data for Vargo
Video:
Illustration 6-9

6-13 LO 2 Apply basic CVP concepts.

 Cost-Volume-Profit (CVP) Review

CVP and Changes in the Business Environment

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
($500 x 10% = $50) have on the breakeven point?
Illustration 6-10

6-14 LO 2 Apply basic CVP concepts.

 Cost-Volume-Profit (CVP) Review

CVP and Changes in the Business Environment

Case II: Management invests in new robotic equipment that will
lower the amount of direct labor required to make camcorders.
Estimates are 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?
Illustration 6-11

6-15 LO 2 Apply basic CVP concepts.

 Cost-Volume-Profit (CVP) Review

CVP and Changes in the Business Environment

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?

6-16 LO 2 Apply basic CVP concepts.

 Cost-Volume-Profit (CVP) Review

CVP and Changes in the Business Environment

Case III:

Variable cost per unit increases to $325 ($300 + $25).

Fixed costs are reduced to $182,500 ($200,000 - $17,500).
Contribution margin per unit becomes $175 ($500 - $325).

Illustration 6-12

6-17 LO 2 Apply basic CVP concepts.

 1 CVP Analysis

Krisanne Company reports the following operating results for the month of June
2017.

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.
6-18 LO 1
 1 CVP Analysis

Krisanne Company reports the following operating results for the month of June
2017.

6-19 LO 1
 1 CVP Analysis

Krisanne Company reports the following operating results for the month of June
2017.

6-20 LO 1
 1 CVP Analysis

Krisanne Company reports the following operating results for the month of June
2017.

(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 contribution margin of
$112,500 (6,250 x $18), which is $7,500 less than the current amount.

6-21 LO 1
 LEARNING Explain the term sales mix and its
2
OBJECTIVE effects on break-even sales.

Break-Even Sales in Units

 Sales mix is the relative percentage in which a
company sells its products.

 If a company’s unit sales are 80% printers and 20%

computers, its sales mix is 80% to 20%.

 Sales mix is important because different products

often have very different contribution margins.

6-22 LO 2
 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.

Illustration: Vargo Video sells not only camcorders but TV sets

as well. Vargo sells its two products in the following amounts:
1,500 camcorders and 500 TVs. The sales mix, expressed as a
function of total units sold, is as follows.

6-23 LO 2
 Break-Even Sales in Units

Additional information related to Vargo Video.

Illustration 6-13

6-24 LO 2
 Break-Even Sales in Units

First, determine the weighted-average contribution margin.

Illustration 6-14

Illustration 6-15
Weighted-average unit contribution margin

6-25 LO 2
 Break-Even Sales in Units

Second, use the weighted-average unit contribution margin to

compute the break-even point in units
Illustration 6-15

Illustration 6-16
Break-even point in units

6-26 LO 2
 Break-Even Sales in Units

 With a break-even point of 1,000 units, Vargo must sell:

► 750 Camcorders (1,000 units x 75%)
► 250 TVs (1,000 units x 25%)

 At this level, the total contribution margin will equal the fixed
costs of $275,000.

Illustration 6-17
Break-even proof—sales units

6-27 LO 2
 Break-Even Sales in Dollars

 Works well if the company has many products.

 Calculates break-even point in terms of sales dollars for

► divisions or

► product lines,

► NOT individual products.

6-28 LO 2
 Break-Even Sales in Dollars

Illustration: Kale Garden Supply Company has two divisions.

Illustration 6-18
Cost-volume-profit data for Kale Garden Supply

Illustration 6-19
6-29 Contribution margin ratio for each division
LO 2
 Break-Even Sales in Dollars

First, determine the weighted-average contribution margin.

Illustration 6-20
Calculation of weighted-average contribution margin Illustration 6-21
Calculation of break-even
point in dollars

Second, calculate
break-even point in
dollars.

6-30 LO 2
 Break-Even Sales in Dollars

 With break-even sales of $937,500 and a sales mix of 20%

to 80%, Kale must sell:

► $187,500 from the Indoor Plant division

► $750,000 from the Outdoor Plant division

 If the sales mix becomes 50% to 50%, the weighted

average contribution margin ratio changes to 35%, resulting
in a lower break-even point of $857,143.

6-31 LO 2
 Break-Even Sales in Dollars

Question
Net income will be:

a. Greater if more higher-contribution margin units are

sold than lower-contribution margin units.

b. Greater is more lower-contribution margin units are

sold than higher-contribution margin units.

c. Equal as song as total sales remain equal, regardless

of which products are sold.

d. Unaffected by changes in the mix of products sold.

6-32 LO 2
 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.

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.

6-33 LO 2
 2 Sales Mix Break-Even

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

6-34 LO 2
 2 Sales Mix Break-Even

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

6-35 LO 2
 2 Sales Mix Break-Even

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

6-36 LO 2
 2 Sales Mix Break-Even

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

6-37 LO 2
 LEARNING Determine sales mix when a company
3
OBJECTIVE has limited resources.

Determining Sales Mix with Limited Resources

 All companies have limited resources whether it be floor
space, raw materials, direct labor hours, etc.

 Management must decide which products to sell to

maximize net income.

Illustration: Vargo makes camcorders and TVs. Machine

capacity is limited to 3,600 hours per month.

Illustration 6-22
6-38 Contribution margin and machine hours LO 3
 Sales Mix with Limited Resources

Calculate the contribution margin per unit of limited resource.

Illustration 6-23
Contribution margin per
Management should produce more camcorders unit of limited resource

if demand exists or else increase machine

capacity.

6-39 LO 3
 Sales Mix with Limited Resources

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.

Illustration 6-24
To maximize net income, all 600 hours should Incremental analysis—
computation of total
contribution margin
be used to produce and sell camcorders.

6-40 LO 3
 Sales Mix with Limited Resources

Theory of Constraints
 Approach used to identify and manage constraints so as to
achieve company goals.

 Company must continually

► identify its constraints and

► find ways to reduce or eliminate them, where

appropriate.

6-41 LO 3
 Sales Mix with Limited Resources

Question
If the contribution margin per unit is $15 and it takes 3.0
machine hours to produce the unit, the contribution margin per
unit of limited resource is:

a. $25.

b. $5.

c. $4.

d. No correct answer is given.

6-42 LO 3
 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.

6-43 LO 3
 3 Sales Mix with Limited Resources

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

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.

6-44 LO 3
 3 Sales Mix with Limited Resources

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

6-45 LO 3
 3 Sales Mix with Limited Resources

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

additional capacity be used?
Solution
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.
6-46 LO 3
 LEARNING Indicate how operating leverage affects
4
OBJECTIVE profitability.

Cost Structure is the relative proportion of fixed versus

variable costs that a company incurs.

 May have a significant effect on profitability.

 Company must carefully choose its cost structure.

6-47 LO 4
 Cost Structure

Illustration: Vargo Video and one of its competitors, New Wave

Company, both make camcorders. Vargo Video uses a traditional,
labor-intensive manufacturing process. New Wave Company has
invested in a completely automated system. The factory employees
are involved only in setting up, adjusting, and maintaining the
machinery. Illustration 6-25
CVP income statements for two companies

6-48 LO 4
 Effect on Contribution Margin Ratio
Illustration 6-25

First let’s look

at the
contribution
margin ratios.

Illustration 6-26
Contribution margin ratio
for two companies

6-49 LO 4
 Effect on Contribution Margin Ratio
Illustration 6-26

 New Wave contributes 80 cents to net income for each dollar of

increased sales while Vargo only contributes 40 cents.

 New Wave’s cost structure which relies on fixed costs is more

sensitive to changes in sales.

6-50 LO 4
 Effect on Break-Even Point
Illustration 6-27
Calculate the break-even point. Computation of break-even
point for two companies

 New Wave needs to generate $150,000 more in sales than

Vargo to break-even.

 Because of the greater break-even sales required, New Wave is

a riskier company than Vargo.

6-51 LO 4
 Effect on Margin of Safety
Illustration 6-28
Computation of margin of safety ratio Computation of margin of
safety ratio for two companies

 The difference in ratios reflects the difference in risk between New

Wave and Vargo.

 Vargo can sustain a 38% decline in sales before operating at a loss

versus only a 19% decline for New Wave.

6-52 LO 4
 Operating Leverage

 Extent that net income reacts to a given change in sales.

 Higher fixed costs relative to variable costs cause a

company to have higher operating leverage.

 When sales revenues are increasing, high operating

leverage means that profits will increase rapidly.

 When sales revenues are declining, too much operating

leverage can have devastating consequences.

6-53 LO 4
 Operating Leverage

DEGREE OF OPERATING LEVERAGE

 Provides a measure of a company’s earnings volatility.

 Computed by dividing total contribution margin by net

income.
Illustration 6-29

New Wave’s earnings would go up (or down) by about two times

(5.33 ÷ 2.67 = 1.99) as much as Vargo’s with an equal increase
in sales.
6-54 LO 4
 Operating Leverage

Question
The degree of operating leverage:
a. Can be computed by dividing total contribution margin
by net income.

b. Provides a measure of the company’s earnings

volatility.

c. Affects a company’s break-even point.

d. All of the above.

6-55 LO 4
 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.

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 4 Operating Leverage

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

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 4 Operating Leverage

(b) Discuss your results.

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) times as much with the new
technology as it would under the old.
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