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BMAC 5203
ACCOUNTING FOR BUSINESS
DECISION MAKING
Lecturer
Nguyen Phong Nguyen
Lecturer in Accounting-University of Economics HCMC
MA. University of EconomicsHCMC
MBus (Accounting). MonashUniversity (Australia)
DBA. University of Western Sydney(Australia)
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Study Program
1. Managerial accounting and basic cost concepts2. Activity-based costing3. CVP analysis4. Relevant costs for decision making5. Profit planning6. Flexible budgets and performance analysis7. Standard costs and operating performance measures
8. Performance evaluation and decentralization9. Other contemporary issues in managerial accounting[no lecture, self-reading]
Lecture 1Part A:
Introduction to ManagerialAccounting and Ethics
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Learning Objectives
1. Explain the meaning and objectives of
managerial accounting.
2. Explain the differences between managerial
accounting and financial accounting.
3. Explain the IMA Ethical Principles.
Why do managers need
accounting information?
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Comparison of Financial and
Managerial Accounting (continued)
The key point isflexibility
the accounting system should be able to supply
different information for different purposes.
Managerial Accounting
and Ethical Conduct [self reading]
The objective of profit maximization shouldbe constrained by the requirement that profits
be achieved through legal and ethical means.Ethical behavior involves choosing actions
that are right, proper, and just.
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IMA Ethical Principles
Competencemaintain an appropriate level ofprofessional expertise by continually developingknowledge and skills;
Confidentialityrefrain using confidentialinformation for unethical or illegal advantage;
Integrityabstain from engaging in or supporting anyactivity that might discredit the profession; and
Credibilitycommunicate information fairly and
objectively.
Lecture 1Part B:
Basic Cost Concepts
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Learning Objectives
1. Define cost
2. Understand three types of manufacturing costs.
3. Distinguish between product costs and period costs
4. Apply cost estimation methods to separate mixedcosts into fixed and variable elements.
What is cost?
Costis the amount of cash or cash equivalent
sacrificed for goods and/or services that are
expected to bring a current or future benefit tothe organization.
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The Product
DirectMaterials DirectLabor ManufacturingOverhead
Manufacturing Costs
Direct Materials
Raw materials that become an integralpart of the product and that can be
conveniently traced directly to it.
Example: A radio installed in an automobile
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Direct Labor
Those labor costs that can be easily tracedto individual units of product.
Example: Wages paid to automobile assembly workers
Manufacturing costs that cannotbe traced directlyto specific units produced.
Manufacturing Overhead
Examples: Indirect materials and indirect labor
Wages paid to employeeswho are not directly
involved in productionwork.
Examples: maintenanceworkers, janitors and
security guards.
Materials used to supportthe production process.
Examples: lubricants andcleaning supplies used in theautomobile assembly plant.
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Nonmanufacturing Costs
Selling
Costs
Costs necessary to
secure the order anddeliver the product.
Administrative
Costs
All executive,
organizational, andclerical costs.
Product Costs Versus Period Costs
Product costs include
direct materials, directlabor, and manufacturing
overhead.
Period costsinclude all
selling costs andadministrative costs.
Inventory Cost of Good Sold
BalanceSheet
IncomeStatement
Sale
Expense
IncomeStatement
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Manufacturing Cost Flows
Finished
Goods
Cost of
GoodsSold
Selling and
Administrative
Period CostsSelling andAdministrative
ManufacturingOverhead
Work in
Process
Direct Labor
Balance SheetCosts Inventories
IncomeStatement
ExpensesMaterial Purchases Raw Materials
Cost Classifications for Predicting
Cost Behavior
How a cost will react to changesin the level of activity within
the relevant range.Totalvariable costschange
when activity changes.
Total fixed costsremainunchanged when activitychanges.
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RelevantRange
A straight lineclosely
approximates acurvilinear variablecost line within the
relevant range.
Activity
TotalCost
EconomistsCurvilinear Cost
Function
The Linearity Assumption and the
Relevant Range
Accountants Straight-Line
Approximation (constant unitvariable cost)
Fixed Monthly
Utility Charge
Variable
Cost per KW
Activity (Kilowatt Hours)
TotalUtilityCost
X
Y
A mixed cost contains both variable and fixed elements.
Consider the example of utility cost.
Mixed Costs (also called semivariable costs)
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Mixed Costs
The total mixed cost line can be expressed
as an equation: Y= a+ bX
Where: Y = The total mixed cost.
a = The total fixed cost (the
vertical intercept of the line).
b = The variable cost per unit of
activity (the slope of the line).
X = The level of activity.
Fixed Monthly
Utility Charge
Variable
Cost per KW
Activity (Kilowatt Hours)
TotalU
tilityCost
X
Y
Plot the data points on a graph(Total Cost Yvs. Activity X).
0 1 2 3 4
*
MaintenanceCost
1,0
00sofDollars
10
20
0
***
**
**
*
*
Patient-days in 1,000s
X
Y
The Scattergraph Method
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The Scattergraph MethodDraw a line through the data points with about anequal numbers of points above and below the line.
0 1 2 3 4
*
MaintenanceCost
1,0
00sofDollars
10
20
0
***
**
**
*
*
Patient-days in 1,000s
X
Y
The Scattergraph Method
Use one data point to estimate the total level of activityand the total cost.
Intercept = Fixed cost: $10,000
0 1 2 3 4
*
MaintenanceCost
1,0
00sofDollars
10
20
0
***
**
**
*
*
Patient-days in 1,000s
X
Y
Patient days = 800
Total maintenance cost = $11,000
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Assigning Costs to Cost Objects
Direct costs
Costs that can beeasily and convenientlytraced to a unit ofproduct or other costobject.
Examples: directmaterial and directlabor
Indirect costs
Costs that cannot beeasily and convenientlytraced to a unit ofproduct or other costobject.
Example:manufacturingoverhead
McGraw-Hill/Irwin
Every decision involves a choice between
at least two alternatives.
Only those costs and benefits that differ
between alternatives are relevant in a
decision. All other costs and benefits can
and should be ignored.
Cost Classifications for Decision Making
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Differential Cost and Revenue
Costs and revenues that differ amongalternatives.
Example: You have a job paying $1,500 per month in yourhometown. You have a job offer in a neighboring city that
pays $2,000 per month. The commuting cost to the city is$300 per month.
Differential revenue is:
$2,000$1,500 = $500
Differential cost is:
$300
Opportunity Cost
The potential benefit that is givenup when one alternative is selected
over another.
Example: If you were not attending college,you could be earning $15,000 per year.Your opportunity cost of attending collegefor one year is $15,000.
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Sunk Costs
Sunk costs have already been incurred and cannot bechanged now or in the future. These costs should be
ignored when making decisions.
Example:You bought an automobile that cost $10,000two years ago. The $10,000 cost is sunk becausewhether you drive it, park it, trade it, or sell it, you
cannot change the $10,000 cost.
Homework
Exercises 2-2; 2-3; 2-6; 2-7; 2-13; 3-2; 3-3;3-7; 3-8; 3-10
Problem 3-12
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Product Cost Assignment under Traditional
Overhead Costing Approach
Direct materials
Direct labors Product A
PRIME COSTS
ManufacturingOverhead
(plantwide costs)Product B
Allocating based ona pre-determined
overhead rate
Tracing
Tracing
COST OBJECTS
How Costs are Treated UnderActivityBased Costing
Traditional cost systems usually rely on volumemeasures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
ABC definesfive levels of activity
that largely do not relateto the volume of units
produced.
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Activity Based Costing
The costing system that first trace costs to
activities (activity cost pools) and then to cost
objects.
The underlying assumption is that
Activities consume resources, and
Cost objects, in turn, consume activities
ABC is a two-stage process
Steps in Activity Based Costing
First stage cost allocation
1. Define activities, activity cost pools, and
activities measures.2. Assign overhead costs to activities cost poolsSecond stage cost allocation
3. Calculate activity rates
4. Assign overhead costs to cost objects usingactivity rates and activity measures
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First Stage Cost Allocation - Example
Exercise 7-6 - Define activities, activity cost pools, and activitiesmeasures
ActivityLevel of
activity
Examples of
measures
a. Direct labor workers assemble a product. Unit
b. Products are designed by engineers. Product
c. Equipment is set up. Batch
d. Machines are used to shape and cut materials. Unit
e. Monthly bills are sent out to regular customers. Customerf. Materials are moved from the receiving dock
to production lines.Batch
g. All completed units are inspected for defects. Unit
First Stage Cost Allocation - Example
Exercise 7-2 -Assign overhead costs to activities cost pools
TravelPickup and
delivery
Customer
serviceOther Totals
Driver and guard wages 360,000 252,000 72,000 36,000 720,000
Vehicle operating expense 196,000 14,000 70,000 280,000
Vehicle depreciation 72,000 18,000 30,000 120,000
Customer representativesalaries and expenses
- 144,000 16,000 160,000
Office expenses 6,000 9,000 15,000 30,000
Administrative expenses 16,000 192,000 112,000 320,000
Total cost 628,000 306,000 417,000 279,000 1,630,000
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Second Stage Cost Allocation - Example
Exercise 7-3 - Calculate activity rates
Activity cost pool
Estimated
overhead
cost ($)
Expected activity Activity rate ($)
Caring for lawn 72,000 150,000 square feet oflawn
0.48 per square footof lawn
Caring for gardenbedslowmaintenance
26,400 20,000 square feet of lowmaintenance beds(LMB)
1.32 per square footof LMB
Caring for gardenbedshighmaintenance
41,400 15,000 square feet of highmaintenance beds(HMB)
2.76 per square footof HMB
Travel to jobs 3,250 12,500 miles 0.26 per mile
Customer billingand service
8,750 25 customers 350 per customer
Second Stage Cost Allocation - Example
Exercise 7-4 -Assign overhead costs to cost objects using activityrates and activity measures
Product - K425
Activity Cost Pool Activity Rate ($) Expected activity ABC costSupporting direct labor 6 per DLH 80 direct DLHs 480
Machine processing 4 per machine-hour 100 machine-hours 400
Machine setups 50 per setup 1 setup 50
Production orders 90 per order 1 order 90
Shipments 14 per shipment 1 shipment 14
Product sustaining 840 per product 1 product 840
Total 1,874
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Second Stage Cost Allocation - Example
Exercise 7-4 -Assign overhead costs to cost objects using activityrates and activity measures
ProductM67
Activity Cost Pool Activity Rate ($) Expected activity ABC cost
Supporting direct labor 6 per DLH 500 direct DLHs 3,000
Machine processing 4 per machine-hour 1,500 machine-hours 6,000
Machine setups 50 per setup 4 setup 200
Production orders 90 per order 4 order 360
Shipments 14 per shipment 10 shipment 140
Product sustaining 840 per product 1 product 840
Total 10,540
ABC Limitations
Substantial resourcesrequired to implement
and maintain.
Resistance tounfamiliar numbers
and reports.
Desire to fullyallocate all costs
to products.
Potentialmisinterpretation ofunfamiliar numbers.
Does not conform toGAAP. Two costing
systems may be needed.
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Homework
Exercises 7-7; 7-8; 7-9; 7-10; 7-11; 7-12; 7-
13; 7-14
Problem 7-18
Lecture 3:Cost-Volume-Profit (CVP)
Analysis
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Learning Objectives
1. Understand the basics of CVP analysis
2. Determine the break-even point, the amount
of sales required for a target profit, the margin
of safety, and the degree of operating leverage.
3. .
4. Understand the underlying assumptions and
limitations of the CVP analysis tool.
Basics of Cost-Volume-Profit Analysis
Contribution Margin (CM) is the amount remaining from sales
revenue after variable expenses have been deducted.
Sales (500 bicycles) 250,000$
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income 20,000$
Racing Bicycle Company
Contribution Income Statement
For the Month of June
The contribution income statement is helpful to managers in
judging the impact on profits of changes in selling price, cost, or
volume. The emphasis is on cost behavior.
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Basics of Cost-Volume-Profit Analysis
CM is used first to cover fixed expenses. Any remaining
CM contributes to net operating income.
Sales (500 bicycles) 250,000$
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Net operating income 20,000$
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (500 bicycles) 250,000$ 500$
Less: Variable expenses 150,000 300
Contribution margin 100,000 200$
Less: Fixed expenses 80,000
Net operating income 20,000$
Racing Bicycle Company
Contribution Income Statement
For the Month of June
The Contribution Approach
Sales, variable expenses, and contribution margin can also beexpressed on a per unit basis. If Racing sells an additional
bicycle, $200 additional CM will be generated to coverfixed expenses and profit.
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Total Per Unit
Sales (500 bicycles) 250,000$ 500$
Less: Variable expenses 150,000 300Contribution margin 100,000 200$
Less: Fixed expenses 80,000
Net operating income 20,000$
Racing Bicycle Company
Contribution Income Statement
For the Month of June
The Contribution Approach
Each month, RBC must generate at least
$80,000 in total contribution margin to break-even (whichis the level of sales at which profit is zero).
Total Per Unit
Sales (400bicycles) 200,000$ 500$
Less: Variable expenses 120,000 300
Contribution margin 80,000 200$
Less: Fixed expenses 80,000
Net operating income -$
Racing Bicycle CompanyContribution Income Statement
For the Month of June
The Contribution Approach
If RBC sells 400 unitsin a month, it will be
operating at the break-even point.
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Total Per Unit
Sales (401bicycles) 200,500$ 500$
Less: Variable expenses 120,300 300
Contribution margin 80,200 200$Less: Fixed expenses 80,000
Net operating income 200$
Racing Bicycle Company
Contribution Income Statement
For the Month of June
The Contribution Approach
If RBC sells one more bike (401 bikes), net
operating income will increase by $200.
The Contribution Approach
We do not need to prepare an income statement to estimateprofits at a particular sales volume. Simply multiply the
number of units sold above break-even by the contribution
margin per unit.
If Racing sells 430bikes, its net
operating incomewill be $6,000.
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CVP Relationships in Equation Form
This equation can also be used to show the $200 profit RBCearns if it sells 401 bikes.
Profit = (SalesVariable expenses)Fixed expenses
Profit = (P QV Q)Fixed expenses
Profit = ($500 401$300 401)$80,000$200 = ($500 401$300 401)$80,000
Unit CM = Selling price per unitVariable expenses per unit
It is often useful to express the simple profit equation in terms ofthe unit contribution margin (Unit CM) as follows:
Profit = (P QV Q)Fixed expensesProfit = (PV) QFixed expensesProfit = Unit CM QFixed expenses
Unit CM = PV
CVP Relationships in Equation Form
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Contribution Margin Ratio (CM Ratio)
Total Per Unit CM Ratio
Sales (500 bicycles) 250,000$ 500$ 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 200$ 40%
Less: Fixed expenses 80,000Net operating income 20,000$
Racing Bicycle Company
Contribution Income Statement
For the Month of June
$100,000 $250,000 = 40%
The CM ratio is calculated by dividing the total contribution
margin by total sales.
Contribution Margin Ratio (CM Ratio)
The contribution margin ratio at Racing Bicycle is:
The CM ratio can also be calculated by dividingthe contribution margin per unit by the selling
price per unit.
CM per unitSP per unit
CM Ratio = = 40%$200$500
=
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400 Units 500 Units
Sales 200,000$ 250,000$
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income -$ 20,000$
Contribution Margin Ratio (CM Ratio)
A $50,000 increase in sales revenue results in a $20,000increase in CM. ($50,000 40% = $20,000)
If Racing Bicycle increases sales by $50,000, contributionmargin will increase by $20,000 ($50,000 40%).
Here is the proof:
The Variable Expense Ratio
The variable expense ratio is the ratio of variable expenses tosales. It can be computed by dividing the total variable expenses bythe total sales, or in a single product analysis, it can be computedby dividing the variable expenses per unit by the unit selling price.
Total Per Unit CM Ratio
Sales (500 bicycles) 250,000$ 500$ 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 200$ 40%
Less: Fixed expenses 80,000
Net operating income 20,000$
Racing Bicycle Company
Contribution Income Statement
For the Month of June
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A shortcut solution using incrementalanalysis
Increase in CM (40 units X $200) 8,000$
Increase in advertising expenses 10,000
Decrease in net operating income (2,000)$
Changes in Fixed Costs and Sales Volume
Change in Variable Costs and Sales Volume
What is the profit impact if Racing Bicycle can
use higher quality raw materials, thus increasingvariable costs per unit by $10, to generate an
increase in unit sales from 500 to 580?
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500 units 580 units
Sales 250,000$ 290,000$
Less: Variable expenses 150,000 179,800
Contribution margin 100,000 110,200
Less: Fixed expenses 80,000 80,000
Net operating income 20,000$ 30,200$
580 units $310 variable cost/unit = $179,800
Sales increaseby $40,000, and net operating
income increasesby $10,200.
Change in Variable Costs and Sales Volume
Change in Fixed Cost, Sales Price
and Volume
What is the profit impact if RBC: (1) cuts its
selling price $20 per unit, (2) increases its
advertising budget by $15,000 per month, and (3)increases sales from 500 to 650 units per month?
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Sales increaseby $62,000, fixed costs increase by $15,000, and
net operating income increasesby $2,000.
Change in Fixed Cost, Sales Price and Volume
500 units 650 units
Sales 250,000$ 312,000$
Less: Variable expenses 150,000 195,000
Contribution margin 100,000 117,000
Less: Fixed expenses 80,000 95,000
Net operating income 20,000$ 22,000$
650 units $480 = $312,000
Change in Variable Cost, Fixed Cost
and Sales Volume
What is the profit impact if RBC: (1) pays a $15 salescommission per bike sold instead of paying
salespersons flat salaries that currently total $6,000 permonth, and (2) increases unit sales from 500 to 575
bikes?
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Sales increaseby $37,500, fixed expenses decreaseby $6,000.
Net operating income increasesby $12,375.
500 units 575 units
Sales 250,000$ 287,500$
Less: Variable expenses 150,000 181,125
Contribution margin 100,000 106,375
Less: Fixed expenses 80,000 74,000
Net operating income 20,000$ 32,375$
575 units $315 = $181,125
Change in Variable Cost, Fixed Cost
and Sales Volume
Change in Regular Sales Price
If RBC has an opportunity to sell 150 bikes toa wholesaler without disturbing sales to other
customers or fixed expenses, what price wouldit quote to the wholesaler if it wants to
increase monthly profits by $3,000?
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Change in Regular Sales Price
3,000$ 150 bikes = 20$ per bike
Variable cost per bike = 300 per bike
Selling price required = 320$ per bike
150 bikes $320 per bike = 48,000$
Total variable costs = 45,000
Increase in net operating income = 3,000$
Target Profit Analysis
Suppose Racing Bicycle management wants
to know how many bikes must be sold toearn a target profit of $100,000.
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Target Profit Analysis in Terms of Unit Sales
Suppose Racing Bicycle Company wants to know
how many bikes must be sold to earn a profit of
$100,000.
Target profit + Fixed expenses
CMper unit=
Unit sales to attain
the target profit
Unit sales = 900
$100,000 + $80,000$200Unit sales =
Target Profit Analysis in Terms of Dollar Sales
We can calculate the dollar sales needed to attain atarget profit (net operating profit) of $100,000 at
Racing Bicycle.
Target profit + Fixed expenses
CM ratio=
Dollar sales to attain
the target profit
Dollar sales = $450,000
$100,000 + $80,00040%
Dollar sales =
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Break-even Analysis
The equation and formula methods can be used to
determine the unit sales and dollar sales needed to achieve
a target profit of zero. Lets us the RBC information to
complete the break-even analysis.
Total Per Unit CM Ratio
Sales (500 bicycles) 250,000$ 500$ 100%
Less: Variable expenses 150,000 300 60%Contribution margin 100,000 200$ 40%
Less: Fixed expenses 80,000
Net operating income 20,000$
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Break-even in Unit Sales
Lets apply this formula to determine the break-
even point.
Unit sales = 400
$80,000$200
Unit sales =
Fixed expenses
CMper unit=
Unit sales to
break even
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Break-even in Dollar Sales:
Formula MethodNow, lets use the formula method to calculate the dollar
sales at the break-even point.
Dollar sales = $200,000
$80,00040%Dollar sales =
Fixed expenses
CM ratio=
Dollar sales to
break even
$0
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
0 100 200 300 400 500 600
Sales
Total expenses
Fixed expenses
Preparing the CVP Graph
Break-even point
(400 units or $200,000 in sales)
UnitsLoss Area
Profit Area
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The Margin of Safety in Dollars
The margin of safety in dollars is the excess of
budgeted (or actual) sales over the break-even
volume of sales.
Margin of safety in dollars = Total sales - Break-even sales
Lets look at Racing Bicycle Company and
determine the margin of safety.
The Margin of Safety in Dollars
If we assume that RBC has actual sales of $250,000, giventhat we have already determined the break-even sales tobe $200,000, the margin of safety is $50,000 as shown.
Break-even
sales
400 units
Actual sales
500 units
Sales 200,000$ 250,000$
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income -$ 20,000$
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The Margin of Safety Percentage
RBCs margin of safety can be expressed as
20%of sales. ($50,000 $250,000)
Break-even
sales
400 units
Actual sales
500 units
Sales 200,000$ 250,000$
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000Less: fixed expenses 80,000 80,000
Net operating income -$ 20,000$
The Margin of Safety
The margin of safety can be expressed in terms of thenumber of units sold. The margin of safety at RBC is
$50,000, and each bike sells for $500; hence, RBCsmargin of safety is 100 bikes.
Margin ofSafety in units
= = 100 bikes$50,000
$500
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Operating Leverage
Operating leverage is a measure of how sensitive net operatingincome is to percentage changes in sales. It is a measure, atany given level of sales, of how a percentage change in sales
volume will affect profits.
** Profit Before Tax is a commonly used alternative to Net Operating Income
in the degree of operating leverage calculation
**IncomeOperatingNet
MarginonContributiLeverageOperatingofDegreeDOL
Operating Leverage
Actual sales
500 Bikes
Sales 250,000$Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income 20,000$
$100,000
$20,000 = 5
Degree of
Operating
Leverage=
To illustrate, lets revisit the contribution income
statement for RBC.
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Operating Leverage
With an operating leverage of 5, if RBC increases its
sales by 10%, net operating income would increase
by 50%.
Percent increase in sales 10%
Degree of operating leverage 5
Percent increase in profits 50%
Heres the verification!
Operating Leverage
Actual sales
(500)
Increased
sales (550)
Sales 250,000$ 275,000$
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net operating income 20,000$ 30,000$
10% increase in sales from
$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.
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What does higher value of Operating
Leverage mean?
High Operating Leverage ratiosignals the existence of high fixed costs.
increases risk of making loss in adverse market conditions.
increases opportunity to make profit when higher demandexists.
has lower margin of safety percentage (MoS%)
MoS%1DOL
The Concept of Sales Mix
Sales mix is the relative proportion in which acompanys products are sold.
Different products have different selling prices, cost
structures, and contribution margins.When a company sells more than one product, break-
even analysis becomes more complex as the followingexample illustrates.
Lets assume Racing Bicycle Company sells bikes andcarts and that the sales mix between the two products
remains the same.
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Key Assumptions of CVP Analysis
Selling price is constant.
Costs are linear and can be accurately divided intovariable (constant per unit) and fixed (constant in total)elements.
In multiproduct companies, the sales mix is constant.
In manufacturing companies, inventories do not
change (units produced = units sold).
Homework
Exercises 4-12; 4-13; 4;15; 4-16; 4-18
Problems 4-19; 4-22; 4-23; 4-27; 4-28
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Lecture 4:
Relevant Costs for Decision
Making
Learning Objectives
1. Understand the concepts of relevant costs andbenefits.
2. Identify and apply relevant costs and benefits, in avariety of business decisions
a. Make or buy.
b. Drop or retain a business segment.
c. Accept or reject a special order.
d. Determine the most profitable use of a constrained resources.
e. Sell or process further.
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Cost Concepts for Decision Making
A relevant costis a cost that differs between
alternatives.
Is sunk cost a relevant cost?
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Is opportunity cost a relevant cost?
Relevant Cost Analysis: A Two-Step Process
Eliminate costs and benefits that do not differ
between alternatives.
Use the remaining costs and benefits that differbetween alternatives in making the decision. The
costs that remain are the differential, or avoidable,
costs.
Step 1
Step 2
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Adding/Dropping Segments
Due to the declining popularity of digital
watches, Lovell Companys digital watch
line has not reported a profit for several
years. Lovell is considering discontinuing
this product line.
Adding/Dropping SegmentsSegment Income Statement
Digital Watches
Sales 500,000$
Less: variable expenses
Variable manufacturing costs 120,000$
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin 300,000$
Less: fixed ex penses
General factory overhead 60,000$
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000Net operating loss (100,000)$
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The Make or Buy Decision
When a company is involved in more than oneactivity in the entire value chain, it is verticallyintegrated. A decision to carry out one of the
activities in the value chain internally, rather thanto buy externally from a supplier is called a
make or buy decision.
The Make or Buy Decision: An Example
Essex Company manufactures part 4A that is used inone of its products.
The unit product cost of this part is:
Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10Unit product cost 30$
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The Make or Buy Decision
The special equipment used to manufacture part 4A has noresale value.
The total amount of general factory overhead, which isallocated on the basis of direct labor hours, would beunaffected by this decision.
The $30 unit product cost is based on 20,000 partsproduced each year.
An outside supplier has offered to provide the 20,000 partsat a cost of $25 per part.
Should we accept the suppliers offer?
The Make or Buy Decision
The avoidable costsassociated with making part 4A include direct
materials, direct labor, variable overhead, and the supervisors salary.
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000
Direct materials (20,000 units) 9$ 180,000
Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -Total cost 30$ 340,000$ 500,000$
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Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000
Direct materials (20,000 units) 9$ 180,000
Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -Total cost 30$ 340,000$ 500,000$
The Make or Buy Decision
The depreciation of the special equipment represents a sunk cost.The equipment has no resale value, thus its cost and associated
depreciation are irrelevant to the decision.
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000
Direct materials (20,000 units) 9$ 180,000
Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -Total cost 30$ 340,000$ 500,000$
The Make or Buy Decision
Not avoidable; irrelevant. If the product is dropped, it
will be reallocated to other products.
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The Make or Buy Decision
Should we make or buy part 4A?Given that the total avoidable costsare less than the cost of buying the part, Essex should continue to
make the part.
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000
Direct materials (20,000 units) 9$ 180,000
Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost 30$ 340,000$ 500,000$
Opportunity Cost
Anopportunity cost is the benefit that is foregone as a
result of pursuing some course of action.
Opportunity costs are not actual cash outlays and are
not recorded in the formal accounts of anorganization.
How would this concept potentially relate to the Essex
Company?
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Key Terms and Concepts
A special order is a one-time order
that is not considered part of the
companys normal ongoing
business.
When analyzing a special order,
only the incremental costs and
benefits are relevant.
Since the existing fixedmanufacturing overhead costs
would not be affected by the
order, they are not relevant.
Special Orders
Jet Corporation. makes a single product whose normal
selling price is $20 per unit.
A foreign distributor offers to purchase 3,000 units for $10
per unit.This is a one-time order that would not affect the
companys regular business.
Annual capacity is 10,000 units, but Jet Corporation is
currently producing and selling only 5,000 units.
Should Jet accept the offer?
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Special Orders
Jet Corporation
Contribution Income Statement
Revenue (5,000 $20) 100,000$
Variable costs:
Direct materials 20,000$
Direct labor 5,000
Manufacturing overhead 10,000
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead 28,000$
Marketing costs 20,000
Total fixed costs 48,000Net operating income 12,000$
$8 variable cost
Special Orders
If Jet accepts the special order, the incremental revenuewill exceed the incremental costs. In other words, netoperating income will increase by $6,000. This suggests
that Jet should accept the order.
Increase in revenue (3,000 $10) 30,000$
Increase in costs (3,000 $8 variable cost) 24,000Increase in net income 6,000$
Note: This answer assumes that the fixed costs areunavoidableand that variable marketing costs must be
incurred on the special order.
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Utilization of a Constrained Resource
When a limited resource of
some type restricts the
companys ability to satisfy
demand, the company is said to
have a constraint.
The machine or process
that is limiting overalloutput is called the
bottleneckit is the
constraint.
Fixed costs are usually unaffected in these situations,so the product mix that maximizes the companys total
contribution margin should ordinarily be selected.
A company should not necessarily promote thoseproducts that have the highest unit contribution
margins.
Rather, total contribution margin will be maximized bypromoting those products or accepting those orders
that provide the highest contribution margin in relation
to the constraining resource.
Utilization of a Constrained Resource
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Utilization of a Constrained Resource:
An ExampleEnsign Company produces two products and selected data
are shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit 24$ 15$
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.
Machine A1 is the constrained resource and isbeing used at 100% of its capacity.
There is excess capacity on all other machines.
Machine A1 has a capacity of 2,400 minutes perweek.
Should Ensign focus its efforts on Product1 or Product 2?
Utilization of a Constrained Resource:
An Example
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Utilization of a Constrained Resource
The key is the contribution margin per unit of theconstrained resource.
Ensign should emphasize Product 2because it generates
a contribution margin of $30 per minute of the
constrained resource relative to $24 per minute for
Product 1.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time re quired to produce one unit 1.00 min. 0.50 min.
Contribution margin per minute 24$ 30$
Utilization of a Constrained Resource
Ensign can maximize its contribution margin by
first producing Product 2to meet customer demand
and then using any remaining capacity to produce
Product 1. The calculations would be performed as
follows.
The key is the contribution margin per unit of the
constrained resource.Product
1 2Contribution margin per unit $ 24 $ 15
Time re quired to produce one unit 1.00 min. 0.50 min.
Contribution margin per minute 24$ 30$
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Utilization of a Constrained Resource
According to the plan, we will produce 2,200 units of
Product 2 and 1,300 of Product 1. The
contribution margin looks like this.
Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit 24$ 15$
Total contribution margin 31,200$ 33,000$
The total contribution margin for Ensign is $64,200.
In some industries, a number of end products
are produced from a single raw material input.
Two or more products produced from acommon input are called joint products.
The point in the manufacturing process where
each joint product can be recognized as a
separate product is called the split-off point.
Sell or Process Further
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SeparateProcessing
Separate
Processing
Final
Sale
Final
Sale
FinalSale
Separate
Product
Costs
JointInput
CommonProduction
Process
Split-Off
Point
Oil
Gasoline
Chemicals
Joint costs
are incurredup to the
split-off point
Sell or Process Further
Sell or Process Further: An Example
Sawmill, Inc. cuts logs from which unfinished lumberand sawdust are the immediate joint products.
Unfinished lumber is sold as is or processed furtherinto finished lumber.
Sawdust can also be sold as is to gardening
wholesalers or processed further into presto-logs.
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Sell or Process Further
Data about Sawmills joint products includes:
Per Log
Lumber Sawdust
Sales value at the split-off point 140$ 40$
Sales value after further processing 270 50
Allocated joint product costs 176 24
Cost of further processing 50 20
Sell or Process Further
The lumber should be processedfurther and the sawdust should be
sold at the split-off point.
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Sales value after further processing 270$ 50$
Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20Profit (loss) from further processing 80$ (10)$
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Homework
Exercises 14-2; 14-3; 14-4; 14-5; 14-6; 14-7; 14-9; 14-11; 14-12; 14-13; 14-14; 14-15; 14-17