ACCT 2302 Fundamentals of Accounting II Spring 2011 Lecture 7 Professor Jeff Yu

1. ACCT 2302 Fundamentals of Accounting II Spring 2011 Lecture 7 Professor Jeff Yu

2. Used primarily forexternal reporting Used primarily for Managerial Decision making Review: The Contribution Format Income Statement

3. Review: The Contribution Margin Method

4. Review: The Equation Method Let B.E.P. in units = X Sales – Variable Expenses – Fixed Expenses = NOI $$$ $0 VC/unit * X Price * X B.E.P in sales dollars = B.E.P. in Units * Price

5. CVP Analysis: Changes in Break-even Point • How can a company change its break-even point? 1. If fixed costs change by X%, then break-even point would also change by X% (assuming everything else remains constant) 2. An increase or decrease in CM per unit will also change break-even point.

6. CVP Analysis: predicting profit • Expected profit (NOI) may change due to: • a change in fixed expenses • a change in CM per unit (=price - VC/unit) • a change in sales volume: • once the break-even point has been reached, NOI will increase by CM per unit for each additional unit sold. • Two approaches to predict profit using CVP analysis: • Income Statement approach • Incremental approach

7. Example Razor Inc. is currently selling 500 scooters per month. The owner believes that an increase of $10,000 in the monthly advertising budget would increase sales of scooters to 540 per month. Q: Should the increase in advertising be made?

8. Margin of Safety The amount by which sales can drop before losses are incurred. Margin of Safety in units = Budgeted or actual units sold – Break-even point in units Margin of Safety in sales dollars = Budgeted or actual sales – Break-even point in sales dollars Margin of Safety percentage = Margin of Safety in units / Budgeted or actual units sold = Margin of Safety in sales dollars / Budgeted or actual sales

9. Coffee Klatch is an espresso stand in a downtown office building. The price of a cup of coffee is $1.5 and the variable expense per cup is $0.36. The fixed expense per month is $1,140. Each month 2,000 cups are sold. Q: (1) What is the margin of safety in cups? (2) Margin of safety in sales dollars? (3) Margin of safety percentage? Example

10. A measure of how sensitive net operating income is to percentage changes in sales. Degree of Operating Leverage Contribution Margin Net operating income = Operating Leverage Thought Question: How will cost structure (relative proportion of fixed costs) or sales volume affect the degree of operating leverage?

11. Example Q: (1) What is the degree of operating leverage? (2) If sales increase by 10%, net operating income will increase by ___%?

12. Sales Mix and Break-even Analysis • The sales mix is the relative proportions in which a company’s multiple products are sold. Profits will often be greater if high-margin items make up a larger proportion of total sales. • For simplicity, we assume sales mix is always CONSTANT, that is, the relative proportions of each product as a percentage of total sales do not change as sales volume changes.

13. Example Okabee Co. makes two products: A100 & B900. Q: Based on the current sales mix, (1) What is its break-even point in total sales dollars? (2) Prepare a contribution format income statement for Okabee. (3) If sales increase by $50,000 per month, by how much would you expect net operating income to increase?

14. Practice Problem Razor sells scooters and bicycles. Total fixed cost is $95,000. Q: What is Razor’s breakeven point based on the current sales mix (for every 1 bicycle sold, 2 scooters are sold)?

15. For Next Class • Review for Midterm Exam 1

16. Homework Problem 1 Acoustic Concepts is currently selling 400 speakers per month; monthly sales are $100,000. Variable cost per speaker is 60% of the speaker price. The sales manager feels that a $10,000 increase in the monthly advertising budget would increase monthly sales by $30,000. Q: Should the advertising budget be increased?

17. Homework Problem 2 In 2008, Voltar Co. sold 20,000 units of a special telephone at $60 each, variable expenses were $900,000 and fixed expenses were $240,000. Q:(1) Sales are expected to increase by $400,000 in 2010. If cost behavior remain unchanged, by how much will NOI increase in 2010? (2) Compute its margin of safety in dollars and percentages. (3) Compute its degree of operating leverage at current sales volume. (4) If sales increase by 8% in 2011, by what % will NOI increase? (5) If a high-quality speaker is used, annual sales will increase by 20%, variable cost will increase by $3 per unit, but annual salary of $30,000 paid to one quality inspector can be eliminated. Should the change be made?

18. Homework Problem 3 Pittman Co. produces two products, A and B. Product A accounts for 20% of total sales, while B accounts for 80% of sales. Variable expense ratios are 75% for A and 50% for B. Pittman’s total fixed cost is $90,000. Q: Based on the current sales mix, (1) What is its break-even point in total sales? (Hint: CM ratio = 1 – variable expense ratio) (2) Assume the unit price of product B is $24, how many units of B should Pittman sell to break even?