managerial accounting 07

60
he lnternet boom of the 1990s led many entrepreneurs to believe that they couldearn profits well abovethose of traditional retail stores by avoiding the highfixed costs of brick-and-mortar retail outlets. Online business flourished for a while, but when the dot.com bubble burst, many of these Internet dreams died. Many, but not all. Consider art.com, an e-tail business that offers over 100,000 different prints, pho- tos, and posters to customers ranging from budget-minded college stu- dentsto professional decorators searching for high-end art. Founded in 1995, art.com hasenjoyed positive cash flows and double-digit revenue growth since 2000.In 2003, Deloitte & Touche named art.com one of the fastest-growing tech companies in America. lt attracts more than a mil- lion people to its award-winning Web site eachmonth. Eventhough art.comdoesn'tface the fixed costsof traditional retailoutlets,it still incurs fixed costs tied to its Web site and its custom- framing facilities. lt also incurs variable costs for each piece of art.The bot- tom line: e-tail or retail, every business faces fixed and variable costs, and L-r'{.ruca yavr lporeo $earch 0ver300,0tr0 prints: i Novr ts ftrt,cofn? $tart here Explore I 0000+ Subjects ' Antm,ils . Arcliitectrlr e r Children . Cultures . Edr:cati*nal , Fant.tst, * f'lnti'/stiilndl . morE... fir"0(,rseT$0fl+ n*istr $ Addfil$ . Sali + l"lofiet * O'K*eff,* . Fic*ss,r + tr** Goqh | 'rlt ,irh$l . n.rr)r*. ,, S*e our Collecti0nf n Thomas KirikBd* C,ri{eftion r {,xn'rds Translars * tJinteqe 0riginel Flsters . lland C+l,lr"ed Fri*ts " Lirnit*d tditinns ' 5F*cinltT Fri*ti r rft*f&. ,, Sriginal Art & Fhotography " fllnd r:rigin+lart € 8,ro+!se $Ele[t Pffnt' * lnir' tlAP rr*w, it's frg*l :: t\.. ,, ;,i' ';,; 'rir';;,i '" ll lJ,il ,,ll;',' WHfla,Jr,rr,c4,j,i":+,rh guhjerts Mistl , Colterlliflns , Besl$sllers Bring your"favorite ortio life onCANVAS

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he lnternet boom o f t h e 1 9 9 0 s le d ma n y e n t re p re n e u rso t believe that they couldearn profitswell abovethose of traditional retail storesby avoiding the high fixed costsof brick-and-mortar retailoutlets. On line business flourished for a wh ile , b u t wh e n t h e d o t . c o m b u b b le burst, many of these Internetdreamsdied. Many,but not all. Consider art.com, e-tailbusiness an that offersover 100,000 differentprints,photos, and postersto customers rangingfrom budget-minded collegestudentsto professional decorators searching high-end for art. Foundedin 1995,art.comhasenjoyedpositivecashflows and double-digit revenue growth since2000.In 2003,Deloitte& Touche namedart.comone of the fastest-growing tech companies America.lt attractsmore than a milin lion peopleto its award-winning Web site eachmonth. Eventhough art.comdoesn'tface the fixed costsof traditional retailoutlets,it still incursfixed coststied to its Web site and its customframing facilities. alsoincurs lt variable costs eachpieceof art.The botfor tom line:e-tailor retail, everybusiness facesfixed and variable costs, andL-r'{.ruca yavr lporeo

$earch 0ver300,0tr0 i prints:Novr ts ftrt,cofn? $tart here E x p l o r e I 0 0 0 0 + Su b je cts . Ar cliite ctre lr ' Antm,ils r Children . Cu ltu r e s . Edr:cati*nal , Fant.tst, * f'lnti'/stiilndl . morE... fir"0(,rseT$0fl+ n*istr $ Addfil$ . Sali + l"lofiet * O'K*eff,* . Fic*ss,r + tr ** Go q h | 'rlt . n.rr)r*. ,irh$l ,, S * e o u r C o l l e c ti0 n f n T h o m a s K i r i kBd *C,r i{ e ftio n r {,xn'rds Translars * tJinteqe0riginel Flsters . lland C+l,lr"ed Fri*ts " Lirnit*d tditinns Fri*ti ' 5F*cinltTr rft*f&. ,,

::t\.. ,,;,i' ';,;

'rir';;,i '" ll lJ,il,,ll;','

guhjerts WHfla,Jr,rr,c4,j,i":+,rh Mistl , ColterlliflnsBesl$sllers ,

Bringyour"favorite io lifeonCANVAS ort

Sriginal Art & Fhotography art " fllnd r:rigin+l Pffnt' 8,ro+!se $Ele[t * lnir' tlAP rr*w, it's frg*l

Chapter7

the company,how did art.com is no exception.Beforethey launched volumethey hadto reachto break figureout what sales art.commanagers their target even?How did they forecastthe volume neededto achieve to And asthe companycontinues operate,how do managers profit levels? changing variable and fixed business conditions, respondto fluctuating costs, and pricing pressurefrom new competitors?Cost-volume-profit (CVP) answersuchquestions. W helpsmanagers analysis

LearningObjectivesffi C"l.ulate the unit contributionmarginand the contributionmarginratio

ffi ffi ffi ffi

points andtargetprofitvolumes analysis find breakeven to Ut" CVP in business conditions to eerform sensitivity analysis response changing for companies rina breakeven targetprofitvolumes multiproduct and of and leverage O"t"rrine a firm'smargin safety operating

ffinthe last chapter, we discussedcost behavior patterns and methods managers use to determine how their costs behave. We showed how managers use the contribution margin income statement to separately display the firm's variable and fixed costs. In this chapter, we show how managers identify the volume of salesnecessary to achieve breakeven and target profit levels. !7e also look at how changesin costs, salesprice, and volume affect the firm's profit. Finally, we discussways to identify the firm's risk level, including ways to gauge how easily a firm's profits could turn to loss if salesvolume declines.

I

Analysis How Does Cost-Volume-Profit Help Managers?Cost-volume-profit, or CVP, analysis is a powerful tool that helps managers make important business decisions. Cost-volume-profit analysis expressesthe relationships among costs,volume, and profit or loss. For example, at art.com, managersneed to determine how many pieces of art the company must sell each month just to cover costs or to break even. CVP can provide the answer. CVP also helps art.com's managers determine how many pieces of art the company must sell to earn a target profit, such as $1,000,000 per month. And if costsor salespriceschange,CVP can help managers decide how salesvolume would need to change to achieve the same profit level. However, to use CVP, managers need certain data. They must also make sure the data are consistent with the assumptions underlying CVP analysis. In addition, managersneed a solid understanding of the contribution margin concept introduced in the last chapter. In this section, we'll take a look at the data requirements, assumptions, and contribution margin in more detail.

Cost-Volume-ProfAnalysis it

361

Data Requinedfor Effective CVP AnalysisCVP analysis relies on the interdependency of five components, or pieces of information. shown in Exhibit 7-1.

Components CVPAnalysis of

tilill'

If you know or can estimate four of these five components, you can use CVP analysis to compute the remaining unknown amount. Therefore, CVP helps managers discover how changes in any of these components will affect their business. Becausebusinessconditions are always changing, CVP helps managers prepare for and respond to economic changes.Now, let's review the assumptions required for CVP analysis.

CVPAssumptionsCVP analysis assumesthat: 1. A change in volume is the only factor that affects costs. 2, Managers can classify each cost (or the components of mixed costs) as either variable or fixed. These costs are linear throughout the relevant range of volume. 3. Revenuesare linear throughout the relevant range of volume. 4. Inventory levels will not change. 5. The sales mix of products will not change. Salesmix is the combination of products that make up total sales.For example, art.com may sell 157o posters, 25Yo unframed photographs, and 60%" fuamed prints. If profits differ across products, changesin salesmix will affect CVP analysis. Let's start by looking at a simple firm that has only one product. Later, we'll expand the firm to include a wider selection of products. Kay Pak, an entrepreneur, has just started an e-tail businessselling art posters on the Internet. Kay is a "virtual retailer" and carries no inventory. Kay's software tabulates all customer orders each day and then automatically places the order to buy posters from a wholesaler. Kay buys only what she needs to fill the prior day's sales orders. The posters cost $21 each, and Kay sells them for $35 each. Customers pay the shipping costs, so there are no other variable selling costs. Monthly fixed costs for server leasing and maintenance, software, and office rental total $7,000. Kay's relevant range extends from 0 to 2,000 posters a month. Beyond this volume, Kay will need to hire an employee and upgrade her \7eb site sofrware in order to handle the increased volume.

362

Chaoter7

Let's seeif Kay's businessmeets the CVP assumptions: 1. Salesvolume is the only factor that affects her costs. 2. The $21 purchase cost for each poster is a variable cost. Thus, Kay's total in uariable cosl increases direct proportion to the number of posters she sells (an extra $Zt in cost for each extra poster she sells). The $7,000 monthly server leasing and maintenance, software, and office rental costs are fixed and do not change no matter how many posters she sellswithin the relevant range. \7e could graph each of these costs as a straight line, so they are linear within the relevant range. 3. Kay's revenueis also lilear. She sellseach poster for $35, so a graph of her revenues is a straight line beginning at the origin (if she doesn't sell any posters, she won't have any revenue) that slopesupward at a rate of $35 per poster. 4. Kay has no inventory. If she did carry inventory, she wouldn't need to worry about this assumption as long as she didn't allow her inventory levels to fluctuate too much. 5. Kay sells just one size poster, so her salesmix is constant at 1.0004art posters. Later, we'll expand her product line to include two different size posters-each with a different salesprice and variable cost. The resulting CVP modification works for any firm that offers two or more products as long as it assumesthat salesmix will remain constant. Kay's businessmeets all five assumptions,so her CVP analysiswill be accurate. Becausemost business conditions do not meet these assumptions perfectly, managers regard CVP analysis as approximate, not exact.

$Wmn"gfiut Whm Mmf;* ffi.mrnffimffihwtfimmCalc ulat t he uni t e contribution margin and t he c ont r ibu ti o n m ar ginr at io The last chapter introduced the contribution margin income statement, which separates costs by behavior rather than function. Many managersprefer the contribution margin income statement becauseit gives them the information for CVP analysis in a "ready-to-use" format. On these income statements, the contribution margin is the "dividing line"-all variable expensesgo above the line, and all fixed expenses go below the line. The results of l(ay's first month of operations is shown in ExhtbitT-2.

Contribution

Sa le sr e ve n ue(550 posters).... L e ss:Va r ia b l e expenses Co n tr ib u tio n margi n............ L e ss:F ixe d expenses.......... Op e r a tin g income.............

$

19,250 (11,550 ) 7,700 (7,000 )

$

700

Notice that the contribution margin is the excessof salesrevenueover variable expenses.The contribution margin tells managers how much revenue is left-after paying variable expenses-f or contribwting toward covering fixed costs and then generating a profit. Hence the name contribution margin.

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363

The contribution margin is stated as a total amount on the contribution margin income statement. However, managers often state the contribution margin on a per unit basis and as a percentage,or ratio. A product's contribution margin per unitor unit contribution margin-is the excessof the selling price per unit over the variable cost of obtaining and sellingeach unit. Some businesses pay a salescommission on each unit or have other variable costs, such as shipping costs, for each unit sold. However, Kay's variable cost per unit is simply the price she pays for each poster. Therefore, her unit contribution margin is: price per poster... Sales Les s :V ar iab l e c o s t p e r p o s te r... Contribution margin per poster... .................;:; $35 (21) $;14

The unit contribution margin indicates how much profit each unit provides before fixed costs are considered. Each unit first contributes this profit toward covering the firm's fixed costs. Once the company sells enough units to cover its fixed costs,the unit contribution margin contributes directly to profit. For example, every poster Kay sellsgenerates$14 of contribution margin that can be used to pay for the monthly $7,000 of fixed costs. After l(ay sells enough posters to cover fixed costs, each additional poster she sellswill generate$14 of operating income. Managers can use the unit contribution margin to quickly forecast income at any volume within their relevant range. First, they project the total contribution margin by multiplying the unit contribution margin by the number of units sold. Then, they simply subtract fixed costs. For example, let's assumethat Kay hopes to sell 650 posters next month. She can project her operating income as follows: Contributionmargin (650 postersX $14 per poster) Less: Fixedexpenses Operating income.......... .. $9,100 (7,000) $2,100

If Kay sells650 postersnext month, her operating income should be $2,100.

The Ccnmtnthutf,mm gfir'n tV1an RmtimIn addition to computing the unit contribution margin, managers often compute the contribution margin ratio, which is the ratio of contribution margin to salesrevenue. Kay can compute her contribution margin ratio at the unit level as follows:q14 bJJ

Kay could also compute the contribution margin ratio using any volume of sales.Let's use her current salesvolume, pictured inExhlbit 7-2:

$7,700 $tq,zs0The 40% contribution margin ratio means that each $1.00 of salesrevenuecontributes $0.40 toward fixed expenses and profit, as shown in Exhibit 7-3.The remaining $0.60 of each salesdollar is used to pay for variable costs.The contribution margin ratio is the percentage of each sales dollar that is auailable for couering fixed expenses and generatinga profit.

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Chapter 7

Breakdown of $1 of Sales Revenue

Managers can also use the contribution margin ratio to quickly forecast operating income within their relevant range. \7hen using the contribution margin ratio, project income basedon sales managers dollars rather than salesunits.For example, what will I(ay's income be if salesrevenue reaches$70,000 one month? To find out, simply rnultiply projected salesrevenue by the contribution margin ratio to get the total contribution margin. Then, subtract fixed expenses: Contribution margin ($70,000 salesX 40o/.) = Less:Fixed expenses..... Operating income........ $28,000 (7,000) $Z1pg0

Let's verify. If I(ay has $70,000 of salesrevenue,she has sold 2,000 posters ($70,000 + $35 price per poster).Her completecontribution margin income statement would be calculatedas follows: Sa l e s v e n u e(2,000 postersx $3S /poster) re ................ (2,000 posters x $21lposter)........... Less:Variable expenses $70,000 (42,000)

C o n tri b u ti o n margi n (2,000 postersx $14l poster) ............... $28,000 Less:Fixed expenses..... Op e ra ti n gi n c ome........ (7,000) $21,000

The contribution margin per unit and contribution margin ratio help managers quickly and easily project income at different salesvolumes. However, when projecting profits, managersmust keep in mind the relevant range. For instance,if I(ay wants to project income at a volume of 5,000 posters, she shouldn't use the existing contribution margin and fixed costs. Her current relevant range extends to only 2,000 postersper month. At a higher volume of sales, her variable cost per unit may be lower than $21 (due to volume discountsfrom her suppliers)and her monthly fixed costsmay be higher than $7,000 (due to upgrading her systemand hiring an employeeto handle the extra salesvolume). Rather than use individual unit contribution margins on each of their products, Iarge companies that offer hundreds or thousands of products (like art.com) use their contribution margin ratio to predict profits. As long as the salesmix remains constant (one of our CVP assumptions), the contribution margin ratio will remain constant. 'We'veseenhow managersuse the contribution margin to project income; but managersuse the contribution margin for other purposestoo, such as motivating the sales force. Salespeople who know the contribution margin of each product can generatemore profit by emphasizinghigh-margin products. This is why many

Cost-Vol me-Prof Analvsis u it \ companies base sales commissions on the contribution margins produced by sales rather than on sales revenue alone. In the next section,we'll seehow managersuse the contribution margin in CVP analysis to determine their breakeven point and to determine how many units they need to sell to reach target profits.

365

UsingCVPAnalysisto Find the BreakevenPointA company's point is the saleslevel at which operatingincomeis zero. breakeven Sales below the breakeven point result in a loss. Sales point abovethe breakeven provide a profit. BeforeKay startedher business, wanted to figure out how she many posters would haveto selljust to breakeven. she Therearethreewaysto calculate breakeven point. AII of the approaches the are based the incomestatement, they all reachthe sameconclusion. on so The first two methods find breakeven termsof sales in finds breakeven wnits.Thelast approach in terms of sales dollars. 1. The incomestatement approach 2. The shortcut approachusing the wnit contribution margin 3. The shortcutapproach usingthe contribution marginratio Let'sexamine these threeapproaches detail. inUseCVPanalysis to find breakeven points and target profit vol umes

The Income StaternentApproachThe income statement approach simply breaks the income statement equation into smaller components:

Let'susethis approachto find Kay's breakeven point. Recallthat Kay sellsher postersfor $35 each and that her variablecost is $21 per poster.Kay's fixed expenses total $7,000.At the breakeven point, operating incomeis zero.Weusethis informationto solvethe incomestatement equationfor the numberof posters Kay must sellto breakeven.

($:s($3s

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Chapter 7

point in sales to Kay must sell500 posters breakeven.Her breakeven dollarsis (500posters $35). x $17,500 the numberof units into the You cancheckyour answerby substituting breakeven that this levelof sales resultsin zero profit: incomestatement and checkine (500posters $35)........ x revenue Sales (500posters $21) x Variable expenses Less: Contributionmargin Fixedexpenses..... Less; Operatingincome........ . $ (7,000) 0 $tZ,50O (10,500)

a equalits contributionmargin. Notice that at breakeven, firm's fixed expenses just In other words, the firm hasgenerated enoughcontributionmargin to coverits (but to fixed expenses not enough generate profit). a

The ShortcutApproachUsingthe UnitMfimngf;n ffiontributimmThe shortcut method simply rearrangesthe income statement equation and isolates "Units sold" on the left: = income Sales revenue Variableexpenses Fixedexpenses Operating Contributionmargin = - Fixedexpenses Operating income= Fixed expenses+ Operating income

(Contribution per margin unit x Unitssold)

Dividing both sidesof the equationby contributionmargin per unit yieldsthe shortcutmethod:salesin ,rnrr,Fixgl expjnses operatingincome + uontnDutlonmargmper unlt

Kay can use this shortcut method to find her breakeven point in units. Kay's fixed expensestotal $7,000, and her unit contribution margin is $14. At the breakeven point, operating income is zero. Thus, Kay's breakevenpoint in units is: $7,000+ $0 ., satesn unrts= l g14 = 50Spqrsters Why does this shortcut method work? Recall that each poster provides $14 of contribution margin. To break even, Kay must generateenough contribution margin to cover $7,000 of fixed expenses.At the rate of $14 per poster, Kay must sell Because the short500 posters($7,000/$14)to cover her $7,000 of fixed expenses. method simply rearrangesthe income statement equation, the breakevenpoint is cut the sameunder both methods (500 posters).

Cost-Volume-Profit Analvsis

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