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# Exam II Review Notes

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Management Accounting D. Vance Copyright 2007 1 Exam II Review Notes THIS EXAM ONLY INCLUDES MATERIAL THROUGH CHAPTER SEVEN 1. Types of Costs There are two major types of costs. a. Full Absorption Cost (FAC) is cost derived by ..

Management Accounting D. Vance Copyright 2007

Exam II Review Notes

THIS EXAM ONLY INCLUDES MATERIAL THROUGH CHAPTER SEVEN

1. Types of Costs

There are two major types of costs.

a. Full Absorption Cost (FAC) is cost derived by using Generally Accepted Accounting Principals (GAAP). It is used to value COGS on the income statement and inventory on balance sheets. GAAP accounting is based on historical costs. GAAP reporting is historical in nature.

b. Variable Cost accounting focuses on separating costs into fixed and variable costs. Variable cost accounting is used to help management make better decisions. This implies it is about the future and not the past. It is not constrained by historical costs. It uses the best estimates available of future costs and revenues.

2. Full Absorption Cost

FAC = Direct Materials (DM)

+ Direct Labor (DL)

Fixed factory overhead are costs which are incurred whether a factory produces 0, 100 or 10,000 units. That is it does not change with production volume over very wide ranges.

The concept of FFOH as a component of product cost has no meaning unless one knows the budgeted or estimated number of units a company will produce.

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Management Accounting D. Vance Copyright 2007 4. Computation of Fixed Factory Overhead

A company leases a factory for \$40,000. Depreciation on the equipment is \$5,000. Real estate taxes and insurance on the building are \$14,000 and \$6,000. Direct labor is \$3.00 per unit; Direct material is \$5.00 per unit. Inputs which vary with manufacturing volume like electricity and fuel oil are \$10,000 and \$5,000 per month when the factory is running at full capacity of 150,000 units and zero when the factory is not running. Gosh! This sounds like variable costs are about \$0.10 per unit (\$15,000/150,000). The factory expects to produce 100,000 sets of brake pads this month.

What FFOH should be applied to every set of brake pads?

Fixed Factory Overhead Costs = \$40,000 lease

+ \$5,000 depreciation

+ \$14,000 Real estate taxes

+ \$6,000 insurance

= \$65,000

FFOH = \$65,000 fixed costs / 100,000 units = \$0.65/unit.

FAC = \$3.00 DL + \$5.00 DM + \$0.10 VFOH + \$0.65 FFOH

= \$8.75

Consider this: If the plant capacity is 200,000 units and the variable cost when the plant is running at full capacity is \$20,000, what is the VFOH? Wouldn’t it be \$20,000/200,000 = \$0.10? Now suppose the plant is running at a production level of 100,000 units, wouldn’t VFOH still be \$0.10?

5. Variable Costs (VC)

VC = DL + DM + VFOH + Variable Admin & Selling Costs

Variable selling costs often include things like sales commissions.

Variable administrative costs are rarer, but sometimes occur.

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Management Accounting D. Vance Copyright 2007 6. Gross Profit

Gross profit can be computed at the level of a unit as well as for a whole company. It is the amount of sales dollars left over after the cost of an item or service is deducted.

Gross Profit = Price - Unit Cost

7. Contribution

Contribution is the amount that is left over after variable costs are subtracted from sales. It can be computed at the level of an item or at a company level.

Contribution = Price - Variable Costs

8. Gross Margin

Gross Margin is Gross Profit as a percentage of sales.

Gross Margin for a company GM = (Sales COGS)/Sales

Gross Margin for a product GM = (Price Unit Cost)/Price

9. Contribution margin is the percent of sales left over after variable costs are covered.

Contribution Margin for a company CM = (Sales VC) / Sales

Contribution Margin for a product CM = (Price Unit VC) / Price

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Management Accounting D. Vance Copyright 2007 10. Example: A company makes and sells 10,000 brief cases for \$30 each. DL is \$5, DM is \$7, VFOH is \$2, Variable selling costs \$1. Fixed factory overhead is \$40,000. What is: a. Full Absorption cost per unit? b. Variable unit cost? c. Gross profit per unit? d. Contribution per unit? e. Gross profit per unit? Contribution margin per unit? f. Gross profit? g. Contribution? h. Gross profit for the company? i. Contribution margin for the company?

Per Unit: FAC VC

Price \$30 \$30

DL 5 5

DM 7 7

VFOH 2 2

FFOH (\$40,000/10,000) 4

Variable Selling 1

Unit Cost \$18 \$15

Gross profit per unit \$12

Contribution per unit \$15

Gross margin per unit = 40.0% (\$30 - \$18) / \$30

Contribution margin per unit = 50% (\$30 -\$15) / \$30

Company Wide: GAAP VC

Sales \$300,000 \$300,000

COGS \$180,000

Variable Costs \$150,000

Gross Profit \$120,000

Contribution \$150,000

Gross margin (GM) = 40.0% (\$300,000 - \$180,000) / \$300,000 THIS IS ALWAYS STATED AS A PERCENT. STATED AS A DECIMAL IT IS WRONG, 0.40 IS WRONG

Contribution Margin (CM) = 50.0% (\$300,000 -\$150,000)/\$300,000 THIS IS ALWAYS STATED AS A PERCENT. STATED AS A DECIMAL IT IS WRONG. 0.50 IS WRONG.

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Management Accounting D. Vance Copyright 2007 11. Break-even Analysis

Break-even analysis is a way to model decisions, set targets and generally understand the relationship between cost, profit and volume. Break-even is defined as the volume at which profit is zero. Here profit means income before interest and taxes.

0 = P * U - VC * U - FC

Where P is unit price, U is number of units, VC variable costs per unit and FC is total fixed costs.

Factoring U out of the first and second terms give the following:

0 = (P VC) * U - FC

The term (P VC) is so important it has a name. It is called the Contribution. Sound familiar?

12. Example: Rupert produces shirts which he sells wholesale for \$9 each. His variable costs are \$3. His fixed costs are \$8,000 per month. How many shirts must Rupert make and sell to break even?

0 = (\$9 - \$3) * U - \$8,000

\$8,000 = \$6 * U

\$8,000/6 = U

U = 1,333

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Management Accounting D. Vance Copyright 2007 13. Modeling Profit

Loretta invests in Rupert’s shirt company. But Loretta expects Rupert to generate \$10,000 profit. In modeling his business plan, Rupert can treat his profit target as though it were another fixed cost. How many shirts must Rupert make and sell to hit his profit target?

New FC = \$8,000 Old FC + \$10,000 Profit Target

= \$18,000

0 = (\$9 - \$3) * U - \$18,000

\$18,000 = \$6 * U

U = \$18,000 / \$6

= 3,000

14. Substituting Fixed Costs for Variable Costs

Rupert buys a machine that costs \$2,000 per month, but saves \$.50 per shirt in variable costs. What is Rupert’s new break even?

0 = (\$9 - \$2.50) * U - \$20,000

\$20,000 = \$6.50 * U

U = \$20,000 / \$6.50

= 3,077

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Management Accounting D. Vance Copyright 2007 15. General Rules

a. Generally, lower break even is better than higher break even because there are no production “profit” until break even is exceeded.

b. The exception is that where anticipated production far, far exceeds break even, then increasing fixed costs might be a good trade off for increasing the contribution on each unit.

In the prior example, Rupert increased fixed costs \$2,000 per month in return for an increase of contribution of \$0.50 per shirt.

16. Contribution Version of Income Statement

Sales \$300,000

Less Variable Costs \$150,000

Contribution \$150,000

Less Fixed Costs \$80,000

Operating Income \$70,000

This format emphasizes cost behavior and might be useful for budgeting, internal reporting and projections. It is NOT GAAP.

17. Modeling Sales & Profits

The Brief Case Company of Ohio has a contribution margin of 60% and fixed costs of \$300,000. Current sales are \$700,000. Marketing says they can increase sales 10% by spending \$10,000 on advertising. What is the impact?

Current Proposed

Sales \$700,000 \$770,000

Variable Costs \$280,000 \$308,000

Contribution \$420,000 \$462,000

Fixed Costs \$300,000 \$310,000

Operating Income \$120,000 \$152,000

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Management Accounting D. Vance Copyright 2007 18. Setting Target Price

Suppose a wholesaler in Ontario wants to purchase 100 brief cases for sale in Ontario. This is outside your regular market so the price you charge this wholesaler will not affect the price you charge your other customers. You decide you must make \$10,000 on the order or it is not worth taking. What do you charge the wholesaler per briefcase given the following facts: Regular price \$30, VC \$15?

Logic: The price of each briefcase must cover your costs plus your target profit.

Since fixed costs are already covered by your regular production you only have to cover variable costs.

Profit target per briefcase = \$10,000 / 100 = \$10 / briefcase Plus variable costs \$15 / briefcase

Price to this customer \$25 / briefcase

Caution: This price setting mechanism is for exceptional orders only. If you used this method for all customers you would effectively be cutting price by \$5 per briefcase which would dramatically reduce gross profit, gross margin, contribution and contribution margin. Use this method with care.

20. Margin of Safety

Margin of safety is the amount by which one exceeds breakeven.

Margin of safety\$ = Total Sales Breakeven Sales

THIS IS ONE OF THE FEW TIMES THE WORD MARGIN DOES NOT AUTOMATICALLY MEAN PERCENT.

Margin of safety can also be expressed as a percentage.

Margin of safety% = Margin of safety\$ / Total sales

Example: Break even sales are \$900,000. Total sales are \$1,100,000.

Margin of safety\$ = \$1,100,000 - \$900,000 = \$200,000

Margin of safety% = \$200,000 / \$1,100,000 = 18.2%

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Management Accounting D. Vance Copyright 2007 21. Operating Leverage

Operating leverage is contribution over operating income.

Operating Leverage = Contribution

Operating Income

Current Proposed

Sales \$700,000 \$770,000

Variable Costs \$280,000 \$308,000

Contribution \$420,000 \$462,000

Fixed Costs \$300,000 \$310,000

Operating Income \$120,000 \$152,000

Operating Leverage Current = \$420,000 / \$120,000 = 3.5

Operating Leverage Proposed = \$462,000 / \$152,000 = 3.04

22. Applying Operating Leverage

Operating leverage can be used to estimate the change in net income with a change in sales.

%? Operating Income = Operating Leverage x %? Sales

Example: For the Proposed example above, suppose the company can increase sales another 10% without adding new costs. What is the percent change in operating income?

%? Operating Income = 3.04 x 10% = 30.4%

So a 10% increase in sales would translate to a 30.4% increase in operating income or an increase of about \$46,208 (30.4% x \$152,000). Caution: Does the exam question ask for the change in operating income or the new operating income?

23. Sales Commissions

Sales commissions should be based on contribution, not on gross sales.

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Management Accounting D. Vance Copyright 2007

24. Comparison of GAAP vs. Contribution Format Income Stmt

GAAP Income Statement Contribution Income Statement

Sales Sales

less COGS less Variable Costs

Variable COGS Variable COGS

COGS ____ Variable Costs _____

Gross Profit Contribution

Operating Income Operating Income

Consider the simplest example in which there is no beginning inventory and no ending inventory. Sales are \$100M, Variable COGS are \$40M, Fixed COGS are \$20M, Variable Overhead is \$5 and Fixed Overhead is \$15. What are the GAAP and Contribution Format Income Statements?

GAAP Format ---------------------- Contribution Format--------------

Sales \$100M Sales \$100M

Variable COGS \$40M Variable COGS \$40M

Fixed COGS \$20M Variable Overhead \$5M

COGS \$60M Variable Costs \$45M

Gross Profit \$40M Contribution \$55M

Variable Overhead \$5M Fixed COGS \$20M