Exam 2 Study Packet Notes

contribution margin

the difference between total sales and total variable expenses

• total sales - total variable costs

unit contribution margin

the difference between the unit selling price and the unit variable expense

• unit selling price - unit variable expense

Net operating income

equal to contribution margin less fixed expenses

• CM - Fixed Expenses

Net Operating Income Graphic

Sales	$
Variable expenses	-$
Contribution Margin	$
Fixed Expenses	-$
Net Operating Income	$$$

break-even point

the level of sales at which profit is zero

• Below break-even point, every unit sold reduces the loss by the amount of the unit contribution margin

• Once reached, net operating income will increase by the amount of the unit contribution margin for each additional unit sold

Relation between contribution margin and net operating income

• gives the manager the ability to predict what profits will be at various activity levels without the necessity of preparing detailed income statements

• increase in CM = increase in Net Income

• decrease in CM = decrease in Net income

Loss

contribution margin must first cover fixed expenses and if it doesn’t company has a loss

CM Ratio

expresses the contribution margin as a percentage of sales

• used to predict the change in total contribution margin that would result from a given change in dollar sales

CM Ratio Formula

Contribution margin/Sales

CM Ratio Single Product Formula

Unit contribution margin/unit selling price

Change in Contribution margin

change in dollar sales x CM Ratio

Incremental Analysis

based on only those costs and revenues that differ between alternatives

Break-Even analysis

a special case of target profit analysis

target profit analysis

used to find out how much would have to be sold to attain a specific target profit

target profit analysis formula

Profit = Sales - Variable expenses - fixed expenses

Profit = Unit CM x Q - Fixed expense

Profit = CM Ratio x sales - fixed expense

Unit Sales to attain target profit

(target profit + fixed expenses)/ Unit CM

Dollar sales to attain target profit

(target profit + fixed expenses)/ CM Ratio

Unit Sales to break-even

Fixed expenses/Unit CM

Dollar Sales to break-even

Fixed expenses/CM Ratio

Margin of Safety

the excess of budgeted (or actual) sales over the break-even volume of sales

• the amount by which sales can drop before losses begin to be incurred

Margin of Safety in dollars

Total budgeted or actual sales - break even sales

Margin of Safety percentage

margin of safety/total budgeted or actual sales

Cost Structure

the relative proportion of fixed and variable costs

• has an impact on how sensitive a company’s profits are to changes in sales

CM Ratio vs. costs

• Low fixed costs and High variable costs = Lower CM ratio

Operating Leverage

refers to the effect a given percentage increase in sales will have on net operating income

degree of operating leverage formula

CM/Net Income

Percentage change in net income

Percent change in dollar sales x degree of operating leverage

Degree of operating leverage

• not constant

• changes as sales increase or decrease

• decreases the further a company moves away from its break-even point

sales mix

refers to the relative proportions in which the company’s products are sold

Overall CM Ratio Formula

Overall CM/ Overall Sales

Overall CM Ratio

used when company has more than one product

• overall CM ratio used in target profit and break-even formulas instead of CM ratio

Sales Mix vs. Overall CM ratio

• shift toward less profitable products = Overall CM ratio falls

• shift toward more profitable products = Overall CM ratio rises

CVP Analysis

• selling price is constant; it does not change as unit sales change

• costs are linear; can be accurately divided into variable and fixed elements

  • variable cost per unit constant

  • total fixed cost is constant

• in multi-product situations, sales mix is constant

• in manufacturing companies, inventories don’t change

Budget

a detailed plan for the acquisition and use of financial and other resources over a specified time period

• planning

• control

Master budget

consists of a series of separate but interdependent budgets that formally lay out the company’s sales, production, and financial goals and that culminates in a cash budget, budgeted income statement, and budgeted balance sheet

Planning

involves developing objectives and preparing budgets to achieve these objectives

control

involves the steps taken by management to increase the likelihood that all parts of the organization are working together to achieve the goals set down at the planning stage

Benefits of Budgeting

• communicates management’s plans throughout the entire organization

• forces managers to think ahead and to formalize their planning efforts

• provides a means of allocating resources to those parts of the organization where they can be used most effectively

• uncovers potential bottlenecks before they occur

• coordinates the activities of the entire organization by integrating the plans and objectives of the various parts

• provides goals and objectives that serve as benchmarks for evaluating subsequent performance

Responsibility accounting

each manager’s performance should be judged by how well he or she manages those items - and only those items - under his or her control

• each manager is assigned responsibility for those items of revenues and costs in the budget that the manager is able to control

• manager is held responsible for difference between budget and actual results

Operating budgets

ordinarily cover a one-year period divided into quarters and months

Why should the manager be involved in setting his or her own budget?

1. likely to have the best information concerning their own operations

2. more likely to be committed to attaining a budget if the manager is given a major role in developing the budget

sales budget

beginning point in the budgeting process

• details the expected sales, in both unit and dollars, for the budget period

• accompanied by schedule of expected cash collections

schedule of expected cash collections

shows the anticipated cash inflow from sales and collections of accounts receivable for the budget period.

production budget

shows what must be produced to meet sales forecasts and to provide for desired levels of inventory

production budget format

1. Budgeted unit sales

2. add desired ending inventory

3. total needs

4. less beginning inventory

5. required production

• desired ending inventory for year is desired ending inventory for 4th quarter

• beginning inventory for the year is the beginning inventory for the 1st quarter

merchandise purchases budget

details the amount of goods that must be purchased from suppliers to meet customer demand and to maintain adequate stocks of ending inventory

merchandise purchases budget format

1. budgeted unit sales

2. add desired ending inventory

3. total needs

4. less beginning inventory

5. required purchases

direct materials budget

details the amount of raw materials that must be acquired to support production and to provide for adequate inventories

• should be accompanied by a schedule of expected cash disbursements for raw materials

• year is not sum of amounts for the quarters

direct materials budget format

1. required production in units of finished goods

2. raw materials required per unit of finished goods

3. raw materials needed to meet the production schedule

4. add desired ending raw materials inventory

5. total raw materials needs

6. less beginning raw materials inventory

7. raw materials to be purchased

8. unit cost of raw materials

9. raw materials to be purchased

• year column is not sum of amounts for quarters

• beginning cash balance for the year is the beginning cash balance for the first month or quarter

• ending cash balance for year is the ending cash balance for the final month or quarter

direct labor budget

follows the production budget

manufacturing overhead budget

follows the production budget

• details all of the production costs that will be required other than direct materials and direct labor

ending finished goods inventory budget

provides computations of unit product costs and of the carrying value of the ending inventory

selling and administrative expense budget

prepared in all types of companies

cash budget

summarizes all of the cash inflows and cash outflows appearing on the various budgets

• provides critical advance warnings of potential cash problems

• allows managers to arrange for financing before a crisis develops

cash budget format

1. cash balance, beginning

2. add receipts

3. total cash available

4. less disbursements

5. excess (deficiency) of cash available over disbursements

6. financing

7. cash balance, ending

   • year column is not sum of amounts for quarters

   • beginning cash balance for the year is the beginning cash balance for the first month or quarter

   • ending cash balance for year is the ending cash balance for the final month or quarter