Chapter 12 Module 6. AMIS 310 Foundations of Accounting

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1 Chapter 12, Module 6 Slide 1 CHAPTER 1 MODULE 1 AMIS 310 Foundations of Accounting Professor Marc Smith Hi everyone welcome back! Let s continue our problem from the website, it s example 3 and requirement #4 asks us to calculate another type of break-even point. This one wants the break-even point in sales dollars. Let s go ahead and get started go ahead to the next slide with me. AMIS 310 Professor Marc Smith

2 Slide 2 : Break-Even Point (sales $) The break-even point (in sales dollars) represents the amount of sales revenue that must be generated to break-even Variable cost ratio = OR Variable costs Sales Revenue Variable cost per unit Selling price per unit NOTE: Since variable costs are a function of activity, they will always be a constant percentage of sales The break-even point in sales dollars simply represents the total amount of sales revenue that needs to be generated in order to break-even. It s basically the same story as the break-even point in units except the break-even point in units says how many units we have to sell. The break-even point in sales dollars tells me how much I have to generate or earn in sales revenue in order to simply break even. To do the break-even in sales dollars we re going to need to be able to come up with what s called the variable cost ratio. And the variable cost ratio can be calculated by taking our variable costs divided by the sales revenue or you get the same number if you put it on a per unit basis, variable cost per unit divided by the selling price per unit. Since variable costs are a function of activity and that s basically been the theme of this entire chapter, these cost behaviors. AMIS 310 Professor Marc Smith

3 Since variable costs are a function of activity we know they will always be a constant percentage of sales. So we re able to calculate this variable cost ratio and use that ratio in doing our cost volume analysis. Now go ahead to the next slide with me. Slide 3 : Example #3 d. Variable cost ratio = = 79.20% Net income = Sales Variable costs Fixed Costs 0 = Sales (Variable cost ratio x Sales) Fixed costs 0 = Sales.792Sales Fixed costs 0 =.208Sales $468, Sales = $468,000 Sales = $2,250,000 Remember our basic income statement sales revenue minus variable costs minus fixed costs equals net income. And we remember at the break-even point net income is zero. And we re going to set that equal to our sales I m going to rewrite the variable costs to now take the sales revenue times the variable cost ratio, that s our variable costs expressed as a percentage of sales, and then subtract the fixed costs. And so we need to calculate the variable cost ratio and I think we have all the numbers in the problem to do that. AMIS 310 Professor Marc Smith

4 Variable cost ratio is the variable cost per unit given as $ Divide by the selling price per unit of $25 giving you a variable cost ratio of 79.2%. Now that we have that it becomes some basic algebra. So we have zero equals sales minus.792sales minus our fixed costs. And we know the fixed costs are $468,000. And sales minus.792sales is.208sales. Do the algebra, end up solving for X. We must earn sales of $2,250,000 in order to simply break even. Now go ahead to the next slide with me. Slide 4 : Example #3 Alternative formula to calculate the break-even point in sales dollars: Amount of revenue = Total Fixed costs Contribution margin ratio $468, = $2,250,000 AMIS 310 Professor Marc Smith

5 Just like we saw with the break-even point in units there is an alternative formula to calculate the break-even point in sales dollars. The equation that we could use if you don t like the algebra, take the total fixed costs divide by the contribution margin ratio and we calculated that back in part B of this problem. We know the total fixed costs are $468,000. Divide by.208 which gives us the break-even point in sales dollars just like we saw in the previous slide $2,250,000. One thing to make note of, it doesn t matter if you use the equation or the algebra setup to solve the problems. You get to the same place. So whatever you prefer, whatever you see easier, whatever is easier for you is fine. You can use either/or, either this basic formula or the basic algebra and you get to the exact same answer. Go ahead to the next side with me. AMIS 310 Professor Marc Smith

6 Slide 5 : Example #3 e. Target Profit Units For break-even 0 = ($25 x Units) ($19.80 x Units) $468, ,000 = ($25 x Units) ($19.80 x Units) $468, ,000 = ($5.20 x Units) $468,000 ($5.20 x Units) = $598,000 Units = 115,000 Proof Sales (115,000 $25) $2,875,000 Less: Variable costs 2,277,000 Contribution margin $598,000 Less: Fixed costs 468,000 Net income $ 130,000 And take a look at the next requirement letter e of the problem. Letter e says you know that break-even point that s nice, but boy I don t want to be there, I want to be above that, I want to be a lot above that. This deals with what s called a target profit. And we re interested in knowing in letter e how many units do we have to sell if we want to earn $130,000 of net income? Well remember how we set up the algebra equation with the break-even point? We knew that the net income was zero at the break-even point. And we set that equal to the selling price per unit, times the number of units, minus the variable cost per unit, times the number of units, minus the fixed costs. We re going to use the same logic here. AMIS 310 Professor Marc Smith

7 The only thing that s going to change is we don t want to break even anymore. We want to earn a net income of $130,000. So replace the zero with $130,000 and solve for X. When you do the algebra you come up with the number of units that must be sold, 115,000. If you want to make a profit of $130,000 you must sell 115,000 units. Let s check that. Again maybe pausing, it will only take you a second. Pause me, do an income statement assuming we sell 115,000 units. Do we in fact earn a net income of $130,000? Okay I assume you ve tried it on your own, you ve answered it, let s answer it together. There s the income statement, sales, units times selling price, variable cost, units times the 19.8 variable cost per unit gives us our contribution margin, $598,000, subtract the fixed costs of $468,000. We do in fact earn net income of $130,000 if we sell 115,000 units. Go ahead to the next slide. AMIS 310 Professor Marc Smith

8 Slide 6 : Example #3 f. Target Profit Units XYZ Company wants to know the number of units that must be sold in order to earn a profit equal to 8 percent of sales revenue. 0.08($25)(Units) = ($25 x Units) ($19.8 x Units) $468,000 $2 x Units= ($25 x Units) ($19.8 x Units) $468,000 $2 x Units= ($5.20 x Units) $468,000 $3.20 x Units= $468,000 Units = 146,250 That really was the easier target profit question. Letter f is a little bit tougher. Letter f says to calculate the number of units that we would have to sell if we want our net income to equal 8% of our sales revenue. It s the same algebra. It s just a little bit tougher to put the equation together. Here in this particular part or requirement we know that the income that we want needs to be 8% of our sales revenue. So we re going to set this up, well on one side of the equation simply the selling price $25 times the units, minus the variable cost per unit 19.8 times the units, minus the fixed costs $468,000. Set that equal to our net income which we want to be 8% of our sales. AMIS 310 Professor Marc Smith

9 And the sales are expressed as 25x 25 times the units. So take 25, the selling price per unit, times units, times 8%. And know just do the algebra. When you do the algebra you get 2x equals 25x, minus 19.8x, minus 468,000. 2x equal 5.2x, just simplifying down, minus 468,000. Move the like terms to the same side. We get 3.2x equal 468,000. We must sell 146,250 units if our net income is to equal 8% of our sales. Let s test that. Go to the next slide with me. AMIS 310 Professor Marc Smith

10 Slide 7 : Example #3 Proof Sales (146,250 $25) $3,656,250 Less: Variable costs 2,895,750 Contribution margin $ 760,500 Less: Fixed costs 468,000 Net income $ 292, ,500 3,656,250 = 8% Alright I ve done the income statement for us. Assuming we sell 146, 250 units, we now know how to put those income statements together. The net income would be $292,500. The question is, is that 8% of our sales? Well if we take the $292,500, the net income, divide by the sales that are generated, $3,656,250, that is in fact 8% of our sales. So if we want to earn a net income equal to 8% of our sales we must sell 146, 250 units. And we proved it, that in fact it does translate to 8% of sales being reported as profits. Very good, go ahead to the next slide with me. AMIS 310 Professor Marc Smith

11 Slide 8 : Example #3 g. Income statement before any changes are made Units sold 120,000 Sales (120,000 $25) $3,000,000 Less: Variable costs (120,000 $19.8) 2,376,000 Contribution margin $ 624,000 Less: Fixed costs 468,000 Net income $ 156,000 Take a look at the last requirement of the problem. And here s what it says, assume that XYZ Company is currently selling 120,000 units. In an attempt to increase their profits they are considering increasing advertising by $50,000 and decreasing the selling price per unit to $24. If they were to make these changes they would expect to sell more units, and they would expect to sell 160,000 units. Should XYZ Company make the change? To analyze this let s start by doing an income statement before the change would be made. And it says to assume that we re currently selling 120,000 units. We know how to put an income statement together, sales, units times selling price, minus variable costs, the 19.8, times the units sold. AMIS 310 Professor Marc Smith

12 That gives us a contribution margin, $624,000. Subtract the fixed costs to give us net income of $156,000. That s where we currently stand. We would like to increase that, we want to improve our profits. If we make these changes that are suggested, increasing the advertising and reducing the selling price, is that a good idea? Will that increase profit? Go ahead to the next slide and let s test it. Slide 9 : Example #3 g. Income statement after the changes are made Units sold 160,000 Sales (160,000 $24) $3,840,000 Less: Variable costs (160,000 $19.8) 3,168,000 Contribution margin $ 672,000 Less: Fixed costs 518,000 Net income $ 154,000 Do not make the changes net income is $2,000 less if the changes are made. If we make the changes we will now sell 160,000 units. Well we calculate the sales in the same way, 160,000 units but remember we ve reduced the selling price to $24 per unit, total sales $3,840,000. AMIS 310 Professor Marc Smith

13 Variable costs, units sold of 160,000, times variable cost per unit of 19.8, which gives us a contribution margin, $672,000. Fixed costs, well you now have to include the increase in advertising, the $50,000 that we re going to put into advertising. So total fixed costs are now $518,000. Making these changes will result in a net income of $154,000. So don t do it, it s a bad idea. If you make the changes, if you increase the advertising, reduce the selling price thus sell more units, you ll actually earn $2,000 less than where you are currently operating. This is how managers use this information. This is all understanding cost behaviors, variable and fixed and it let s them make all sorts of predictions. And it let s them analyze all sorts of different alternatives and possible things to do to determine their effect on profits. AMIS 310 Professor Marc Smith