Chapter 12, Module 4 AMIS 310: Foundations of Accounting Slide 1 CHAPTER 1 MODULE 1 AMIS 310 Foundations of Accounting Professor Marc Smith Hi everyone welcome back! Let s continue our discussion of cost behavior analysis and go ahead to the next slide with me. AMIS 310 Professor Marc Smith
Slide 2 : Income Statement TRADITIONAL INCOME STATEMENT FORMAT Sales Revenue - Cost of Goods Sold Gross Profit - S&A Expenses Net Income NOTE: This is the traditional income statement format where the expenses are classified by function. What you see is something we have seen basically all quarter long, our income statement. And you see it there as sales revenue minus the cost of goods sold which we know that s called our gross profit. We then subtract all of our other expenses, what I m calling here S and A expenses. S and A stands for our selling and all of our administrative expenses, the salaries, and the utilities, and the rent, and all of that stuff. We subtract those to get to our net income. That s what we ve seen since we ve been talking about income statements which again is basically all quarter. Please note this is the traditional income statement format. This is the format we use to share information with our outsiders. AMIS 310 Professor Marc Smith
In this format the expenses on the income statement are classified and listed by function. So again you would actually see salaries expense, and utilities expense, and rent expense. So each function, each expense would be listed individually. That s how we share, that s how we are required to share information with the outsiders. GAP requires usage of the traditional format however, for internal purposes, for making inside decisions this is not how managers want to see an income statement. It doesn t facilitate decision-making. Go ahead to the next slide with me. Slide 3 : Income Statement The traditional income statement format is not used for internal decision-making. Instead, managers prefer to classify expenses by cost behavior as follows: Sales Revenue - Variable Costs Contribution Margin - Fixed Costs Net Income NOTE: This is the contribution income statement format where the expenses are classified by cost behavior pattern. AMIS 310 Professor Marc Smith
Managers aren t interested in looking at the traditional income statement; it doesn t help them with making their decisions. Rather they want to see an income statement that lists out the expenses not by function but by cost behavior. And the type of income statement on would provide to a manager to use to make decisions would look like this. Take the sales revenue minus the variable costs. Remember we re now classifying all of our expenses by behavior. Sales revenue minus variable costs is called our contribution margin. We then calculate all of our fixed costs to calculate the company s net income. This is referred to as the contribution income statement format. The contribution income statement format shows the expenses not by function but by cost behavior, variable and fixed. Now go ahead to the next slide with me. AMIS 310 Professor Marc Smith
Slide 4 AMIS 310: Foundations of Accounting : Contribution Margin Contribution margin represents the amount of revenue that is available to: 1. pay (cover) fixed costs 2. contribute toward a profit There s that middle number that s really very important, the contribution margin. Remember sales revenue minus variable costs is the contribution margin. And the contribution margin represents the amount of our sales that are available to do two things, the amount of sales available to 1, pay our fixed costs. We have to cover those costs that will be constant no matter how many units we actually sell. Once they re paid however everything left we can stick in lour pocket. That s what goes to our net income. So contribution margin, a very important idea, one that we ll deal a lot with in doing our work, represents the amount of sales available to pay our fixed costs and contribute toward a profit. AMIS 310 Professor Marc Smith
Now go ahead to the next slide with me. AMIS 310: Foundations of Accounting Slide 5 : Contribution Margin Contribution margin can be expressed in 3 different ways: 1. Total contribution margin = Sales Revenue - Variable Costs 2. Contribution margin per unit = Selling price per unit - Variable costs per unit Contribution margin can be expressed in one of 3 ways. And depending on who the user of the data is and what type of decision they want to make we would give them the information in one of 3 different formats. We can express contribution margin as a total dollar amount. Our total contribution margin is the total sales revenue minus the total variable costs. We can express it in probably the most common expression, we can express contribution margin on a per unit basis. The contribution margin per unit is simply the selling price per unit minus the variable cost per unit. So those 2 equations are basically the same thing. AMIS 310 Professor Marc Smith
There the same thing ones just total and ones on a per unit basis. Go ahead to the next slide with me. Slide 6 : Contribution Margin 3. As a percentage of sales (called the contribution margin ratio) = Contribution Margin Sales Revenue OR CM per unit Selling price per unit The third way to express contribution margins, it s also fairly common, is to express contribution margin as a percentage of our sales and this is called our contribution margin ratio. To calculate the contribution margin ratio we ll take either the total contribution margin divided by the total sales revenue or the contribution margin per unit divided by the selling price per unit. You get the exact same answer. The idea is we are expressing contribution margin as a percentage of our sales. Now go ahead to the next slide with me. AMIS 310 Professor Marc Smith
Slide 7 AMIS 310: Foundations of Accounting : Contribution Margin The key to this very important concept lies in understanding cost behavior patterns. As revenues increase as a result of selling more products or providing more services, variable costs will increase proportionately, and so will contribution margin. However, fixed costs will not increase because they are NOT a function of the level of revenuegenerating activity The key to understanding this really very important concept this contribution margin idea, and again we make a lot of use of contribution margins, the key to understanding it lies in understanding our cost behavior patterns. The variable costs, variable costs are a function of activity. They are directly related to our activity. So as the activity increases, as we end up selling more and more units to customers our sales revenue will increase but so will the variable costs. The variable costs will increase in direct proportion to our activity, the sales. So as sales go up so does variable costs and thus so will contribution margin because it is the sales minus the variable costs. However the fixed costs don t change. The fixed costs will not increase as sales increase because they re not a function of activity. AMIS 310 Professor Marc Smith
They are constant in total and they re not based on the level of our revenue generating activity. So the contribution margin will increase in direct proportion to changes in sales but the net income will not because the net income, we subtract the fixed costs to get there and the fixed costs do not change as the activity, the sales do change. So contribution margin, very important idea, so go to the next slide with me and let s see if we can get a little bit of practice in dealing with contribution margin. Slide 8 : Example #2 1. Variable cost per unit = 109-18 Variable cost per unit = $91 Sales revenue 69,750 [250 units x $279] Variable costs 22,750 [250 units x $91] Cont. margin 47,000 Fixed costs 40,000 Net income 7,000 Take a look at example #2 from the problems posted on our website, our lecture problems. And here s what it says, the following monthly data is available for MN Company and the only product it makes is product SD. AMIS 310 Professor Marc Smith
And you can see a basic contribution margin income statement giving both total dollar numbers and per unit numbers for sales, variable costs, and contribution margin. The company it says produces and sold 300 units during the month had no beginning or ending inventories. Given that information answer the following three independent questions. Here s question 1, management is considering the use of plastic gearing rather than metal gearing in product SD. This change would reduce our variable cost by $18 per unit. However the company s sales manager predicts it would reduce the overall quality of the product, using plastic instead of metal, and thus resulting in a decline in sales to a level of 250 units per month. Is this a good idea? Calculate the monthly net income of MN Company assuming these changes are made. Well here s what we know, our variable cost per unit will be decreased, we won t incur as much variable cost. It will decrease by $18 per unit so it will go from $109 to $91 per unit. We can then start putting our income statement together. We know that we re going to sell 250 units and we sell each unit for $279 so total sales $69.750. Subtract from that the variable costs and they are a function of sales. We sell more units and the variable costs will be more, we sell fewer units and the variable costs will be less. AMIS 310 Professor Marc Smith
250 units were sold at a now variable cost of $91 per unit, total variable cost of $22,750, subtract that from sales to get contribution margin of $47,000. We then subtract the fixed costs which are constant, they will not change as the level of activity, as we sell more or less, they re constant at $47,000, resulting in a net income of $7,000. That doesn t look like such a good idea. If you look in the problem the net income of the company before the change was $11,000. If we implement these changes we ll actually see a decline in income to $7,000. So this doesn t look like a very good idea. Go ahead to the next slide. Slide 9 : Example #2 2. Units sales = 300 x 1.50 = 450 units Sales revenue 115,650 [450 units x $257] Variable costs 49,050 [450 units x $109] Cont. margin 66,600 Fixed costs 60,000 [40,000 + 20,000] Net income 6,600 AMIS 310 Professor Marc Smith
And look at requirement #2. AMIS 310: Foundations of Accounting Management wants to increase sales, their goal is to increase sales and they think this can be done by cutting the selling price by $22 per unit and increasing advertising. If we advertise more, more folks will know about the product and they may buy more. So they want to increase the advertising budget by $20,000 per month. Management believes if they do this, if they slash the selling price and increase the advertising then the unit sales will increase by 50%. Is this a good idea? Well let s start by determining how many units we re going to sell. The problem says we re currently selling 300 units. To increase that by 50% multiply by 1.5, it s a little algebra trick. If you wanted to increase something by 80% you d multiply by 1.8. You want to increase something by 22% multiply by 1.22. Here we re increasing the sales by 50% so multiply by 1.5. The total number of units of product SD we re going to sell is 450. Now put together our income statement. Units times selling price per unit $257, note the $22 slash, we cut the selling price by $22 per unit, results in total sales of $115,650. Calculate the variable costs, by the variable costs per unit given at $109 times the number of units we re producing and selling, 450, giving us contribution margin $66,600. AMIS 310 Professor Marc Smith
Subtract the fixed costs which are now $60,000, the $40,000 that we had plus the $20,000 we re going to spend on advertising to give us a net income of $6,600. This also does not look like a good idea. It may generate more sales but the amount of income we re actually going to keep is decreased. Previously we were making $11,000. If we make these changes, increase the advertising and cut the selling price the income will fall to $6,600. I don t think we d want to do that either. Let s go to the next slide and look at requirement #3. Slide 10 : Example #2 3. Units sales = 300 x 1.12 = 336 units Sales revenue 93,744 [336 units x $279] Variable costs 29,904 [336 units x $89] Cont. margin 63,840 Fixed costs 50,000 [40,000 + 10,000] Net income 13,840 AMIS 310 Professor Marc Smith
Management wants to automate a portion of the production process for product SD. The new equipment would reduce the direct labor cost by $20 a unit due to the automation. However it would result in a monthly rental cost of the new robotic equipment amounting to $10,000. Management believes that the new equipment will increase the reliability of the product thus making it more valuable, thus making more folks want to buy it, thus resulting in a 12% increase in the monthly unit sales. Is this a good idea? Well to analyze it start by figuring out how many units we re going to sell. We know we re currently selling 300, a 12% increase multiply by 1.12, tells me we re now going to be selling 336 units. Do your income statement, units times selling price per unit to get the sales. And the units times the variable costs per unit, note the $20 decrease due to the $20 reduction in direct labor, so the variable cost per unit is now only $89. Resulting in contribution margin of $63,840, subtract the fixed costs which are now $50,000 when you include the $10,000 rental for the equipment, giving us net income of $13,840. It looks like, it looks like in this problem this is the only option that seems like a good idea. We actually increase our income from $11,000 to $13,840 if we make these changes. Management would not want to make changes from the first 2 situations as that resulted in a decrease in profits. AMIS 310 Professor Marc Smith
And this is just a wonderful illustration of how managers use this cost behavior data. They re able to make predictions. If this occurs well what will the costs be and what will the income look like and they can decide if these sorts of recommendations or possible changes are worth implementing. AMIS 310 Professor Marc Smith