CHAPTER 20
LEARNING OBJECTIVES
1. APPLY BASIC CVP CONCEPTS.
2. EXPLAIN THE TERM SALES MIX AND ITS EFFECTS
ON BREAK-EVEN SALES.
3. DETERMINE SALES MIX WHEN A COMPANY HAS
LIMITED RESOURCES.
CHAPTER REVIEW
Cost-Volume-Profit Income Statement
1. (L.O. 1) The Cost-Volume-Profit (CVP) income statement classifies costs as variable or fixed
and computes a contribution margin. Contribution margin is the amount of revenue remaining
after deducting variable costs. It is often stated both as a total amount and on a per unit basis.
Desossa Music Player Company
CVP Income Statement
For the Month Ended June 30, 2017
Basic Computations
2. Desossa Music Player’s CVP income statement shows that total contribution margin (sales minus
variable expenses) is $175,000, and the company’s contribution margin per unit is $50. The
contribution margin ratio (contribution margin divided by sales) is 45% ($54 ÷ $120). Desossa’s
break-even point in units (using unit contribution margin) or in dollars (using contribution margin
ratio) are calculated as follows:
CVP and Changes in the Business Environment
5. To better understand how CVP analysis works, let’s assume that shipping costs have increased
significantly causing the unit variable cost to increase by 10%, what effect will this have on
Desossa’s break-even point?
Sales Mix
6. (L.O. 2) Sales mix is the relative percentage in which a company sells its multiple products. For
example, if 80% of Company A’s unit sales are shoes and the other 20% are jeans, its sales mix
is 80% shoes to 20% jeans.
To compute break-even for Seth Inc., we use the weighted-average unit contribution margin as
follows:
Tables Chairs
8. At any level of units sold, net income will be greater if more high contribution margin units are sold
than low contribution margin units. An analysis of these relationships generally shows that a shift
from low-margin sales to high-margin sales may increase net income, even though there is a
decline in total units sold.
9. The calculation of the break-even point computed in units works well if a company has only a
Sales Mix with Limited Resources
10. (L.O. 3) When a company has limited resources (e.g., floor space, raw materials, direct labor
hours), management must decide which products to make and sell in order to maximize net
Unit contribution margin $40 $10
Machine hours required per unit .8 .16
The contribution margin per unit of limited resource is calculated as follows:
Tables Chairs
Machine hours (a) 400 400
Contribution margin per unit of
limited resource (b) $ 50 $ 62.50
Contribution margin [(a) X (b)] $20,000 $25,000
Cost Structure and Operating Leverage
Variable Costing vs. Absorption Costing
*13. (L.O. 5) There are two approaches to product costing.
a. Under full or absorption costing all manufacturing costs are charged to the product. This is
also the approach required under generally accepted accounting principles.
b. Under variable costing only direct materials, direct labor, and variable manufacturing overhead
costs are treated as product costs; fixed manufacturing overhead costs are recognized as
period costs (expenses) when incurred.
Financial Information
THIBODEAU COMPANY
Income Statement
For the Year Ended 2017
Absorption Costing
THIBODEAU COMPANY
Income Statement
For the Year Ended 2017
Variable Costing
*16. The effects of the alternative costing methods on income from operations are:
Effects on Income
Circumstance From Operations
LECTURE OUTLINE
A. Cost-Volume-Profit (CVP) Review.
1. Because CVP analysis is important for decision making, management
often wants this information reported in a CVP income statement format
for internal use.
MANAGEMENT INSIGHT
Analysts closely watch the “conversion rate” when analyzing an Internet business.
This rate is computed by dividing the number of people who buy something at an
Internet site by the number of people who visit the site. Conversion rates have an
obvious effect on the break-even point. Studies show that conversion rates increase
if the site has an easy–to-use interface, fast-performing screens, a convenient
ordering process, and advertising that is clear.
Besides increasing their conversion rates, what steps can online merchants use
to lower their break-even points?
B. Sales Mix
1. When a company sells many products, it is important that managers
understand the company’s sales mix.
3. Break-even sales in units can be computed for a mix of two or more
products by determining the weighted-average unit contribution margin
of all the products.
4. The calculation of the break-even point in units works well if a company
has only a small number of products. In a company with many products,
break-even sales in dollars is calculated using the weighted-average
contribution margin ratio.
SERVICE COMPANY INSIGHT
Zoom kitchen, a chain of four restaurants in the Chicago area, is known for
serving sizable portions of meat and potatoes. During the past four years salad
sales have increased from 18% of its sales mix to 40%. This has pleased
company management because the contribution margin on salads is much
higher than on meat.
Why do you suppose restaurants are so eager to sell beverages and desserts?
C. Limited Resources.
1. When a company has limited resources (i.e., machine hours), it is
necessary to find the contribution margin per unit of limited resource.
MANAGEMENT INSIGHT
When fragrance sales recently went flat, retailers turned up the heat on fragrance
manufacturers. They reduced the amount of floor space devoted to fragrances,
and chose the fragrance with the highest contribution margin per square foot for
a given period of time.
What is the limited resource for a retailer, and what implication does this have for
sales mix?
D. Cost Structure and Operating Leverage.
1. Cost structure is the relative proportion of fixed versus variable costs
that a company incurs.
b. When a company’s sales revenue is increasing, high operating
leverage is good because it means that profits will increase rapidly.
However, when sales are declining, too much operating leverage
can have devastating consequences.
SERVICE COMPANY INSIGHT
Warren Buffet recently purchased Burlington Northern Railroad for 31% above its
market value. The company has fixed costs of approximately 50 – 60%, and
therefore huge operating leverage. Railroads have barriers to entry, are an
energy-efficient method of transportation, and there are a limited number of
railroads operating.
Why did Warren Buffett think that this was good time to invest in railroad stocks?
*E. Absorption Costing Versus Variable Costing.
1. Under absorption costing, all manufacturing costs are charged to, or
absorbed by, the product. This approach is used for external reporting
under generally accepted accounting principles.
6. The one primary difference between variable and absorption costing is
that under variable costing companies charge fixed manufacturing
overhead as an expense in the current period, instead of being deferred
to a future period through the ending inventory as under absorption
costing.
*F. Decision-Making Concerns.
1. For external reporting purposes, companies must report financial infor–
mation using GAAP, which requires that absorption costing be used for
the costing of inventory.
4. Management may be tempted to overproduce in a given period in order
to increase net income, but this decision may not be in the company’s
best interest since the buildup of inventories will lead to additional costs
to the company in the long run.
*G. Potential Advantages of Variable Costing.
1. Variable costing has several potential advantages relative to absorption
costing:
a. Net income computed under variable costing is unaffected by
changes in production levels.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. The CVP income statement classifies costs as variable or fixed and computes a contribution
margin.
True False
2. The margin of safety indicates how much sales must increase before a company will be
operating at a profit.
True False
3. Sales mix is the relative percentage in which each product is sold when a company sells more
than one product.
True False
4. When multiple products exist, the break-even point in dollars is computed by dividing fixed costs
by the weighted-average contribution margin.
True False
5. When a company has limited resources, management must decide which product to make and
sell in order to maximize contribution margin ratio.
True False
6. Contribution margin per unit of limited resource is obtained by dividing the contribution margin
per unit of each product by the number of units of the limited resource required for each product.
True False
7. Operating leverage refers to the extent to which a company’s net income reacts to a given
change in production.
True False
8. Companies that have higher fixed costs relative to variable costs have higher operating leverage.
True False
*9. Under variable costing, all variable costs are considered product costs.
True False
*10. Fixed manufacturing costs are a product cost under absorption costing but are a period cost
under variable costing.
True False
Multiple Choice
1. For a company selling multiple products, the break-even point in dollars is computed by
dividing fixed costs by the
a. contribution margin per unit.
b. contribution margin ratio.
c. weighted-average contribution margin per unit.
d. weighted-average contribution margin ratio.
2. In order to maximize net income a company should produce and sell the product with the
highest.
a. contribution margin ratio.
b. contribution margin per unit.
c. contribution margin per unit of limited resource.
d. weighted-average unit contribution margin.
3. Operating leverage refers to the extent to which a company’s net income reacts to a
given change in
a. fixed costs.
b. production.
c. sales.
d. variable costs
*4. Under variable costing, all of the following are considered product costs except
a. direct materials.
b. direct labor.
c. variable manufacturing overhead.
d. variable selling and administrative expenses.
*5. All of the following are potential advantages of variable costing except that
a. its use is consistent with cost-volume-profit and incremental analysis.
b. variable costing net income is affected by changes in production levels.
c. variable costing net income is closely tied to changes in sales levels.
d. the presentation of fixed and variable cost components makes it easier
to identify these costs.
ANSWERS TO QUIZ
True/False
Multiple Choice