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www.downloadslide.com Part III Using Costing Techniques for Decision-Making www.downloadslide.com T In this part . . . he costing techniques from Part II come into play in this part, where you see how to use them in order to make management decisions. You first need to understand contribution margin because it provides key insights into how specific transactions affect sales. Contribution margin helps you compute how much you need in sales to break even or achieve a target level of profit. I also explain how to decide whether to invest in longterm assets, using time value of money techniques. I discuss using contribution margin techniques when you make more than one product; this analysis helps you to decide how much of each product you should make. Next, I explore setting prices and describe transfer pricing techniques that encourage different divisions of a company to work together. www.downloadslide.com Chapter 9 Straight to the Bottom Line: Examining Contribution Margin In This Chapter ▶ Figuring contribution margin ▶ Meeting income goals with cost-volume-profit analysis ▶ Analyzing your break-even point and target profit ▶ Finding the margin of safety ▶ Exploring operating leverage C onsider the following exchange: “I’ve got a million-dollar idea. Everybody wants a Rolls Royce, but no one wants to pay for a Rolls Royce, right?” “Yeah. They’re way too expensive.” “Okay, here’s my idea: I’m going to sell Rolls Royces but at a price that people can afford: just $999.95.” “But making a Rolls Royce costs a lot of money. How will you ever earn a profit?” “Who cares? At these prices, I can sell so many cars, I’ll make it up in volume.” As this discussion shows, when you have to make a business decision about what to sell, how much of it to sell, or how much to charge, you first need to understand how your decision will affect net income, which is your profit. Suppose you sell one Rolls Royce for $999.95. How does that sale affect your net income? Now suppose you sell 1,000 Rolls Royce cars at this price. How does that sales volume affect net income? www.downloadslide.com 148 Part III: Using Costing Techniques for Decision-Making Contribution margin simplifies these decisions. In this chapter, I show you how to calculate contribution margin and how to apply it to different business decisions, using both graphs and formulas. I describe how to prepare something called a cost-volume-profit analysis, which explains how the number of products sold affects profits. I demonstrate how to prepare a break-even analysis, which indicates exactly how many products you must sell in order to break even and start earning a profit. Suppose you set a target profit, a goal for net income this period. In this chapter, I show you how to estimate the number of units you need to sell in order to meet your target profit. I also explain how to measure something called margin of safety, or how many sales you can afford to lose before your profitability drops to zero. Finally, I explain and demonstrate operating leverage, which measures a company’s riskiness. Computing Contribution Margin Contribution margin measures how sales affects net income or profits. To compute contribution margin, subtract variable costs of a sale from the amount of the sale itself: For example, if you sell a gadget for $10 and its variable cost is $6, the contribution margin for the sale would be $4 ($10 – $6 = $4). Selling this gadget would increase your profit by $4. When computing contribution margin, subtract all variable costs, including variable manufacturing costs and variable selling, general, and administrative costs. Don’t subtract any fixed costs. As I explain in Chapter 2, you compute gross profit by subtracting cost of goods sold from sales. Because cost of goods sold usually includes a mixture of fixed and variable costs, gross profit doesn’t equal contribution margin. You can calculate contribution margin in three forms, which I discuss in the following sections: ✓ In total ✓ Per unit ✓ As a ratio www.downloadslide.com Chapter 9: Straight to the Bottom Line: Examining Contribution Margin Contribution margin, in any of its forms, explains how different factors in the company — sales price, sales volume, variable costs, and fixed costs — interact. This understanding helps you make better decisions when planning sales and costs. Figuring total contribution margin Total contribution margin measures the amount of contribution margin earned by the company as a whole. You calculate it by using this formula: To determine overall profitability, compare total contribution margin to fixed costs. Net income equals the excess of contribution margin over fixed costs. You can use total contribution margin to create something called a contribution margin income statement. This document is different from a multi-step income statement (shown in Figure 9-1), where you first subtract cost of goods sold from sales and then subtract selling, general, and administrative costs. Figure 9-1: Multi-step income statement. Illustration by Wiley, Composition Services Graphics A contribution margin income statement first subtracts the variable costs and then subtracts fixed costs, as shown in Figure 9-2. Here, variable costs include variable costs of both manufacturing and selling. Likewise, fixed costs include more manufacturing and selling costs. 149 www.downloadslide.com 150 Part III: Using Costing Techniques for Decision-Making Figure 9-2: Contribution margin income statement. Illustration by Wiley, Composition Services Graphics The contribution margin income statement makes understanding cost behavior and how sales will affect profitability easier. In Figure 9-2, the company earned $1,000 in sales, $400 of which went toward variable costs. This scenario resulted in $600 of contribution margin. These amounts — sales, variable costs, and contribution margin — change in proportion to each other. If sales were to increase by 10 percent, then variable costs and contribution margin would also increase by 10 percent; $1,100 in sales would increase variable costs to $440 and contribution margin to $660. On the other hand, fixed costs always remain the same: The $300 in fixed costs will be $300 regardless of any increase or decrease in sales and contribution margin. The contribution margin income statement presents the same net income figure as a traditional income statement. However, the contribution margin income statement is not in accordance with Generally Accepted Accounting Principles (GAAP), the set of rules companies must use for external reporting. Managers can internally use a contribution margin income statement to better understand their own companies’ operations. Calculating contribution margin per unit Contribution margin per unit measures how the sale of one additional unit would affect net income. You calculate it by subtracting variable costs per unit from sales price per unit, as in this formula: www.downloadslide.com Chapter 9: Straight to the Bottom Line: Examining Contribution Margin Say a company sells a single gadget for $100, and the variable cost of making the gadget is $40. Contribution margin per unit on this gadget equals $60 (100 – 40 = 60). Therefore, selling the gadget increases net income by $60. Increasing the sales price doesn’t affect variable costs because the number of units manufactured, not the sales price, is what usually drives variable manufacturing costs. Therefore, if the gadget company raises its sales price to $105, the variable cost of making the gadget remains at $40, and the contribution per unit increases to $65 per unit ($105 – $40 = $65). The $5 increase in sales price goes straight to the bottom line as net income. Working out contribution margin ratio Contribution margin ratio measures the percentage of sales that would increase net income. To calculate it, divide contribution margin by sales, either in total or per unit: Suppose a gadget selling for $100 per unit brings in $40 per unit of contribution margin. Its contribution margin ratio is 40 percent: To find out how sales affect net income, multiply the contribution margin ratio by the amount of sales. In this example, $1,000 in gadget sales increases net income by $400 ($1,000 × 40 percent = $400). Preparing a Cost-Volume-Profit Analysis Contribution margin indicates how sales affects profitability. When running a business, a decision-maker needs to consider how four different factors affect net income: 151 www.downloadslide.com 152 Part III: Using Costing Techniques for Decision-Making ✓ Sales price ✓ Sales volume ✓ Variable cost ✓ Fixed cost Cost-volume-profit analysis helps you understand different ways to meet your net income goals. In the following sections, I explain cost-volume-profit analysis by using graphical and formula techniques. I pay special attention to computing net income based on different measures of contribution margin: total contribution margin, contribution margin per unit, and the contribution margin ratio. The graphs provide a helpful way to visualize the relationship among cost, volume, and profit. However, when solving problems, you’ll find that plugging numbers into formulas is much quicker and easier. Drafting a cost-volume-profit graph Figure 9-3 visually describes the relationship among cost, volume, and profit. Pemulis Basketballs sells basketballs for $15 each. The variable cost per unit of the basketballs is $6. Pemulis had total fixed costs of $300 per year. In this figure, fixed costs are represented by a horizontal line because no matter the sales volume, fixed costs stay the same. Total variable costs are a diagonal line, starting at the origin (the point in the lower-left corner of the graph where there are zero sales). Total costs (the sum of total variable costs and total fixed costs) are a diagonal line starting at the $300 mark because when the company makes and sells zero units, total costs equal the fixed costs of $300. Total costs then increase with volume. Finally, total sales forms a diagonal line starting at the origin and increasing with sales volume. Figure 9-4 shows when the company will earn net income or incur a loss. When the sales curve exceeds total costs, the company earns net income (represented by the shaded right side of the X in Figure 9-4). However, if total sales is too low to exceed total costs, then the company incurs a net loss (the shaded left side of the X). The higher the sales volume — that is, the more sales volume moves to the right of the graph — the higher the company’s net income. www.downloadslide.com Chapter 9: Straight to the Bottom Line: Examining Contribution Margin Figure 9-3: Costvolumeprofit graph. Illustration by Wiley, Composition Services Graphics Figure 9-4: Identifying net income and loss in a costvolumeprofit graph. Illustration by Wiley, Composition Services Graphics 153 www.downloadslide.com 154 Part III: Using Costing Techniques for Decision-Making Dropping numbers into the chart shows exactly how much income can be earned at different sales levels. Assuming Pemulis has a sales price of $15 per unit, a variable cost per unit of $6, and total fixed costs of $300, what happens if Pemulis sells 60 basketballs? Total sales come to $900 (60 units × $15). Total variable costs multiply to $360 (60 units × $6). Add these total variable costs to total fixed costs of $300 to get total costs of $660. Figure 9-5 illustrates these amounts. Total sales ($900) sits on the Total sales line. Total costs ($660) sits on the Total cost line. The difference between these amounts ($240) represents the net income from selling 60 units. Figure 9-5: Applying a costvolumeprofit graph to a specific case. Illustration by Wiley, Composition Services Graphics Trying out the total contribution margin formula The following formula, based on total contribution margin, follows the same structure as the contribution margin income statement. (Flip to the earlier section “Figuring total contribution margin” for details on total contribution margin and its related income statement.)