Accounting III Week 2 Assignment 1

Question 1

Perform an Internet search using the term break-even analysis. Select and read a case study or article from the results of your search. (Make sure that you do not select an instructor's lecture notes or a class assignment from the results of your search.) Summarize the case study or article, and relate the ideas of the article to what you have learned this week in this course.

Question 2

Your friend remarked, A company will never drop a product from its product line that has a positive contribution margin. It will want to garner every bit of profit that it can. Is this true in all cases? What are the risks and benefits of evaluating product continuation or implementation using the contribution margin?

Here is some of what we went over this week to help you with question 1

Cost-Volume-Profit Relationship

One tool that is very helpful is cost-volume-profit analysis. This gives management the ability to look at relationships of these areas and help improve the bottom line. It also helps in understanding how changes in activity affect contribution margin and net operating income.

The contribution margin is calculated by taking thesales variable costs. This helps management to isolate the effect of variable costs on sales and to see the impact on profit of different decisions that they might make. The contribution margin income statement begins with the contribution margin formula and then deducts fixed costs to arrive at net operating income.

The complete contribution margin income statement looks like this:

Sales Variable Expenses

= Contribution Margin

Fixed Expenses

= Net Operating Income

The contribution margin shows management the amount that is remaining to help cover fixed costs. Management can also change amounts to see what the effect would be on other areas. For example, management might want to know what will happen to the bottom line if there is a 10 percent increase in sales, and this statement can help them determine that.

The contribution margin ratio (CM ratio) is the percentage that the contribution margin is when compared to sales, so the percent of every sales dollar that we have left to cover fixed costs. The formula is:

Contribution Margin Ratio = Contribution Margin / Sales

The breakeven point is the point when the profit of the company is equal to $0. It is the point when sales equals fixed costs and variable costs. There are two different methods that can be used to calculate the breakeven point, the equation method and the contribution margin method.

The equation method formula is as follows:

Sales = Variable Costs + Fixed Costs + $0

Lets look at an example. Here is the data:

Sales = $50 per unit

Variable expenses = $10 per unit

Fixed expenses = $20,000

So, the breakeven point (X) would be:

$50X = $10X + $20,000

$40X = $20,000

X = 500 units

The contribution margin method takes the fixed expenses and divides it by the unit contribution margin to determine the breakeven point in units so using the same data above in that example:

Contribution margin per unit = ($50 $10)

Breakeven point in units sold = $20,000 / ($50 $10) = $20,000 / $40 = 500 units

If you want to determine the breakeven point in sales dollars, you will take the fixed expenses and divide it by the contribution margin ratio. Contribution margin ratio is found by taking the contribution margin and dividing it by the sales. So, for example, using the same data:

$20,000 / 0.80* = $25,000

*The contribution margin ratio is found by taking the contribution margin ($40) and dividing it by the sales ($50) = 0.80. Each $1.00 increase in sales results in a total contribution margin increase of 80.

We can also calculate the breakeven point with profit that a company wants to make by plugging in the desired profit into the breakeven formula. So, looking at the same data given above, lets calculate the number of units needed to generate $30,000 of profit: (X is units)

$50X = $10X + $20,000 + $30,000

$40X = $50,000

X = 1,250 units

As you have been learning about costing of jobs, you have primarily been doing absorption costing, which is treating all manufacturing costs, variable and fixed, as product costs. Another name for absorption costing is full costing, because it considers all types of manufacturing costs.

An alternative to absorption costing is variable costing, which only considers variable costs as product costs. This will normally include direct materials, direct labor, and variable manufacturing overhead. Under variable costing, fixed manufacturing overhead will not be included as a product cost, but instead it will be like a period cost and deducted all in the period incurred. Due to this treatment, cost of goods sold will normally be a lower number as well as value of ending inventory. It is important to note that when we say variable costs, we are only referring to variable product costs so other types of variable costs that are normal period costs, will remain period costs.

So, for example, if we produced 100 units that had $8 in direct materials, $9 in direct labor, $5 in variable manufacturing overhead, and $1,000 of total fixed costs for the period, we would calculate the unit cost under the absorption costing method as follows:

Direct Material	$8
+ Direct Labor	$9
+ Variable Manufacturing Overhead	$5
+ Fixed Manufacturing Overhead*	$10
= Unit Product Cost	$32

*Manufacturing Overhead = $1,000 total fixed costs / 100 units = $10 per unit

Now, under variable costing, the unit product cost would be calculated like this:

Direct Material	$8
+ Direct Labor	$9
+ Variable Manufacturing Overhead	$5
= Unit Product Cost	$22

The difference is that fixed manufacturing overhead under variable costing will no longer be considered as part of the cost of the product.