Homework Problem

Purpose

The purpose of this assignment is to assess your ability to:

• Explain the management planning and control cycle, and identify the major differences between financial accounting and managerial accounting.
• Describe the difference between variable and fixed cost behavior patterns.
• Explain and illustrate the difference between the traditional income statement format and the contribution margin income statement format.
• Describe the meaning and significance of the break-even point and illustrate how the break-even point is calculated.

Action Items

1. Complete the following items listed in the Module 7 Reading and Preparation object:
   • Review Chapter 12 in Marshall, D., McManus, W., & Viele, D. (2023).
2. Complete the two following problems from the textbook:
   • Problem 12.18: Use the attached Excel worksheet for Problem 12.18 . Reference from the textbook will be Exhibit 12-5.
   • Problem 12.20: Use the attached Excel worksheet for Problem 12.20. Reference from the textbook will be sections L07, 8, 9, and 12 and the Business in Practice article titled: Estimating Cost Behavior Patterns Using Microsoft Excel.

12.18

Special promotioneffects of a 1-cent sale The management of Rockos Pizzeria is considering a special promotion for the last two weeks of May, which is normally a relatively low-demand period. The special promotion would involve selling two medium pizzas for the price of one, plus 1 cent. The medium pizza normally sells for $11.99 and has variable expenses of $4. Expected sales volume without the special promotion is 400 medium pizzas per week.

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Required:

Calculate the total contribution margin generated by the normal volume of medium pizzas in a week.

Calculate the total number of medium pizzas that would have to be sold during the 1-cent sale to generate the same amount of contribution margin that results from the normal volume.

What other factors should management consider in evaluating the pros and cons of the special promotion?

• Problem 12.20: Use the attached Excel worksheet for Problem 12.20. Reference from the textbook will be sections L07, 8, 9, and 12 and the Business in Practice article titled: Estimating Cost Behavior Patterns Using Microsoft Excel.

Submission Instructions

Submit the two Excel files.

O 12-7

Explain and illustrate the difference between the traditional income statement format and the contribution margin income statement format.

The traditional income statement format classifies costs according to the reason they were incurred: cost of goods sold, selling expenses, administrative expenses, research and development expenses, and so on. This format is used for financial accounting statements prepared for external use, according to generally accepted accounting principles. For internal purposes, however, managers need an income statement that can serve decision-makers needs. Therefore, the income statement format used in CVP analysis, frequently referred to as the contribution margin format, classifies costs according to their cost behavior patternvariable or fixed. Here are the comparative formats with assumed dollar amounts for illustration:

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Traditional Format

(Expenses Classified by Function)

Contribution Margin Format

(Expenses Classified by Cost Behavior Pattern)

Revenues

$100,000

Revenues

$100,000

Cost of goods sold

50,000

Variable expenses

60,000

Gross profit

$ 50,000

Contribution margin

$ 40,000

Operating expenses

40,000

Fixed expenses

30,000

Operating income

$ 10,000

Operating income

$ 10,000

Revenues and operating income (income before interest and taxes) are the same under either alternative. The difference is in the classification of expenses: a functional classification in the traditional format and according to cost behavior pattern in the contribution margin format. Although the behavior pattern classification could be carried beyond operating income to other income and expense and income taxes, it usually isnt because the greatest benefits of the contribution margin approach are realized in the planning and control evaluation processes applied to a firms operations.

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Business in

Practice

Estimating Cost Behavior Patterns Using Microsoft Excel

Now that you understand the process by which cost behavior patterns are determined using the highlow method, Microsoft Excel can be used to quickly and easily create the cost formula. Several functions in Excel can do this; all of them mathematically calculate the best fit of the data to a linear equation that is generated. The data from Exhibit 12-5 are illustrated below. Two functions are highlighted: INTERCEPT, which solves for the fixed cost, and SLOPE, which solves for the variable rate. Recall the discussion from Exhibit 12-5 regarding the April outlier and notice how different the solution is when the data are included on the left rather than excluded on the right. Also notice how close the mathematically precise results are when April is excluded from the analysis determined by the highlow method used in Exhibit 12-5.

Source: Microsoft Excel 2016

The contribution margin format derives its name from the difference between revenues and variable expenses (in managerial accounting, the terms costs and expenses are often used interchangeably). Contribution margin means that this amount is the contribution to fixed expenses and operating income from the sale of products or provision of services. The key to this concept lies in understanding cost behavior patterns. As revenues increase by selling more products or providing more services, variable expenses will increase proportionately and so will the contribution margin. However, fixed expenses will not increase because they are not a function of the level of revenue-generating activity.

LO 12-8

Use the contribution margin format to analyze the impact of cost and sales volume changes on operating income.

Use of the traditional income statement model can result in misleading and erroneous conclusions when changes in activity levels are being considered because it is assumed that all expenses change in proportion to changes in activity. This error is made because cost behavior patterns are not disclosed. The error is avoided when the contribution margin model is used correctly. For example, assume again that the firm illustrated in the income statement presentations earlier currently has revenues of $100,000 and operating income of $10,000. If revenues were to drop by 20 percent to $80,000, a quick conclusion might be that operating income also would decline by 20 percent to $8,000. However, analysis using the contribution margin format results in a much more accurate, and disturbing, result:

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Current Results

Results Assuming a 20% Decline in Revenue

Revenues

$100,000

$80,000

Variable expenses (60%)

60,000

48,000

Contribution margin (40%)

$ 40,000

$32,000

Fixed expenses

30,000

30,000

Operating income

$ 10,000

$2,000

Because fixed expenses did not change (the firm did not move into a different relevant range), the $8,000 reduction in contribution margin resulting from the 20 percent reduction in revenues carried right through to reduce operating income by the same dollar amount. This is an example of why it is misleading to think of fixed costs on a per unit basis. Although fixed costs (and especially the relevant range assumption) should not be overlooked by the manager, it must be recognized that they behave differently from variable costs.

The contribution margin ratio is the ratio of contribution margin to revenues. Think of this ratio as the portion of each sales dollar that remains after covering the variable costs and is available to cover fixed costs or provide profits. Continuing with the same data, each sales dollar generated will provide $0.40 ($1.00 40%) of contribution margin as follows:

O 12-12

Use operating leverage to evaluate cost structures.

When an entitys revenues change because the volume of activity changes, variable expenses and contribution margin will change proportionately. But the presence of fixed expenses, which do not change as the volume of activity changes, means that operating income will change proportionately more than the change in revenues. This magnifying effect on operating income resulting from a change in revenue is called operating leverage. This concept was illustrated in the discussion of the contribution margin format income statement example earlier in this chapter. It showed a 20 percent decline in volume, with revenues, variable expenses, and contribution margin also declining by 20 percent; but operating income declined 80 percent (from $10,000 to $2,000). Note the similarity of operating leverage to the discussion of financial leverage, explained in Chapter 11, in which fixed interest expense causes a proportionately larger change in ROE than the percentage change in ROI resulting from any given change in operating income.

Just as high financial leverage increases the risk that a firm may not be able to meet its required interest payments, high operating leverage increases the risk that a small percentage decline in revenues will cause a relatively larger percentage decline in operating income. The higher a firms contribution margin ratio, the greater its operating leverage. Management can influence the operating leverage of a firm by its decisions about incurring variable versus fixed costs. For example, if a firm substitutes automated production equipment for employee labor, it has changed a variable cost (assuming the employees could be laid off if demand for the firms products declined) to a fixed cost (the machine will depreciate, be insured, and be included in the property tax base whether or not it is being used) and as a result has increased its contribution margin ratio and operating leverage. If the management of a firm anticipates a decline in demand for the firms products or services, it may be reluctant to change its cost structure by shifting variable costs to fixed costs, even though productivity increases could be attained, because the equipment has to be operating to realize the benefits of productivity gains.

The effect of different cost structures, being the relative trade-off of deploying variable versus fixed costs or vice versa, on operating leverage is illustrated in Exhibit 12-9. Observe in Part I that with alternative cost structures and a volume of 10,000 units, Company A and Company B achieved an identical amount of operating income of $100,000. This exhibit illustrates an important element of the decision-making process involving this trade-off between fixed cost (capital-intensive) and variable cost (labor-intensive) alternatives and is referred to as the indifference point. The indifference point is found by setting the cost structure (total cost) of each alternative (Company A and Company B in this example) equal to one another and solving for the volume of activity that equates total cost: