Company X produces a molded hard plastic covers for I-pads. Summary data from its 2020 income statement are as follows:

“It’s the accounting.” That’s what many investors seem to be saying these days. Even the slightest hint of an accounting irregularity can negatively affect a company’s stock price. Investors require, relevant and reliable information, or they will take their money elsewhere.

To restore public confidence in the financial reporting process, many have argued that accounting standards should be principles-based rather than rules-based. They believe that companies have exploited the detailed provisions in rules-based pronouncements to manage accounting reports, rather than the economic substance of transactions. Under principles-based rules, management’s financial reporting focus would shift away from demonstrating compliance with rules, and rest more squarely on professional judgment. In fact, the International Accounting Standards Board (IASB) already uses this approach. Follow the instructions below to access the Free Basic version of the Accounting Standards Codification (ASC). The ASC is a complete reference resource for all U.S. Generally Accepted Accounting Principles (GAAP).

(Video Transcript

Unit three, lecture one, cost volume, profit analysis.

In this unit, we begin our study of how managers can used cost volume, profit CVP analysis to understand how profits respond to prices, costs and production volume. This model can be used to predict when a company will begin to turn a profit and what is likely to happen if specific changes are made to product prices, the cost of production or the number of units produced.

A CVP graph depicts these relationships visually in the graph. We see the components of the cost volume, profit analysis represented by solid lines are fixed costs. This is the horizontal red line, total costs, the diagonal blue line and total revenue diagonal green line.

In addition to these graft lines, the chart also indicates several other very important pieces of information, the triangular shaped area between the total coastline, which is blue and the fixed coastline, which is red, is the area that represents the variable costs of the company.

This area is highlighted yellow and extends all the way over to the y axis, as you will notice, the total cost line does not begin at zero, but instead intersects the Y axis at twenty dollars. This is because even when the company is not producing anything, meaning that it has zero variable costs. It still incurs the fixed cost of twenty dollars as the company begins to produce units, the total costs increase proportionately in a linear fashion equal to the additional amount of variable costs that are incurred. This linear quality, a variable cost is an important assumption and CVP analysis. The total cost line, therefore, represents the sum of the increasing variable costs and the fixed costs.

The point at which the blue total coastline and the green total revenue line intersect is an important number at this point represented by the star, we see that the total cost and the total revenue of the company are equal. This point is called the break even point in our example here, when revenue is twenty eight dollars and the number of units sold is one hundred. The company will have achieved the break even point. Any volume of sales above a hundred units will generate a profit for the company, as indicated by the green shaded area above the cost line and any volume of sales below 100 hundred units. And the company will incur a loss as indicated by the red shaded area below the cost line.

So how do we compute this point, the equation for the break even point requires that you first understand the contribution margin. You have already studied the contribution margin in Unit one when you studied the variable costing method, the contribution margin is what is left over from revenue after all of the variable costs have been met. The formula for the break even point in the number of units equals fixed costs divided by the contribution margin.

Here’s an example, let’s say an airline wants to know how many tickets must be sold in order to break even a ticket sells for two hundred and eighty dollars. Variable costs are eighty dollars per flight and the fixed costs are 20 million dollars per year. If we plug these numbers into the formula. We see that we need to sell 100000 tickets in order to break even. If we want to know how much revenue we need to earn in order to break even, we simply multiply the number of break, even units by the price per that per unit or price per ticket in this case break even revenue equals hundred thousand tickets times two hundred and eighty dollars or approximately twenty eight million dollars.

If we don’t know the breakeven number of units, there’s another way to figure out the required sales revenue to break even, we can use the contribution margin ratio. This is a ratio of the contribution margin to the selling price. And it tells us what percentage of the selling price is available to cover the fixed costs contribution. Margin ratio equals the contribution margin divided by the price in this case. Two hundred dollars divided by two hundred and eighty dollars equals seventy one point four two percent. If we plug that into our breakeven revenue formula, we can see that we need to sell twenty eight million dollars worth of ticket revenue in order to break even.

These formulas can be modified to compute the number of units or revenue dollars needed to achieve a desired target profit. For example, if we want to earn a profit of five hundred thousand, then we would modify the examples by adding the desired profit to the fixed costs and then dividing by contribution margin in order to obtain the breakeven number of units. Or we would add the desired profit to the fixed costs and divide by the contribution margin ratio to determine the break even amount of revenue.

Generally speaking, most companies have more than one product for sale in these situations, it’s still possible to predict the break even point by taking a weighted average of the impact of each product on total sales.

To continue with our airline example, let’s say that our company offers three types of tickets, first class business and coach of the 100 seats available on each airplane, 10 are reserved for first class, 20 for business and the remaining 70 for coach. The respected information on ticket prices and variable costs are listed here in this chart. To compute the weighted average contribution margin, we multiply the contribution margin of each product by the percentage of sales mix that that product represents. For example, a first class ticket sells for five hundred and fifty dollars and has a variable cost of two hundred and thirty dollars. This makes the contribution margin for this product three hundred and twenty dollars to determine the weight of this product. In the total product mix, we multiply the three hundred and twenty dollars by the 10 percent. This gives us a weighting of thirty two dollars. We repeat this process for each product and then some the weightings to arrive at the weighted average contribution margin of a hundred and twenty nine dollars. Next, we use the weighted average contribution margin in our break-even formula. We divide the fixed cost of 20 million dollars by the one hundred and twenty nine dollars. And we see that we need to sell one hundred and fifty five total tickets in order to break even in a multiproduct scenario.

Of these hundred and fifty five thousand tickets, we can compute the required number of tickets for each class of service by multiplying the total breakeven number by the respective percentage of the sales mix for each product. Here we see that we need to sell fifteen thousand five hundred first class tickets. Thirty one thousand business class tickets. And one hundred and eight thousand five hundred coach tickets.

Using this information and the pricing information per ticket, we can compute the revenue required by each product to achieve the break even point. First, we must compute the weighted average price per ticket, and we do that by multiplying the price times, the percentage of sales mix and then summing the weightings together like we did for the weighted average contribution margin. Here we see that the weighted average price is three hundred and thirty six dollars.

Using the weighted average contribution margin, one hundred and twenty nine dollars and the weighted average price, three hundred and thirty six dollars, we can compute the weighted average contribution margin ratio here. We see it’s thirty eight point four percent. Once we have this information, we can plug that contribution margin ratio into the regular break, even for revenue formula, and we see that we need to earn fifty two million eighty thousand dollars in order to break even in this multiproduct scenario.

Finally, we can compute the required revenue for each class of ticket by multiplying the breaking even number of units by the respective price per ticket.

Sometimes a company will not know the variable cost per unit because sometimes costs are not strictly fixed or variable, a mixed cost contains both a variable and a fixed element. For example, the cost of delivering pizza in a company truck would be a mixed cost. The cost of having the truck and the driver available to make the deliveries is fixed. But the cost of fuel to make the deliveries is dependent on the number of deliveries that is made and is variable. In this case, the manager will have to estimate what the variable costs are in order to compute the break even point. There are several methods for estimating variable costs, and the three popular methods are scattered Grofe the high-low method and the linear regression model.

The behavior, of course, can be analyzed by using a scatter graph to determine if the costs are linear or related to a specific activity level cause behavior is considered to be linear. If the graphed points roughly lie along a straight line, pass through them. If you will recall, an essential assumption of CVP analysis is that cost, volume and profit have a linear relationship. Here is an example of some cost data and a scatter graph for pizza deliveries, I have graphed the total cost of making the deliveries per quarter with the activity level or the number of deliveries that were made since we can pass a line roughly through the points. It appears that these costs have a linear relationship to the activity.

Assuming that our data has a linear relationship, we can determine the equation of the line that best fits through these data points. This equation allows us to predict costs. Mix costs can be represented by the equation. Y equals A plus B X. Using this cost equation and the Hielo method, we can determine the equation that expresses the relationship between the delivery cost and the number of deliveries made. To use the High-Low method. We must determine the highest level of activity and the lowest level of activity.

From our data set, we can see that the most deliveries were made in the third quarter of the second year. Five hundred and forty deliveries were made at a cost of twenty five thousand two hundred dollars. And the fewest number of deliveries occurred in the first quarter of the first year when three hundred and sixty deliveries were made at a cost of eighteen thousand. These two data points will allow us to determine the slope of our cost line. Using the high and low data, we can estimate the variable cost per delivery by determining the change in cost from the highest and lowest levels of activity here. B represents the slope of the cost equation.

The next step is to determine the fixed cost component of the total cost for the quarter, plugging our numbers into the cost equation. We see that the fixed cost represented by the variable AI was thirty six hundred dollars.

Using the variables that we have just calculated, we can see that our cost equation is Y equals thirty six hundred plus forty X. Now we can use this equation to estimate costs for any activity level.

Here is our original graph of the delivery points, the green line represents our cost equation and is the total cost of our deliveries. The red line represents the fixed cost of thirty six hundred dollars. The total cost line never goes below this fixed cost line because we always have to pay the thirty six hundred dollars for the truck and the delivery drivers. Therefore, costs never go down to zero. The yellow shaded area represents the variable costs that are dependent on the level of activity or in this case, the number of deliveries that are made.

Another method of cost estimation is the linear regression model. This model is a more sophisticated version of the Hielo method. It is the statistical model that can be manually calculated. However, the math required for this calculation is beyond the scope of this course. Luckily, we can use this method in Excel. Please see page 311 of your textbook for a discussion of the specific steps for how to perform this model in Excel. To use this method is important to understand the required components. The independent variable or X is the activity level and that represents the number of deliveries in our pizza delivery example. The Y or dependent variable represents the delivery costs.

Using the data for these two variables, Excel will analyze the linear relationship of the data points and determine if the two items, the activity level and the delivery costs are related to each other. Using the data for the number of deliveries and the delivery costs from the Hielo method example above, Excel will return the following results.

Here, the y intercept is computed as sixty seven forty two, with a standard error of plus or minus twenty eight seventeen, if we subtract a standard error from the sixty seven forty two, the result is thirty nine. Twenty five. This is fairly close to the Y intercept that we computed using the High-Low method, which was thirty six hundred. Additionally, the coefficient of the X variable is roughly equal to the slope of the line here. Excel returned a value of thirty four, which again is fairly close to our estimate of forty that we got using the High-Low method. The R-squared value equals the percentage of variation in the dependent Y variable that is explained by the independent X variable. In other words, it explains the percentage of delivery costs that can be explained by changes in the number of delivery. The closer to 100 percent that this number is, the more confident that you are that these two items affect each other. In this case, Excel returned an R squared value of eighty two percent. This means that we are eighty two percent certain that the cost of the deliveries depends upon the number of deliveries.

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(Read Scenario

Company X produces a molded hard plastic covers for I-pads. Summary data from its 2020 income statement are as follows:

Revenues: $5,000,000

Variable costs: $3,100,000

Fixed costs: $2,500,000

Operating income: ($600,000)

The Company X president, Jane Harvey, is very concerned about the firm’s poor profitability. She asks Joe Smith, the Production Manager (managerial accounting) to see if there are any ways in which they can reduce costs.

A few weeks later, Joe returns with a proposal to reduce variable costs to 48% of revenues by reducing the costs that the company currently incurs for safe disposal of wasted plastic.

The Controller (Financial Accounting) is concerned that this would expose the company to potential environmental liabilities. He tells Joe that he thinks that the company would need to estimate some of the potential environmental costs and include them in the break-even analysis. Joe Smith disagrees. He feels that the company will not be violating any laws and that there is only a possibility of environmental costs in the future.

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In your original post, you must address all of the following:

1. Calculate the breakeven revenues for 2020 using the information given above.

2. Re-calculate the breakeven revenues if variable costs are 48% of revenues.

3. Calculate the company’s operating income for 2020 if variable costs had been 48% of revenues.

4. Answer the following questions

What are the ethical issues involved in this case? Explain your answer.

How do these issues relate to rules-based standard-setting and principles-based standard setting?

Do you feel that the Production Manager is acting improperly, unethically, or immorally? Why or why not? Please explain your response.

What stakeholders would be affected if the Controller implemented the Production Manager’s suggestions? Why?

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