Profitability Analysis : Profitability Analysis
Profits = Revenues - Costs : Profits = Revenues - Costs To analyze the profitability of a firm we need to analyze the revenues and the costs separately
Costs Analyses : Costs Analyses So far we covered various topics that help us understand the costs side of the equation such as: 1. Budget analysis (Static versus flexible) 2. Product costing (DM, DL, OH) 3. Cost Behavior (Variable versus Fixed costs) 4. Variance analysis (covered in the lab in detail)
One additional piece that we need to add here is to distinguish between variable vs. absorption costing
Absorption and Variable Costing : Absorption and Variable Costing Absorption costing: It assigns all manufacturing costs, DM, DL, VOH, and a share of FOH to each unit of product.
Variable Costing: It assigns only unit-level variable manufacturing costs to the product; these costs include DM, DL, and VOH. FOH is treated as period costs and is not inventoried with the other product costs.
Slide5 : Classification of Costs as Product or Period Costs Under Absorption and Variable Costing Absorption Variable Costing Costing
Direct Materials Product Product
Direct Labor Product Product
Variable Overhead Product Product
Fixed Overhead Product* Period*
Selling Expenses Period Period
Administrative Expenses Period Period
* Fixed overhead is the only cost that changes classifications between the two methods.
Slide6 : Absorption and Variable Costing Example Estimated and Actual Costs:
Manufacturing: Direct materials $100,000
Direct labor 50,000
Variable overhead 80,000
Fixed overhead 90,000
Total manufacturing cost $320,000
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Non-manufacturing:
Variable selling $ 32,000
Fixed selling & administrative 100,000
Total manufacturing $132,000
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Slide7 : Absorption and Variable Costing Example (continued) Estimated and actual production 100,000 units
Sales 80,000 units
Price $6.50 per unit
Beginning finished goods 0
Slide8 : Absorption and Variable Costing Example (continued) Unit Cost: Variable Absorption
Direct materials $1.00 $1.00
Direct labor 0.50 0.50
Variable overhead 0.80 0.80
Fixed overhead 0.00 0.90
Total $2.30 $3.20
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Value of ending finished goods inventory:
Variable costing: $2.30 x 20,000 = $46,000
Absorption costing: $3.20 x 20,000 = $64,000
Slide9 : Income Statements: Absorption Costing Sales ($6.50 x 80,000) $520,000
Less: COGS ($3.20 x 80,000) 256,000
Gross profit $264,000
Less: S & A expenses 132,000
Operating income $132,000
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Slide10 : Income Statements: Variable Costing Sales ($6.50 x 80,000) $520,000
Less variable expenses:
Variable COGS: ($2.30 x 80,000) $184,000
Variable selling 32,000 216,000
Contribution margin $304,000
Less fixed expenses:
Fixed overhead $ 90,000
Fixed administrative 100,000 190,000
Operating income $114,000
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Slide11 : Income Statements: Analysis and Comparison Difference:
Absorption income $132,000
Variable income 114,000
$ 18,000
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Explained:
Production (in units) 100,000
Sales (in units) 80,000
Increase in inventory (in units) 20,000
Fixed overhead rate x $0.90
$ 18,000
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Slide12 : Production, Sales, and Income Relationships If Then
Production > Sales Absorption NI > Variable NI
Production < Sales Absorption NI < Variable NI
Production = Sales Absorption NI = Variable NI
Advantages of Variable Costing : Advantages of Variable Costing Does not bury fixed costs in the cost of goods sold calculation.
Enables one to focus on fixed costs.
Enables one to perform incremental analysis and assists in decision making.
Enables one to perform segmented reporting.
Net income under variable costing is highly correlated with changes in sales and production.
Disadvantages of Variable Costing : Disadvantages of Variable Costing Too much focus on the short-run.
May ignore the impact of fixed costs on decisions.
Very expensive to install.
Revenues Analysis : Revenues Analysis We nee to analyze the effect on the budgeted profit of:
changes in selling prices
changes in the volume of sales
Allowing for changes in market size,
and changes in market share
if more than one product, changes in sales mix.
Slide16 : Revenue variances If more than one product,
Sales activity variance breaks down into
Sales mix variance
Sales volume variance
The sales volume variance breaks down into
Market size variance
Market share variance
If only one product: Sales activity = Sales volume
Slide17 : Example: Krueger Company The Krueger Company produces three kinds of folding chairs: #64, #65, and #66. Its budget for the accounting period was based on the following:
Slide18 : Example: Krueger Company Krueger Company anticipated a 20 percent market share and the actual total industry market was 70,000 units sold. Compute the following variances: Sales price variances: #64: $8 x 2,000 - $12,000 = $4,000 #65: $12 x 4,000 - $64,000 = $16,000 #66: $10 x 6000 - $78,000 = $18,000 Total = $30,000 U F F F
Slide19 : Example: Krueger Company Use budgeted contribution margins for the remaining variances: A weighted average CM WACM = $4x(3/15) + $3x(7.5/15) + $6x(4.5/15) Sales volume variance = (change in units sold) x WACM = (15000 - 12000) x $4.10 = $12,300 U WACM = $4.10 Or: Budgeted total contribution margin/budgeted sales
WACM = $61,500/15,000 = $4.10
Slide20 : Example: Krueger Company Sales mix variance = (change in 64 sales) x ($4 - $4.10) + (change in 65 sales) x ($3 - $4.10) +
(change in 66 sales) x ($6 - $4.10) = $6,800 F
Slide21 : Example: Krueger Company Sales volume variance = Total change in volume x WACM (15,000 - 12,000) x $4.10 = $12,300 U Sales activity variance = Sales mix + Sales volume $6,800 - $12,300 = -$5,500 U Sales activity variance = (3000 - 2000) x $4 + (7500 - 4000) x $3 + (4500 - 6000) x $6 = $5,500 U
Slide22 : Example: Krueger Company Market size variance = (budgeted market size - actual market size) x budgeted market share x WACM = ((15,000/.2) - 70,000) x .2 x $4.10 = $4,100 U Market share variance = (budgeted market share - actual market share) x actual market size x WACM = (.2 - (12000/70000)) x 70,000 x $4.10 = $8,200 U