Transcript Accounting Based Equity Valuation Model: One Period

ACCT 2302
Fundamentals of Accounting II
Spring 2011
Lecture 6
Professor Jeff Yu
Review: Cost Behavior
True Variable Cost (a=0, b>0)
Total cost: Y=bX, increases with X
Unit cost: Y/X=b, constant
Fixed Cost (a>0, b=0)
Total cost: Y=a, constant
Unit cost: Y/X=a/X, decreases with X
Mixed Cost (a>0, b>0)
Total cost: Y=a+bX, increases with X
Unit cost: Y/X=a/X + b, decreases
with activity level X.
Review: Cost Function & High-low Method
Cost Function: Y = a + bX
(1) Select the highest- & the lowest- activity levels: Xh, Xl
(2) Fit a line through the two data points: (Xh, Yh), (Xl, Yl)
Yh =a + bXh
Yl =a + bXl
b=(Yh - Yl)/(Xh - Xl)
a= ?
The slope of the line: b = Variable Cost per unit
The intercept of the line: a = Total Fixed Cost
The Contribution Format Income Statement
Used primarily for
external reporting
Used primarily for Managerial
Decision making
The Contribution Format Income Statement
Sales
Less: Variable costs
Contribution margin
Less: Fixed costs
Net income
Total
$ 100,000
60,000
$ 40,000
30,000
$ 10,000
Unit
$ 50
30
$ 20
The contribution format emphasizes cost behavior.
Contribution Margin (CM) covers fixed costs
and then contributes to net operating income.
Example
Comparative income statements for Boggs Co. for the last two months are
presented below (assume all costs are either fixed, true variable or mixed):
Sales in units
Sales
Cost of goods sold
Gross margin
Selling and administrative expenses:
Rent
Sales commissions
Maintenance expenses
Clerical expense
Total S&A expense
Net operating income
July
11,000
$165,000
72,600
92,400
August
10,000
$150,000
66,000
84,000
12,000
13,200
13,500
16,000
12,000
12,000
13,000
15,000
54,700
$ 37,700
52,000
$ 32,000
Q: Prepare a contribution margin format income statement for August.
Practice Problem
The 2010 income statement for Janna Company is as follows:
Sales
Less: Cost of goods sold
Gross Margin
Less: Selling expenses
Administrative expenses
Net Income
$1,600,000
$1,200,000
$ 400,000
$ 196,000
$ 98,000
$ 106,000
The price of the product is $50 per unit and CGS is entirely variable. Variable
selling expenses are $5.5 per unit. The remaining selling expenses are fixed.
Variable administrative expenses are 2% of CGS. The remaining administrative
expenses are fixed.
Q: (1) What is the contribution margin for year 2010?
(2) Let X be the number of units sold, what is the cost function for total S&A
expenses?
Chapter 6: CVP Analysis
Break-even point is the amount of units needed to be
sold to make the company’s revenues equal to
expenses (NOI = 0).
Sales
Less: Variable Expenses
Contribution Margin
Less: Fixed Expenses
Net Operating Income
$250,000
150,000
$100,000
100,000
0
Break-even Point: The Equation Method
Sales – Variable Expenses – Fixed Expenses = NOI
Units
Unit
price × sold
VC
Per
Unit
Units
× Sold
$$$
At the break-even point, NOI=0.
$0 or
target Profit
Break-even Point: Contribution Margin Method
Contribution Margin = NOI + Fixed Expenses
At the Break-even Point, NOI = 0,
Contribution Margin = Fixed Expenses.
Fixed Expenses
Break Even Pointin Units
Contribution Margin per Unit
Once the Break-even Point has been reached, NOI will increase by
contribution margin per unit for each additional unit sold.
Example
Consider Razor Inc, a scooter manufacturer. For each additional
scooter sold, Razor Inc. generates $200 in contribution margin.
Total
$ 250,000
Per Unit
Percent
Sales (500 scooters)
Less: variable expenses
Contribution margin
Less: fixed expenses
80,000
Net Operating Income
$ 20,000
Q: calculate the break-even point in units for Razor Inc.
Break Even Point in Sales Dollars
We can calculate the break-even point in sales dollars rather than in
units using the Contribution-Margin (CM) ratio.
CM
CM Ratio 
Sales
CM = Fixed Expenses
at the break-even point
Fixed Expenses
Break Even Point in Sales Dollars 
CM Ratio
What is the break-even point in Sales Dollars for Razor Inc.?
Target Profit: CM Approach
We can determine the number of scooters that Razor must sell to
earn a target profit of $100,000 by slightly modifying the break-even
point formula:
Original formula:
Fixed Expenses
Break Even Pointin Units
CM per Unit
Target profit modification:
Unitssales to attainT argetProfit
Fixed Expenses T argetProfit
CM per Unit
Target Profit: Equation Approach
Sales revenue – Variable expenses – Fixed expenses = NOI
($500 × X)
–
($300 × X)
($200X)
=
–
$80,000
$180,000
X = 900 units
= $100,000
Practice Problem
Asphalt is a gravel making firm. Gravel is made by crushing stones.
The variable cost of making gravel is estimated to be $15 per ton.
The fixed costs of operating the gravel making plant for the year are
$100,000. The sales price of gravel is $25 per ton.
Q:
(1)How many tons of gravel must Asphalt sell to break even?
(2)What is the break-even point in sales dollars for Asphalt?
(3)How many units you have to sell if the target profit is $100,000?
(4)What will the NOI be if 11,000 tons of gravel are sold?
For Next Class
 Continue covering Chapter 6.
 Complete assigned readings.
 Attempt the assigned HW problems.
Homework Problem 1
Fill in the blanks of the following table:
Units Sold
Unit
Price
120,000
$30
VC per CM per Total CM
unit
unit
$720,000
100,000
$6
80,000
$9
$4
Total fixed
costs
NOI
$640,000
$320,000
$160,000
$40,000
Homework Problem 2
In 2010, Voltar Co. sold 20,000 units of a special telephone at $60
each, variable expenses were $900,000 and fixed expenses were
$240,000.
Q:(1) Compute its CM ratio and variable expense ratio.
(2) Compute its break-even point in units and sales dollars.
(3) How many units have to be sold to earn a profit of $90,000 in
2011?
Homework Problem 3
Air Safety Systems manufactures a component used in aircraft
radar systems. The firm’s fixed costs are $4,000,000 per year. The
variable cost per unit is $2,000 and the sales price is $3,000 per
component. The company sold 5,000 components in 2010.
Q: (1) What is the breakeven point in units? (2) What is the
breakeven point in units if fixed costs increase 10%? (3) What if
sales price and VC per unit both decrease 10%, while other things
remain unchanged?
The sales manager believes that reducing sales price to $2,500 per
unit will increase the sales volume to 7,500 components.
(4) What will the new break-even point in units be? Should the
change be made?