Profitability Analysis

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Information about Profitability Analysis

Published on February 24, 2008

Author: Cannes


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 ======= Non-manufacturing: Variable selling $ 32,000 Fixed selling & administrative 100,000 Total manufacturing $132,000 ======= 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 ==== ==== 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 ======== 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 ======== Slide11:  Income Statements: Analysis and Comparison Difference: Absorption income $132,000 Variable income 114,000 $ 18,000 ======= 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 ======= 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

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