CHAPTER 11 DEVELOPING A BUSINESS PLAN FOR A MANUFACTURING COMPANY:

1. CHAPTER 11 DEVELOPING A BUSINESS PLAN FOR A MANUFACTURING COMPANY: COST-VOLUME-PROFIT PLANNING AND ANALYSIS

2. Chapter Overview • How does the fact that a manufacturing company makes the products it sells affect its business plan? • How does a manufacturing company determine the cost of the goods that it manufactures? • Why are standard costs useful in controlling a company’s operations?

3. Chapter Overview • How do manufacturing costs affect cost-volume-profit analysis? • What is the effect of multiple products on cost-volume-profit analysis? • How does a manufacturing company use cost-volume-profit analysis for its planning?

4. The Production Plan • The production plan is part of a manufacturing company’s overall business plan. • It describes how the company plans to efficiently produce its goods while maintaining a desired level of product quality. • It also describes the company’s plan for achieving specific levels of productivity through the use of raw materials, labor, equipment, and facilities.

5. Manufacturing Costs • A major difference between accounting of a manufacturing company and that of a retail company is the way in which inventories and cost of goods sold are measured. • Unlike retail companies, a manufacturing company has no products to sell until they are manufactured. • The manufacturing cost of goods includes three components: raw materials, direct labor, and factory overhead.

6. Direct materials are the raw materials that physically become part of a manufactured product Direct labor is the labor of the employees who work with the direct materials to convert or assemble them into finished products. Factory overhead includes all items, other than direct materials and direct labor, that are necessary to manufacture products. They usually cannot be traced to individual products. Manufacturing CostsExhibit 11-3

7. Standard Costs • Standard costs are the costs that should be incurred in performing an activity or producing a product. • Many factors influence the determination of standard costs, because assumptions must be made about the set of conditions under which the costs will be incurred. • These cost assumptions are incorporated into the company’s production plan and, ultimately, its financial plan.

8. Standards provide the benchmark to analyze why costs vary from what is planned. Standards simplify decision-making, providing a more reliable basis for estimating costs and to project costs when needed. Standards are very useful in developing a company’s operating budget as part of its production plan. Usefulness of Standard Costs

9. Behavior of Manufacturing Costs: Using CVP Analysis • To study manufacturing costs with CVP analysis, the cost behavior of each cost must be determined. • Like other costs, manufacturing costs can ultimately be classified into fixed or variable costs.

10. What were the characteristics of variable and fixed costs that we learned in Chapter 3? Reflection

11. Fixed costs are constant in total but change on a per unit basis. At a level of 500 boxes of chocolate, the monthly rent is $1,000 or $2 per box; at 1,000 boxes, it is still $1,000 in total but only $1 per box. Fixed manufacturing costs react in the same way. Fixed Cost BehaviorExhibit 3-3 • Recall how Sweet Temptation’s monthly rent remained constant at $1,000 per month as sales volume increased.

12. Variable costs change in total but are constant on a per unit basis. At a level of 500 boxes of chocolate, variable costs are $2,250, or $4.50 per box. At 1,000 boxes, the variable costs are $4,500 in total, but still $4.50 per box. Variable manufacturing costs react in the same way. Variable Cost BehaviorExhibit 3-4 • Recall how Sweet Temptation’s variable costs increased proportionately as sales volume increases.

13. Classifying Manufacturing Costs • The costs of direct materials and direct labor are variable manufacturing costs because these costs change as production varies. • Factory overhead can be both fixed and variable, depending on the type of cost incurred. • For example, indirect materials and labor would be variable factory overhead and depreciation would be fixed factory overhead.

14. Total mixed cost = F + vX Mixed Cost BehaviorExhibit 11-5 Some costs have a fixed and a variable component. These are called mixed costs.

15. High Low Method of Cost Estimation • The high-low method is an accounting tool to calculate the cost of operating at a given level of activity. • It assumes that any change in total costs from one operating level to another is due to an increase in variable costs. • By determining the variable cost at any given level, total costs can then be computed.

16. Cost change from lowest to highest volume v = High Low Method of Cost Estimation • Variable cost per unit at any given level (defined as “v”) may be calculated with the following equation: Volume change from lowest to highest volume

17. $110,000 v = High Low Method of Cost Estimation • Assume Unlimited Decadence’s power cost and related volume data for the last 6 years is as follows: • Variable cost per unit can be estimated at: = $0.05 2,200,000

18. High Low Method of Cost Estimation • By multiplying the variable cost per unit times the volume (at any level), the total variable costs at the given level can be calculated: X $0.05 = $250,000 5,000,000 cases • By subtracting total variable costs from the total cost, the total fixed costs can be calculated:

19. Fixed costs Variable costs High Low Method of Cost Estimation • Now we can create a total cost formula for any given level of activity. Remember the total cost equation is expressed as follows: Total Costs = F + vX • Thus, Unlimited Decadence’s total power costs can be expressed in the following total cost equation: Total Power Costs = $42,000 + $0.05X

20. Cost ($) 5,000 25,000 Activity level Relevant Range • Relevant range is the normal level of activity over which costs are predictable: Relevant range

21. Using CVP Analysis with Product Sales Mix • In Chapter 3, we learned how CVP analysis is used to calculate profit under alternative sales volumes, selling prices, and costs. • Calculating contribution margin per unit was a key factor in performing CVP analysis. • An implicit assumption used in Chapter 3, in computing contribution margin, was that the product equaled 100% of the sales mix.

22. Darkly Decadent accounts for 5/6th or 83% of Unlimited Decadence’s sales Using CVP Analysis with Product Sales Mix • In most cases, a company produces more than one product, so assuming that contribution margin of any one product is 100% of the sales mix is not valid. • Product sales mix is the relative proportion of units of different products sold.

23. Using CVP Analysis with Product Sales Mix • When more than one product is sold, the total contribution margin is weighted to reflect that portion of contribution margin each product contributes.

24. Fixed costs Contribution margin per unit $24,800,000 $31 per unit Calculating Break-Even Point • Using the $31 weighted contribution margin per unit, Unlimited Decadence’s break-even point in units can be calculated using the breakeven formula: = 800,000 units

25. Pre-tax net income can be defined as after-tax net income/(1 – tax rate), or $60,000/ (1 -.40),or $100,000 After-tax net income can be defined as 1 – tax rate (1 -.40), or .60 (60%), or $60,000 The Impact of Taxes on Break-Even Point • A company usually wants to project its break-even point in pre-tax or after-tax dollars. If a company earns $100,000 in net income and pays 40% in income taxes, its pre-tax and after tax income can be expressed as:

26. Fixed costs + Desired pretax income Contribution margin per unit $24,800,000 + 5,400,000* $31 per unit *$3,240,000/(1-0.40) Calculating Pre-Tax Break-Even Point in Units • If we assume Unlimited Decadence is subject to a 40% tax rate and projects after tax income of $3,240,000, the pre-tax break-even point, in units, would be computed as follows: = 974,194 units

27. Fixed costs + Desired pretax income Contribution margin ratio $24,800,000 + 5,400,000** 31% **$3,240,000/(1-0.40) Calculating Pre-Tax Sales Volume • We can also project sales volume by using the contribution margin ratio of 31%* instead of the contribution margin per unit of $31. *Sales price $100 VC 69 CM $ 31 CMR 31% = $97,419,355

28. Calculating Break-Even of Adding a New Product • Assume Unlimited Decadence is considering making a new chocolate bar, Empty Decadence. • The new bar would require $1,188,000 in special processing equipment to be purchased, but is expected to yield a contribution margin per case of $5.50. • How many cases of Empty Decadence bars would have to sold to break-even?

29. Additional Fixed costs Contribution margin per unit The numerator includes the additional fixed costs of the new product line (the special processing equipment) Contribution margin per unit The denominator includes the contribution margin of the new product (projected sales price less variable costs) Calculating Break-Even of Adding a New Product • CVP concepts can easily be applied to determine the break-even point for this new product:

30. $1,188,000 $5.50 Additional Fixed costs Contribution margin per unit Contribution margin per unit Unlimited Decadence would have to evaluate the likelihood of achieving this unit sales target in deciding to go forward with the new product. Calculating Break-Even of Adding a New Product • Unlimited Decadence would have to sell 216,000 cases of Empty Decadence to break-even: = 216,000 cases