Contribution and Functional Income Statement - Coursework Example

Contribution and Functional Income Statement A. What is the difference between a contribution income statement and a functional income statement? A contribution income statement is one that associates costs within a specific parameter, whether a sales division of a company or one product in a multi-product line. Its purpose is to demonstrate the relationship of variable costs and fixed costs and establish contribution margin. A functional income statement is one that separates both product and period costs. The functional income statement will deduct COGS from Sales, to get Gross Profit, then deduct Operating Expenses to obtain Operating Income. The contribution income statement will consider variable direct costs and variable indirect costs relevant to the product or division to determine the contribution margin, and then deduct fixed operating costs to get Operating Income. B. What is the contribution margin? The contribution margin is the amount (by percentage or by dollar) generated by sales that is available to cover fixed costs and contribute to the profitability of the whole enterprise. C. What does the contribution margin “contribute” toward? The contribution margin is an indicator of how much money is left after the variable product expenses and the variable operating expenses associated with that product are deducted. It “contributes” to the funds a company has available to cover its fixed costs and, ultimately, to the profitability of the company. D. How does total contribution margin differ from contribution margin per unit? Total contribution margin is the aggregate total revenue minus total variable costs and provides the gross margin for the enterprise. The contribution margin per unit is simply the sales revenue of the particular unit minus that unit’s variable costs (both direct and indirect), which reflects the gross margin for that one product or service. E. What is the contribution margin ratio, and how does it differ from the contribution margin? The contribution margin ratio is the percentage of sales available to cover fixed costs and profit. It differs from the contribution margin in that the data is represented as a percentage rather than as a number. Where contribution margin is sales minus variable costs, contribution ratio is sales minus variable costs divided by sales. Managers often find it more convenient to use the percentage of sales as a metric to determine performance rather than a specific dollar amount. F. What is cost-volume-profit (CVP) analysis? CVP analysis considers how costs and revenue change in relation to the volume of sales. It evaluates how profits will be affected by changes in variable costs, fixed costs, unit pricing, and sales volume. It is most often used to determine the breakeven point for unit sales, the volume of sales necessary to obtain a particular profit amount, the profit returned on a given sales volume, and/or how changes in any one (or all) of these will impact profits. G. What does the term break-even point mean? The breakeven point is that amount of sales revenue that exactly covers all variable and fixed expenses. It can be calculated for a single product or division, or for multiple products. In the case of multiple products, calculations for percentage of revenues and weighted averages must be made to correctly establish the contribution margins. Simply stated, it is the number of units or dollars of sales that will allow the company to “break even” and begin to make profits. H. In what ways does the calculation of the brake-even point in units differ from the calculation of the break-even point in sales dollar? In the breakeven point for units, fixed costs are divided by the contribution margin amount per unit. The breakeven point for sales dollars is determined by dividing fixed costs by the contribution margin ratio. The difference between the two is the way each interfaces with fixed costs. In the former, the contribution margin per unit has addressed all variable costs, and when fixed costs are divided by the unit contribution margin, the result is the number of units needed to sell. In the latter, the same fixed costs are divided by the contribution margin ratio to convert a percentage of contribution into dollars. I. How would you calculate the required sales in units to attain a target profit? I would add the fixed costs and the desired amount of profit together, and then divide that by the contribution margin per unit. Similar to the calculation used for breakeven analysis, this simply adds the amount of desired profit to the fixed costs and then divides it by the amount of revenue each unit produces after allowing for variable costs. J. How would you calculate the required sales in dollars to attain a target profit? I would add the amount of the target profit to the amount of fixed costs, and then divide that by the contribution margin ratio. Again, similar to the breakeven analysis, this provides the desired amount of profit and all fixed costs and then considers the percentage of revenues left after variable costs are taken into account to yield the amount of revenues that will yield the desired profit. K. What is relevant information? Relevant information is used when making a decision about a future project. Information is considered relevant if it directly bears on the particular situation or question facing the decision maker in terms of future action and/or if it changes when there are competing alternatives; any information that is not directly related to the decision at hand is irrelevant. Any one piece of information may be important in one situation, but not relevant in another. For example, if the manager of a transportation company is considering whether expansion is a good idea, she has three alternatives; she can add to the company’s fleet of vehicles, making the price of new trucks relevant, consider expansion by constructing a new distribution center, in which case the price of new trucks is irrelevant, or not expand at all in which case there is no relevant information because neither piece of information has any bearing on the future. The importance of identifying relevant and irrelevant information is to simplify the decision process. By complicating a decision with irrelevant information, the manager may take into consideration things that have no bearing on the actual cost of the proposed project and come to the wrong conclusion. L. What is a relevant cost? Relevant cost is a cost that is directly related to the decision being made, and one that will change when evaluating alternatives. Again, the consideration of only relevant costs permit decisions to be properly framed without extraneous data or data which might skew the metrics driving the decision. Sunk costs, for example, are never relevant because they never have bearing on a new decision. Potential future costs might be relevant, but only if they are directly related to the proposition under considerations. If the cost is a result of the new project or alternative, it is relevant. If the cost is money that would be spent regardless of whether the proposed project is undertaken or not, it isn’t relevant. For example, if ABC Consulting, Inc. is considering whether to add a new consultant to is current services bundle, the relevant costs would be things like salary, employee benefits, employer portion of taxes, and the like. It’s fixed costs, like rent (assuming it has the space for a new office) or insurance, are not relevant to the decision. Its future costs may be relevant, e.g., standard cost of living increases in salary, or irrelevant, e.g., contractual lease increases over the next year. Relevant cost is only that cost which attaches to the decision or its alternatives. Things like depreciation are never relevant costs because they reflect the cost of something already purchased and placed in service. M. What is a relevant benefit? Similar in nature to relevant information and relevant costs, relevant benefits are those directly related to—and only those related to—the decision under consideration. The relevant benefit to a manufacturing company considering the purchase and implementation of a new machine will be calculated in terms of increases in outputs, savings on labor, product process efficiencies, etc. If the alternative decision is to simply add additional workers and extra shifts to its current production line, these benefits will not necessarily be relevant, e.g., outputs may increase but labor savings will not. Thus, within the decision matrix of any particular consideration, management must ensure that the benefits brought by the new project are relevant to the project so that an accurate cost/benefit analysis can be conducted. N. What two important characteristics do all relevant costs possess? All relevant costs will be directly incurred as a result of making a decision, and not be incurred if the decision is not made (all relevant costs apply to the future). The second characteristic is that the relevant cost will change if an alternative decision is chosen. O. What is a sunk cost? Sunk costs are costs that have been incurred in the past, and are not relevant to the future or to a future decision. With sunk costs, a decision has already been made in the past, and that specific decision cannot be changed nor can those costs be un-incurred. A new decision can be made regarding the past decision, but that is a new decision as sunk costs cannot be changed. By definition, then, sunk costs are never relevant to a future decision and should be ignored. For example, if a manufacturing company is considering replacing an old machine with a new one, the depreciation expense is a sunk cost; the decision to purchase the old machine has been made, cannot be unmade, and therefore the cost has no bearing on the decision regarding the purchase of the new machine. P. Describe the difference between qualitative and quantitative factors. Quantitative factors are those factors that provide a number; they give a numerical basis for making a decision. These could be anything from anticipated or projected sales revenues to anticipated costs of investment in equipment, personnel, etc. While informative in a concrete sense, quantitative factors do not provide a complete picture; they should be used in conjunction with qualitative factors. These are factors or issues that may influence non-quantifiable data such as the effects of the decision on people or the business environment. At the point of any decision, both quantitative and qualitative inputs should be considered. For example, Company A is in competition with Company B and is deciding whether to launch a new product or simply acquire Company B for its ability to produce that product. Company A’s management runs the numbers, factoring all relevant information, costs, and benefits and determine that the acquisition of Company B is a sound financial decision. Company A’s acquisition of Company B, however, will put Company A in violation of anti-trust laws and its stakeholders will suffer. Under a strictly quantitative analysis, the company would move forward with a decision that would ultimately be a mistake based on consideration of all factors. Q. When trying to determine whether a cost or benefit is relevant, what are the two questions the decision maker should ask? The first question will be “is this cost or benefit directly related to a future decision without consideration of past costs or benefits?” The second question is “will this cost or benefit change if an alternative solution is chosen?” If the answer to both questions is “yes,” the cost or benefit is relevant. If the answer to either question is “no,” the cost or benefit is not relevant. R. Why the depreciation for existing assets is considered irrelevant for equipment replacement decisions? Depreciation is, by definition, a sunk cost and not relevant to any decision. The reason for this is that the decision to purchase the fixed asset was made in the past, and its cost is being depreciated into the future. It is a known quantity that does not change. There is no way to go back and un-purchase the item. In equipment replacement decisions, the relevant information is future costs and benefits related only to the purchase, and how those costs and benefits change as alternative purchase decisions are considered. Accordingly, the cost of the old machine is of consequence to the present decision and depreciation is a simple write off of that previously incurred cost. S. What is the time value of money? The time value of money is the ability of current funds (PV) to generate interest in the future (FV), thus increasing its value. This can be accomplished through simple interest, but is most commonly calculated using compound interest. The future value of any given amount of money is its present value plus the interest it earns in a single period, raised to the power of the number of periods. The formula is mathematically calculated as: FV=PV(1+I)º where: FV=Future Value PV=Present Value I=Periodic Interest Rate º=Number of Periods This is best understood in a simple example. If $100 is invested today at an interest rate of 5%, what will it’s value be in five years? FV=100(1-.05)^5th FV=100(1.276) FV=127.60 The time value of $100 invested at 5% interest for five years is $27.60. T. Why is the time value of money important for decisions involving the purchase of long-lived assets? Time value is important in these situations because making the decision to purchase a long-lived asset includes considering the future value of the money used to purchase that asset. For example, XYZ, Inc. is considering the purchase of new office furniture for corporate headquarters at a cost of $ 100,000.00. The controller advises management that this furniture has a useful life of five years, with a salvage value of $ 25,000.00. The CFO advises management that the current market rate for investments of this size is 7.5%. Management has the ability to determine the quantitative values. If it invests the money, it will be worth over $ 143,000.00 in five years. Thus the time value of money in this example aids in the decision of whether to purchase new furniture or not. If management feels that it is worth $ 118,000.00 (FV of investment minus salvage value) to have new furniture, it should proceed with the purchase. Qualitative decisions may indicate that it IS a good decision; if the new furniture results in better efficiency and reputation with clients causing a $250,000.00 annual increase in revenues, it is money well spent. Without calculating the time value of money, however, management would not be able to establish the real cost of the decision. Read More