Cvp.docx

COST VOLUME PROFIT ANALYSIS MULTIPLE CHOICE a. b. c. d.

1. CVP analysis requires costs to be categorized as either fixed or variable. fixed, mixed, or variable. product or period. standard or actual.

ANS: A a. b. c. d.

DIF:

Easy

OBJ:

9-1,9-6

2. With respect to fixed costs, CVP analysis assumes total fixed costs per unit remain constant as volume changes. remain constant from one period to the next. vary directly with volume. remain constant across changes in volume.

ANS: D

DIF:

Easy

OBJ:

9-2,9-6

3. CVP analysis relies on the assumptions that costs are either strictly fixed or strictly variable. Consistent with these assumptions, as volume decreases total a. fixed costs decrease. b. variable costs remain constant. c. costs decrease. d. costs remain constant. ANS: C

DIF:

Easy

OBJ:

9-2,9-6

4. According to CVP analysis, a company could never incur a loss that exceeded its total a. variable costs. b. fixed costs. c. costs. d. contribution margin. ANS: C a. b. c. d.

DIF:

Easy

OBJ:

9-2,9-6

5. CVP analysis is based on concepts from standard costing. variable costing. job order costing. process costing.

ANS: B

DIF:

Easy

OBJ:

9-2

6. Cost-volume-profit analysis is a technique available to management to understand better the interrelationships of several factors that affect a firm's profit. As with many such techniques, the accountant oversimplifies the real world by making assumptions. Which of the following is not a major assumption underlying CVP analysis? a. All costs incurred by a firm can be separated into their fixed and variable components. b. The product selling price per unit is constant at all volume levels. c. Operating efficiency and employee productivity are constant at all volume levels. d. For multi-product situations, the sales mix can vary at all volume levels. ANS: D

DIF:

Easy

OBJ:

9-2

a. b. c. d.

7. In CVP analysis, linear functions are assumed for contribution margin per unit. fixed cost per unit. total costs per unit. all of the above.

ANS: A

DIF:

Easy

OBJ:

9-2,9-6

8. Which of the following factors is involved in studying cost-volume-profit relationships? a. product mix b. variable costs c. fixed costs d. all of the above ANS: D

DIF:

Easy

OBJ:

9-2

9. Cost-volume-profit relationships that are curvilinear may be analyzed linearly by considering only a. fixed and mixed costs. b. relevant fixed costs. c. relevant variable costs. d. a relevant range of volume. ANS: D a. b. c. d.

DIF:

Easy

OBJ:

10. After the level of volume exceeds the break-even point the contribution margin ratio increases. the total contribution margin exceeds the total fixed costs. total fixed costs per unit will remain constant. the total contribution margin will turn from negative to positive.

ANS: B 11.

DIF:

Easy

OBJ:

Increase in direct labor cost

yes yes yes no

yes no no yes

ANS: B a. b. c. d.

9-2

Which of the following will decrease the break-even point?

Decrease in fixed cost a. b. c. d.

9-2

DIF:

Easy

Increase in selling price yes yes no no

OBJ:

9-2

12. At the break-even point, fixed costs are always less than the contribution margin. equal to the contribution margin. more than the contribution margin. more than the variable cost.

ANS: B

DIF:

Easy

OBJ:

9-2

13. a. variable. b. standard.

The method of cost accounting that lends itself to break-even analysis is

c. absolute. d. absorption. ANS: A 14.

DIF:

Easy

OBJ:

9-2

Given the following notation, what is the break-even sales level in units?

SP = selling price per unit, FC = total fixed cost, VC = variable cost per unit a. SP/(FC/VC) b. FC/(VC/SP) c. VC/(SP - FC) d. FC/(SP - VC) ANS: D a. b. c. d.

OBJ:

9-2

DIF:

Moderate

OBJ:

9-2

16. If a firm's net income does not change as its volume changes, the firm('s) must be in the service industry. must have no fixed costs. sales price must equal $0. sales price must equal its variable costs.

ANS: D a. b. c. d.

Easy

15. Consider the equation X = Sales - [(CM/Sales)  (Sales)]. What is X? net income fixed costs contribution margin variable costs

ANS: D a. b. c. d.

DIF:

DIF:

Moderate

OBJ:

9-2

17. Break-even analysis assumes over the relevant range that total variable costs are linear. fixed costs per unit are constant. total variable costs are nonlinear. total revenue is nonlinear.

ANS: A

DIF:

Easy

OBJ:

9-2,9-6

a. b. c. d.

18. To compute the break-even point in units, which of the following formulas is used? FC/CM per unit FC/CM ratio CM/CM ratio (FC+VC)/CM ratio

ANS: A

DIF:

Easy

OBJ:

9-2

19. A firm's break-even point in dollars can be found in one calculation using which of the following formulas? a. FC/CM per unit b. VC/CM c. FC/CM ratio d. VC/CM ratio ANS: C a. b. c. d.

DIF:

Easy

OBJ:

9-2

20. The contribution margin ratio always increases when the variable costs as a percentage of net sales increase. variable costs as a percentage of net sales decrease. break-even point increases. break-even point decreases.

ANS: B

DIF:

Easy

OBJ:

9-2,9-6

21. In a multiple-product firm, the product that has the highest contribution margin per unit will a. generate more profit for each $1 of sales than the other products. b. have the highest contribution margin ratio. c. generate the most profit for each unit sold. d. have the lowest variable costs per unit. ANS: C

DIF:

Easy

OBJ:

9-4,9-6

22. _____________ focuses only on factors that change from one course of action to another. a. Incremental analysis b. Margin of safety c. Operating leverage d. A break-even chart ANS: A a. b. c. d.

DIF:

Easy

OBJ:

9-3

23. The margin of safety would be negative if a company('s) was presently operating at a volume that is below the break-even point. present fixed costs were less than its contribution margin. variable costs exceeded its fixed costs. degree of operating leverage is greater than 100.

ANS: A

DIF:

Easy

OBJ:

9-5

a. b. c. d.

24. The margin of safety is a key concept of CVP analysis. The margin of safety is the contribution margin rate. difference between budgeted contribution margin and actual contribution margin. difference between budgeted contribution margin and break-even contribution margin. difference between budgeted sales and break-even sales.

ANS: D

DIF:

Easy

OBJ:

9-5

25. Management is considering replacing an existing sales commission compensation plan with a fixed salary plan. If the change is adopted, the company's a. break-even point must increase. b. margin of safety must decrease. c. operating leverage must increase. d. profit must increase. ANS: C a. b. c. d.

DIF:

Moderate

OBJ:

9-5

26. As projected net income increases the degree of operating leverage declines. margin of safety stays constant. break-even point goes down. contribution margin ratio goes up.

ANS: A

DIF:

Moderate

OBJ:

9-5

27. A managerial preference for a very low degree of operating leverage might indicate that a. an increase in sales volume is expected. b. a decrease in sales volume is expected. c. the firm is very unprofitable. d. the firm has very high fixed costs. ANS: B

DIF:

Moderate

OBJ:

9-5

Thompson Company Below is an income statement for Thompson Company: Sales Variable costs Contribution margin Fixed costs Profit before taxes a. b. c. d.

28. 3.67 5.33 1.45 2.67

$400,000 (125,000) $275,000 (200,000) $ 75,000

Refer to Thompson Company. What is Thompson’s degree of operating leverage?

ANS: A $(275,000/75,000) = 3.67 DIF:

Moderate

OBJ:

9-5

29. Refer to Thompson Company. Based on the cost and revenue structure on the income statement, what was Thompson’s break-even point in dollars? a. $200,000 b. $325,000 c. $300,000 d. $290,909 ANS: D CM Percentage = $(275/400) = .6875 .6875x - $800,000 = 0 x = $290,909 DIF: a. b. c. d.

Moderate

30. $200,000 $75,000 $100,000 $109,091

OBJ:

9-3

Refer to Thompson Company. What was Thompson’s margin of safety?

ANS: D Margin of Safety = $(400,000 - 290,909) = $109,091 DIF:

Easy

OBJ:

9-5

31. Refer to Thompson Company. Assuming that the fixed costs are expected to remain at $200,000 for the coming year and the sales price per unit and variable costs per unit are also expected to remain constant, how much profit before taxes will be produced if the company anticipates sales for the coming year rising to 130 percent of the current year’s level? a. $97,500 b. $195,000 c. $157,500 d. A prediction cannot be made from the information given. ANS: C Contribution Margin * 1.20 = New Contribution Margin $275,000 * 1.20 = $357,500 Contribution Margin - Fixed Costs = Profit $(357,500 - 200,000) = $157,500 DIF:

Moderate

OBJ:

9-3

Value Pro Value Pro produces and sells a single product. Information on its costs follow: Variable costs: SG&A Production Fixed costs: SG&A Production

$2 per unit $4 per unit $12,000 per year $15,000 per year

32. Refer to Value Pro. Assume Value Pro produced and sold 5,000 units. At this level of activity, it produced a profit of $18,000. What was Value Pro's sales price per unit? a. $15.00 b. $11.40 c. $9.60 d. $10.00 ANS: A Profit + Fixed Costs = Contribution Margin $18,000 + $27,000 = $45,000 $45,000 / 5,000 units = $9 contribution margin per unit Contribution Margin + Variable Costs = Sales Price/Unit $(9 + (4 + 2)) = $15/Unit DIF:

Moderate

OBJ:

9-3

33. Refer to Value Pro. In the upcoming year, Value Pro estimates that it will produce and sell 4,000 units. The variable costs per unit and the total fixed costs are expected to be the same as in the current year. However, it anticipates a sales price of $16 per unit. What is Value Pro's projected margin of safety for the coming year? a. $7,000 b. $20,800 c. $18,400 d. $13,000 ANS: B Profit at 4,000 units Gross Sales = $16 * 4,000 units = $64,000 Contribution Margin = $(16 - 6) = $10/unit ($10*4,000) - $27,000 = $(40,000 - 27,000) = $13,000 Breakeven 0.625x - $27,000 = $0 x = $43,200 $(64,000 - 43,200) = $20,800 DIF:

Moderate

OBJ:

9-5

34. Harris Manufacturing incurs annual fixed costs of $250,000 in producing and selling a single product. Estimated unit sales are 125,000. An after-tax income of $75,000 is desired by management. The company projects its income tax rate at 40 percent. What is the maximum amount

that Harris can expend for variable costs per unit and still meet its profit objective if the sales price per unit is estimated at $6? a. $3.37 b. $3.59 c. $3.00 d. $3.70 ANS: C Before Tax Income: $75,000 / 0.60 = $125,000 Fixed Costs: 250,000 Contribution Margin: $375,000 Projected Sales less: Contribution Margin Variable Costs

$750,000 375,000 $375,000

$375,000 / 125,000 units DIF:

Moderate

OBJ:

$3/unit 9-3

Folk Company The following information relates to financial projections of Folk Company: Projected sales Projected variable costs Projected fixed costs Projected unit sales price

60,000 units $2.00 per unit $50,000 per year $7.00

35. Refer to Folk Company. How many units would Folk Company need to sell to earn a profit before taxes of $10,000? a. 25,714 b. 10,000 c. 8,571 d. 12,000 ANS: D Contribution Margin per Unit: $5 $5x - $50,000 - $10,000 $5x = $60,000 x = 12,000 units DIF:

Moderate

OBJ:

9-3

36. Refer to Folk Company. If Folk Company achieves its projections, what will be its degree of operating leverage? a. 6.00 b. 1.20 c. 1.68 d. 2.40 ANS: B Net profit = (60,000 units * $5/unit) - $50,000 = $300,000 - $50,000 = $250,000 DOL = $(300,000/120,000) = 1.20 DIF:

Moderate

OBJ:

9-5

37. Unique Company manufactures a single product. In the prior year, the company had sales of $90,000, variable costs of $50,000, and fixed costs of $30,000. Unique expects its cost structure and sales price per unit to remain the same in the current year, however total sales are expected to increase by 20 percent. If the current year projections are realized, net income should exceed the prior year’s net income by: a. 100 percent. b. 80 percent. c. 20 percent. d. 50 percent. ANS: B Contribution margin: $40,000 Net profit: $(40,000 - 30,000) = $10,000 20% CM increase: Net profit:

$40,000 * 1.20 = $48,000 $(48,000 - 30,000) = $18,000

Increase in profit

$8,000

$8,000/$10,000 = 80% DIF:

Moderate

OBJ:

9-3

Eclectic Corporation Eclectic Corporation manufactures and sells two products: A and B. The operating results of the company are as follows: Sales in units Sales price per unit Variable costs per unit

Product A

Product B

2,000 $10 7

3,000 $5 3

In addition, the company incurred total fixed costs in the amount of $9,000.

38. Refer to Eclectic Corporation.. How many total units would the company have needed to sell to break even? a. 3,750 b. 750 c. 3,600 d. 1,800 ANS: A Let B = 1.5A 3A + 2(1.5A) - $9,000 = $0 6A - $9,000 = $0 A = 1,500 B = 2,250 Total units = 3,750 DIF:

Moderate

OBJ:

9-4

39. Refer to Eclectic Corporation. If the company would have sold a total of 6,000 units, consistent with CVP assumptions how many of those units would you expect to be Product B? a. 3,000 b. 4,000 c. 3,600 d. 3,500 ANS: C A + 1.5A = 6,000 units 2.5A = 6,000 units A = 2,400 units B = 3,600 units DIF:

Moderate

OBJ:

9-4

40. Refer to Eclectic Corporation. How many units would the company have needed to sell to produce a profit of $12,000? a. 8,750 b. 20,000 c. 10,000 d. 8,400 ANS: A 3A + 2(1.5A) - $9,000 = $12,000 6A = $21,000 A = 3,500 units B = 5,250 units Total = 8,750 units DIF:

Moderate

OBJ:

9-4

Brittany Company Below is an income statement for Brittany Company: Sales Variable costs Contribution margin Fixed costs Profit before taxes a. b. c. d.

41. $50,000 $100,000 $150,000 $25,000

$300,000 (150,000) $150,000 (100,000) $ 50,000

Refer to Brittany Company. What was the company's margin of safety?

ANS: B Margin of safety = Sales - BEP Sales CM = .50 BEP Sales = .50x - $100,000 = 0 = .50x = $100,000 x = $200,000 $(300,000 - 200,000) = $100,000 DIF:

Moderate

OBJ:

9-5

42. Refer to Brittany Company. If the unit sales price for Brittany’s sole product was $10, how many units would it have needed to sell to produce a profit of $40,000? a. 27,500 b. 29,000 c. 28,000 d. can't be determined from the information given ANS: C Contribution Margin at $40,000 profit: $(40,000 + 100,000) = $140,000 Contribution Margin Ratio: 0.50 $140,000 / .50 = $280,000 $280,000 / $10 = 28,000 units DIF:

Moderate

OBJ:

9-3

43. A firm estimates that it will sell 100,000 units of its sole product in the coming period. It projects the sales price at $40 per unit, the CM ratio at 60 percent, and profit at $500,000. What is the firm budgeting for fixed costs in the coming period? a. $1,600,000 b. $2,400,000 c. $1,100,000 d. $1,900,000 ANS: D Profit + Fixed Cost = (100,000 units * $60/unit CM) Fixed Cost = (100,000 units * $24/unit CM) - Profit = $2,400,000 - $500,000 = $1,900,000 DIF:

Moderate

OBJ:

9-3

44. Sombrero Company manufactures a western-style hat that sells for $10 per unit. This is its sole product and it has projected the break-even point at 50,000 units in the coming period. If fixed costs are projected at $100,000, what is the projected contribution margin ratio? a. 80 percent b. 20 percent c. 40 percent d. 60 percent ANS: B Fixed Costs=Contribution Margin at Breakeven Point = $100,000 Breakeven Sales: $500,000 CM Ratio: $(100,000/500,000) = 20% DIF:

Moderate

OBJ:

9-3

Brandon Company Brandon Company manufactures a single product. Each unit sells for $15. The firm's projected costs are listed below: Variable costs per unit: Production SG&A Fixed costs: Production SG&A Estimated volume

$5 $1 $40,000 $60,000 20,000 units

45. current year? a. $133,333 b. $150,000 c. $80,000 d. $100,000

Refer to Brandon Company. What is Brandon's projected margin of safety for the

ANS: A Contribution Margin = $9/unit Contribution Margin Ratio = 60% Breakeven Point = $100,000/.60 = $166,667 Sales Volume = 20,000 units * $15/unit = $300,000 Margin of Safety = $(300,000 - 166,667) = $133,333 DIF:

Moderate

OBJ:

9-5

46. Refer to Brandon Company. What is Brandon's projected degree of operating leverage for the current year? a. 2.25 b. 1.80 c. 3.75 d. 1.67 ANS: A Contribution Margin = $180,000 Net Income = 80,000 Degree of Operating Leverage = $180,000/80,000 = 2.55 DIF:

Moderate

OBJ:

9-5

Alpha, Beta, and Epsilon Companies Below are income statements that apply to three companies: Alpha, Beta, and Epsilon: Sales Variable costs Contribution margin Fixed costs Profit before taxes

Alpha Co.

Beta Co.

Epsilon Co.

$100 (10) $ 90 (30) $ 60

$100 (20) $ 80 (20) $ 60

$100 (30) $ 70 (10) $ 60

47. Refer to Alpha, Beta, and Epsilon Companies. Within the relevant range, if sales go up by $1 for each firm, which firm will experience the greatest increase in profit? a. Alpha Company b. Beta Company c. Epsilon Company d. can't be determined from the information given ANS: A Alpha Company will have the greatest increase in profit, because it has the greatest contribution margin per unit. DIF:

Easy

OBJ:

9-3

48. Refer to Alpha, Beta, and Epsilon Companies. Within the relevant range, if sales go up by one unit for each firm, which firm will experience the greatest increase in net income? a. Alpha Company b. Beta Company c. Epsilon Company d. can't be determined from the information given ANS: D Price per unit is not given. DIF:

Easy

OBJ:

9-3

49. Refer to Alpha, Beta, and Epsilon Companies. At sales of $100, which firm has the highest margin of safety? a. Alpha Company b. Beta Company c. Epsilon Company d. They all have the same margin of safety. ANS: C Epsilon Company has the lowest amount of fixed costs to be covered. DIF:

Moderate

OBJ:

9-3

50. Mike is interested in entering the catfish farming business. He estimates if he enters this business, his fixed costs would be $50,000 per year and his variable costs would equal 30 percent of sales. If each catfish sells for $2, how many catfish would Mike need to sell to generate a profit that is equal to 10 percent of sales? a. 40,000 b. 41,667 c. 35,000 d. No level of sales can generate a 10 percent net return on sales. ANS: B Let x = sales in dollars x - .30x - $50,000 = .10x .60x = $50,000 x = $83,333 Units = $83,333/$2 per unit = 41,667 units DIF:

Difficult

OBJ:

9-3

51. relationships:

The following information pertains to Saturn Company’s cost-volume-profit

Break-even point in units sold Variable costs per unit Total fixed costs

1,000 $500 $150,000

How much will be contributed to profit before taxes by the 1,001st unit sold? a. $650 b. $500 c. $150 d. $0 ANS: C Fixed Cost = Contribution Margin = $150,000 Contribution Margin/Unit = Contribution Margin/Units $150,000/1,000 units = $150/unit DIF:

Moderate 52.

OBJ:

9-3

Information concerning Averie Corporation's Product A follows:

Sales Variable costs Fixed costs

$300,000 240,000 40,000

Assuming that Averie increased sales of Product A by 20 percent, what should the profit from Product A be? a. $20,000 b. $24,000 c. $32,000 d. $80,000 ANS: C Contribution margin at $300,000 in sales = $60,000 Increase contribution margin by 20% = $60,000 * 1.20 = $72,000 Contribution margin - fixed costs = Profit $(72,000 - 40,000) = $32,000 DIF:

Moderate

OBJ:

9-3

53. Ledbetter Company reported the following results from sales of 5,000 units of Product A for June: Sales Variable costs Fixed costs Operating income

$200,000 (120,000) (60,000) $ 20,000

Assume that Ledbetter increases the selling price of Product A by 10 percent in July. How many units of Product A would have to be sold in July to generate an operating income of $20,000? a. 4,000 b. 4,300 c. 4,545 d. 5,000 ANS: A If sales price per unit is increased by 10 percent, less units will have to be sold to generate gross revenues of $200,000. Sales price per unit = $200,000/5,000 units = $40/unit $40/unit * 1.10 = $44/unit $(200,000 / 44/unit) = 4,545 units DIF: a. b. c. d.

Moderate

9-3

54. On a break-even chart, the break-even point is located at the point where the total revenue line crosses the total fixed cost line. revenue line crosses the total contribution margin line. fixed cost line intersects the total variable cost line. revenue line crosses the total cost line.

ANS: D a. b. c. d.

OBJ:

DIF:

Easy

OBJ:

9-3

55. In a CVP graph, the slope of the total revenue line indicates the rate at which profit changes as volume changes. rate at which the contribution margin changes as volume changes. ratio of increase of total fixed costs. total costs per unit.

ANS: B

DIF:

Moderate

OBJ:

9-3

56. In a CVP graph, the area between the total cost line and the total revenue line represents total a. contribution margin. b. variable costs. c. fixed costs. d. profit. ANS: D

DIF:

Easy

OBJ:

9-3

57. In a CVP graph, the area between the total cost line and the total fixed cost line yields the a. fixed costs per unit. b. total variable costs. c. profit. d. contribution margin.

ANS: B

DIF:

Easy

OBJ:

9-3

58. If a company's fixed costs were to increase, the effect on a profit-volume graph would be that the a. contribution margin line would shift upward parallel to the present line. b. contribution margin line would shift downward parallel to the present line. c. slope of the contribution margin line would be more pronounced (steeper). d. slope of the contribution margin line would be less pronounced (flatter). ANS: B

DIF:

Moderate

OBJ:

9-3

59. If a company's variable costs per unit were to increase but its unit selling price stays constant, the effect on a profit-volume graph would be that the a. contribution margin line would shift upward parallel to the present line. b. contribution margin line would shift downward parallel to the present line. c. slope of the contribution margin line would be pronounced (steeper). d. slope of the contribution margin line would be less pronounced (flatter). ANS: D a. b. c. d.

DIF:

Easy

OBJ:

9-3

60. The most useful information derived from a cost-volume-profit chart is the amount of sales revenue needed to cover enterprise variable costs. amount of sales revenue needed to cover enterprise fixed costs. relationship among revenues, variable costs, and fixed costs at various levels of activity. volume or output level at which the enterprise breaks even.

ANS: C

DIF:

Easy

OBJ:

9-3

SHORT ANSWER 1.

How do changes in volume affect the break-even point?

ANS: Within the relevant range, the break-even point does not change. This is due to the linearity assumptions that apply to total revenues, fixed costs, and variable costs. DIF:

Moderate

OBJ:

9-2,9-6

2. What major assumption do multi-product firms need to make in using CVP analysis that single-product firms need not make? ANS: The assumption that must be imposed is a constant sales mix. A multi-product firm assumes that (within the relevant range) the sales mix is constant. This permits CVP analysis to be performed using a unit of the constant sales mix. DIF:

Moderate

3. analysis?

OBJ:

9-4

What important information is conveyed by the margin of safety calculation in CVP

ANS: The break-even point in CVP analysis is critical because it divides profitable levels of operation from unprofitable levels of operation. The margin of safety gives managers an idea of the extent to which sales can fall before operations will become unprofitable.

DIF:

Moderate 4.

OBJ:

9-5

What are the major assumptions of CVP analysis?

ANS: 1. All revenue and variable cost behavior patterns are constant per unit and linear within the relevant range. 2. Total contribution margin (total revenue divided by total variable cost) is linear within the relevant range and increases proportionally with output. 3. Total fixed cost is constant within the relevant range. This assumption, in part, indicates that no capacity additions will be made during the period under consideration. 4. Mixed costs can be accurately separated into their fixed and variable elements. 5. Sales and production are equal; thus, there is no material fluctuation in inventory levels. This assumption is necessary because fixed cost can be allocated to inventory at a different rate each year. Thus, variable costing information must be available. Because CVP and variable costing both focus on cost behavior, they are distinctly compatible with one another. 6. In a multi-product firm, the sales mix remains constant. This assumption is necessary so that a weighted average contribution margin can be computed. 7. Labor productivity, production technology, and market conditions will not change. If any of these changes were to occur, costs would change correspondingly, and selling prices might change DIF:

Moderate

OBJ:

9-6

PROBLEM 1. The Coontz Company sells two products, A and B, with contribution margin ratios of 40 and 30 percent and selling prices of $5 and $2.50 a unit. Fixed costs amount to $72,000 a month. Monthly sales average 30,000 units of product A and 40,000 units of product B. Required: a. Assuming that three units of product A are sold for every four units of product B, calculate the dollar sales volume necessary to break even. b. As part of its cost accounting routine, Coontz Company assigns $36,000 in fixed costs to each product each month. Calculate the break-even dollar sales volume for each product. c. Coontz Company is considering spending an additional $9,700 a month on advertising, giving more emphasis to product A and less emphasis to product B. If its analysis is correct, sales of product A will increase to 40,000 units a month, but sales of product B will fall to 32,000 units a month. Recalculate the break-even sales volume, in dollars, at this new product mix. Should the proposal to spend the additional $9,700 a month be accepted? ANS: a.

CM = (3  $2) + (4  $.75) = $9 SP = (3  $5) = (4  $2.50) = $25 BE = $72,000 = $400,000 $9/$25

b.

A = $36,000 = $90,000 .4

B = $36,000 = $120,000 .3

c.

CM = (5  $2) + (4  $.75) = $13 SP = (5  $5) + (4  $2.50) = $35 BE = $72,000 + $9,700 = $219,962 $13/35 OLD CM

NEW

A = 30,000  $2 = B = 40,000  $.75 =

$60,000 30,000 $90,000 (72,000) $18,000

- FC OI

A = 40,000  $2 = B = 32,000  $.75

CM

- FC OI

$ 80,000 24,000 $104,000 (81,700) $ 22,300

At current sales levels increase advertising. DIF:

Moderate

2. as follows:

OBJ:

9-4

The Graves Company makes three products. The cost data for these three products is

Selling price Variable costs

Product A

Product B

Product C

$10 7

$20 12

$40 16

Total annual fixed costs are $840,000. The firm's experience has been that about 20 percent of dollar sales come from product A, 60 percent from B, and 20 percent from C. Required: a. Compute break-even in sales dollars. b.

Determine the number of units to be sold at the break-even point.

ANS: a.

SP - VC = CM CMR

A

B

C

$10 (7) $ 3 30%

$20 (12) $ 8 40%

$40 (16) $24 60%

CMR = (.2  30%) + (.6  40%) + (.2  60%) = 42% BE = $840,000/.42 = $2,000,000 b.

A ($2,000,000  .20)/$10 = 40,000 units B ($2,000,000  .60)/$20 = 60,000 units C ($2,000,000  .20)/$40 = 10,000 units

DIF:

Moderate

OBJ:

9-4

3. Anderson Company produces and sells two products: A and B in the ratio of 3A to 5B. Selling prices for A and B are, respectively, $1,200 and $240; respective variable costs are $480 and $160. The company's fixed costs are $1,800,000 per year. Compute the volume of sales in units of each product needed to: Required: a. break even. b.

earn $800,000 of income before income taxes.

c.

earn $800,000 of income after income taxes, assuming a 30 percent tax rate.

d.

earn 12 percent on sales revenue in before-tax income.

e.

earn 12 percent on sales revenue in after-tax income, assuming a 30 percent tax rate.

ANS: A

SP - VC CM

B

$1,200 (480) $ 720

SP - VC CM

$240 (160) $ 80

Weighted CM = (3  $720) + (5  $80) = $2,560 a.

$1,800,000 = 703.125 $2,560

A = 704  3 = 2,112 units B = 704  5 = 3,520

b.

$1,800,000 + $800,000 = 1015.625 $2,560

A = 1,016  3 = 3,048 units B = 1,016  5 = 5,080

c.

$800,000/1 - .3 = $1,142,857 $1,800,000 + $1,142,857 = 1,149.55 $2,560

d.

A = 1,150  3 = 3,450 units B = 1,150  5 = 5,750

SP = (3  $1,200) + (5  $240) = $4,800 X = $1,800,000 + $.12X = $4,354,839 $2,560/$4,800 A = ($4,354,839  .75)/$1200 = 2,722 units B = ($4,354,839  .25/$240 = 4,537

e.

X = $1,800,000 + $.12X 1 - .3 = $4,973,684 $2,560/$4,800 A = ($4,973,684  .75)/$1,200 = 3,109 units B = ($4,973,684  .25/$240 = 5,181

DIF:

Moderate

OBJ:

9-4

Bradley Corporation Information relating to the current operations of Bradley Corporation follows: Sales Variable costs Contribution margin Fixed costs Profit before taxes

$120,000 (36,000) $ 84,000 (70,000) $ 14,000

4. Refer to Bradley Corporation. Bradley's break-even point was 1,000 units. Compute Bradley's sales price per unit. ANS: The break-even point is found by dividing the fixed costs by the CM ratio. The CM ratio is: $84,000/$120,000 = 70%. Breakeven would then be: $70,000/.70 = $100,000. Since we also know that the break-even point is defined as 1,000 units, it must follow that the unit sales price is $100,000/1,000 = $100. DIF:

Moderate 5.

OBJ:

9-3

Refer to Bradley Corporation. Compute Bradley's degree of operating leverage.

ANS: The degree of operating leverage is computed as the contribution margin divided by profit before taxes: $84,000/$14,000 = 6. DIF:

Moderate

OBJ:

9-5

McKinney Corporation McKinney Corporation manufactures and sells two products: A and B. The projected information on these two products for the coming year is presented below: Sales in units Sales price per unit Variable costs per unit

Product A

Product B

4,000 $12 8

1,000 $8 4

Total fixed costs for the company are projected at $10,000. 6. Refer to McKinney Corporation. Compute McKinney Corporation's projected breakeven point in total units. ANS: The company anticipates a sales mix consisting of 4 units of Product A and 1 unit of Product B. The total contribution margin for one unit of sales mix would be $20. This consists of $16 of contribution margin from the 4 units of Product A and $4 of contribution margin from 1 unit of Product B.

The overall company break-even point is found by dividing total fixed costs by the contribution margin on one unit of sales mix: $10,000/$20 = 500 units. The 500 units of sales mix contain 500  5 units of product for a total of 2,500. Of the 2,500 total units, 2,000 are units of Product A and 500 are units of Product B. DIF:

Moderate

OBJ:

9-4

7. Refer to McKinney Corporation. How many units would the company need to sell to produce an income before income taxes equal to 15 percent of sales? ANS: Again, using a unit of sales mix as the unit of analysis, one unit of sales mix sells for $56. Since the contribution margin is $20 on one unit of sales mix, the CM ratio on one unit of sales mix is $20/$56 = .3571. This implies that variable costs as a percentage of sales are equal to 1 - .3571 = .6429. Income before income taxes equal to 15 percent of sales can be found by solving a formula of the following type: Sales - VC - FC = Income before income taxes In this particular case, we solve the following formula: Sales - (.6429  Sales) - $10,000 = (.15  Sales) Solving for Sales, we get $48,286. We can find out how many units of sales mix are required to generate sales of $48,286 by dividing $48,286 by $56 = 863. These 863 units of sales mix each contain 5 units of product, so the correct answer would be 863  5 = 4,315 units of product, 3,452 of Product A and 863 of Product B. DIF:

Moderate

OBJ:

9-4

Perry Corporation Perry Corporation predicts it will produce and sell 40,000 units of its sole product in the current year. At that level of volume, it projects a sales price of $30 per unit, a contribution margin ratio of 40 percent, and fixed costs of $5 per unit. 8. Refer to Perry Corporation. What is the company's projected breakeven point in dollars and units? ANS: Given the CM ratio of 40 percent, and the Sales price per unit of $30, the CM per unit must be $30  .40 = $12. The total fixed costs would be projected at $5  40,000 = $200,000. Breakeven would be: $200,000/$12 = 16,667 units. This would also equate to $500,000 of sales. DIF:

Moderate

OBJ:

9-3

9. Refer to Perry Corporation. What would the company's projected profit be if it produced and sold 30,000 units? ANS: Projected profit would be: Sales (30,000  $30) Variable costs (30,000  $18) Contribution margin

$900,000 (540,000) $360,000

Fixed costs Profit DIF:

(200,000) $160,000

Moderate

OBJ:

9-3

Castle Corporation The following questions are based on the following data pertaining to two types of products manufactured by Castle Corporation:

Product Y Product Z

Per unit Sales price

Variable costs

$120 $500

$ 70 $200

Fixed costs total $300,000 annually. The expected mix in units is 60 percent for Product Y and 40 percent for Product Z. 10.

Refer to Castle Corporation. How much is Castle’s break-even point sales in units?

ANS: BEP units = FC/(unit SP - unit VC) or unit CM(UMC) For multiple products, use the weighted CM with weights based on units of sales weights. BEP = FC / [60% ($120 - $70) + 40% ($500 - $200)] = $300,000/ ($30/u + $120/u) = 2,000 units DIF:

Moderate 11.

OBJ:

9-4

Refer to Castle Corporation. What is Castle’s break-even point in sales dollars?

ANS: BEP dollars = FC/CMR For multiple products, use weighted CMR with weights based on sales dollars as weights or sales mix. Sales mix is 60 percent and 40 percent in units or in dollars. Weighted average CMR = WACM/WASale WACMR = [60% ($120 - $70) + 40% ($500 - $200)] ÷ (60%  $120) + (40%  $500) WACMR = [$30 + $120] ÷ [$72 + $200] = .551 BEP sales = 2,000  $272 = $544,000 DIF:

Moderate

OBJ:

9-4

1.) Which of the following is the correct description of the break-even point? - Where total 2.)

revenue equals total fixed and variable costs In a profit-volume chart, what does the point at which the contribution line touches the vertical axis represent? - Total fixed costs

ABSORPTION AND VARIABLE COSTING

Example 1 A company manufactures and sells 5000 units of product X per year . Suppose one unit of product X requires the following costs: Direct materials: $5 per unit Direct labor: $4 per unit Variable manufacturing overhead: $1 per unit Fixed manufacturing overhead: $20,000 per year The unit product cost of the company is computed as follows: Absorption Costing $5 $4 $1 $4* ——$14 ——-

Variable Costing $5 $4 $1 – ——$10 ——-

* $20,000 / 5,000 Notice that the fixed manufacturing overhead cost has not been included in the unit cost under variable costing system but it has been included in the unit cost under absorption costing system. This is the primary difference between variable and absorption costing.

Example 2 Sunshine company produces and sells only washing machines. The company uses variable costing for internal reporting and absorption costing for external reporting. The data for the year 2010 is given below: Direct materials Direct labor variable manufacturing overhead Fixed manufacturing overhead Fixed marketing and administrative expenses Variable marketing and administrative expenses

$150/unit $45/unit $25/unit $160,000 per year $110,000 per year $15/unit sold

Company produced and sold 8,000 machines during the year 2010.

Required: Compute unite product cost under variable costing and absorption costing.

Solution Materials Labor Variable overhead Fixed overhead

Absorption Costing $150 $45 $25 $20* ——240 ——-

Variable Costing $150 $45 $25 — ——220 ——-

*$160,000 / 8,000 Units = $20 Note: Marketing and administrative expenses are period costs and are not relevant in the computation of unit product cost.

Example A company prepares variable costing income statement for the use of internal management and absorption costing income statement for the use of external parties like creditors, banks, tax authorities etc. The company manufactures a product that is sold for $80. The variable and fixed cost data is given below: Direct materials

$30.00

Direct labor

$19.00

Factory over head: Variable cost

$6.00

Fixed cost ($45,000 / 9000 units)

$5.00

Marketing, general and administrative: Variable cost (per unit sold) Fixed cost (per month)

$4.00 $28,000

During June 9,000 units were produced and 7,500 units were sold. The opening inventory was 2,000 units. Required: 1. Prepare two income statements, one using variable costing method and one using absorption costing method. 2. Explain the difference in net operating income (if any) under two approaches.

Solution (1) Income Statement – Absorption Costing Sales (7,500 units × $80)

$600,000

Cost of goods sold: Beginning inventory (2000 units × $60)

$120,000

Units manufactured this month (9,000 × $60)

$540,00 ———-

Available for sale

$660,000

Ending inventory (3,500* × $60)

$210,000 ———-

Cost of goods sold

$450,000 ———-

Gross profit

$150,000

Marketing, general and administration expenses: Variable (7,500 units × $4)

$30,000

Fixed

$28,000

$58,000

———-

———-

Net operating income

$92,000 ———-

*Computation of units in ending inventory: Beginning inventory

2,000 units

Produced during the month

9,000 units ————

Units available for sale

11,000 units

Sold during the month

7,500 units ————

Ending inventory

3,500 units ————-

Income Statement – Variable Costing Sales (7,500 × $80)

$600,000

Variable cost of goods sold: Beginning inventory (2000 units × $55)

$110,000

Units manufactured this month (9,000 units × $55)

$495,00 ———-

Available for sale

$605,000

Ending inventory (3,500 units × $55)

$192,500 ———-

Variable cost of goods sold

$412,500 ———-

Gross contribution margin

$187,500

Variable marketing, general and administration expenses:

$30,000 ———-

Contribution margin

$157,500

Less fixed costs: Manufacturing overhead

$45,000

Marketing, general and administration expenses

$28,000

$73,000

———-

———-

Net operating income

$84,500 ———-

(2) Reconciliation of net operating income: Net operating income under variable costing

$84,500

Fixed manufacturing overhead cost deferred (1500 units × $5)

$7,500 ——–

Net operating income under absorption costing

$92,000 ——–

Example: The following data relates to two manufacturing companies – company A and company B. Company A uses traditional manufacturing system and company B uses a strict just in time (JIT) manufacturing system. Company B does not manufacture a unit unless an order is received for it. Company A

Company B

$40

$60

Direct materials

$15

$15

Labor

$5

$10

Variable

$2

$10

Fixed – (A: 7,500/m B: $9,375/m )

$3

$5

——-

——-

$25

$40

——-

——-

500 Units

0

2,500 Units

1875 Units

————–

————–

3,000 Units

1875 Units

300 Units

0

————–

————–

2,700 Units

1,875 Units

————–

————–

$5

$8

$5000

$4,000

Sales price per unit Manufacturing expenses:

Factory overhead:

Total manufacturing expenses

Opening inventory Production

Available for sale Closing inventory

Sales

Marketing and admin expenses: Variable (per unit sold) Fixed

Now we will prepare income statements of both the companies under variable costing and absorption costing methods and observe the impact of just in time (JIT) manufacturing system on the company B’s net operating income figure.

Absorption costing: Company A

Company B

108,000

112,500

———-

———-

Opening inventory

12,500

0

Cost of goods manufactured

62,500

75,000

———-

———-

Cost of goods available for sale

75,000

75,000

Closing inventory

7,500

0

———-

———-

67,500

75,000

———-

———-

40,500

37,500

———-

———-

13,500

15,000

5,000

4,000

———-

———-

18,500

19,000

———-

———-

22,000

18,500

———-

———-

Sales revenue

Less cost of goods sold (COGS):

Cost of goods sold (COGS)

Gross margin (sales – COGS)

Less marketing and administration exp: Variable Fixed

Total marketing and administration exp.

Net operating income

Variable costing: Company A

Company B

108,000

112,500

———-

———-

Opening inventory

11000

0

Cost of goods manufactured

55,000

65,625

———-

———-

66,000

65,625

6,600

0

———-

———-

59,400

65,625

———-

———-

Gross contribution margin (Sales – VCOGS)

48,600

46,875

Less variable marketing and admin. exp

13,500

15,000

Sales revenue

Less variable cost of goods sold (VCOGS):

Cost of goods available for sale Closing inventory

Variable cost of goods sold (VCOGS)

———-

———-

35,100

31,875

———-

———-

Manufacturing

7,500

9,375

Marketing and administration

5,000

4,000

———-

———-

12,500

13,375

———-

———-

22,600

18,500

———-

———-

Contribution margin

Less fixed expenses:

Total fixed expenses

Net operating income

1. In an income statement prepared as an internal report using the variable costing method, variable selling and administrative expenses would: A) not be used. B) be treated the same as fixed selling and administrative expenses. C) be used in the computation of net operating income but not in the computation of the contribution margin. D) be used in the computation of the contribution margin. The answer is d. All variable costs and expenses are subtracted from Sales Revenue to produce the contribution margin. 2. If the number of units produced exceeds the number of units sold, then net operating income under absorption costing will: A) be equal to the net operating income under variable costing. B) be greater than net operating income under variable costing. C) be equal to the net operating income under variable costing plus total fixed manufacturing costs. D) be equal to the net operating income under variable costing less total fixed manufacturing costs. The answer is b. The amount by which the operating income reported under absorption costing exceeds the operating income reported under variable costing is given by the following formula.

Fixed Factory Overhead Per Unit x Unsold Units

Use the following to answer questions 3-6: Janos Company, which has only one product, has provided the following data concerning its most recent month of operations: Selling price............................................................$111 Units in beginning inventory....................................300 Units produced......................................................2,000 Units sold...............................................................2,200 Units in ending inventory.........................................100 Variable costs per unit: Direct materials.................................... $29 Direct labor..............................................................30 Variable manufacturing overhead.............................4 Variable selling and administrative...........................9 Fixed costs: Fixed manufacturing overhead.......................$34,000 Fixed selling and administrative......................39,600 The company produces the same number of units every month, although the sales in units vary from month to month. The company's variable costs per unit and total fixed costs have been constant from month to month. 3. What is the unit product cost for the month under variable costing? A) $63 B) $80 C) $72 D) $89 The answer is a. Variable costing only includes variable manufacturing costs in the cost of a product. ($29 + $30 + 4 = $63). 4. What is the unit product cost for the month under absorption costing? A) $80 B) $72 C) $63 D) $89

The answer is a. Absorption costing includes all manufacturing costs in the cost of a product. This would include all of the variable manufacturing costs ($63) plus the fixed manufacturing cost per unit of $17. ($34,000/2,000 units produced). That is $80.

5. What is the net operating income for the month under variable costing? A) $8,800 B) $12,200 C) $1,700 D) $24,800 The answer is b. ($111 x $244,200 2,200)

Sales Revenue: Less Variable Costs: Variable COGS:

($63 x 2,200) ($9 x 2,200)

$138,600

Var. S,G&Adm:

19,800 -158,400

Contribution Margin: Less Fixed Costs: Fixed Manf. Costs: Fixed S,G&Adm:

$85,800

$34,000 39,600

Operating Profit

-73,600 $12,200

6. What is the net operating income for the month under absorption costing? A) $8,800 B) $24,800 C) $1,700 D) $12,200 The answer is a. You could do an absorption costing income statement or you could use the formula that I showed you in class: Fixed Manufacturing Overhead Per Unit x Unsold Units: $17 x -200 = -$3,400 The fact that you dipped into inventory (sold more than you

produced) means that variable costing operating is higher than absorption costing operating profit. That is why it is shown as negative numbers. $12,200 - $3,400 = $8,800

Use the following to answer questions 7-10: Kosco Corporation's absorption costing income statement for March follows: Kosco Corporation Income Statement For the Month Ended March 31 Sales (2,400 units).................................................... Cost of goods sold: Beginning Inventory (100 units) ........................... Add Cost of Goods Manufactured (2,500 units)... Goods Available for Sale ...................................... Less Ending Inventory (200 units)........................ Cost of Goods Sold .................................................. Gross Margin ........................................................... Less Selling and Administrative Expenses: Fixed ..................................................................... Variable ................................................................. Net Operating Income ..............................................

$48,000 $ 1,000 25,000 26,000 2,000

7,200 9,600

24,000 24,000

16,800 $ 7,200

During March, the company's variable production costs were $8 per unit and its fixed manufacturing overhead totaled $5,000. 7. Net operating income under the variable costing method for March would be: A) $7,200. B) $7,000. C) $7,600. D) $6,800. The answer is b. You could do a variable costing income statement or you could use the formula that I showed you in class. Fixed Overhead per unit is $2 ($5,000/2,500 units): Fixed Manufacturing Overhead Per Unit x Unsold Units: $2 x 100 = $200

$7,200 - $200 = $7,000

8. The contribution margin per unit during March was: A) $8. B) $12. C) $10. D) $3. The answer is a. Sales Revenue: Less Variable Costs: Variable COGS: Var. S,G&Adm:

$48,000 $19,200 9,600

Contribution Margin: Contribution Margin per Unit:

($8 x 2,400) -28,800 $19,200 ($19,200/2,4 $8 00)

9. The break-even point in units for the month under variable costing would be: A) 600 units. B) 900 units. C) 1,017 units. D) 1,525 units. The answer is d. X = Fixed Costs / Contribution Margin Per Unit Fixed Costs = $5,000 + $7,200 = $12,200 Break Even point = $12,200/8 = 1,525 units.

10. The dollar value of Kosco's ending inventory on March 31 under variable costing would be: A) $1,600. B) $2,400. C) $2,000. D) $3,400. The answer is a. $8 x 200 = $1,600.

1 Gordon Company began its operations on January 1, and produces a single product that sells for $10 per units. Gordon uses an actual (historical) cost system. In the year, 100,000 units were produced and 80,000 units were sold. There was no work-in-process inventory at December 31. Manufacturing costs and selling and administrative expenses were as follows: Type of Costs Fixed cost Variable cost Raw materials $2.00 per unit produced Direct labor $1.25 per unit produced Factory overhead $120,000 $ .75 per unit produced Selling and administrative $ 70,000 $1.00 per unit sold What would be Gordon's finished goods inventory at December 31, under the absorption costing method? a. $ 80,000 b. $104,000 c. $110,000 d. $124,000

1 Gyro Gear Company produces a special gear used in automatic transmissions. Each gear sells for $28, and the Company sells approximately 500,000 gears each year. Unit cost data are presented below: Direct material: $6.00; Direct labor: 5.00 Other costs:

Variable

Fixed

Manufacturing

$2.00

$7.00

Distribution

4.00

3.00

The unit cost of gears for direct-cost-inventory purposes is: a. $13 b. $20 c. $17 d. $27

1 Information from Peterson Company's records for the year ended December 31 is available as follows: Net sales Cost of goods manufactured:

Variable Fixed Variable Fixed

Operating expenses: Units manufactured Units sold Finished goods inventory, January 1

$1,400,000 630,000 315,000 98,000 140,000 70,000 60,000 None

There were no work-in-process inventories at the beginning and end of the year. What would be Peterson's finished goods inventory cost at December 31, under the variable (direct) costing Method? a. $90,000 b. $104,000 c. $105,000 d. $135,000

1 See Preceding Question. With absorption costing, Peterson's operating income for the year would be a. $217,000 b. $307,000 c. $352,000 d. $374,500

(Source: CPA)

1 During January Gable, produced 10,000 units of product F with cost as follows: Direct materials

$40,000

Direct labor

32,000

Variable overhead

13,000

Fixed overhead

10,000 $95,000

What is Gable's unit cost of product F for January on the direct costing basis? a. $6.20 b. $7.20 c. $7.50 d. $8.50

(Source: CPA)

1 Indiana Corporation began its operations on January 1, and produces a single product that sells for $9.00 per unit. Indiana uses an actual (historical) cost system. 100,000 units were produced and 90,000 units were sold in the year. There was no work-in-process inventory at December 31. Manufacturing costs and selling and administrative expenses for the year were as follows: Type of Costs Raw materials

Fixed costs

Variable costs $1.75 per unit produced

Direct labor Factory overhead Selling and administrative

1.25 per unit produced $100,000 70,000

.50 per unit produced .60 per unit sold

What would be Indiana's operating income using the direct-costing method? a. $181,000 b. $271,000 c. $281,000 d. $371,000

1 Which of the following is a more descriptive term of the type of cost accounting often called "direct costing"? a. Out-of-pocket costing. b. Variable costing c. Relevant costing

d. Prime costing.

1 Absorption costing differs from direct costing in the a. Fact that standard cost can be used with absorption costing but not with direct costing. b. Kind of activities for which each can be used to report. c. Amount of costs assigned to individual units of product. d. Amount of fixed costs that will be incurred.

1 The direct (variable) costing method includes in inventory a. Direct materials cost, direct labor cost, but no factory overhead cost. b. Direct materials cost, direct labor cost, and variable factory overhead cost. c. Prime cost but not conversion cost. d. Prime cost and all conversion cost.

FINANCIAL RATIOS

A: Multiple Choice Questions

1. Which of the following is considered a profitability measure?

a. b. c. d. e.

Days sales in inventory Fixed asset turnover Price-earnings ratio Cash coverage ratio Return on Assets

2. Firm A has a Return on Equity (ROE) equal to 24%, while firm B has an ROE of 15% during the same year. Both firms have a total debt ratio (D/V) equal to 0.8. Firm A has an asset turnover ratio of 0.9, while firm B has an asset turnover ratio equal to 0.4. From this we know that

a. b. c. d. e.

Firm A has a higher profit margin than firm B Firm B has a higher profit margin than firm A Firm A and B have the same profit margin Firm A has a higher equity multiplier than firm B You need more information to say anything about the firm's profit margin

3. If a firm has $100 in inventories, a current ratio equal to 1.2, and a quick ratio equal to 1.1, what is the firm's Net Working Capital? a. b. c. d. e.

$0 $100 $200 $1,000 $1,200

4. To measure a firm's solvency as completely as possible, we need to consider

a. The firm's relative proportion of debt and equity in its capital structure b. c. d. e.

The firm's capital structure and the liquidity of its current assets The firm's ability to use Net Working Capital to pay off its current liabilities The firms leverage and its ability to make interest payments on its long-term debt The firm leverage and its ability to turn its assets over into sales

B: Problem Solving Questions

You have been hired as an analyst for Mellon Bank and your team is working on an independent assessment of Daffy Duck Food Inc. (DDF Inc.) DDF Inc. is a firm that specializes in the production of freshly imported farm products from France. Your assistant has provided you with the following data for Flipper Inc and their industry.

1999Ratio

1999

1998

1997

Industry Average

Long-term debt

0.45

0.40

0.35

0.35

Inventory Turnover

62.65

42.42

32.25

53.25

Depreciation/Total Assets

0.25

0.014

0.018

0.015

Days’ sales in receivables

113

98

94

130.25

Debt to Equity

0.75

0.85

0.90

0.88

Profit Margin

0.082

0.07

0.06

0.075

Total Asset Turnover

0.54

0.65

0.70

0.40

Quick Ratio

1.028

1.03

1.029

1.031

Current Ratio

1.33

1.21

1.15

1.25

Times Interest Earned

0.9

4.375

4.45

4.65

Equity Multiplier

1.75

1.85

1.90

1.88

a. In the annual report to the shareholders, the CEO of Flipper Inc wrote, “1997 was a good year for the firm with respect to our ability to meet our short-term obligations. We had higher liquidity largely due to an increase in highly liquid current assets (cash, account receivables and short-term marketable securities).” Is the CEO correct? Explain and use only relevant information in your analysis. b. What can you say about the firm's asset management? Be as complete as possible given the above information, but do not use any irrelevant information. c. You are asked to provide the shareholders with an assessment of the firm's solvency and leverage. Be as complete as possible given the above information, but do not use any irrelevant information.

ANSWERS:

Answer 1: e Answer 2: b (Profit margin of firm A=5.33% and for firm B=7.5% - use Du Pont Identity) Answer 3: CA/CL=1.2 and (CA-100)/CL=1.1 => solve and find CL=1,000 and CA=1,200=> answer c Answer: d

ANSWERS TO PROBLEM: (note that these are just examples of a good answer)

a. The answer should be focused on using the current and quick ratios. While the current ratio has steadily increased, it is to be noted that the liquidity has not resulted from the most liquid assets as the CEO proposes. Instead, from the quick ratio one could note that the increase in liquidity is caused by an increase in inventories. For a fresh food firm one could argue that inventories are relatively liquid when compared to other industries. Also, given the information, the industry-benchmark can be used to derive that the firm's quick ratio is very similar to the industry level and that the current ratio is indeed slightly higher - again, this seems to come from inventories. b. Inventory turnover, days sales in receivables, and the total asset turnover ratio are to be mentioned here. Inventory turnover has increased over time and is now above the industry average. This is good - especially given the fresh food nature of the firm's industry. In 1999 it means for example that every 365/62.65 = 5.9 days the firm is able to sell its inventories as opposed to the industry average of 6.9 days. Days' sales in receivables has gone down over time, but is still better than the industry average. So, while they are able to turn inventories around quickly, they seem to have more trouble collecting on these sales, although they are doing better than the industry. Finally, total asset turnover is went down over time, but it is still higher than the industry average. It does tell us something about a potential problem in the firm's long term investments, but again, they are still doing better than the industry.

c. Solvency and leverage is captured by an analysis of the capital structure of the firm and the firm's ability to pay interest. Capital structure: Both the equity multiplier and the debt-toequity ratio tell us that the firm has become less levered. To get a better idea about the proportion of debt in the firm, we can turn the D/E ratio into the D/V ratio: 1999: 43%, 1998: 46%, 1997:47%, and the industry-average is 47%. So based on this, we would like to know why this is happening and whether this is good or bad. From the numbers it is hard to give a qualitative judgement beyond observing the drop in leverage. In terms of the firm's ability to pay interest, 1999 looks pretty bad. However, remember that times interest earned uses EBIT as a proxy for the ability to pay for interest, while we know that we should probably consider cash flow instead of earnings. Based on a relatively large amount of depreciation in 1999 (see info), it seems that the firm is doing just fine.

1) In the Balance sheet of a firm,the debt equity ratio is 2:1.The amount of long term sources is Rs.12 lac.What is the amount of tangible net worth of the firm?

a) Rs.12 lac.

b) Rs.8 lac

c) Rs.4 lac. d) Rs.2 lac.

2) Debt Equity Ratio is 3:1,the amount of total assets Rs.20 lac,current ratio is 1.5:1 and owned funds Rs.3 lac.What is the amount of current asset?

a) Rs.5 lac

b) Rs.3 lac

c) Rs.12 lac

d)none of the above.

3) Banks generally prefer Debt Equity Ratio at : a) 1:1

b) 1:3

c)2:1

d) 3:1

4) If a company revalues its assets,its networth : a) Will improve b) Will remain same c) Will be positively affected d) None of the above. 5) If a company issues bonus shares the debt equity ratio will

a) Remain unaffected b) Will be affected c) Will improve d) none of the above. 6) An asset is a a) Source of fund b) Use of fund c) Inflow of funds

d) none of the above.

7) In the balance sheet amount of total assets is Rs.10 lac, current liabilities Rs.5 lac & capital & reserves are Rs.2 lac .What is the debt equity ratio? a)1;1

b) 1.5:1

c)2:1

d)none of the above.

8) The long term use is 120% of long term source.This indicates the unit has a) current ratio 1.2:1 b) Negative TNW c)Low capitalization d)Negative NWC.

9) In last year the current ratio was 3:1 and quick ratio was 2:1.Presently current ratio is 3:1 but quick ratio is 1:1.This indicates comparably a) high liquidity b) higher stock

c) lower stock d) low liquidity

10) Authorised capital of a company is Rs.5 lac,40% of it is paid up.Loss incurred during the year is Rs.50,000.Accumulated loss carried from last year is Rs.2 lac.The company has a Tangible Net Worth of a) Nil

b) Rs.2.50 lac

c) (-)Rs.50,000 d) Rs.1 lac.

11) The degree of solvency of two firms can be compared by measuring a) Net worth b) Tangible Net Worth c) Asset coverage ratio d) Solvency Ratio. 12) Properietory ratio is calculated by a) Total assets/Total outside liability b) Total outside liability/Total tangible assets c) Fixed assets/Long term source of fund d) Properietors’Funds/Total Tangible Assets. 13) Current ratio of a concern is 1,its net working capital will be a) Positive b) Negative c) Nil d) None of the above 14) Current ratio is 4:1.Net Working Capital is Rs.30,000.Find the amount of current Assets. a) Rs.10,000 b) Rs.40,000 c) Rs.24,000

d) Rs.6,000

15) Current ratio is 2:5.Current liability is Rs.30000.The Net working capital is a) Rs.18,000 b) Rs.45,000 c) Rs.(-) 45,000 d) Rs.(-)18000 16) Quick assets do not include a) Govt.bond b) Book debts c) Advance for supply of raw materials d) Inventories. 17) The ideal quick ratio is

a) 2:1

b) 1:1

c) 5:1

d) None of the above

18) A very high current ratio indicates a) High efficiency b) flabby inventory c) position of more long term funds d) b or c 19) Financial leverage means a) Use of more debt capital to increase profit b) High degree of solvency c) Low bank finance

d) None of the above

20) The capital gearing ratio is high for a company.It indicates a position of a) Low debts b) high preference capital c) high equity d) low debt equity ratio.