Building the Income Statement from the Bottom Up: Explaining to students the purpose of
Cost-Volume-Profit Analysis
Thomas J. Grant. CMA
Associate Professor of Accounting
Kutztown University
610-683-4580
The intent of this paper is to suggest a method for assisting Accounting faculty when making the transition from Financial to Managerial Accounting, more specifically when introducing the concepts of cost behavior and cost-volume-profit analysis for the first time.
In the teaching of most Accounting courses, instructors focus of getting students to understand that the calculation of net income or operating income or any income related amount is a top down calculation. By this I mean we teach our students that to determine the profitability of a business (to prepare an Income Statement), we start at the top with revenues. Working our way down the income statement, we next subtract expenses. In our earliest financial accounting classes we stress the basic concept of determining profitability is to subtract total expenses from total revenues and in all succeeding financial accounting courses, while we may add some additional intricacies, we continue to follow that approach: Revenues minus Expenses = Income.
In most Business curriculums, there is a management accounting component as well as the financial accounting one. When I make the transition from recording after the fact to projecting results before the fact, I ask students to reverse their thinking. When we begin discussing the concept of cost-volume-profit analysis, I ask my students a question: Why is the company in business? Usually the answer is “to make money”. So I take this answer and I run with it. How much money do they want to make? Is that in before or after tax dollars? I then point out that these numbers would normally appear at the bottom of our income statement and try to lead the students on a logical journey as to how we build the income statement from the bottom up when we are forecasting or budgeting. I try to impress on these students, who have probably never budgeted before, that, as a business, we have set goals that we have established for ourselves and that getting to those goals will require a certain amount of work. If we change the goals, we change the amount of work. Any time a goal is established as some income amount (either pre or post tax), we can then build the income statement from the bottom up to determine what amount of work (or volume) needs to be done. This bottom up process involves us explaining the concept of cost behavior and the distinction between variable and fixed costs, those that change in total with volume and those that remain constant (within a relevant range) in total regardless of volume.
The teaching of cost behavior is therefore the critical point in introducing the forecasting or budgeting areas to lower level Business students. Trying to make sure these students have an understanding of how various costs react to changes in an organization’s activity level is essential before moving onto the topics that normally follow: break even points, budgeting, and variance analysis.
I would like to demonstrate this with an example:
Show students a simple example of determining cost behavior using the high-low method. For instance:
October November December
Production in units 2,000 3,500 5,000
Cost of Rent $5,000 $5,000 $5,000
Cost of Material Used $20,000 $35,000 $50,000
Cost of Utilities $8,000 $12,000 $14,000
My first goal is to get students to see the behavior patterns that this example points out:
1) Cost of Rent appears from our past experience to be a Fixed Cost, at $5,000 a month and not impacted by the amount of Production (or Volume);
2) Cost of Material Used is not Fixed (as the total varies with changes in Volume) but it is changing as a constant rate, which is $10 per unit. This we would classify as a Variable Cost and proceed as if this pattern will continue in the future;
3) Cost of Utilities meets neither the definition of a Fixed Cost (same total cost) nor a Variable Cost (same per unit cost). For budgeting/forecasting purposes, we will proceed under the assumption that this cost demonstrates some characteristics of each type of cost behavior and by solving (using high-low), we come up with a cost formula for Utility Cost being equal to $4,000 a month fixed and $2 a unit variable.
I now tell the students to think of the total cost equation we have determined: that with $5,000 of Rent and $4,000 of Utility Cost being Fixed each month, we have $9,000 of bills we have to pay, regardless of volume. On top of this, we have $10 of Material and $2 of Utility Cost for each unit we produce, or a total of $12 a unit in variable costs. Thus, we have a cost equation that reads: Total Expected Costs = $9,000 a month + $12 per unit produced.
I next ask the class to consider the fact that we now have to plan for “volume”, the amount of work needed to cover the $12 a unit variable cost and pay the $9,000 a month in fixed costs. We discuss setting a selling price, one that is realistic when taking into account the “3 C’s”: Costs, Customers, and Competition. I stress at this point how important it is that students realize that when those sales’ dollars are recorded, $12 of the selling price has to be allocated to cover the variable cost of each unit, that if we, for example set a selling price of $20 a unit, only $8 a unit remains once the variable costs have been deducted. We now have a “contribution” from each unit sold of $8, BUT, no profit yet. We need enough of those $8 “contributions” to pay off the $9,000 in fixed costs, or we need to sell 1,125 units a month just to pay our bills at a $20 per unit selling price. This can be displayed to students in the following manner:
Sales (at $20 per unit x 1, 125 units) 22,500
Less Variable Costs (at $12 per unit x 1,125 units) - 13,500
Contribution Margin (of $8 per unit x 1,125 units) 9,000
Less Fixed Costs - 9,000
Operating Income 0 (at the break even point)
At this point, I want students to see that the top three amounts (Sales, Variable Costs, and Contribution Margin) will change in total as the amount of volume changes. I also want the students to see that the fourth amount (Fixed Costs) does not change when the volume changes.
Now the building from the bottom up takes shape. Do we only want to sell 1,125 units a month? Did we start this business with the hope of having zero income? Hopefully, students answer “no” to each of those questions and I then get to the point: what is our profit goal? How much do we want to make each month? If a student replies that our goal should be to make $10,000 a month (before Taxes), then I start at the bottom of the income statement and build up. If I want to make $10,000 and have to pay $9,000 in fixed costs, I need my sale of units to “contribute” $19,000. Keeping the $20 selling price, which yielded the $8 contribution, I point out this means we need to sell 2,375 units a month to reach this “profit” goal, with the first 1,125 units paying the fixed costs (1,125 times $8 equaling $9,000) and every unit sold after that (2,375 less 1,125), 1,250 units times $8 yielding our desired profit figure of $10,000. This can be displayed as follows:
Sales (at $20 per unit x 2,375 units) 47,500
Less Variable Costs (at $12 per unit x 2,375 units) - 28,500
Contribution Margin (at $8 per unit x 2,375 units) 19,000
Less Fixed Costs - 9,000
Operating Income 10,000 (1,250 units sold after the break even
point @ $8 of contribution each)
Thus by setting our goal, to make a profit of $10,000 a month (before taxes), we can illustrate the amount of work that will be necessary to achieve that goal. Having already determined the break even point, we now point out that each unit sold above the break even point “contributes” to our desired profit. Once we determined that 1,125 units of volume would be needed to pay our bills or cover our Fixed Costs, we established that to be a profitable business we had to reach a volume level of sales that exceeded 1,125 units. Setting a goal of a pre-tax profit of $10,000 a month, we generate the above analysis to demonstrate that the first 1,125 units sold cover the Fixed Costs, the next 1,250 units sold allow us to reach our pre-set goal, and that the total volume in sales needs to reach 2,375 units per month if a profit of $10,000 is management’s goal.
This can be extended for use in after tax earnings and for multiple product businesses but I have found that once students understand the timing difference, that cost-volume-profit is all about predicting before a time period begins and actual income statement preparation is done after the time period is over, these students are able to grasp the building from the “bottom up” concept. I explain to students how important the principles of cost-volume-profit are in many different areas of business, not just in Accounting so that those students who go on to be Management, Marketing, and Finance majors understand the relevance of this to each of the Business majors.