CHAPTER 4 Cost-Volume-Profit Analysis Variable Costs Fixed Costs Mixed Costs Step Costs Common Cost...

CHAPTER 4CHAPTER 4CHAPTER 4CHAPTER 4

Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis

Variable Costs

Fixed Costs

Mixed Costs

Step Costs

Common Cost Behavior Patterns

Variable CostsVariable Costs

Costs that change in proportion to changes in volume or activity

At restaurants, food costs vary with the number of customers served

For airlines, fuel costs vary with the number of miles flown

Example Activity increases by 10% Cost increases by 10%

Variable CostsVariable Costs

Fixed CostsFixed Costs

Do not change in response to changes in activity level Typical fixed costs are depreciation,

supervisory salaries, and building maintentance

Example Activity increases by 10% Costs remain unchanged

Discretionary Fixed Costs Management can easily change Advertising, Research and

Development

Committed Fixed Costs Cannot be easily changed Rent, Insurance

Mixed CostsMixed Costs

Contain variable and fixed cost elements

Example Salesperson with base salary (fixed) Receives commission on sales

(variable)

Mixed CostsMixed Costs

Step CostsStep Costs

Fixed cost for a specific range

Increases to higher level when upper bound of range is exceeded

Example Company adds third production shift Costs increase to include supervisory

Step CostsStep Costs

Direct LaborDirect Labor

Cost Estimation MethodsCost Estimation Methods

Account Analysis

Scattergraphs

High-Low Method

Regression Analysis

Account AnalysisAccount Analysis

Most common approach

Requires professional judgment of management

Management classifies costs as fixed and variable

Costs are then estimated Variable cost per unit Total fixed costs

Estimates used to find total production costs at various production levels

ScattergraphsScattergraphs

Utilization of cost information from previous periods

Weekly, monthly, or quarterly cost reports

Plot the costs at specific activity levels

ScattergraphsScattergraphs

High-Low MethodHigh-Low Method

Utilization of cost information from previous periods

Connect straight line from lowest activity level to highest activity level

High-Low MethodHigh-Low Method

Cost Estimations Variable cost equals the slope of the

line Fixed cost equals the intercept of

cost axis

Estimates used to find total production costs at various production levels

Regression AnalysisRegression Analysis

Statistical technique

Estimates the slope and intercept of a cost equation

Typically spreadsheet programs are utilized

Regression AnalysisRegression Analysis

The Relevant RangeThe Relevant Range

Limitation of estimates

Accuracy expected only for production levels within range

Difficult to assess costs outside the relevant range

The Relevant RangeThe Relevant Range

Equation Abbreviations

x = Quantity of units produced and sold

SP = Selling price per unit VC = Variable cost per unitTFC = Total fixed cost

The Profit Equation

Profit = SP(x) – VC(x) – TFC

Fundamental to CVP analysis

Break-Even Point Number of units sold that allow the

company to neither a profit nor a loss

$0 = SP(x) – VC(x) – TFC

Margin of Safety Difference between expected sales

and break-even sales

Break-Even PointBreak-Even Point

Contribution Margin (CM) Difference between selling price

and variable cost per unit

Profit = (SP – VC)(x) – TFC

Profit = CM per unit(x) - TFC

Contribution Margin Ratio Contribution of every sales dollar to

covering fixed cost

CM Ratio = SP – VC SP

Profit Equation (utilizing CM Ratio)

Sales($) = Profit + TFC CM Ratio

“What If” Analysis Utilize profit equation to determine

impact of managerial decisions

Change in Fixed and Variable Costs

Change in Selling Price

Taxes in CVP Analysis Profit Formula without Tax

Considerations

Before Tax Profit = SP(x) – VC(x) – TFC

Profit Formula with Tax Considerations

After Tax Profit = [SP(x) – VC(x) – TFC](1-t)

Break-EvenBreak-Even

Gabby’s Wedding Cakes creates elaborate wedding cakes. Each cake sells for $500. The variable cost of baking the cakes is $200 and the fixed cost per month is $6,000

1. Calculate the break-even point for a month.

2. How many cakes must be sold to earn a monthly profit of $9,000?

Break-Even Pointx = (Profit + TFC) / CM per Unitx = ($0 + $6,000) / $300x = 20 cakes

What if monthly profit is $9,000?x = ($9,000 + $6,000) / $300x = 50 cakes

Multiproduct AnalysisMultiproduct Analysis

Contribution Margin Approach Used if products are similar

Identify number of units needed to be sold to break even

Calculate weighted average contribution margin based on expected units sold

Multiproduct AnalysisMultiproduct Analysis

Contribution Margin Ratio Approach Products are substantially different

Identify dollar amount of sales needed to break even

Calculate total CM Ratio and use to determine break-even point

Assumptions in CVP Analysis

Costs can be accurately separated into fixed and variable components

Fixed costs remain fixed

Variable costs per unit do not change

Operating LeverageOperating Leverage

Level of fixed versus variable costs in a company

High level of fixed costs has a high operating leverage

Typically have large fluctuations in profit when sales fluctuate

OutsourcingOutsourcing

ConstraintsConstraints

Constraints on how many items can be produced

Shortage of space, equipment, or labor

Utilize contribution margin per unit to analyze situations

Decisions that Increase Sales or Production

Rhetorix, Inc. produces stereo speakers. The selling price per pair of speakers is $800. The variable cost of production is $300 and the fixed cost per month is $50,000.

1. Calculate the contribution margin associated with a pair of speakers.

2. Calculate the contribution margin ratio for Rhetorix associated with a pair of speakers.

Contribution MarginCM = SP – VCCM = $800 - $300CM = $500

If the company sells five more speakers than planned, what is the expected effect on profit of selling the additional speakers?Expected Effect = $500 * 5 units = $2,500

Contribution Margin RatioCM Ratio = (SP – VC)/SP = ($800 - $300)/$800

= 62.5%

If the company has sales that are $5,000 higher than expected, what is the expected effect on profit?Expected Effect = 62.5% * $5,000 = $3,125

1. At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Contribution Margin per unit is?a. $65b. $75c. $175d. $30

1. At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Contribution margin per unit is?a. $65b. $75c. $175d. $30

2. At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Break-Even Point is?

a. 1,000 units

b. 1,083 units

c. 2,000 units

d. None of these

2. At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Break-Even Point is?

a. 1,000 units

b. 1,083 units

c. 2,000 units

d. None of these

3. At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Expected sales are 4,200 units. The Margin of Safety is?a. $264,000b. $384,000c. $143,000d. $121,000

4. At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Expected sales are 4,200 units. What is profit expected to be?

Answer here: _________________

4. At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Expected sales are 4,200 units. What is profit expected to be?

Answer here: $143,000

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