Cost-Volume-Profit Analysis - Home - Faculty 1… · PPT file · Web view · 2012-03-12Cost-Volume-Profit Analysis. Chapter 19. Chapter 19 explains cost-volume-profit analysis (CVP

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Cost-Volume-Profit Analysis

Chapter 19

1


Learning Objectives

2

Analyze Costs and identify how changes in volume affect costsUse CVP analysis to compute breakeven points

Use CVP analysis for profit planning, and graph the CVP relationsUse CVP methods to perform sensitivity analyses


Learning Objectives

3

Calculate the breakeven point for multiple products or servicesDistinguish between variable costing and absorption costing (see Appendix 19A, located at myaccountinglab.com)


Analyze Costs and identify how changes in volume affect costs

4

1


A justification for cost analysis: Budgeting

Standard entry level budgeting process:$12,000 annual expense = $1,000 each month

The $1,000 is a lousy benchmark for measuring our cost control performance.

If this is a VOLUME driven expense, what is wrong with that $1,000 target in:

Busy months?Slow months?

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.6

Straight-line vs. Volume drivenLet’s review this worksheet used to plan that budget.

Sales

Month

2010 orders

shipped

2011 Simple Budget

2010 $$ Actual

Costs2011 Volume

Based BudgetJan 1,400 1,000$ 450$ 527Feb 2,200 1,000$ 650$ 820Mar 2,900 1,000$ 1,000$ 1076Apr 3,200 1,000$ 1,100$ 1186May 4,000 1,000$ 1,300$ 1479Jun 4,900 1,000$ 1,500$ 1808Jul 6,000 1,000$ 2,600$ 2211Aug 2,400 1,000$ 1,000$ 893Sep 2,000 1,000$ 950$ 747Oct 1,300 1,000$ 550$ 491Nov 1,100 1,000$ 450$ 417Dec 900 1,000$ 450$ 344Totals 32,300 12,000$ 12,000$ 12,000$

Distribution Center Costs


Your new tools

The tools we will learn today will allow us to plan more realistic cost estimates that follow the cost behaviors we’ll be studying.Good for budgeting,

Meaningful performance measuresGood for one time decision making too.

Measure revenue changes against more useful cost estimates.


Cost Behavior Types

Defined by the effect of volume of activity on cost expenditure

Variable costsTotal expenditure increases or decreases in direct proportion to changes in the volume of activity

Fixed costsTotal expenditure does not change over wide ranges of volume

Mixed costsHave both variable and fixed components so they share behavior of both variable & fixed costs

8


Variable vs. Fixed Costs

These costs are defined by their TOTAL cost behavior.The cost per unit are different, but are derived based from the total cost behavior


Total Variable Cost

Your total gasoline expenses are based on how many miles you drive.

Miles Driven

Tota

l Gas

olin

e E

xpen

se $

$


Variable Cost Per Unit

Miles Driven

Per

Mile

Gas

Exp

ense

The gasoline cost per mile is constant regardless of the number of miles driven.


Variable Cost

Miles Driven

Per

Mile

Gas

Exp

ense

$

The definition “Variable” is based on the total, NOT the individual unit cost.

Miles Driven

Tota

l Gas

olin

e E

xpen

se $


Total Fixed Cost

Your monthly Car Insurance bill probably does not change when you drive more or less in a

given month.

Number of Miles Driven

Mon

thly

Car

In

sura

nce

Bill

$$


Fixed Cost Per Unit


Mon

thly

Insu

ranc

e C

ost

Per

Mile

$$

The average insurance cost PER MILE decreases as more miles are driven.


Total Fixed Cost


Mon

thly

Car

In

sura

nce

Bill

$$


Mon

thly

Insu

ranc

e C

ost

Per

Mile

$$

The definition “Fixed” is based on the total, NOT the individual unit cost.


Fixed Cost Per Unit

Number of Cars Sold

Car

Lot

Ren

t Per

Car

Sol

d

Relate this curve to business volume

$4,000

$2,000

$4001 2 10

Will you be able to price competitively if you sell one car?

What if you sold 10 cars,

or maybe 100 cars……?


The Economy and cost types

What would you do to save costs in a recession?Which cost situation would you rather have in a growth boom?


Mixed CostsHave both a fixed and variable componentExample:

Your total automobile ownership costsWhat fixed costs are involved?What variable costs are involved?

18


Mixed CostA mixed cost is made of combined fixed and

variable costs

Miles Driven

Tota

l Aut

omob

ile

oper

atio

n ex

pens

es $

Fixed costs: no change

with volume

Variable costs: vary with volume

Mixed costs: Fixed & Variable

combined


A costly quiz – at no extra charge

Fixed

20

Variable Mixed

For the rest of class, we are going to work on splitting this one up into the other two cost types.

Within the relevant range, this cost has a constant per unit cost.

Within the relevant range, this cost will not increase.At 10 units, each per unit cost is $50. At 20 units, each costs $25, At 100 units, each costs $5.

The total COGS in just about any merchandiserThe total COGS in just about any manufacturerBake one cupcake, spend $0 on paper cups. Bake 900 cupcakes, spend $9.00

Your store rent is $2,000/month


Fixed Cost

Variable Cost

Number of miles driven

Tota

l Aut

omob

ile

Ope

ratio

n Ex

pens

es

X

Y

Total Costs: Typical Mixed Costs

The total mixed cost line can be expressed as an equation: Y = a + bXTC = FC + VC*N

Where: TC = the total mixed costFC = the total fixed cost (the

vertical intercept of the line)VC = the variable cost per unit of

activity (the slope of the line)N = the level of activity

Total cost TC = FC + VC*N


Mixed Costs: Why separate them?

We break mixed costs down into their variable and fixed components so we can get an equation to work with:

TC = VC*N + FC If we know our Fixed Costs (FC) and Variable Costs per unit (VC), we can predict our Total Cost (TC) at a given Number of units output (N)

What good is this?What can the variable unit cost alone tell us?

Total mixed cost = (Variable cost per unit x number of units) + Total fixed cost


Cost separation: High-Low MethodIdentify the highest and lowest levels of activity over a period of time

STEP 1: Calculate variable cost per unit

STEP 2: Calculate total fixed cost

STEP 3: Create and use equation to show the behavior of a mixed cost

23

Variable cost per unit = Change in total cost ÷ Change in activity volume

Total fixed cost = Total mixed cost – Total variable cost

Total mixed cost = (Variable cost per unit X number of units) + Total fixed costs

TC = VC*N + FC


0 1 2 3 4

*

Tota

l Cos

t in

1,00

0’s

of D

olla

rs

10

0

***

**

* **

*

Activity, 1,000’s of Units Produced

X

Y

Ignore the mid points, and just use the highest and lowest activity data points

The High-Low MethodVisual Introduction

20


0 1 2 3 4

*

Tota

l Cos

t in

1,00

0’s

of D

olla

rs

10

20

0

*

Activity, 1,000’s of Units Produced

X

Y

Ooh, this looks easier, and somehow more precise. Why might we still want to plot all the points?

The High-Low MethodVisual Introduction

- - - - - - - - - - - - - - - - - - - - - - - - - - -

High-Low cost separation:VC/unit = FC = TC – total variable costWrite up useful equation


High-Low Method: Steps 1 and 2

Data

Step 1

Step 2

Step 326


Now check your formula against the original data

27

($2 x 480 event-playing hours) + $1,000 = $1,960

($2 x 240 event-playing hours) + $1,000 = $1,480OR


High-Low Issues

Consistent: Get the same answer each time!Arbitrary: Who says the two furthest outlying numbers are most predictive of future activities?Misleading precision: See 1 & 2 above.What happens when fixed costs do change?How important or fine is your decision?


Busting the skimming cashier at your hotel in Montana

MonthOccupancy-

Days

Actual Electrical

Costs

Predicted Electrical

Costs

January 1,736 1,889$

February 1,904 2,023$

March 2,356 2,385$

April 2,250 2,300$

May 1,500 2,132$ 1,700$

June 744 1,985$ 1,095$

July 2,108 2,186$ 2,186$

August 2,406 2,425$

September 840 1,172$

October 124 599$

November 720 1,076$

December 1,364 1,591$ Totals 18,052 21,763$ 4,981$

Use the high-low method to find your predictive cost equation.

Use that cost equation to find your expected electrical costs at each Occupancy volume.

Evaluate actual costs against expected costs.

When were they skimming?


Busting the skimming cashier at your hotel in Montana

MonthOccupancy-

Days

Actual Electrical

Costs

Predicted Electrical

Costs

January 1,736 1,889$ 1,889$

February 1,904 2,023$ 2,023$

March 2,356 2,385$ 2,385$

April 2,250 2,300$ 2,300$

May 1,500 2,250$ 1,700$

June 744 1,985$ 1,095$

July 2,108 2,186$ 2,186$

August 2,406 2,425$ 2,425$

September 840 1,172$ 1,172$

October 124 599$ 599$

November 720 1,076$ 1,076$

December 1,364 1,591$ 1,591$ Totals 18,052 21,881$ 20,442$

Use the high-low method to find your predictive cost equation.

Use that cost equation to find your expected electrical costs at each Occupancy volume.

Do this on the grid to the left

Evaluate your actual costs against expected costs.

See which actual results differ the most from your predicted results

When were they skimming?

High-Low cost separation:VC/unit = FC = TC – total variable costWrite up useful equation


Busting the skimming cashier at your Montana resort

MonthOccupancy-

Days

Actual Electrical

Costs

Expected Electrical

Costs

January 1,736 1,889$ 1,889$

February 1,904 2,023$ 2,023$

March 2,356 2,385$ 2,385$

April 2,250 2,300$ 2,300$

May 1,500 2,250$ 1,700$

June 744 1,985$ 1,095$

July 2,108 2,186$ 2,186$

August 2,406 2,425$ 2,425$

September 840 1,172$ 1,172$

October 124 599$ 599$

November 720 1,076$ 1,076$

December 1,364 1,591$ 1,591$ Totals 18,052 21,881$ 20,442$

Hi-Low:($2,425-$599) ÷ (2,406-124) = VC/Unit VC per unit ≈ $0.80 per Occupancy dayTC=$2,425=FC + $0.80*2406FC ≈ $500 Cost equation:TC = $500 + $0.80 * N


Software can be used to fit a regression line through the data points.The cost analysis objective is the same: Y = a + bx

Or: TC = FC + VC*N

Least-squares regression also provides a statistic,

called R2, that is a measure of the goodness of fit, or the predictive value* of your cost driver (volume).

* Assuming a causal relationship

Excel based regression analysis


0 1 2 3 4

Tota

l Cos

t

10

20

0

Activity

****

**

* ***

Least-Squares Regression Method

R2 is the percentage of the variation in total cost explained by the activity.

R2 for this relationship is near100% since the data points are

very close to the regression line.X

Y


0 1 2 3 40

ActivityX

To

tal C

ost

10

20 ****

**

* ***

Least-Squares Regression Method

R2 is the percentage of the variation in total cost explained by the activity.

Y

**** **

** * *

* **

*

* *

*

**

** ** *

*

*

*

**

*

R2 for this relationship is near0%. It is useless


QuarterPlaying Hours

Total Maintenance

Costs1st 3 $1,8002nd 6 $2,3003rd 4 $1,7004th 5 $2,000

Y intercept, Fixed Costs:1,140.00$ =INTERCEPT(C2:C5,B2:B5)

Slope, Variable cost per unit:180.00$ =SLOPE(C2:C5,B2:B5)

R Squared, Error:0.77 =RSQ(C2:C8,B2:B8)

One more playing hour will cost you $180.00 in maintenance

Maintenance costs $1,140 even if you don't play at all.

About 3/4 of the variance in cost is explained by playing hours. There are other factors.Re

gres

sion

appl

ied

to ex

ampl

e


Busting the skimming cashier at your Montana resort

MonthOccupancy-

Days

Actual Electrical

Costs

Expected Electrical

Costs

January 1,736 1,889$ 1,984$

February 1,904 2,023$ 2,100$

March 2,356 2,385$ 2,412$

April 2,250 2,300$ 2,339$

May 1,500 2,250$ 1,821$

June 744 1,985$ 1,298$

July 2,108 2,186$ 2,241$

August 2,406 2,425$ 2,447$

September 840 1,172$ 1,364$

October 124 599$ 870$

November 720 1,076$ 1,281$

December 1,364 1,591$ 1,727$ Totals 18,052 21,881$ 21,882$

Regression analysis and Scattergraph results

y = 0.6911x + 783.87R2 = 0.7783

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

0 500 1,000 1,500 2,000 2,500 3,000


Relevant RangeRange of volume:

Where total fixed costs remain constant and variable cost per unit remains constant

Outside the relevant range, costs can differ

37


CVP analysis

44

2


From Cost Equation to CVP Equation

SP*N – (VC*N) - FC = Profits

Where: N = Number of units soldSP = Unit selling price

VC = variable cost per unit FC = Total fixed Costs

These equations work for Break Even, Target Profit, and many CVP problems.

Total Costs = (VC*N + FC)Revenues = SP*N

Profits

Since-= = Profits

-=

Or (SP – VC)*N – FC = Profits

Income Statement Approach

Contribution Margin Approach


Total Per UnitSales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$ Less: fixed expenses 80,000 Net operating income 20,000$

BCA Cycle Co.Contribution Income Statement

For the Month of June

Functional income statement

Contribution Margin income statement

TotalSales (500 bikes) 250,000$ Less:COGS 100,000 Gross Margin 150,000 Less: Operating expenses 130,000 Net operating income 20,000$

BCA Cycle Co. Income Statement


Arranged by functionRequired for GAAPPoorly suited to internal CVP decision making

Arranged by cost behaviorNot GAAP approvedIdeal for CVP decision making

Financial reporting vs. Managerial CVP friendly reporting





Interpreting contribution margin dollars: If we cover fixed cost, all contribution margin dollars

after that go to profits.

Using the Contribution Margin Income Statement


Total Per Unit PercentSales (500 bikes) 250,000$ 500$ 100%Less: variable expenses 150,000 300 60%Contribution margin 100,000$ 200$ 40%Less: fixed expenses 80,000 Net operating income 20,000$

For each additional cycle that BCA sells, $200 more in contribution margin will help to cover

fixed expenses and profit.


How many units must they sell to break even?


Total Per UnitSales (400 bikes) 200,000$ 500$ Less: variable expenses 120,000 300 Contribution margin 80,000 200$ Less: fixed expenses 80,000 Net operating income $ 0



If BCA sells 400 units in a month, it will be operating at the break-even point.



Total Per Unit % SalesSales (500 bikes) 250,000$ 500$ 100%Less: variable expenses 150,000 300 60%Contribution margin 100,000 200$ 40%Less: fixed expenses 80,000 Net operating income 20,000$




40% of incremental bike sales goes to fixed costs and profits

How is that fact useful for BCA?





CVP Q & A What if we increase sales

price?

What if our unit variable costs

increase?

What if we buy a huge

marketing campaign?

What if we buy a huge marketing campaign, raise our prices and increases the

sales commission?!?!?


CVP Analysis basicsExpresses the relationships among costs, volume, and profit or lossAnswers:

How many products or services must the company sell to break even?What will profits be if sales double?How will changes in selling price, variable costs, or fixed costs affect profits?

Assumptions:Managers can classify each cost as either variable or fixedOnly factor that affects total costs is change in volume, which increases variable and mixed costs

Fixed costs do not change

52


Breakeven Point & target profits

Breakeven: Sales level at which operating income is zero

Total revenues equal total costs (expenses)Target profits

Instead of zero profits, insert desired profits and repeat exactly like breakeven analysis

Two methods to compute breakeven point:Either formula method Create a Contribution Margin Income Statement

53


Break even using the Contribution Margin Formula

N = Number of units sold SP = Unit selling price VC = variable cost per unitFC = Total fixed Costs

Our hamburger stand plans to capture $8.00 on the average sale. The variable cots per order run about $3.50. Our

monthly fixed costs are $3,600. What is out break even volume in orders and Dollars?

(SP – VC)*N – FC = Profits

($8.00 - $3.50) * N - $3,600 = $0$4.50 * N - $3,600 = $0

+$3,600 + $3,600$4.50 * N = $3,600

÷$4.50 ÷$4.50 N = 800 customers

$6,400 in revenue = 800 * $8.00 per customer


Break even using the Contribution Margin Formula


What will our break even targets be if we increase our cost per meal to $3.75 by adding a dessert and raise our average selling price to $9.00 per meal? Assume the same $3,600 fixed costs


($9.00 - $3.75) * N - $3,600 = $0$5.25 * N - $3,600 = $0

+$3,600 + $3,600$5.25 * N = $3,600

÷$5.25 ÷$5.25 N = 686 customers

$6,171 in revenue = 686 * $9.00 per customer


One change makes this a much more optimistic tool: Target profit


Our hamburger stand plans to capture $8.00 on the average sale. The variable costs per order run about $3.50. Our

monthly fixed costs are $3,600. How many customers will it take to earn $4,000 per month?


($8.00 - $3.50) * N - $3,600 = $4,000$4.50 * N - $3,600 = $4,000

+$3,600 + $3,600$4.50 * N = $7,600

÷$4.50 ÷$4.50 N = 1,689 customers

$16,511 in revenue = 1,689 * $8.00 per customer


Target profit using the Contribution Margin Approach formula


What sales numbers will achieve our $4,000 target profit if we increase our cost per meal to $3.75 by adding a dessert and raise

our average selling price to $9.00 per meal? Assume the same $3,600 fixed costs


($9.00 - $3.75) * N - $3,600 = $4,000$5.25 * N - $3,600 = $4,000

+$3,600 + $3,600$5.25 * N = $7,600

÷$5.25 ÷$5.25 N = 1,448 customers

$13,027 in revenue = 1,448 * $9.00 per customer


Contribution Margin Full StatementWhy bother?

Error preventionDisplay for decision makersHelpful in understanding and deriving shortcut

Shortcut methodTime saving, error prone derivatives of statement

58

Total Per Unit %Sales (500 bikes) 250,000$ 500$ 100%Less: variable expenses 150,000 300 60%Contribution margin 100,000 200$ 40%Less: fixed expenses 80,000 Net operating income 20,000$




Contribution Margin Full Detail

59

Total Per Unit %Sales (500 bikes) 250,000$ 500$ 100%Less: variable expenses Variable COGS 70,000 140 28% Variable compensation 50,000 100 20% Variable other expenses 30,000 60 12%Contribution margin 100,000 200$ 40%Less: fixed expenses 80,000 Fixed COGS 35,000 Fixed compensation 25,000 Fixed other expenses 20,000 Net operating income 20,000$



To convert from functional to CM, we must separate mixed costs, as we did earlier in the chapterNote how the statement is organized by cost behavior, not strictly business function.Spreadsheet software enables efficient sensitivity analysis, including break even


Building a Contribution Margin Income Statement

Your assistant already separated the functional cost areas into variable and fixed costs.Prepare a contribution margin income statement from the results of that work shown:

60

Benson Music, Inc.Keyboard Division

Information for the Month Ended March 31, 2011

Sales in units 250Selling price per unit $800

Cost information:

Variable cost per

unit

Fixed Costs per

MonthCOGS $450 $0Selling expenses $80 $20,000Administrative expenses $15 $8,000


Using a Contribution Margin Income Statement

61

Here, individual changes can be made to reflect suggestions or altered realities.You can do this by hand to learn it, but really…..Spreadsheet software enables efficient sensitivity analysis, including break evenLet’s play with Excel

Show break evenShow target profitTarget costing

Benson Music, Inc.Keyboard Division

Contribtion Margin Income StatementFor the Month Ended March 31, 20xx

Sales $200,000Variable Expenses:

COGS $112,500Selling expenses 20,000Administrative Expenses 3,750 136,250

Contribution Margin 63,750Fixed Expenses

Selling expenses 20,000Administrative Expenses 8,000 28,000

Net operating income $35,750


Sensitivity AnalysisPredict how changes in sale prices, cost, or volume affect profits“What-if?” analysisAllows managers to see how various business strategies affect profits

Changing selling priceChanging variable CostsChanging fixed Costs

62


Ideas into numbers into decisionsYou are in a meeting trying to boost company profits.People are suggesting approaches that they think will maximize company profitability.You can test their assumptions instantly with CVP.You can test their assumptions too, but that’s another subject.

We should buy cheaper

materials and cut price to grow sales

volume!

Let me punch in the #’s:

Lower variable costs 10%,Lower sales

price 5%,Boost volume

25%.

Great idea Ralph! Let’s get started making second rate stuff right

away!

Ralph, You’re an idiot. We should raise prices and then upgrade

packaging to offset any pricing caused

volume decline.

I like peanut butter.


Sensitivity Analysis with a Contribution Margin Income Statement

64

Decrease sales price by 10%Increase unit sales by 20%

What suggestion likely drove those numbers?

What outcome would you expect on profitability?

Georgia Peach PiesContribtion Margin Income StatementFor the Month Ended March 31, 20xx

Volume $/Unit2,500 10 Sales $25,000 100%

Variable Expenses:2,500 8 Combined variable costs 20,000 80%

Contribution Margin 5,000 20%Fixed Expenses

Combined fixed costs 6,000 6,000 24%Net operating income -$1,000 -4%








65

Increase price by 10%Increase variable costs 5% per unitIncrease fixed costs by $1,000

What suggestion likely drove those numbers?


What should we be wary of ?








Variable Expenses:2,500 8.4 Combined variable costs 21,000 76%


Combined fixed costs 7,000 7,000 25%Net operating income -$500 -2%



66

Variable costs increase by 25%Increase selling price by $2.00Decrease volume by 10%Decrease fixed costs by $2,000.

What situation likely drove those numbers?











Combined fixed costs 4,000 4,000 15%Net operating income $500 2%


Contribution margin ratioRelate to the Contribution margin format income statement

Use to solve for breakeven

Use to solve for target profits

67






Contribution margin dollarsSales revenue dollars

=CM Ratio

Fixed costsContribution margin ratio

Breakeven sales in dollars =


S19-5: COMPUTING BREAKEVEN POINT IN SALES DOLLARS

Story Park is an entertainment theme park. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month.1. Compute Story Park’s contribution margin ratio. Carry

your computation to two decimal places.

68

$50 - $10 = $40$40 ÷ $50 = 0.80 or 80%

2. Use the contribution margin ratio CVP formula to determine the sales revenue Story Park needs to break even.

$240,000 ÷ 0.80 = $300,000


CVP with multiple product lines or services

69

5


Multiple Product Lines

Selling prices and variable costs differ for each product

Different contribution to profitsWeighted-average contribution margin computedSales mix provides weights to make up total product sales

Weights equal 100% of total product sales

70


Steps for Computing Breakeven Point with Multiple Product Lines

To compute breakeven sales in units for multiple products, complete the following three steps:

STEP 1: Calculate the weighted-average contribution margin per unitSTEP 2: Calculate the breakeven point in units for the “package” of productsSTEP 3: Calculate the breakeven point in units for each product and then multiply the “package” breakeven point in units by each product’s proportion of the sales mix

71


Step 1Calculate the weighted-average contribution margin per unit:

72


Step 2Calculate the breakeven point in units for the “package” of products:

73


Step 3Calculate the breakeven point in units for each product. Multiply the “package” breakeven point in units by each product’s proportion of the sales mix:

74


ProofProve this breakeven point by preparing a contribution margin income statement:

75


A deeper look Assume that management sets an incentive based on unit sales.Customers come in to buy cat bedsScratching posts are add-on salesIf two customers are waiting, how will your sales people maximize their bonus?

76

Sale price per unit 44.00$ 100% 100.00$ 100%Variable cost per unit 24.00 55% 30.00 30%Contribution margin per unit 20.00$ 45% 70.00$ 70%Sales mix in units 3 2 5Contribution margin 60.00$ 140.00$ 200Weighted average $CM 40.00$

Scratching PostsCat Beds


Multiproduct CVPWe need to increase profits in our pet store:

We want to sell more of everything.

If pressed for time, sales people will make decisions that maximize their bonuses

Assuming equal spiffs, sales of the easier to sell product will increase more.

How does CVP analysis accommodate these issues?


Multi Product Break even using CM Ratio

1. Contribution Margin Income Statement

Sales revenue 26,400$ 100% 40,000$ 100% 66,400$ 100%Variable costs 14,400$ 55% 12,000$ 30% 26,400$ 40%Contribution margin 12,000$ 45% 28,000$ 70% 40,000$ 60%Less fixed costs 40,000

-$

Cat Beds Scratching Posts Total

Note how average CM ratio is calculated.How will increased Cat bed sales change average CM?How can sales incentives be formulated to avoid this shift?


Reading a CVP Graph

79


Leverage and the CVP graph

82

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

100 200 300 400 500 600 700 800 900 1,000


Variable costing (Appendix 19A—online at myaccountinglab.com

83

6


Variable Costing Agenda

Variable Costing introductionClass attack on in-class problem“I enjoy Challenges” caseThe great debate!


What is Variable Costing?

CVP analysis tore mixed costs into two pieces for more effective analysis:

Fixed costsVariable costs

Variable costing tracks product costs consistent with that emphasis on cost behavior

Stresses the fact that fixed production costs are really incurred in a period no matter the output, so treats them as period costsFits perfectly into contribution margin income statements


What is Variable Costing?

It is only a PRODUCT costing techniqueThe only new thing:

Fixed manufacturing overhead is NOT assigned to WIP, and is NOT part of the product cost.Fixed manufacturing overhead is treated as a period cost. How are period costs treated?

So what? This one change removes an uncomfortable incentive inherent in GAAP approved absorption costing.


Balance Sheet Costs Inventories

Reminiscing: Cost Flow

Income StatementExpenses

Variable Cost of GoodsSold

Selling andAdministrativePeriod Costs

Work in Process

FinishedGoods

Raw Materials

VariableManufacturing

Overhead

Material Purchases

Direct Labor

Selling andAdministrative

FixedManufacturing

OverheadAbsorption co

sting

Variable costing Fixed MOH


Where do fixed manufacturing overhead costs end up?

Inventoried Expensed$0

$25,000

$50,000

$75,000

$100,000

Variable CostingAbsorption Costing

Fixed manufacturing overhead treatment when production exceeds sales


Above is our airplane cost flow work:4 planes made, 3 sold$100 DM per plane$75 DL per plane$100 total fixed MOH

Note ending inventory contains fixed MOH

Absorption CostingRaw Materials Work In Process Finished Goods COGS400 400 b b 400 f 800 g 600

0 c 300 600 ge 100 EB 200

subtotal 800 800 fEB 0

300 c

100 100 e0

Manufacturing Overhead

Wages Payable

Raw Materials Work In Process Finished Goods COGS400 400 b b 400 f 700 g 525

0 c 300 525 gEB 175

subtotal 700 700 fEB 0

300 c

e 100

Manufacturing Overhead

Wages Payable

Fixed Manufacturing Expense


Variable Costing Walk Through

90

Stainless Chef ToolsSelected financial information

For the year ended December 31, 2010

Units sold 5,000 Units produced 8,000 Sales price 100

Direct materials per unit 30 Direct labor per unit 10 Variable manufacturing overhead per unit 5 Variable selling costs per unit sold 16 Fixed manufacturing overhead 48,000 Fixed Selling, general, and administrative 150,000

Prepare unit product costs under

Absorption costingVariable costing

Product costs per unitAbsorption Variable

DM 30$ 30$ DL 10 10VMOH 5 5FMOH 6Total 51$ 45$


Variable Costing Walk Through

91

Stainless Chef ToolsSelected financial information

For the year ended December 31, 2010

Units sold 5,000 Units produced 8,000 Sales price 100

Direct materials per unit 30 Direct labor per unit 10 Variable manufacturing overhead per unit 5 Variable selling costs per unit sold 16 Fixed manufacturing overhead 48,000 Fixed Selling, general, and administrative 150,000

Prepare income statements using

Absorption costingVariable costing

Product costs per unitAbsorption Variable

DM 30$ 30$ DL 10 10VMOH 5 5FMOH 6Total 51$ 45$

Stainless Chef ToolsIncome StatementAbsorption Costing

Year ended Dec. 31, 2010

Sales 500,000$ Less COGS 255,000 Gross margin 245,000 Less SG&A 230,000 Net Operating Income 15,000$

Stainless Chef ToolsIncome Statement

Variable CostingYear ended Dec. 31, 2010

Sales 500,000$ Less Variable costs VCOGS 225,000 VSG&A 80,000 Contribution Margin 195,000 Less Fixed costs FMOH 48,000 FSG&A 150,000 Net Operating Income (3,000)$


I Enjoy ChallengesKelly company is unprofitableSuperman(ager) is hired to turn that aroundHe accomplishes his profitability goal and leaves with an overflowing briefcase to excitedly pursue his next challengeWhat do we do?

The Case Study:


What we do?Answer the initial observation questionsPrepare a variable costing contribution margin income statement.Reconcile it with the supplied Absorption costing income statement.Answer the next interpretation questions.Would you like a quick once-over of the case financial statement formatting?

I Enjoy Challenges Case:



Kelly CompanyIncome Statement

for the Year Ending December 31, 2009

Sales (10,000,000 units @ $3 ea) $30,000,000Less Cost of Goods Sold:

Variable (10,000,000 units @ $1 ea) $10,000,000Fixed Manufacturing Costs 24,000,000 $34,000,000

Gross Margin ($4,000,000)Less Marketing and Administrative

costs (all fixed) 5,000,000Operating Profit (loss) ($9,000,000)


I Enjoy Challenges Case:Kelly Company

Income Statementfor the Year Ending December 31, 2010

Sales (10,000,000 units each $3.00) $30,000,000Less Cost of Goods Sold: Beginning inventory 0 Add production costs:

Variable (30,000,000 units @ $1 ea) $30,000,000Fixed 24,000,000Cost of Goods Manufactured $54,000,000

Less Ending Inventory:Variable (20,000,000 units @ $1 ea) $20,000,000Fixed (20m/30m x $24,000,000) 16,000,000Total Ending Inventory $36,000,000

Cost of Goods Sold 18,000,000Gross Margin $12,000,000Less Marketing and Administrative

costs (all fixed) 5,000,000Operating Profit Before Bonus $7,000,000Less Bonus 700,000Operating Profit after Bonus $6,300,000



Kelly CompanyVariable Costing Income Statement


Sales (10,000,000 units each $3.00) $30,000,000Less cost of goods sold:

Made 30m units @$1 variable cost ea$30,000,000Less ending inventory 20,000,000Variable COGS $10,000,000

Contribution margin $20,000,000Less fixed costs

Fixed manufacturing overhead 24,000,000Marketing and administrateive $5,000,000

Total fixed costs 29,000,000Income before bonus ($9,000,000)Bonus 700,000Net operating income (9,700,000)



Kelly CompanyVariable Costing to Absorption Reconciliation


Net operating income, absorption $6,300,000Less fixed costs deferred in inventory

2/3 * 24,000,000 ($16,000,000)Net operating income, variable ($9,700,000)


Benefits of Variable Costing

Unneeded production increases don’t result in false perceived profits

Increases in sales bring increases in profits, aligning reporting with performing

Unit cost becomes a truly variable figure so your CVP analysis works right

Know it, so you don’t fall for illusion created by the income statement!


Fixed costs arenot really the costs

of any particularproduct.

VariableCosting

Forget the political fighting!Here’s The Real Debate.

AbsorptionCosting

All manufacturingcosts must be assignedto products to properly

match revenues andcosts.


AbsorptionCosting

The Real Debate!Depreciation,

taxes, insurance andsalaries are just as

essential to productsas variable costs.

These are capacitycosts and will be

incurred even if nothingis produced.

VariableCosting


They are the numbers that appear on our

external reports!

The Real Debate!

AbsorptionCosting

Absorptioncosting product costs

are misleading fordecision making.

VariableCosting

Censored


Variable Vs. Absorption Costing

Both absorption and variable costing are valid approaches to cost accounting and, believe it

or not, they can coexist peacefully.


Summary of Differences Between Absorption Costing and Variable Costing

Type of Cost Absorption Costing Variable Costing

Product Costs (capitalized as Inventory until expensed as Cost of goods sold)

Direct materialsDirect laborVariable manufacturing overheadFixed manufacturing overhead

Direct materialsDirect laborVariable manufacturing overhead

Period Costs (expensed in period incurred)

Variable nonmanufacturing costsFixed nonmanufacturing costs

Fixed manufacturing overheadVariable nonmanufacturing costsFixed nonmanufacturing costs

Income Statement Format

Conventional income statement

Contribution margin income statement

103


Variable costs are those costs that increase or decrease in total as the volume of activity increases or decreases. Fixed costs are costs that do not change over wide ranges of volume. Costs that have both variable and fixed components are called mixed costs. The high-low method is an easy way to separate mixed costs into variable and fixed components by requiring you to identify the highest and lowest levels of activity over a period of time. The relevant range is the range of activity where total fixed cost stays the same and variable cost per unit stays the same.

104

Chapter 19 Summary


Chapter 19 SummaryThe breakeven point is the sales level at which operating income is zero—total revenues equal total costs. The breakeven point can be found by using the income statement approach, using zero for operating income. The breakeven point can also be found by dividing total fixed cost by the contribution margin per unit (sales price per unit – variable cost per unit).Breakeven analysis can be used to calculate the sales volume needed to earn a certain amount of profit, called target profit. Target profit is the operating income that results when sales revenue minus variable costs and minus fixed costs equals management’s profit goal.

105


Chapter 19 SummaryGraphing various activity levels and costs gives a visual representation of operating levels that generate net income and operating levels that result in net loss.Sensitivity analysis is a “what if” technique that asks what results are likely if selling price or costs change or if an underlying assumption changes. The income statement approach to breakeven is just adjusted for the new proposed values. The margin of safety is the “cushion” or drop in sales that the company can absorb before incurring a loss.

106


Chapter 19 SummaryMost companies sell more than one product. Selling price and variable costs differ for each product, so each product makes a different contribution to profits. To calculate break even for each product, we compute the weighted-average contribution margin of all the company’s products. The combination of products that make up total sales, called the sales mix (or product mix), provides the weights that make up total product sales.

107


Summary of the AppendixVariable costing assigns only variable manufacturing costs to products. Fixed manufacturing costs are considered period costs and are expensed immediately because the company incurs these fixed costs whether or not it produces any products or services. In variable costing, fixed manufacturing costs are not treated as product costs. Management accountants often prefer variable costing because contribution margin is readily apparent on the variable costing income statement.

108



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