Chapter Cost-Volume-Profit Learning Objectives After studying this chapter, you should be able to: [1] Distinguish between variable and fixed costs [2] Explain the significance of the relevant range [3] Explain the concept of mixed costs [4] List the five components of cost-volume-profit analysis [5] Indicate what contribution margin is and how it can be expressed [6] Identify the three ways to determine the break-even point [7] Give the formulas for determining sales required to earn target net income [8] Define margin of safety, and give the formulas for computing it 5-1 Preview of Chapter Managerial Accounting Sixth Edition Weygandt Kimmel Kieso 5-2 Cost Behavior Analysis Cost Behavior Analysis is the study of how specific costs respond to changes in the level of business activity 5-3 Some costs change; others remain the same Helps management plan operations and decide between alternative courses of action Applies to all types of businesses and entities Starting point is measuring key business activities Cost Behavior Analysis Cost Behavior Analysis is the study of how specific costs respond to changes in the level of business activity 5-4 Activity levels may be expressed in terms of: ► Sales dollars (in a retail company) ► Miles driven (in a trucking company) ► Room occupancy (in a hotel) ► Dance classes taught (by a dance studio) Many companies use more than one measurement base Cost Behavior Analysis Cost Behavior Analysis is the study of how specific costs respond to changes in the level of business activity 5-5 Changes in the level or volume of activity should be correlated with changes in costs Activity level selected is called activity or volume index Activity index: ► Identifies the activity that causes changes in the behavior of costs ► Allows costs to be classified as variable, fixed, or mixed Cost Behavior Analysis Variable Costs 5-6 Costs that vary in total directly and proportionately with changes in the activity level ► Example: If the activity level increases 10 percent, total variable costs increase 10 percent ► Example: If the activity level decreases by 25 percent, total variable costs decrease by 25 percent Variable costs remain the same per unit at every level of activity LO Distinguish between variable and fixed costs Cost Behavior Analysis Illustration: Damon Company manufactures tablet computers that contain a $10 camera The activity index is the number of tablets produced As Damon Illustration 5-1 manufactures each tablet, the total cost of the camera increases by $10 As part (a) of Illustration 5-1 shows, total cost of the cameras will be $20,000 if Damon produces 2,000 tablets, and $100,000 when it produces 10,000 tablets We also can see that a variable cost remains the same per unit as the level of activity changes 5-7 LO Distinguish between variable and fixed costs Cost Behavior Analysis Illustration: Damon Company manufactures tablet computers that contain a $10 camera The activity index is the number of tablets produced As Damon Illustration 5-1 manufactures each tablet, the total cost of the camera increases by $10 As part (b) of Illustration 5-1 shows, the unit cost of $10 for the camera is the same whether Damon produces 2,000 or 10,000 tablets 5-8 LO Distinguish between variable and fixed costs Cost Behavior Analysis Variable Costs 5-9 Illustration 5-1 Behavior of total and unit variable costs LO Distinguish between variable and fixed costs Cost Behavior Analysis Fixed Costs 5-10 Costs that remain the same in total regardless of changes in the activity level Per unit cost varies inversely with activity: As volume increases, unit cost declines, and vice versa Examples: ► Property taxes ► Insurance ► Rent ► Depreciation on buildings and equipment LO Distinguish between variable and fixed costs Target Net Income Contribution Margin Technique To determine the required sales in dollars for Vargo Video: Illustration 5-27 5-61 LO Give the formulas for determining sales required to earn target net income Target Net Income Review Question The mathematical equation for computing required sales to obtain target net income is: Required sales = a Variable costs + Target net income b Variable costs + Fixed costs + Target net income c Fixed costs + Target net income d No correct answer is given 5-62 LO Give the formulas for determining sales required to earn target net income Cost-Volume-Profit Analysis Margin of Safety Difference between actual or expected sales and sales at the break-even point Measures the “cushion” that management has if expected sales fail to materialize May be expressed in dollars or as a ratio Assuming actual/expected sales are $750,000: Illustration 5-28 5-63 LO Define margin of safety, and give the formulas for computing it Cost-Volume-Profit Analysis Margin of Safety Computed by dividing the margin of safety in dollars by the actual or expected sales Assuming actual/expected sales are $750,000: Illustration 5-29 5-64 The higher the dollars or percentage, the greater the margin of safety LO Define margin of safety, and give the formulas for computing it Cost-Volume-Profit Analysis Review Question Marshall Company had actual sales of $600,000 when breakeven sales were $420,000 What is the margin of safety ratio? a 25% b 30% c 33 1/3% d 45% 5-65 LO Define margin of safety, and give the formulas for computing it Zootsuit Inc makes travel bags that sell for $56 each For the coming year, management expects fixed costs to total $320,000 and variable costs to be $42 per unit Compute the following: (a) break-even point in dollars using the contribution margin (CM) ratio; (b) the margin of safety assuming actual sales are $1,382,400; and (c) the sales dollars required to earn net income of $410,000 5-66 LO Define margin of safety, and give the formulas for computing it Compute: (a) break-even point in dollars using the contribution margin (CM) ratio Unit selling price Unit variable costs - 42 Contribution margin per unit 14 Unit selling price 56 Contribution margin ratio Fixed costs Contribution margin ratio Break-even sales in dollars 5-67 $56 25% $320,000 25% $1,280,000 LO Define margin of safety, and give the formulas for computing it Compute: (b) the margin of safety assuming actual sales are $1,382,400 Actual (Expected) sales $ 1,382,400 Break-even sales - 1,280,000 Margin of safety in dollars Actual (Expected) sales Margin of safety ratio 5-68 102,400 1,382,400 7.4% LO Define margin of safety, and give the formulas for computing it Compute: (c) the sales dollars required to earn net income of $410,000 Fixed costs Target net income $ 320,000 + 410,000 730,000 5-69 Contribution margin ratio 25% Required sales in dollars $2,920,000 LO Define margin of safety, and give the formulas for computing it Comprehensive Mabo Company makes calculators that sell for $20 each For the coming year, management expects fixed costs to total $220,000 and variable costs to be $9 per unit Compute: a) Break-even point in units using the mathematical equation b) Break-even point in dollars using the contribution margin (CM) ratio c) Margin of safety percentage assuming actual sales are $500,000 d) Sales required in dollars to earn net income of $165,000 5-70 Comprehensive Mabo Company makes calculators that sell for $20 each For the coming year, management expects fixed costs to total $220,000 and variable costs to be $9 per unit Compute break-even point in units using the mathematical equation $20Q = $9Q + $220,000 + $0 $11Q = $220,000 Q = 20,000 units 5-71 Comprehensive Mabo Company makes calculators that sell for $20 each For the coming year, management expects fixed costs to total $220,000 and variable costs to be $9 per unit Compute break-even point in dollars using the contribution margin (CM) ratio Contribution margin per unit = $20 Contribution margin ratio = $11 / $9 $20 = 55% Break-even point in dollars = $220,000 = $400,000 5-72 = $11 / 55% Comprehensive Mabo Company makes calculators that sell for $20 each For the coming year, management expects fixed costs to total $220,000 and variable costs to be $9 per unit Compute the margin of safety percentage assuming actual sales are $500,000 Margin of safety = 5-73 $500,000 - $400,000 $500,000 = 20% Comprehensive Mabo Company makes calculators that sell for $20 each For the coming year, management expects fixed costs to total $220,000 and variable costs to be $9 per unit Compute the sales required in dollars to earn net income of $165,000 $20Q = $9Q + $220,000 + $165,000 $11Q = $385,000 Q = 35,000 units 35,000 units x $20 = $700,000 required sales 5-74 Copyright “Copyright © 2012 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may 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