Accounting principles, 13th edition ch22

Accounting Principles Thirteenth Edition Weygandt Kimmel Kieso Chapter 22 Cost-Volume-Profit Prepared by Coby Harmon University of California, Santa Barbara Westmont College Chapter Outline Learning Objectives LO Explain variable, fixed, and mixed costs and the relevant range LO Apply the high-low method to determine the components of mixed costs LO Prepare a CVP income statement to determine contribution margin LO Compute the break-even point using three approaches LO Determine the sales required to earn target net income and determine margin of safety Copyright ©2017 John Wiley & Son, Inc Cost Behavior Analysis Cost Behavior Analysis is the study of how specific costs respond to changes in the level of business activity 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 LO Copyright ©2017 John Wiley & Son, Inc Cost Behavior Analysis 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) a Many companies use more than one measurement base LO Copyright ©2017 John Wiley & Son, Inc Cost Behavior Analysis Changes in level or volume of activity should be correlated with changes in costs Activity level selected is called activity or volume index Activity index: LO  Identifies activity that causes changes in behavior of costs  Allows costs to be classified as variable, fixed, or mixed Copyright ©2017 John Wiley & Son, Inc Variable Costs • Costs that vary in total directly and proportionately with changes in the activity level  Example: If activity level increases 10 percent, total variable costs increase 10 percent  Example: If 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 Copyright ©2017 John Wiley & Son, Inc Variable Costs ILLUSTRATION 22.1 Behavior of total and unit variable costs; variable costs per unit remain constant Illustration: Damon Company manufactures tablet computers that contain cameras that cost $10 The activity index is the number of tablet computers produced As Damon manufactures each tablet, the total cost of cameras installed in tablets increases by $10 As part (a) of Illustration 22.1 shows, total cost of the cameras will be $20,000 (2,000 × $10) 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 LO Copyright ©2017 John Wiley & Son, Inc Variable Costs ILLUSTRATION 22.1 Behavior of total and unit variable costs; variable costs per unit remain constant Illustration: Damon Company manufactures tablet computers that contain cameras that cost $10 The activity index is the number of tablet computers produced As Damon manufactures each tablet, the total cost of cameras installed in tablets increases by $10 As part (b) of ILLUSTRATION 22.1 shows, the unit cost of $10 for the camera is the same whether Damon produces 2,000 or 10,000 tablets LO Copyright ©2017 John Wiley & Son, Inc Variable Costs ILLUSTRATION 22.1 Behavior of total and unit variable costs; variable costs per unit remain constant LO Copyright ©2017 John Wiley & Son, Inc Fixed Costs • Costs that remain the same in total regardless of changes in the activity level within a relevant range • Fixed cost per unit cost varies inversely with activity: As volume increases, unit cost declines, and vice versa • Examples:   LO   Rent Depreciation on buildings and equipment  Property taxes Supervisory salaries Insurance Copyright ©2017 John Wiley & Son, Inc 10 Margin of Safety Ratio Computed by dividing margin of safety in dollars by actual (or expected) sales • Higher dollars or percentage, greater margin of safety Assuming actual/expected sales are $750,000: Margin of Safety ÷ Actual (Expected) = In Dollars Sales $250,000 ÷ $750,000 = Margin of Safety Ratio 33% ILLUSTRATION 22.29 Formula for margin of safety ratio LO Copyright ©2018 John Wiley & Son, Inc 67 DO IT! Break-Even, Margin of Safety, and Target Net Income 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 Margin of safety and margin of safety ratio assuming actual sales are $1,382,400 c Sales dollars required to earn net income of $410,000 LO Copyright ©2018 John Wiley & Son, Inc 68 DO IT! Break-Even, Margin of Safety, and Target Net Income 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 break-even point in dollars using the contribution margin (CM) ratio Contribution margin ratio = [($56 − $42) ÷ $56] = 25% Break-even sales in dollars = $320,000 ÷ 25% = $1,280,000 LO Copyright ©2018 John Wiley & Son, Inc 69 DO IT! Break-Even, Margin of Safety, and Target Net Income 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 margin of safety and margin of safety ratio assuming actual sales are $1,382,400 Margin of safety = $1,382,400 − $1,280,000 = $102,400 Margin of safety ratio = $102,400 ÷ $1,382,400 = 7.4% LO Copyright ©2018 John Wiley & Son, Inc 70 DO IT! Break-Even, Margin of Safety, and Target Net Income 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 sales dollars required to earn net income of $410,000 Sales in dollars = ($320,000 + $410,000) ÷ 25% = $2,920,000 LO Copyright ©2018 John Wiley & Son, Inc 71 Appendix 22A Regression Analysis While the high-low method works well, a weakness is that it employs only a few data points and ignores the rest If those two data points are representative of the entire data set, then the high-low method provides reasonable results If the high and low data points are not representative of the rest of the data set, then the results are misleading LO Copyright ©2017 John Wiley & Son, Inc 72 Appendix 22A Regression Analysis While the high-low method works well, a weakness is that it employs only a few data points and ignores the rest ILLUSTRATION 22A.1 Scatter plot for Metro Transit Company LO Copyright ©2017 John Wiley & Son, Inc 73 Appendix 22A Regression Analysis Illustration: Assume that Hanson Trucking Company has 12 months of maintenance cost data, as shown ILLUSTRATION 22A.2 Month January February March April May June Miles Driven 20,000 40,000 35,000 50,000 30,000 43,000 Total Cost $30,000 49,000 46,000 63,000 42,000 52,000 Month July August September October November December Miles Driven 15,000 28,000 60,000 55,000 19,000 65,000 Total Cost $39,000 41,000 72,000 67,000 29,000 63,000 High activities and levels are in BLUE, low activities and levels are in RED LO Copyright ©2017 John Wiley & Son, Inc 74 Appendix 22A Regression Analysis ILLUSTRATION 22A.2 Miles Total Miles Total Month Driven Cost Month Driven Cost January 20,000 $30,000 July 15,000 $39,000 February 40,000 49,000 August 28,000 41,000 March 35,000 46,000 September 60,000 72,000 April 50,000 63,000 October 55,000 67,000 Total cost = number x cost per190,000 mile May variable 30,000 42,000 of miles November 29,000 43,000 level 52,000 65,000 cost 63,000 AtJune the low activity of 15,000December miles, total variable is $7,200 (15,000 × $0.48) To determine fixed costs, subtract total variable costs at the low activity level from the total cost at the low activity level Fixed costs = $39,000 − ($0.48 × 15,000) = $31,800 LO Copyright ©2017 John Wiley & Son, Inc 75 Appendix 22A Regression Analysis • Regression analysis is a statistical approach that estimates the cost equation by employing information from all data points, not just highest and lowest ones • Regression analysis finds a cost equation that results in a cost equation line that minimizes the sum of (squared) distances from line to data points LO Copyright ©2017 John Wiley & Son, Inc 76 Regression Analysis Illustration 22A.4, uses the Intercept and Slope functions in Excel to estimate the regression equation for the Hanson Trucking Company data Intercept: =INTERCEPT(C2:C13,B2:B13) = 18,502 Slope: =SLOPE(C2:C13,B2:B13) = 0.81 LO ILLUSTRATION 22A.4 B C D Miles Total Month Driven Cost January 20,000 $30,000 February 40,000 49,000 March 35,000 46,000 April 50,000 63,000 May 30,000 42,000 June 43,000 52,000 July 15,000 39,000 August 28,000 41,000 10 September 60,000 72,000 11 October 55,000 67,000 12 November 190,000 29,000 13 December 65,000 63,000 14 Copyright ©2017 John Wiley & Son, Inc A 77 Appendix 22A Regression Analysis The resulting cost equation is: Maintenance costs = Intercept + = $18,502 Slope + ($0.81 x Miles driven) Compare this to the high-low cost equation: Maintenance costs = Intercept + = LO $31,800 Slope + ($0.48 x Miles driven) Copyright ©2017 John Wiley & Son, Inc 78 The intercept and slope differ significantly between the regression equation (green) and the high-low equation (red) ILLUSTRATION 22A.5 LO Copyright ©2017 John Wiley & Son, Inc 79 Appendix 22A Regression Analysis While regression analysis usually provides more reliable estimates of the cost equation, it does have limitations The regression approach applied above assumes a linear relationship between the variables If the actual relationship differs significantly from linearity, then linear regression can provide misleading results Regression estimates can be severely influenced by “outliers”—data points that differ significantly from the rest of the observations Regression estimation is most accurate when it is based on a large number of data points LO Copyright ©2017 John Wiley & Son, Inc 80 Copyright Copyright © 2018 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States 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 make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein Copyright ©2018 John Wiley & Son, Inc 81