The contents of this chapter include all of the following: Distinguish between variable and fixed costs, explain the significance of the relevant range, explain the concept of mixed costs, list the five components of cost-volume-profit analysis, indicate what contribution margin is and how it can be expressed.
PART III: Decision Tools Lecture 30 Cost Volume Profit Relationship Learning Learning Objectives Objectives Distinguish between variable and fixed costs Explain the significance of the relevant range Explain the concept of mixed costs List the five components of cost-volume-profit analysis Indicate what contribution margin is and how it can be expressed Identify the three ways to determine the break-even point Give the formulas for determining sales required to earn target net income Define margin of safety, and give the formulas for computing it Describe the essential features of a cost-volume-profit income statement Preamble Preamble To manage any business, you must understand: How costs respond to changes in sales volume and The effect of costs and revenues on profit To understand cost-volume-profit (CVP), you must know how costs behave Cost-Volume-Profit Cost-Volume-Profit Cost Behavior Analysis Cost-VolumeProfit Analysis Variable costs Basic components Fixed costs Relevant range CVP income statement Mixed costs Break-even analysis Identifying variable and fixed costs Target net income Margin of safety Changes in business environment CVP income statement revisited Cost Cost Behavior Behavior Analysis 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 LO 1: Distinguish between variable and fixed costs Cost Cost Behavior Behavior Analysis Analysis continued continued Starting point is measuring key business activities 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 LO 1: Distinguish between variable and fixed costs Cost Cost Behavior Behavior Analysis Analysis continued continued For an activity level to be useful: Changes in the level or volume of activity should be correlated with changes in costs The activity level selected is called the activity or volume index The activity index: Identifies the activity that causes changes in the behavior of costs Allows costs to be classified according to their response to changes in activity as either: Variable Costs Fixed Costs Mixed Costs LO 1: Distinguish between variable and fixed costs Variable Variable Costs Costs 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 constant per unit at every level of activity LO 1: Distinguish between variable and fixed costs Variable Variable Costs Costs –– Example Example Damon Company manufactures radios that contain a $10 clock Activity index is the number of radios produced For each radio produced, the total cost of the clocks increases by $10: If 2,000 radios are made, the total cost of the clocks is $20,000 (2,000 X $10) If 10,000 radios are made, the total cost of the clocks is $100,000 (10,000 X $10) LO 1: Distinguish between variable and fixed costs Variable Variable Costs Costs –– Graphs Graphs 10 LO 1: Distinguish between variable and fixed costs Break-Even Break-Even Analysis: Analysis: Target Target Net Net Income Income Level of sales necessary to achieve a specified income Can be determined from each of the approaches used to determine break-even sales/units: from a mathematical equation, by using contribution margin, or from a cost-volume profit (CVP) graph Expressed either in sales units or in sales dollars 44 LO 7: Give the formulas for determining sales required to earn target net income Break-Even Break-Even Analysis: Analysis: Target Target Net Net Income Income Mathematical Equation Using the formula for the break-even point, simply include the desired net income as a factor The computation for Vargo Video is as follows: 45 LO 7: Give the formulas for determining sales required to earn target net income Break-Even Break-Even Analysis: Analysis: Target Target Net Net Income Income Contribution Margin Technique To determine the required sales in units for Vargo Video: To determine the required sales in dollars for Vargo Video: 46 LO 7: Give the formulas for determining sales required to earn target net income Target Target Net Net Income Income Review Question The mathematical equation for computing required sales to obtain target net income is: Required sales = a Variable costs + Target net income income b Variable costs + Fixed costs + Target net income c Fixed costs + Target net income d No correct answer is given 47 LO 7: Give the formulas for determining sales required to earn target net income Break-Even Break-Even Analysis: Analysis: Margin Margin of of Safety 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 To determine the margin of safety in dollars for Vargo Video assuming that actual/expected sales are $750,000: 48 LO 8: Define margin of safety, and give the formulas for computing it Break-Even Break-Even Analysis: Analysis: Margin Margin of of Safety Safety Margin of Safety Ratio Computed by dividing the margin of safety in dollars by the actual or expected sales To determine the margin of safety ratio for Vargo Video assuming that actual/expected sales are $750,000: The higher the dollars or the percentage, the greater the margin of safety 49 LO 8: Define margin of safety, and give the formulas for computing it CVP CVP Income Income Statement Statement Revisited Revisited 50 LO 9: Describe the essential features of a cost-volume-profit income statement Margin Margin of of Safety Safety Review Question Marshall Company had actual sales of $600,000 when break-even sales were $420,000 What is the margin of safety ratio? a 25% 25% b 30% c 33 1/3% d 45% 51 LO 8: Define margin of safety, and give the formulas for computing it Variable Variable Costing Costing Under variable costing only direct materials, direct labor, and variable manufacturing overhead costs are considered product costs Companies recognize fixed manufacturing overhead costs as period costs (expenses) when incurred 52 LO 10: Explain the difference between absorption costing and variable costing Variable Variable Costing Costing Illustration: Assume that Premium Products Corporation manufactures a polyurethane sealant, called Fix-It, for car windshields Relevant data for Fix-It in January 2010, the first month of production, are as follows 53 LO 10: Explain the difference between absorption costing and variable costing Variable Variable Costing Costing Illustration: The per unit production cost of Fix-It under each costing approach is: Fixed manufacturing overhead Total unit cost * $13 $4 Based on these data, each unit sold and each unit remaining in inventory is costed at $13 under absorption costing and at $9 under variable costing 54 * ($120,000 / 30,000 units produced) LO 10: Explain the difference between absorption costing and variable costing Variable Variable Costing Costing Effects of Variable Costing on Income 55 LO 10: Explain the difference between absorption costing and variable costing Variable Variable Costing Costing Effects of Variable Costing on Income 56 Variable Variable Costing Costing Effects of Variable Costing on Income Summary of effects on income from operations 57 LO 10: Explain the difference between absorption costing and variable costing Variable Variable Costing Costing Rationale for Variable Costing The purpose of fixed manufacturing costs is to have productive facilities available for use The use of variable costing is acceptable only for internal use by management 58 ... costs respond to changes in sales volume and The effect of costs and revenues on profit To understand cost- volume- profit (CVP), you must know how costs behave Cost- Volume- Profit Cost- Volume- Profit. .. Mixed Costs: Costs: Steps Steps in in High–Low-Method High–Low-Method STEP 1: Determine variable cost per unit using the following formula: STEP 2: Determine the fixed cost by subtracting the... remain constant 28 LO 4: List the five components of cost- volume- profit analysis Cost- Volume- Profit Cost- Volume- Profit Analysis Analysis Review Question Which of the following is NOT involved in