Managerial accounting 5th jiambalvo ch04

Fixed Costs Do not change in response to changes in activity level  Typical fixed costs are depreciation, supervisory salaries, and building maintenance • Rent for a bakery will not

Prepared by

Debby Bloom-Hill CMA, CFM

CHAPTER 4

Cost-Volume-Profit Analysis

Cost-Volume-Profit Analysis

Slide 4-2

Management Questions

 Planning

 What level of profit should be in the

budget for the coming year?

 Control

 Did the manager responsible for

production costs do a good job of

controlling costs?

 Decision making

 Should the price be increased?

Learning objective 1: Identify common cost behavior patterns

Slide 4-3

 Variable Costs

 Costs which change directly in

proportion to changes in quantity

or activity

 Fixed Costs

 Costs which do not change when

quantity or activity volume changes

Common Cost Behavior

 Mixed Costs

 Costs that have both variable and

fixed elements

 Step Costs

 Fixed for a range of output, but

increase when upper bound of range is exceeded

Common Cost Behavior

Variable Costs

 Costs that change in proportion to

changes in volume or activity

 An automobile manufacturer will

need 400 tires to make 100 cars,

but 4,000 tires to make 1,000 cars

 A bakery will need 2 eggs to make 1 cake and 20 eggs to make 10 cakes

 If activity increases by a certain

percentage, cost increases by that

same percentage

Learning objective 1: Identify common cost behavior patterns

Slide 4-6

A company has decided that direct

labor costs are 100% variable Last

month total direct labor costs were

$125,000 and total direct labor hours

worked were 10,000.

1.What is the direct labor cost per hour?

$125,000 / 10,000 hours = $12.50 per

hour

2.Predict labor costs in a month when

12,000 labor hours are worked

Fixed Costs

 Do not change in response to

changes in activity level

 Typical fixed costs are depreciation, supervisory salaries, and building

maintenance

• Rent for a bakery will not double if

output increases from 100 to 200

cakes

 If activity increases by a certain

percentage, costs remain

unchanged

Learning objective 1: Identify common cost behavior patterns

Slide 4-9

Fixed Costs

Total fixed cost = $94,000

Learning objective 1: Identify common cost behavior patterns

Slide 4-10

Fixed Costs

 Discretionary fixed costs

advertising, research & development

 Many companies cut back on these costs when sales drop This can be

shortsighted

 A cut in research & development can have

a negative effect on long run profitability

 A cut in repair and maintenance can have

a negative effect on the life of valuable assets

 Committed fixed costs

insurance Learning objective 1: Identify common cost behavior patterns

Slide 4-11

Mixed Costs

 Contain both variable and fixed cost elements

 Can separate mixed costs into

variable and fixed components

 Salesperson with base salary (fixed)

and commission on sales (variable)

 Base salary included with fixed costs

 Commission included with variable

costs

Learning objective 1: Identify common cost behavior patterns

Slide 4-12

Step Costs

 Fixed cost for a specific range of volume

 Increases to higher level when upper

bound of range is exceeded

until another upper bound is exceeded

 Step costs are often classified as either:

activity where the cost is fixed is small, or

where the cost is fixed is large

Learning objective 1: Identify common cost behavior patterns

Slide 4-14

Step Costs

Total step costs =

$7,000 for relevant range 0 – 3,000 units produced

$14,000 for relevant range 3,001 – 6,000 units

$21,000 for relevant range 6,001 – 9,000 units

Learning objective 1: Identify common cost behavior patterns

Slide 4-15

Relevant Range

Learning objective 1: Identify common cost behavior patterns

Slide 4-16

for which assumptions as to how costs

behave are reasonably valid

to be within the relevant range, we can

use assumptions about the fixed and

variable costs

variable costs at production levels well

above or below this range would not be valid

The Relevant Range

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-17

Cost Estimation Methods

Account Analysis

 Most common approach

 Requires professional judgment of management

 Management classifies costs as

fixed, variable, or mixed

 Total variable costs divided by

activity equals variable cost per unit

 Variable cost per unit and total fixed costs can be used in cost equation

Learning objective 2: Estimate the relation between cost and activity using account analysis and the high-low method

Slide 4-19

Account Analysis

Slide 4-20

Learning objective 2: Estimate the relation between cost and activity using account analysis and the high-low method

 Utilization of cost information from

several previous periods

 Weekly, monthly, or quarterly cost

reports are useful

 Plot the actual costs at the observed

activity levels

 Look for relationship between cost

and activity, linear is ideal

 Use relationship to predict future

costs

Learning objective 2: Estimate the relation between cost and activity using account analysis and the

high-low method

Slide 4-21

Is there a relationship between units produced

and production costs? Describe the relationship.

Learning objective 2: Estimate the relation between cost and activity using account analysis and the

high-low method

Slide 4-22

High-Low Method

 Utilization of cost information from

previous periods

 Fits a straight line from lowest

activity level to highest activity level

unit variable cost

cost per unit change in activity level

level minus variable cost at that level

equals fixed cost

Learning objective 2: Estimate the relation between cost and activity using account analysis and the

high-low method

Slide 4-23

Total cost

at low activity level

High-Low Method

Learning objective 2: Estimate the relation between cost and activity using account analysis and the

high-low method

Slide 4-25

High-Low Method

Learning objective 2: Estimate the relation between cost and activity using account analysis and the

high-low method

Slide 4-26

During the past year, Island Air flew 15,000

miles in August (its busiest month) and had

total costs of $300,000 In November (its least

busy month) the company flew 5,000 miles and

had $200,000 of costs Using the high-low

method, estimate variable cost per mile and

fixed cost per month.

a $20 of variable cost and $100,000 fixed

b $15 of variable cost and $250,000 fixed

c $10 of variable cost and $150,000 fixed

d $5 of variable cost and $250,000 fixed

During the past year, Island Air flew 15,000

miles in August (its busiest month) and had total costs of $300,000 In November (its least busy

month) the company flew 5,000 miles and had

$200,000 of costs Using the high-low method,

estimate variable cost per mile and fixed cost per month.

Estimate of variable cost = = = $10

Variable cost at low level = $10 * 5,000 miles =

typically include statistical operations

Learning objective 2: Estimate the relation between cost and activity using account analysis and the

high-low method

Slide 4-29

SP = Selling price per unit

VC = Variable cost per unit

TFC = Total fixed cost

 Fundamental to CVP analysis

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-30

Cost-Volume-Profit Analysis

 Break-Even Point

company to neither earn a profit nor

incur a loss

 CodeConnect has the following cost

structure

 Find CodeConnect’s break-even point

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-31

Break-Even Point

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-33

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

What is the break-even point in number of

Test Your Knowledge 3

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-34

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

What is the break-even point in number of

Test Your Knowledge 3

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-35

Margin of Safety

 The margin of safety is the

difference between the expected

level of sales and break-even sales

$293,600 and expected sales are

$350,000, calculate the margin of

Margin of Safety Ratio

 The margin of safety can also be

expressed as a ratio

by expected sales

have to drop before the product shows

Contribution Margin

Contribution Margin

 Difference between revenue and

variable costs

 Contribution margin = total revenue

minus total variable costs

 Contribution margin per unit =

selling price minus variable cost per

unit

contribution margin is the $200.00 selling price less the variable cost of

$90.83

$200.00 – $90.83 = $109.17Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-38

Contribution Margin

Contribution Margin

 The contribution margin per unit

measures the amount of incremental

profit generated by selling an

additional unit

incremental profit would be generated

by selling 100 more units?

Incremental profit = number of units sold * contribution margin per unit

Incremental profit = 100 * $109.17 =

$10,917

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-39

Units Needed for Target

Profit

Units Needed for Target

Profit

 Solve the profit equation for the

sales quantity in units

 Unit sales (x) needed to attain a

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

Test Your Knowledge 4

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-42

Contribution Margin Ratio

 The unit contribution margin ratio

measures the amount of incremental

profit generated by an additional

dollar of sales

 Two methods to calculate the

contribution margin ratio

sales revenue (Sales – TVC) / Sales

selling price (SP – VC) / SP

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-43

Contribution Margin Ratio

 For the Model DX375 bar code reader,

the contribution margin ratio is

= 0.54585

 This indicates that the company earns

an incremental $0.54585 for every

“What If” Analysis

 “What if” analysis examines what will

happen if an action is taken

profit will be affect by various options

under consideration

at $200, with variable cost of $90.83 and fixed cost of $160,285

“What If” Analysis

 Change in fixed and variable costs

 Without the change, the profit is

$200(3,000) - $90.83(3,000) - $160,285 =

$167,225

same, the profit assuming the

alternative is selected would be

$200(3,000) - $80(3,000) - $210,285 = $149,715

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-46

“What If” Analysis

 Change in selling price

 Any one of the variables in the profit equation can be considered

3,000 units, what selling price is

required to earn a profit of $200,000?

$200,000 = SP(3,000) - $90.83(3,000) -

$160,285 SP(3,000) = $632,775

SP = $210.93

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-47

Matthews Consulting expects to work 5,000 hours next month It has variable costs of

$100 per hour and fixed costs of $600,000

What price must the company charge to earn

Test Your Knowledge 5

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-48

Matthews Consulting expects to work 5,000 hours next month It has variable costs of

$100 per hour and fixed costs of $600,000

What price must the company charge to earn

Test Your Knowledge 5

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-49

Multiproduct Analysis

 Contribution margin approach

contribution margin per unit

margin in the profit formula to

calculate breakeven point and target

sales

calculate the required sales of

individual items

Learning objective 3: Perform cost-volume profit analysis for single products

Slide 4-50

Multiproduct Analysis

=

= 2,500 units

must sell 1,667 Model A (2/3 of 2,500) and 833

Model B units (1/3 0f 2,500)

  

Learning objective 4: Perform cost-volume profit analysis for multiple products

Slide 4-52

Multiproduct Analysis

 Contribution Margin Ratio Approach

 Calculate total company contribution

margin ratio

 Use total company contribution

margin ratio to compute required sales

in dollars

costs) are not included for contribution margin approach but used for

contribution margin ratio approach

Learning objective 4: Perform cost-volume profit analysis for multiple products

Slide 4-53

Multiproduct Analysis

A company with 4 divisions has the

following information available:

Total sales $6,450,000

Total variable costs $4,706,000

Total direct fixed costs $484,000

Total common fixed costs $1,120,000

1.Calculate total contribution margin ratio

1 Costs can be separated into fixed

and variable components

2 Total fixed cost and unit variable

cost do not change over the levels of interest

3 Multiproduct analysis assumes the

product mix does not change

 Despite assumptions, CVP is useful

Learning objective 4: Perform cost-volume profit analysis for multiple products

Slide 4-55

Operating Leverage

 Level of fixed versus variable costs in

a company

 A company with a high level of fixed

costs has a high operating leverage

leverage have large fluctuations in

profit when sales increase or decrease

risky

sales are expected to increase

Learning objective 5: Discuss the effect of operating leverage

Slide 4-56

 Due to shortages of space, equipment or labor there can be constraints on how

many items can be produced

 Utilize contribution margin per unit to

analyze situations

constraint

contribution margin per unit of

A company can produce Product A or

Product B using the same machinery

Only 1,000 machine hours are available

Learning objective 6: Use the cost per unit of the constraint to analyze situations involving a

 Although Product A has the higher

contribution margin per unit, Product

B has the higher contribution margin

per unit of constraint

Learning objective 6: Use the cost per unit of the constraint to analyze situations involving a

resource constraint

Slide 4-59

CHAPTER 4

Cost-Volume-Profit Analysis

Appendix

Cost-Volume-Profit Analysis

Appendix

Slide 4-60

Regression Analysis

Learning objective 2: Estimate the relation between cost and activity using account analysis and the

high-low method

Slide 4-61

Regression Analysis

Learning objective 2: Estimate the relation between cost and activity using account analysis and the

high-low method

Slide 4-62

Regression Analysis

Learning objective 2: Estimate the relation between cost and activity using account analysis and the

high-low method

Slide 4-63

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