Lecture Issues in financial accounting – Lecture 30: Cost volume profit relationship

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.

Learning Objectives

Learning Objectives

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.

9 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

Variable costs Fixed costs Relevant range Mixed costs Identifying variable and fixed costs

Basic components CVP income

statement Break-even analysis Target net income Margin of safety Changes in business environment

CVP income statement revisited

Cost Behavior Analysis

Profit Analysis

Cost-Volume-Cost-Volume-Profit

Cost-Volume-Profit

Cost Behavior Analysis 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

LO 1: Distinguish between variable and fixed costs.

Cost Behavior Analysis - continued Cost Behavior Analysis - continued

Starting point is

Starting point is measuring key business activitiesmeasuring 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 Behavior Analysis - continued

Cost Behavior Analysis - 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 Costs Variable 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.

Activity index is the number of radios produced

For each radio produced, the total cost of the

Variable Costs – Graphs

Variable Costs – Graphs

LO 1: Distinguish between variable and fixed costs.

Fixed Costs Fixed Costs

Costs that remain the same in total regardless of

changes in the activity level.

Per unit cost

Per unit cost varies varies inversely with activity:

As volume increases, unit cost declines, and vice versa

Examples include:

Property taxesInsurance

RentDepreciation on buildings and equipment

LO 1: Distinguish between variable and fixed costs.

On a per unit per unit basis, the cost of rent decreases as

activity increases and vice versa

At 2,000 radios, the unit cost is

At 2,000 radios, the unit cost is $5 $5

($10,000 ÷ 2,000 units)

At 10,000 radios, the unit cost is

At 10,000 radios, the unit cost is $1 $1

($10,000 ÷ 10,000 units)

LO 1: Distinguish between variable and fixed costs.

Variable costs are costs that:

a Vary in total directly and proportionately with

changes in the activity level

changes in the activity level.

b Remain the same per unit at every activity level

c Neither of the above.

d Both (a) and (b) above

Variable Costs Variable Costs

LO 1: Distinguish between variable and fixed costs.

Review Question

Relevant Range Relevant Range

Throughout the range of possible levels of activity, a

straight-line relationship usually does not exist for

either variable costs or fixed costs

The relationship between variable costs and changes

in activity level is often curvilinear

For fixed costs, the relationship is also nonlinear –

some fixed costs will not change over the entire range of activities while other fixed costs may change

LO 2: Explain the significance of the relevant range.

Relevant Range Relevant Range

Defined as the range of activity over which a company

Defined as the range of activity over which a company

expects to operate during a year

Within this range, a straight-line relationship

Within this range, a straight-line relationship usually exists for both variable and fixed costs

LO 2: Explain the significance of the relevant range.

Illustration 22-4

The relevant range is:

a The range of activity in which variable costs will be

curvilinear

curvilinear.

b The range of activity in which fixed costs will be

curvilinear

c The range over which the company expects to

operate during a year.

d Usually from zero to 100% of operating capacity

Relevant Range Relevant Range

LO 2: Explain the significance of the relevant range.

Review Question

Mixed Costs Mixed Costs

Costs that have

The difference in costs between the high and low

levels represents variable costs, since only

variable costs change as activity levels change

LO 3: Explain the concept of mixed costs.

STEP 2: Determine the fixed cost by subtracting

the total variable cost at either the high

or the low activity level from the total cost

at that level

LO 3: Explain the concept of mixed costs.

High Level of Activity: April $63,000 50,000 miles

Low Level of Activity: January 30,000 20,000 miles

Difference $33,000 30,000 miles

Step 1: Using the formula, variable costs per unit are

$33,000 30,000 = $1.10 variable cost per mile 30,000 = $1.10 variable cost per mile Data for Metro Transit Company for 4 month period:

LO 3: Explain the concept of mixed costs.

Step 2: Determine the fixed costs by subtracting total

variable costs at either the high or low activity

level from the total cost at that same level

LO 3: Explain the concept of mixed costs.

$8,000 per month plus $1.10 per mile

To determine maintenance costs at a particular activity level:

variable cost per unit

EXAMPLE: If the activity level is 45,000 miles, the

estimated maintenance costs would be $8,000 fixed and $49,500 variable ($1.10 X 45,000 miles) for a total of $57,500

LO 3: Explain the concept of mixed costs.

Mixed costs consist of a:

a Variable cost element and a fixed cost element Variable cost element and a fixed cost element

b Fixed cost element and a controllable cost element

c Relevant cost element and a controllable cost

element.

d Variable cost element and a relevant cost element

High–Low Method High–Low Method

LO 3: Explain the concept of mixed costs.

Review Question

Cost-Volume-Profit Analysis Cost-Volume-Profit Analysis

Study of the effects of changes of costs and volume on a company’s profits

A critical factor in management decisionsImportant in profit planning

LO 4: List the five components of cost-volume-profit analysis.

Cost-Volume-Profit Analysis Cost-Volume-Profit Analysis

CVP analysis considers the interrelationships among five basic components

LO 4: List the five components of cost-volume-profit analysis.

Assumptions Underlying CVP Analysis

Assumptions Underlying CVP Analysis

Behavior of both costs and revenues is linear throughout the relevant range of the activity index

All costs can be classified as either variable or fixed with reasonable accuracy

Changes in activity are the only factors that affect costsAll units produced are sold

When more than one type of product is sold, the sales

mix will remain constant

LO 4: List the five components of cost-volume-profit analysis.

Which of the following is

Which of the following is NOT NOT involved in CVP analysis?

a Sales mix Sales mix

b Unit selling prices

c Fixed costs per unit.

d Volume or level of activity

Cost-Volume-Profit Analysis Cost-Volume-Profit Analysis

LO 4: List the five components of cost-volume-profit analysis.

Review Question

CVP Income Statement CVP Income Statement

A statement for internal use

Classifies costs and expenses as fixed or variable

Reports contribution margin in the body of the

statement.

Contribution margin –

amount of revenue remaining after

deducting variable costs

Reports the same net

income as a traditional

income statement

LO 5: Indicate what contribution margin is and how it can be expressed.

CVP Income Statement - Example CVP Income Statement - Example

Vargo Video Company produces DVD players

Relevant data for June 2010:

Unit selling price of DVD player $500

LO 5: Indicate what contribution margin is and how it can be expressed.

Illustration 22-11

Contribution Margin Per Unit Contribution Margin Per Unit

Contribution margin is available

Contribution margin is available to cover fixed costs and to contribute to income

The formula for contribution margin per unit and

the computation for Vargo Video are:

LO 5: Indicate what contribution margin is and how it can be expressed.

Contribution Margin Ratio Contribution Margin Ratio

Shows the percentage of each sales dollar available

to apply toward fixed costs and profits

The formula for contribution margin ratio and the

computation for Vargo Video are:

LO 5: Indicate what contribution margin is and how it can be expressed.

Contribution Margin Ratio Contribution Margin Ratio

Ratio helps to determine the effect of changes in

sales on net income

LO 5: Indicate what contribution margin is and how it can be expressed.

Contribution margin:

a Is revenue remaining after deducting variable costs Is revenue remaining after deducting variable costs

b May be expressed as contribution margin per unit

c Is selling price less cost of goods sold.

d Both (a) and (b) above

Contribution Margin Per Unit Contribution Margin Per Unit

LO 5: Indicate what contribution margin is and how it can be expressed.

Review Question

Break-Even Analysis Break-Even Analysis

Process of finding the break-even point

level of activity at which total revenues equal total costs (both fixed and variable)

Can be computed or derived

 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

LO 6: Identify the three ways to determine the break-even point.

Break-Even Analysis: Mathematical Equation

Break-Even Analysis: Mathematical Equation

Break-even occurs where total sales equal variable costs plus fixed costs; i.e., net income is zero

The formula for the break-even point and the

computation for Vargo Video are:

To find

To find sales dollars sales dollars required to break-even:

1000 units X $500 = $500,000 (break-even dollars)

LO 6: Identify the three ways to determine the break-even point.

Break-Even Analysis:

Contribution Margin Technique

Break-Even Analysis:

Contribution Margin Technique

At the break-even point, contribution margin must equal total fixed costs

(CM = total revenues – variable costs)

The break-even point can be computed using either

contribution margin per unit or contribution margin

ratio

LO 6: Identify the three ways to determine the break-even point.

Contribution Margin Technique

Contribution Margin Technique

When the BEP in units is desired, contribution margin

computation for Vargo Video:

When the BEP in dollars is desired, contribution margin

computation for Vargo Video:

LO 6: Identify the three ways to determine the break-even point.

Break-Even Analysis: Graphic Presentation

Break-Even Analysis: Graphic Presentation

A cost-volume profit (CVP) graph shows costs, volume and profits

Used to visually find the break-even point

To construct a CVP graph:

level Plot the total fixed cost using a horizontal line Plot the total cost line (starts at the fixed-cost line at zero activity

Determine the break-even point from the

sales line

LO 6: Identify the three ways to determine the break-even point.

Break-Even Analysis: Graphic Presentation

Break-Even Analysis: Graphic Presentation

LO 6: Identify the three ways to determine the break-even point.

Gossen Company is planning to sell 200,000 pliers for $4 per unit The contribution margin ratio is 25% If Gossen will break even at this level of sales, what are the fixed costs?

Break-Even Analysis: Target Net Income

Break-Even Analysis: Target Net 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, orfrom a cost-volume profit (CVP) graph

Expressed either in sales units or in sales dollars

LO 7: Give the formulas for determining sales required to

earn target net income.

Break-Even Analysis: Target Net Income

Break-Even Analysis: Target Net Income

Mathematical Equation

Using the formula for the

Using the formula for the break-even point, simply

computation for Vargo Video is as follows:

LO 7: Give the formulas for determining sales required to

earn target net income.

Break-Even Analysis: Target Net Income

Break-Even Analysis: Target Net Income

Contribution Margin Technique

To determine the required sales in units for Vargo

Video:

To determine the required sales in dollars for Vargo

Video:

LO 7: Give the formulas for determining sales required to

earn target net income.

Target Net Income Target Net Income

The mathematical equation for computing required sales

to obtain target net income is:

Required sales =

a Variable costs + Target net income 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

LO 7: Give the formulas for determining sales required to earn

target net income.

Review Question

Break-Even Analysis: Margin of Safety

Break-Even 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

To determine the margin of safety in dollars for Vargo Video assuming that actual/expected sales are

$750,000:

LO 8: Define margin of safety, and give the formulas for computing it.

Break-Even Analysis: Margin of Safety

Break-Even Analysis: Margin of 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

LO 8: Define margin of safety, and give the formulas for computing it.