Lecture Accounting: What the numbers mean (5/e) - Chapter 12: Managerial accounting and cost-volume-profit relationships

After reading this chapter, you should be able to answer the following questions: What is the managerial planning and control cycle? What are the major differences between financial accounting and managerial accounting? What is the difference between variable and fixed cost behavior patterns, and what simplifying assumptions are made in this classification method?...

CHAPTER 12

MANAGERIAL ACCOUNTING

AND PROFIT RELATIONSHIPS

COST-VOLUME-Learning Objectives

1 What is the managerial planning and

control cycle?

2 What are the major differences

between financial accounting and

managerial accounting?

3 What is the difference between

variable and fixed cost behavior

patterns, and what simplifying

assumptions are made in this

classification method?

Learning Objectives

4 Why are fixed costs expressed on a per

unit of activity basis misleading, and why

may this result in faulty decisions?

5 What kinds of costs are likely to have a

variable cost behavior pattern, and what

kinds of costs are likely to have a fixed

costs behavior pattern?

6 How can the high-low method be used to

determine the cost formula for a cost that

has a mixed behavior pattern?

Learning Objectives

7 What is the difference between the

traditional income statement format

and the contribution statement

format?

8 What is the importance of using the

contribution margin format to analyze

the impact of cost and sales volume

changes on operating income?

9 How is the contribution margin ratio

calculated, and how can it be used in

CVP analysis?

Learning Objectives

10.How can changes in sales mix affect

the projections using CVP analysis?

11.What are the meaning and

significance of the break-even point,

and how is the break-even point

calculated?

12.What is the concept of operating

leverage?

Learning Objective 1

• What is the managerial

planning and control cycle?

Managerial Accounting Contrasted to Financial

Accounting

• Managerial accounting supports the

internal planning decision made by

management

• Financial accounting has more of a

score-keeping, historical orientation

• Planning is a key part of the

management process

Strategic, Operational, and Financial Planning

Planning and Control Cycle

Planning and Control

• The management process consists of

planning, organizing, and controlling an

entity’s activities

• Control provides feedback in which

actual results are compared to planned

results, and if a variance exists, the

plan or actions or both are changed

Learning Objective 2

• What are the major differences

between financial accounting

and managerial accounting?

Managerial Accounting

• Emphasis is on the future

• Concerned with units within the

organization

• Reports issued frequently and promptly

• Relevance more important than reliability

• No reporting standards

• Intended to management’s use

Financial Accounting

• Intended for external investors and creditors

• Deals with the past – historical

• Reports are prepared for the company as a

whole

• Reports are issued monthly – a week or more

after the end of the month

• High accuracy is desired

• Generally Accepted Accounting Standards are used for reports

The Management Accountant

• Works extensively with people in other

functions of the organization

• Helps develop production standards

• Helps production people interpret

Learning Objective 3

• What is the difference between

variable and fixed cost behavior

patterns, and what simplifying

assumptions are made in this

classification method?

Cost Classifications

• Different costs for different purposes:

–Relationship between total cost and volume

of activity

–Relationship to product or activity

–For cost accounting purposes

–Time frame perspective

–Other analytical purposes

• These classifications are not mutually

exclusive

Relationship of Total Cost

to Volume of Activity

• The relationship of total cost to volume of

activity describes the cost behavior pattern

• A variable cost changes in TOTAL as the

volume of activity changes

• A fixed cost does NOT change in TOTAL as the volume of activity changes

• Variable cost example is raw materials

• Fixed cost example is depreciation

Semivariable Costs

• Some costs have components of both

fixed and variable costs

• A cost formula for such a cost is:

Total cost = Fixed cost + Variable cost

or

Total cost = Fixed cost + (Variable rate

per unit X Activity)

Learning Objective 4

• Why are fixed costs expressed

on a per unit of activity basis

misleading, and why may this

result in faulty decisions?

Fixed Cost Unitization

• Do NOT unitize fixed expenses

because they do not behave on a per unit basis

• Dividing fixed expenses by activity

level will give varying results

depending on the activity level

Learning Objective 5

• What kinds of costs are likely to

have a variable cost behavior

pattern, and what kinds of costs

are likely to have a fixed cost

behavior pattern?

Cost Behavior Pattern

• Two assumptions made in determining cost behavior patterns:

– The behavior pattern is true only within a

relevant range

– The behavior pattern is assumed to be linear in the relevant range

• The relevant range is the level of activity

over which a particular pattern exists

Learning Objective 6

• How can the high-low method

be used to determine the cost formula for a cost that has a mixed behavior pattern?

The High-Low Method

• A cost behavior pattern can be analyzed

using a technique that employs a

scattergram to identify high and low

cost-volume data

• A scattergram is a graph with total units

produced as the horizontal axis and cost

as the vertical axis

• Points are plotted on the graph for various production levels and costs

Steps in Using the

Steps in Using the High-Low

Method

3 Compute the fixed rate by using the

following formula and inserting the

variable rate computed above and

either the high activity level or the low

activity level

Total cost = Fixed cost + Variable cost

Total cost = Fixed cost + (Activity level

x Variable rate)

Learning Objective 7

• What is the difference between

the traditional income statement

format and the contribution

statement format?

Modified Income Statement Format

• Referred to as the contribution margin

format

• Classifies costs according to their

behavior

• Revenues and operating income are

the same as under the traditional format

of revenues minus cost of goods sold,

etc

Contribution Margin Format

Learning Objective 8

• What is the importance of using

the contribution margin format to

analyze the impact of cost and

sales volume changes on

operating income?

Contribution Margin

• Contribution margin is the amount that is

available to cover fixed expenses and

Learning Objective 9

• How is the contribution

margin ratio calculated, and how can it be used in CVP analysis?

Contribution Margin Ratio

• Contribution margin ratio is the ratio

of contribution margin to revenues

• Using either total dollars or dollars

per unit, divide the contribution

margin by the revenue

• The result is a percentage

Using the Contribution

Margin Model

• Steps in using the model are as follows:

–Express revenue, variable expense, and

contribution on a per unit basis

–Multiply the contribution per unit by the

volume to get the total contribution margin

–Subtract fixed expenses from the total

contribution margin to get operating income (Fixed expenses are NOT unitized!)

Contribution Margin in Action

• Four relationships to notice as you study:

–Revenue - Variable expenses =

Contribution margin

–Contribution margin / Revenue =

Contribution margin ratio

–Total contribution margin depends on the

volume of activity

–Contribution margin must cover fixed

expenses before an operating income is

Learning Objective 10

• How can changes in sales

mix affect the projections using CVP analysis?

Multiple Products and Sales

Mix Considerations

• When using the contribution margin

model with more than one product, the

sales mix must be considered

• Sales mix is the relative proportion of

total sales accounted for by different

products

• Different products usually have different

contribution margins

Learning Objective 11

• What are the meaning and

significance of the break-even point, and how is the break-

even point calculated?

Break-Even Point Analysis

• Break-even point is usually expressed as the amount of revenue that must be

realized in order to have neither a profit

nor a loss

• Expresses minimum target revenue

• Use the contribution margin model to

determine the break-even point by setting operating income to zero

Break-Even Point Formulas

• Total revenues at break-even =

•

Fixed expenses Contribution margin ratio

• Volume in units at bread-even =

Fixed expenses

Contribution margin per unit

• Volume in units at break-even =

Total revenues required

Target Operating Income

• The revenues and units necessary may be

determined as follows:

• Total revenues for desired level of operating

income =

• Fixed expenses + Desired operating income

Contribution margin ratio

• Volume in units for desired level of operating income =

• Fixed expenses + Desired operating income

Break-Even Graph

Loss

Profit Break-even point

Variable expenses Fixed expense

Total expenses

Total revenues

Sales volume in units

$000

Learning Objective 12

• What is the concept of

operating leverage?

Operating Leverage

• Operating income will change

proportionately more than changes in

revenues because fixed expenses do not change with changes in volume

• This magnification effect on operating

income due to a change in revenues is

called operating leverage

Operating Leverage Effects

• The higher a firm’s contribution margin

ratio, the greater its operating leverage

• High operating leverage increases the

risk that a small percentage decline in

revenues will cause a large percentage

decline in operating income