Copyright © 2013 Nelson Education Ltd. PowerPoint Presentations for Cornerstones of Cost Accounting First Canadian Edition Adapted by George Gekas Ryerson University Copyright © 2013 Nelson Education Ltd.

COST-VOLUME- PROFIT ANALYSIS 3 CHAPTER 3-2 Copyright © 2013 Nelson Education Ltd.

The Break-Even Point and Target Profit in Units and Sales Revenue OBJECTIVE 1 Cost-Volume-Profit (CVP) analysis is a powerful tool for planning and decision making Emphasizes the interrelationships of costs, quantity sold, and price and profit Brings together all of the firm’s financial information All manufacturing, marketing, and administrative costs are separated into fixed and variable components 3-3 Copyright © 2013 Nelson Education Ltd.

The Break-Even Point and Target Profit in Units and Sales Revenue OBJECTIVE 1 Break-Even Point: Where revenues equal expenses and there is zero operating income/profit 3-4 Copyright © 2013 Nelson Education Ltd.

The Break-Even Point and Target Profit in Units and Sales Revenue OBJECTIVE 1 How many units will yield the desired profit? Operating income = Sales revenues – Variable expenses – Fixed expenses Operating income = (Price × Number of units) – (Variable cost per unit × Number of units) – Total fixed costs Note: All further CVP equations are derived from the contribution- margin-based income statement. See Cornerstones 3-1 and 3-2 3-5 Copyright © 2013 Nelson Education Ltd.

The Break-Even Point and Target Profit in Units and Sales Revenue OBJECTIVE 1 Contribution Margin = Sales revenue – Total variable costs Income Statement Equation: Sales – Variable expenses – Fixed costs = Profit Price × Quantity – Variable cost per unit XQ – FC = Profit Price – Var. cost per unit)X – FC=Profit Contribution margin × Q – FC = Profit For BE profit is zero, so CM × Q = FC BE Number of units = Fixed costs /CM per unit See Cornerstone 3-3 3-6 Copyright © 2013 Nelson Education Ltd.

The Break-Even Point and Target Profit in Units and Sales Revenue OBJECTIVE 1 3-7 Copyright © 2013 Nelson Education Ltd.

After-Tax Profits OBJECTIVE 2 When calculating the break-even point, income taxes play no role because the taxes paid on zero income are zero After-tax profit = Operating income – Income taxes or AT Profit = BT Profit – Profit × Tax rate) AT Profit = BT Profit(1– t) BT Profit = AT Profit /(1 – Tax rate) See Cornerstone 3-4 3-8 Copyright © 2013 Nelson Education Ltd.

Multiple-Product Analysis OBJECTIVE 3 Direct fixed expenses: Fixed costs that can be traced to each segment and would be avoided if the segment did not exist Common fixed expenses: Fixed costs that are not traceable to the segments and that would remain even if one of the segments was eliminated Sales mix: The relative combination of products being sold by a firm Break-even sales = Fixed costs/Contribution margin ratio See Cornerstone 3-5 3-9 Copyright © 2013 Nelson Education Ltd.

Graphical Representation of CVP Relationships OBJECTIVE 4 Profit-volume graph: Portrays the relationship between profits and sales volume The vertical axis is measured in dollars The horizontal axis is measured in units sold Operating income is the dependent variable Number of units is the independent variable The fixed cost line is a parallel line to the horizontal axis intercepting the vertical axis The variable cost line is an upwards line originating at the intercept of the two axis 3-10 Copyright © 2013 Nelson Education Ltd.

Graphical Representation of CVP Relationships OBJECTIVE 4 3-11 Copyright © 2013 Nelson Education Ltd.

Graphical Representation of CVP Relationships OBJECTIVE 4 The total cost line is an upwards line parallel to the VC line originating at the intercept of the fixed cost and the vertical axis The 45 degree line is the dichotomy on which every point, revenue equals expenditures It is necessary to graph two separate lines: Total revenue line: Revenue = Price × Units Total cost line: (Unit variable cost × Units) + Fixed costs 3-12 Copyright © 2013 Nelson Education Ltd.

Graphical Representation of CVP Relationships OBJECTIVE 4 3-13 Copyright © 2013 Nelson Education Ltd.

Graphical Representation of CVP Relationships OBJECTIVE 4 Assumptions of Cost-Volume-Profit Analysis Assumes a linear revenue function and a linear cost function. Assumes that price, total fixed costs, and unit variable costs can be accurately identified and remain constant over the relevant range. Assumes that what is produced is sold. For multiple-product analysis, the sales mix is assumed to be known. Selling price and costs are assumed to be known with certainty. 3-14 Copyright © 2013 Nelson Education Ltd.

Graphical Representation of CVP Relationships OBJECTIVE 4 3-15 Copyright © 2013 Nelson Education Ltd.

Changes in the CVP Variables OBJECTIVE 5 3-16 Copyright © 2013 Nelson Education Ltd.

Changes in the CVP Variables OBJECTIVE 5 3-17 Copyright © 2013 Nelson Education Ltd.

Changes in the CVP Variables OBJECTIVE 5 3-18 Copyright © 2013 Nelson Education Ltd.

Changes in the CVP Variables OBJECTIVE 5 Margin of Safety The units sold or expected to be sold or the revenue earned or expected to be earned above the break-even volume If a firm’s margin of safety is large, the risk of suffering losses should sales take a downward turn is less than if the margin of safety was small. See Cornerstone 3-6 3-19 Copyright © 2013 Nelson Education Ltd.

Changes in the CVP Variables OBJECTIVE 5 Operating Leverage The use of fixed costs to extract higher percentage changes in profits as sales activity changes The greater the degree of operating leverage, the more that changes in sales activity will affect profits The greater the proportion of fixed costs, the greater the operating leverage See Cornerstone 3-7 3-20 Copyright © 2013 Nelson Education Ltd.

Changes in the CVP Variables OBJECTIVE 5 Operating Leverage The mix of costs than an organization chooses can have a considerable influence on its operating risk and profit level Degree of operating leverage = Total contribution margin/profit See Cornerstone 3-7 3-21 Copyright © 2013 Nelson Education Ltd.

Changes in the CVP Variables OBJECTIVE 5 3-22 Copyright © 2013 Nelson Education Ltd.

Changes in the CVP Variables OBJECTIVE 5 Conventional CVP Analysis Assumes that all costs can be divided into variable category that varies with sales (a linear relationship) and fixed costs that remain constant 3-23 Copyright © 2013 Nelson Education Ltd.

Changes in the CVP Variables OBJECTIVE 5 ABC System Divides costs into unit- and non-unit-based categories Some products are produced in batches (no unit variability) and some fixed costs under the conventional CVP actually vary Example: number of setups, engineering cost More accurately depicts cost behaviour 3-24 Copyright © 2013 Nelson Education Ltd.

CVP Analysis and Non-Unit Cost Drivers OBJECTIVE 6 The ABC Cost Equation Total cost = Fixed costs + (Unit variable cost × Number of units) + (Setup cost × Number of setups) + (Engineering cost × Number of engineering hours) Operating Income Operating income = Total revenue – [Fixed costs + (Unit variable cost × Number of units) + (Setup cost × Number of setups) + (Engineering cost × Number of engineering hours)] 3-25 Copyright © 2013 Nelson Education Ltd.

CVP Analysis and Non-Unit Cost Drivers OBJECTIVE 6 Break-Even in Units Break-even units = [Fixed costs + (Setup cost × Number of setups) + (Engineering cost × Number of engineering hours)]/Price – Unit variable cost) Differences between ABC Break-Even and Conventional Break-Even Fixed costs differ Numerator of ABC break-even equation has two non-unit-variable cost terms 3-26 Copyright © 2013 Nelson Education Ltd.

End of Chapter 3