Previous Lecture Chapter 17: Accounting Systems For Measuring Costs Cost Accounting Systems Basic Cost Accounting Procedures Job Order Costing The Job Cost Sheet Job Order Costing : Document Flow Summary Flow of Costs in Job Costing

Previous Lecture Closing Under- or Over applied Manufacturing Overhead Flow of Costs in Job Costing Process Costing Comparing Job and Process Costing Job and Process Costing Job and Process Costing Similarities Work in Process Accounts -The Key to Process Costing

Previous Lecture Computing Unit Cost Computing and Using Equivalent Units of Production Cost Per Equivalent Unit Equivalent Units

Cost-Volume-Profit Analysis Chapter 19 2

Questions Addressed by Cost-Volume-Profit Analysis CVP analysis is used to answer questions such as: How much must I sell to earn my desired income? How will income be affected if I reduce selling prices to increase sales volume? What will happen to profitability if I expand capacity?

Cost Behavior

Variable Cost Jason Inc. produces stereo sound systems under the brand name of J-Sound. The parts for the stereo are purchased from an outside supplier for $10 per unit (a variable cost).

Total Variable Cost Graph $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 Total Costs 10 20 30 Units Produced (in thousands)

Unit Variable Cost Graph $20 $15 $10 $5 Cost per Unit 10 20 30 Units Produced (000)

Direct Materials Cost per Unit Total Direct Materials Cost Variable Cost $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $20 $15 $10 $5 Cost per Unit Total Costs 10 20 30 Units Produced (000) 10 20 30 Units Produced (000) Number of Units Produced Direct Materials Cost per Unit Total Direct Materials Cost 5,000 units $10 $ 50,000 10,000 10 l00,000 15,000 10 150,000 20,000 10 200,000 25,000 10 250,000 30,000 10 300,000

Fixed Costs The production supervisor for Minton Inc.’s Los Angeles plant is Jane Sovissi. She is paid $75,000 per year. The plant produces from 50,000 to 300,000 bottles of perfume. La Fleur

Total Salary for Jane Sovissi Salary per Bottle Produced Fixed Costs $75,000/50,000= $1.5 Number of Bottles Produced Total Salary for Jane Sovissi Salary per Bottle Produced 50,000 bottles $75,000 $1.500 100,000 75,000 0.750 150,000 75,000 0.500 200,000 75,000 0.375 250,000 75,000 0.300 300,000 75,000 0.250

Total Salary for Jane Sovissi Salary per Bottle Produced Fixed Costs Total Fixed Cost Graph Unit Fixed Cost Graph $150,000 $125,000 $100,000 $75,000 $50,000 $25,000 $1.50 $1.25 $1.00 $.75 $.50 $.25 Total Costs Cost per Unit 100 200 300 100 200 300 Bottles Produced (000) Units Produced (000) Number of Bottles Produced Total Salary for Jane Sovissi Salary per Bottle Produced 50,000 bottles $75,000 $1.500 100,000 75,000 0.750 15,000 75,000 0.500 20,000 75,000 0.375 25,000 75,000 0.300 30,000 75,000 0.250

Mixed Costs Simpson Inc. manufactures sails using rented equipment. The rental charges are $15,000 per year, plus $1 for each machine hour used over 10,000 hours.

Mixed costs are sometimes called semivariable or semifixed costs. Total Mixed Cost Graph $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 Mixed costs are usually separated into their fixed and variable components for management analysis. Total Costs 10 20 30 40 Total Machine Hours (000)

Mixed Costs The high-low method is a simple way to separate mixed costs into their fixed and variable components. Low High

What month has the highest level of activity in terms of cost? High-Low Method Actual costs incurred Production Total (Units) Cost What month has the highest level of activity in terms of cost? June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 Highest level of activity ($) minus lowest level of activity ($) Variable cost per unit = Highest level of activity (n) minus lowest level of activity (n)

What month has the highest level of activity in terms of cost? High-Low Method Actual costs incurred Production Total (Units) Cost What month has the highest level of activity in terms of cost? June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 $61,500 minus lowest level of activity ($) Variable cost per unit = Highest level of activity (n) minus lowest level of activity (n)

For the highest level of cost, what is the level of production? High-Low Method Actual costs incurred Production Total (Units) Cost For the highest level of cost, what is the level of production? June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 $61,500 minus lowest level of activity ($) Variable cost per unit = 2,100 minus lowest level of activity (n) Highest level of activity (n) minus lowest level of activity (n)

What month has the lowest level of activity in terms of cost? High-Low Method Actual costs incurred Production Total (Units) Cost What month has the lowest level of activity in terms of cost? June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 $57,500 – $41,250 $61,500 minus lowest level of activity ($) Variable cost per unit = 2,100 minus lowest level of activity (n) 2,100 – 750

What is the variable cost per unit? High-Low Method Actual costs incurred Production Total (Units) Cost What is the variable cost per unit? June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 $20,250 1,350 $15 $57,500 – $41,250 Variable cost per unit = 2,100 – 750

High-Low Method Actual costs incurred Production Total (Units) Cost Variable cost per unit = $15 What is the total fixed cost (using the highest level)? June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 Total cost = (Variable cost per unit x Units of production) + Fixed cost $61,500 = ($15 x 2,100) + Fixed cost $61,500 = ($15 x 2,100) + $30,000

High-Low Method The fixed cost is the same at the lowest level. Actual costs incurred Production Total (Units) Cost Variable cost per unit = $15 The fixed cost is the same at the lowest level. June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 Total cost = (Variable cost per unit x Units of production) + Fixed cost $41,250 = ($15 x 750) + Fixed cost $41,250 = ($15 x 750) + $30,000

Variable Costs Fixed Costs Total Variable Costs Total Fixed Costs Total Costs Total Costs Total costs increase and decreases with activity level. Unit costs remain the same per unit regardless of activity. Total Units Produced Review Total Units Produced Unit costs remain the same regardless of activity. Total costs increase and decreases proportionately with activity level. Unit Fixed Costs Unit Variable Costs Per Unit Cost Per Unit Cost Total Units Produced Total Units Produced

Total cost remains constant within a narrow range of activity. Stair-Step Costs Total cost remains constant within a narrow range of activity. Cost Activity

Stair-Step Costs Total cost increases to a new higher cost for the next higher range of activity. Cost Activity

Curvilinear Cost Function Curvilinear Costs Curvilinear Cost Function Relevant Range Total Cost A straight line closely (constant unit variable cost) approximates a curvilinear variable cost line within the relevant range. Volume of Output

Cost Behavior Summary

Cost-Volume-Profit Relationships

Contribution Margin Income Statement The contribution margin is available to cover the fixed costs and income from operations. Sales (50,000 units) $1,000,000 Variable costs 600,000 Contribution margin $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 Contribution margin FIXED COSTS Income from Operations

Contribution Margin Income Statement Sales (50,000 units) $1,000,000 Variable costs 600,000 Contribution margin $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 Income from operations Variable costs Fixed costs Sales = + + Sales Variable costs Contribution margin – =

Contribution Margin Ratio Sales (50,000 units) $1,000,000 Variable costs 600,000 Contribution margin $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 100% 60% 40% 30% 10% Sales – Variable costs Sales Contribution margin ratio = Contribution margin ratio = $1,000,000 – $600,000 $1,000,000 Contribution margin ratio = 40%

Contribution Margin Ratio Sales (50,000 units) $1,000,000 Variable costs 600,000 Contribution margin $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 100% 60% 40% 30% 10% $20 12 $ 8 The contribution margin can be expressed three ways: 1. Total contribution margin in dollars. 3. Contribution margin ratio (percentage). 3. Unit contribution margin (dollars per unit).

Cost-Volume-Profit (CVP) Analysis Let’s extend our knowledge of cost behavior to CVP analysis.

Computing Break-Even Point The break-even point (expressed in units of product or dollars of sales) is the unique sales level at which a company neither earns a profit nor incurs a loss.

Computing Break-Even Point Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue.

Computing Break-Even Point How much contribution margin must this company have to cover its fixed costs (break even)?

Computing Break-Even Point How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $30,000

Computing Break-Even Point How many units must this company sell to cover its fixed costs (break even)?

Computing Break-Even Point How many units must this company sell to cover its fixed costs (break even)? Answer: $30,000 ÷ $20 per unit = 1,500 units

Formula for Computing Break-Even Sales (in Units) We have just seen one of the basic CVP relationships – the break-even computation. Break-even point in units = Fixed costs Contribution margin per unit Unit sales price less unit variable cost ($20 in previous example)

Formula for Computing Break-Even Sales (in Dollars) The break-even formula may also be expressed in sales dollars. Fixed costs Break-even point in dollars = Contribution margin ratio Unit sales price Unit variable cost

Computing Break-Even Sales Question 1 ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? a. 100,000 units b. 40,000 units c. 200,000 units d. 66,667 units

Computing Break-Even Sales Question 1 ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to break even? a. 100,000 units b. 40,000 units c. 200,000 units d. 66,667 units Unit contribution = $5.00 - $3.00 = $2.00 Fixed costs Unit contribution $200,000 $2.00 per unit = = 100,000 units

Computing Break-Even Sales Question 2 Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200,000; unit sales price is $5.00; and unit variable cost is $3.00. a. $200,000 b. $300,000 c. $400,000 d. $500,000

Computing Break-Even Sales Question 2 Use the contribution margin ratio formula to determine the amount of sales revenue ABC must have to break even. All information remains unchanged: fixed costs are $200,000; unit sales price is $5.00; and unit variable cost is $3.00. a. $200,000 b. $300,000 c. $400,000 d. $500,000 Unit contribution = $5.00 - $3.00 = $2.00 Contribution margin ratio = $2.00 ÷ $5.00 = .40 Break-even revenue = $200,000 ÷ .4 = $500,000

Costs and Revenue in Dollars Preparing a CVP Graph Starting at the origin, draw the total revenue line with a slope equal to the unit sales price. Revenue Total fixed cost Total fixed cost extends horizontally from the vertical axis. Costs and Revenue in Dollars Volume in Units

Costs and Revenue in Dollars Preparing a CVP Graph Draw the total cost line with a slope equal to the unit variable cost. Revenue Break-even Point Profit Costs and Revenue in Dollars Total cost Loss Total fixed cost Volume in Units

Computing Sales Needed to Achieve Target Operating Income Break-even formulas may be adjusted to show the sales volume needed to earn any amount of operating income. Fixed costs + Target income Unit sales = Contribution margin per unit Fixed costs + Target income Dollar sales = Contribution margin ratio

Computing Sales Needed to Achieve Target Operating Income ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn operating income of $40,000? a. 100,000 units b. 120,000 units c. 80,000 units d. 200,000 units

Computing Sales Needed to Achieve Target Operating Income ABC Co. sells product XYZ at $5.00 per unit. If fixed costs are $200,000 and variable costs are $3.00 per unit, how many units must be sold to earn operating income of $40,000? a. 100,000 units b. 120,000 units c. 80,000 units d. 200,000 units = 120,000 units Unit contribution = $5.00 - $3.00 = $2.00 Fixed costs + Target income Unit contribution $200,000 + $40,000 $2.00 per unit

What is our Margin of Safety? Margin of safety is the amount by which sales may decline before reaching break-even sales: Margin of safety provides a quick means of estimating operating income at any level of sales: Margin of safety = Actual sales - Break-even sales Operating Margin Contribution Income of safety margin ratio = ×

What is our Margin of Safety? Oxco’s contribution margin ratio is 40 percent. If sales are $100,000 and break-even sales are $80,000, what is operating income? Operating Margin Contribution Income of safety margin ratio = × Operating Income = $20,000 × .40 = $8,000

What Change in Operating Income Do We Anticipate? Once break-even is reached, every additional dollar of contribution margin becomes operating income: Oxco expects sales to increase by $15,000. How much will operating income increase? Change in Change in Contribution operating income sales volume margin ratio = × Change in operating income = $15,000 × .40 = $6,000

End of Today’s Session