Cost-Volume-Profit Analysis Chapter 22 HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Objectives 1.Identify different cost behaviour patterns 2.Use a contribution margin statement of financial performance to make business decisions 3.Calculate breakeven sales 4.Calculate the sales level needed to earn a target profit

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Objectives 5.Graph a set of cost-volume-profit relationships 6.Calculate a margin of safety 7.Use the sales mix in CVP analysis 8.Calculate profit using variable costing and absorption costing

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Identify different cost behavior patterns. Objective 1

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Variable Fixed Mixed Types of Costs

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Variable Costs Example l Consider the textbook example of North Coast Railway l Assume that breakfast costs the railway $3 per person. l If the railway carries 2,000 passengers, it will spend $6,000 for breakfast.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Variable Costs Example $24 – $18 – $12 – $6 – – Volume (Thousands of passengers) Total Variable Costs (thousands)

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Fixed Costs Example $400 – $300 – $200 – $100 – – Volume (Thousands of passengers) Total Fixed Costs (thousands)

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Mixed Costs Example l A mixed cost is part variable and part fixed. l Assume the railway’s internet service has fixed costs of $50 per month ($600 per year) and there are also variable costs of $3 per hour of use.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Mixed Costs Example $2,850 – $2,100 – $1,350 – $600 – – Volume (hours) Total Costs Variable Cost Fixed Cost

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Relevant Range... – is a band of volume in which a specific relationship exists between cost and volume. l Outside the relevant range, the cost may either increases or decreases. l A fixed cost is fixed only within a given relevant range and a given time period.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Relevant Range Fixed Costs Volume in Units $160,000 – $120,000 – $80,000 – $40, ,000 10,000 15,000 20,000 25,000 –––––– Relevant Range

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Use a contribution margin statement of financial performance to make business decisions. Objective 2

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Conventional statement of financial performance Contribution margin statement of financial performance Contribution margin statement of financial performance Two Approaches to Calculate Profits

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Conventional Statement Sales – Cost of Goods Sold = Gross Margin – Operating Expenses = Net Profit Gross Margin

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Contribution Margin Statement Sales – Variable Expenses = Contribution Margin – Fixed Expenses = Net Profit Contribution Margin

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Contribution Margin Example l Ly and Thu manufacture a device that allows users to download music from the internet more quickly. l The usual price for the device is $100. l Variable costs are $70. l They receive a proposal from a company in New Delhi to buy 20,000 units at a price of $85 each.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Contribution Margin Example l There is sufficient capacity to produce the order. l How do we analyse this situation? l Selling price – variable cost = contribution margin l $85 – $70 = $15 contribution margin. l $15 × 20,000 units = $300,000 (total increase in contribution margin)

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Assumptions of CVP Analysis 1 Expenses can be classified as either variable or fixed. 2 CVP relationships are linear over a wide range of production and sales. 3 Sales prices, unit variable cost, and total fixed expenses will not vary within the relevant range.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Assumptions of CVP Analysis 4 Volume is the only cost driver. 5 The relevant range of volume is specified. 6 Inventory levels will be unchanged. 7 The sales mix remains unchanged during the period.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Objective 3 Calculate breakeven sales

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Cost-Volume-Profit Analysis — Sales — Fixed — Fixed + Variable

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Sx – Vx – F = 0 Cost-Volume-Profit Analysis l Accountants use two methods to perform CVP analysis. l Both methods use an equation or formula derived from the contribution margin statement of financial performance.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Equation Approach With the equation approach, breakeven sales in units is calculated as follows: Unit sales price × Units sold Variable unit cost × Units sold Fixed expenses Net Profit = – –

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Breakeven Point Example l Assume that fixed expenses amount to $90,000. l How many devices must be sold at the regular price of $100 to break even? l ($100 × Units sold) – ($70 × Units sold) – $90,000 = 0 l Units sold = $90,000 ÷ $30 = 3,000

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Per Unit Percent Ratio Sales price$ Variable expenses Contribution margin$ Contribution Margin

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia (Fixed expenses + Profit) ÷ Contribution margin per unit = Units ($90, ) ÷ $30 = 3,000 Units Contribution Margin Formula

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia (Fixed expenses + Profit) ÷ Contribution margin ratio = $ Sales ($90, ) ÷.30 = $300,000 Contribution Margin Ratio Formula

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Change in Sales Price Example l Suppose that the sales price per device is $106 rather than $100. l What is the revised breakeven sales in units? l New contribution margin: $106 – $70 = $36 l $90,000 ÷ $36 = 2,500 units l $106 x 2,500 = $265,000 Sales

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Change in Variable Costs Example l Suppose that variable expenses per device are $75 instead of $70. l Other factors remain unchanged. l $90,000 ÷ $25 = 3,600 l $90,000 ÷ 0.25 = $360,000 l (or $100 x 3,600 = $360,000 Sales)

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Change in Fixed Costs Example l Suppose that rental costs increased by $30,000. l What are the new fixed costs? l $90,000 + $30,000 = $120,000 l What is the new breakeven point? l $120,000 ÷ $30 = 4,000 units

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Calculate the sales level needed to earn a target net profit. Objective 4

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Target Profit Example l Suppose that a business would be content with a $45,000 profit. l Assuming $100 per unit selling price, variable expenses of $70 per unit, and fixed expenses of $90,000, how many units must be sold? l ($90,000 + $45,000) ÷ $30 = 4,500

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Graph a set of cost-volume-profit relationships. Objective 5

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Various Sales Levels Example l A new example ä (compare to Kay Parker page text) l Assume selling price is $35 per unit. l Variable expense is $21 per unit. l Fixed cost is $7,000. l What is the breakeven point? l 500 units or $17,500 Sales l [$7,000 / ($35 - $21) = 500 units]

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Cost-Volume-Profit Graph Breakeven sales point 500 units or $17,500 Sales revenue line Total expense line Fixed expense line

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Various Sales Levels Example l What profit is expected when sales are 300 units? l (Contribution margin x Units sold) l $14 × 300 = $4,200 total contribution l Total contribution – fixed costs = profit $4,200 – $7,000 = ($2,800)

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Various Sales Levels Example l What profit is expected when sales are 1,000 units? l $14 × 1,000 = $14,000 $14,000 – $7,000 = $7,000

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Calculate a margin of safety. Objective 6

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Margin of Safety Example l Margin of safety is the excess of expected sales over breakeven sales. l Returning to Ly and Thu’s (the previous internet music example) assume breakeven point is 3,000 devices. l Suppose they expect to sell 4,000 during the period. l What is the margin of safety?

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia 4,000 – 3,000 = 1,000 units 1,000 × $100 = $100,000 Margin of Safety Example 1,000 × 4,000 = 25% $100,000 × $400,000 = 25%

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Use the sales mix in CVP analysis. Objective 7

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Sales Mix Example l Suppose that Ly and Thu plan to sell two types of devices instead of one. l They estimate that sales will be 3,000 regular devices and 1,000 large devices. l This is a 3:1 sales mix. l They expect 3/4 of the devices sold to be regular devices and 1/4 to be large devices.

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Regular Large Sales price $100 $154 Variable expenses Contribution margin Sales mix (units) 3 1 $ 90 $ 54 The total is $144. Sales Mix Example

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Sales Mix Example Weighted-average contribution margin $144 ÷ (3 + 1) = $36 Breakeven sales $90,000 ÷ $36 = 2,500 2,500 × 3/4 = 1,875 regular devices 2,500 × 1/4 = 625 large devices

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Sales Mix Example 1,875 regular× $100 =$187, large× $154 = 96,250 Breakeven$283,750 $90,000 ÷ $144 = 625 packages in the mix

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Calculate profit using variable costing and absorption costing. Objective 8

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Absorption costing assigns all manufacturing costs to products. Financial statements prepared under GAAP use absorption costing. Absorption costing assigns all manufacturing costs to products. Financial statements prepared under GAAP use absorption costing. Variable costing assigns only variable manufacturing costs to products. Variable costing is for internal use only. Variable costing assigns only variable manufacturing costs to products. Variable costing is for internal use only. Product Costing

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Sportade has the following costs: Direct material unit cost$6.00 Direct labour unit cost$3.00 Variable manufacturing overhead$2.00 Variable marketing$2.50 Fixed manufacturing overhead per unit$5.00 What is the product cost per unit? Product Costing Example

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Absorption Costing Direct materials $ 6.00 Direct labour 3.00 Variable manufacturing overhead 2.00 Fixed manufacturing overhead 5.00 Total $16.00 Product Costing Example

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia Variable Costing Direct materials $ 6.00 Direct labour 3.00 Variable manufacturing overhead 2.00 Fixed manufacturing overhead -0- Total $11.00 Product Costing Example See the Statements of Financial Performance p974 textbook

Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia End of Chapter 22