Principles of Cost Accounting 15 th edition Edward J. VanDerbeck © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1

Chapter 10 Cost Analysis for Management Decision Making 2

Learning Objectives LO1Compute net income under variable and absorption costing. LO2Discuss the merits and limitations of variable costing. LO3Define segment profitability and distinguish between direct and indirect costs. 3

Learning Objectives (cont.) LO4Compute the break-even point and the target volume needed to earn a certain profit. LO5Calculate the contribution margin ratio and the margin of safety ratio. LO6Discuss the impact of income tax on break-even computations. 4

Learning Objectives (cont.) LO7Use differential analysis to make special decisions. LO8Identify techniques for analyzing and controlling distribution costs. 5

Variable Costing (also known as Direct Costing) The cost of manufacturing a product includes only variable manufacturing costs. The cost of manufacturing a product includes only variable manufacturing costs. Fixed factory overhead is classified as a period cost and is expensed on each month’s income statement. Fixed factory overhead is classified as a period cost and is expensed on each month’s income statement. The difference between sales and all variable costs is termed contribution margin. The difference between sales and all variable costs is termed contribution margin. 6

Variable Costing (cont.) Direct Material Direct Labor Variable Manufacturing OH Fixed Manufacturing OH Selling Costs Administrative Costs Inventory Accounts on Balance Sheet Cost of Goods Sold When Finished Goods are Sold Expense Accounts on Income Statement Product CostsPeriod Costs 7

Absorption Costing (also known as Full Costing) Assigns both fixed and variable manufacturing costs to the product. Assigns both fixed and variable manufacturing costs to the product. Absorption method will report a higher cost of goods sold due to the inclusion of the fixed factory overhead. Absorption method will report a higher cost of goods sold due to the inclusion of the fixed factory overhead. The difference between sales revenue and cost of goods sold is termed gross margin. The difference between sales revenue and cost of goods sold is termed gross margin. 8

Absorption Costing (cont.) Direct Material Direct Labor Variable Manufacturing OH Fixed Manufacturing OH Selling Costs Administrative Costs Inventory Accounts on Balance Sheet Cost of Goods Sold when Finished Goods are Sold Expense Accounts on Income Statement Product CostsPeriod Costs 9

Merits and Limitations of Variable Costing This method highlights the relationship between sales and all variable costs. This method highlights the relationship between sales and all variable costs. May be easier for members of management who are not formally trained in accounting. May be easier for members of management who are not formally trained in accounting. Variable costing is not a generally accepted method of inventory costing for external purposes because total costs are not matched with sales revenue and does not include fixed factory overhead in the work in process and finished goods inventories. Variable costing is not a generally accepted method of inventory costing for external purposes because total costs are not matched with sales revenue and does not include fixed factory overhead in the work in process and finished goods inventories. 10

Segment Reporting for Profitability Analysis A segment of a company may be a division, a product line, a sales territory, or another identifiable unit. A segment of a company may be a division, a product line, a sales territory, or another identifiable unit. This analysis requires that all costs be classified into one of two categories: This analysis requires that all costs be classified into one of two categories: Direct costs – can be traced to the segment being analyzed. Direct costs – can be traced to the segment being analyzed. Indirect costs – cannot be identified directly with a specific segment. Indirect costs – cannot be identified directly with a specific segment. 11

Segment Reporting for Profitability Analysis (cont.) A company’s segment report isolates costs, variable and fixed, that can be directly traced to the segments. A company’s segment report isolates costs, variable and fixed, that can be directly traced to the segments. Costs may be direct costs in one segment and indirect costs in another segment. Costs may be direct costs in one segment and indirect costs in another segment. 12

Cost-Volume-Profit (CVP) Analysis Technique that uses the degrees of cost variability for measuring the effect of changes in volume on resulting profits. Technique that uses the degrees of cost variability for measuring the effect of changes in volume on resulting profits. It is assumed that fixed costs will remain the same in total within a range of production volume in which the firm expects to operate, known as the relevant range. It is assumed that fixed costs will remain the same in total within a range of production volume in which the firm expects to operate, known as the relevant range. 13

Limitations of CVP Analysis CVP analysis assumes that all factors except volume will remain constant for a given period of time. CVP analysis assumes that all factors except volume will remain constant for a given period of time. In some cases, costs are relatively unpredictable except over very limited ranges of activity. In some cases, costs are relatively unpredictable except over very limited ranges of activity. Anticipated results depend on the stability of the CVP relationships as they have been established. Anticipated results depend on the stability of the CVP relationships as they have been established. 14

Break-Even Analysis The break-even point is the point at which sales revenue covers all costs to manufacture and sell the product, but there is no profit. The break-even point is the point at which sales revenue covers all costs to manufacture and sell the product, but there is no profit. Costs must be segregated according to their degree of variability. Costs must be segregated according to their degree of variability. 15

Break-Even Point Calculations Sales revenue (to break even) = Sales revenue (to break even) = Cost to manufacture + Selling and administrative costs Sales revenue (to break even) = Sales revenue (to break even) = Fixed manufacturing and selling and administrative costs + Variable manufacturing and selling and administrative costs 16

Break-Even Point Calculations (cont.) Break-even sales volume (dollars) = Break-even sales volume (dollars) = Total fixed costs / Contribution margin ratio Break-even sales volume (dollars) = Break-even sales volume (dollars) = Total fixed costs / 1 – (Variable costs/Sales revenue) Break-even sales volume (units) = Break-even sales volume (units) = Total fixed cost / Unit contribution margin 17

Margin of Safety Indicates the amount that sales can decrease before the company will suffer a loss. Indicates the amount that sales can decrease before the company will suffer a loss. Margin of safety (dollars) = Margin of safety (dollars) = Sales revenue – Break-even sales revenue Margin of safety ratio = Margin of safety ratio = Margin of safety / Sales 18

Effect of Income Tax on Break-Even Point and Net Income Pre-tax income = Pre-tax income = After-tax income / 1 – Tax rate Target volume (units) = Target volume (units) = {Fixed costs + [Target after-tax income / (1 – Tax rate)] } / Unit contribution margin Target volume (dollars) = Target volume (dollars) = {Fixed costs + [Target after-tax income / (1 – Tax rate)] } / Contribution margin ratio {Fixed costs + [Target after-tax income / (1 – Tax rate)] } / Contribution margin ratio 19

Differential Analysis Differential analysis is a study that highlights the significant cost and revenue data alternatives. Differential analysis is a study that highlights the significant cost and revenue data alternatives. The designated purpose for which a cost measurement is to be made should be included in the cost analysis. The designated purpose for which a cost measurement is to be made should be included in the cost analysis. Where there is excess capacity, only the differential costs per unit should be considered in producing additional units. Where there is excess capacity, only the differential costs per unit should be considered in producing additional units. Generally, differential costs do not include fixed factory overhead costs. Generally, differential costs do not include fixed factory overhead costs. May be used in make or buy decisions. May be used in make or buy decisions. 20

Accept or Reject a Special Order Many companies follow a practice of contribution pricing, meaning accepting a selling price as long as it exceeds variable cost, thus contributing some positive contribution margin in times of excess capacity. Many companies follow a practice of contribution pricing, meaning accepting a selling price as long as it exceeds variable cost, thus contributing some positive contribution margin in times of excess capacity. 21

Make or Buy Unused plant capacity might be utilized to manufacture a finished part that was purchased in the past. Unused plant capacity might be utilized to manufacture a finished part that was purchased in the past. This analysis will determine the savings that may be realized. This analysis will determine the savings that may be realized. 22

Distribution Costs Efficient control of all costs should cover distribution costs as well as production costs. Efficient control of all costs should cover distribution costs as well as production costs. Distribution costs include the costs incurred to sell and deliver the product. Distribution costs include the costs incurred to sell and deliver the product. Accountants must devote more time to the study of distribution costs to answer questions concerning the spreading of selling and administrative expenses to each type of product sold, sales offices, salespersons, and each separate order. Accountants must devote more time to the study of distribution costs to answer questions concerning the spreading of selling and administrative expenses to each type of product sold, sales offices, salespersons, and each separate order. 23