Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fifth Edition Wild, Shaw, and Chiappetta Fifth Edition McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis

Conceptual Learning Objectives C1: Describe different types of cost behavior in relation to production and sales volume. C2: Describe several applications of cost- volume-profit analysis. 18-3

A1: Compute the contribution margin and describe what it reveals about a company’s cost structure. A2: Analyze changes in sales using the degree of operating leverage. Analytical Learning Objectives 18-4

P1: Determine cost estimates using the scatter diagram, high-low, and regression methods of estimating costs. P2: Compute the break-even point for a single product company. P3: Graph costs and sales for a single product company. P4: Compute the break-even point for a multiproduct company. Procedural Learning Objectives 18-5

CVP analysis is used to answer questions such as:  What sales volume is needed to earn a target income?  What is the change in income if selling prices decline and sales volume increases?  How much does income increase if we install a new machine to reduce labor costs?  Will income change if we change the sales mix of our products or services? CVP analysis is used to answer questions such as:  What sales volume is needed to earn a target income?  What is the change in income if selling prices decline and sales volume increases?  How much does income increase if we install a new machine to reduce labor costs?  Will income change if we change the sales mix of our products or services? Questions Addressed by Cost-Volume-Profit Analysis C1 18-6

Number of Local Calls Monthly Basic Telephone Bill Total fixed costs remain unchanged when activity changes. Your monthly basic telephone bill probably does not change when you make more local calls. Total Fixed Cost C1 $ 18-7

Number of Local Calls Monthly Basic Telephone Bill per Local Call Fixed costs per unit decline as activity increases. Your average cost per local call decreases as more local calls are made. Fixed Cost per Unit C1 $ 18-8

Minutes Talked Total Long Distance Telephone Bill Total variable costs change when activity changes. Your total long distance telephone bill is based on how many minutes you talk. Total Variable Cost C1 $ # 18-9

Minutes Talked Per Minute Telephone Charge Variable costs per unit do not change as activity increases. The cost per long distance minute talked is constant. For example, 7 cents per minute. Variable Cost per Unit C1 $ 18-10

Cost Behavior Summary C

Mixed costs contain a fixed portion that is incurred even when the facility is unused, and a variable portion that increases with usage. Example: monthly electric utility charge  Fixed service fee  Variable charge per kilowatt hour used Mixed Costs C

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

The objective is to classify all costs as either fixed or variable. Identifying and Measuring Cost Behavior P1 When presented with a mixed cost, the fixed and variable components must be separated

Vertical distance is the change in cost. Horizontal distance is the change in activity. Unit variable cost = Slope = Change in cost Change in units * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced P1 Scatter Diagram 18-15

The following relationships between units produced and costs are observed: Using these two levels of activity, we can compute:  The variable cost per unit.  The total fixed cost. The High-Low Method P

 Unit variable cost = = = $0.17 /unit  Fixed cost = Total cost – Total variable cost Fixed cost = $29,000 – ($0.17 per unit × 67,500 units) Fixed cost = $29,000 – $11,475 = $17,525 Δ  in cost Δ  in units $8,500 50,000 P1 The High-Low Method (Exhibit 18.6) 18-17

The objective of the cost analysis remains the same: determination of total fixed cost and the variable unit cost. Least-squares regression is usually covered in advanced cost accounting courses. It is commonly used with spreadsheet programs or calculators. Least-Squares Regression P

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

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

How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $24,000 A1 Understanding the Contribution Margin 18-21

How many units must this company sell to cover its fixed costs (break even)? Answer: $24,000 ÷ $30 per unit = 800 units P2 Computing The Break-Even Point 18-22

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 Computing The Break-Even Point (Exhibit 18.11) Unit sales price less unit variable cost ($30 in previous example) P

The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed costs Contribution margin ratio Unit contribution margin Unit sales price P2 Computing The Break-Even Point (Exhibit 18.12) 18-24

Margin of safety is the amount by which sales can drop before the company incurs a loss. Margin of safety may be expressed as a percentage of expected sales. Computing the Margin of Safety Margin of safety Expected sales - Break-even sales percentage Expected sales = P

Number of Units Produced Costs and Revenue in Dollars Total fixed costs Total costs  Draw the total cost line with a slope equal to the unit variable cost.  Plot total fixed costs on the vertical axis. Preparing a Cost-Volume- Profit Chart P

Sales Number of Units Produced Costs and Revenue in Dollars  Starting at the origin, draw the sales line with a slope equal to the unit sales price. Preparing a Cost-Volume- Profit Chart Break- even point Total costs Total fixed costs P

 A limited range of activity called the relevant range, where CVP relationships are linear. 4 Unit selling price remains constant. 4 Unit variable costs remain constant. 4 Total fixed costs remain constant.  Production = Sales (no inventory changes). Assumptions of CVP Analysis C

Sales – Variable costs Contribution margin – Fixed costs Income (pretax) Sales – Variable costs Contribution margin – Fixed costs Income (pretax) Computing Income from Expected Sales C2 Did someone say income? 18-29

Target net income is income after income tax. But we can use target income before tax in our calculations. Computing Sales (Dollars) for a Target Net Income C2 Target income before tax ( Target pretax income) = Net income (after tax) + Income taxes paid on the pretax income 18-30

To convert target net income to pretax income, use the following formula: Target pretax Income Target after-tax net income 1 - Tax rate C2 Computing Sales (Dollars) for a Target Net Income = 18-31

Break-even formulas may be adjusted to show the sales volume needed to earn any amount of income. Unit sales at target after-tax income Fixed costs + Target pretax income Contribution margin ratio Dollar sales at target after-tax income Fixed costs + Target pretax income Contribution margin per unit Computing Sales for a Target Income C2 = = 18-32

The basic CVP relationships may be used to analyze a number of situations such as changing sales price, changing variable cost, or changing fixed cost. Sensitivity Analysis C This sensitivity analysis can be used to generate different sets of revenue and cost estimates that are optimistic, pessimistic, and most likely.

The CVP formulas may be modified for use when a company sells more than one product.  The unit contribution margin is replaced with the contribution margin for a composite unit.  A composite unit is composed of specific numbers of each product in proportion to the product sales mix.  Sales mix is the ratio of the sales volumes for the various products. Computing Multiproduct Break-Even Point P

The resulting break-even formula for composite unit sales is: Break-even point in composite units Fixed costs Contribution margin per composite unit = P4 Computing Multiproduct Break-Even Point A composite unit is composed of specific numbers of each product in proportion to the product sales mix.

The extent, or relative size, of fixed costs in the total cost structure of an organization. A measure of how a percentage change in sales will affect profits. Total contribution margin (in dollars) Pretax income Operating Leverage A Degree of operating leverage =

End of Chapter