Cost-Volume-Profit Analysis and Variable Costing Chapter 7 Cost-Volume-Profit Analysis and Variable Costing

Introduction Cost-volume-profit (CVP) analysis focuses on the following factors: The prices of products or services The volume of products or services produced and sold The per-unit variable costs The total fixed costs The mix of products or services produced

The Contribution Margin Income Statement The contribution margin income statement is structured by behavior rather than by function. Sales - All Variable Costs = Contribution Margin Contribution Margin - All Fixed Costs = Net Income

Contribution Margin Per Unit For every unit change in sales, contribution margin will increase or decrease by the contribution margin per unit multiplied by the increase or decrease in sales volume.

Contribution Margin Ratio = Contribution Margin (in $) Sales (in $)

Contribution Margin Ratio For every dollar change in sales, contribution margin will increase or decrease by the contribution margin ratio multiplied by the increase or decrease in sales dollars.

Break-Even Analysis Break-Even Point: The level of sales where contribution margin just covers fixed costs and consequently net income is equal to zero.

Contribution Margin Per Unit Contribution Margin Ratio Break-Even Analysis Break-Even (units) Fixed Costs Contribution Margin Per Unit = Break-Even (Sales $) Fixed Costs Contribution Margin Ratio =

Break-Even Calculations Using Activity-Based Costing When using activity-based-costing, costs are classified as unit, batch, product, or facility level instead of variable or fixed. Break-Even (units) = Fixed Costs + Batch-Level Costs + Product-Level Costs Contribution Margin Per Unit

Target Profit Analysis (Before and After Tax) To determine the sales units required to achieve a target profit before taxes: Sales Volume = Fixed Costs + Target Profit (before taxes) Contribution Margin Per Unit

The Impact of Taxes If After-Tax Profit = Before-Tax Profit (1-tax rate) then Before-Tax Profit = After-Tax Profit / (1-tax rate) Therefore, to determine after-tax Target Profit Fixed Costs + After-Tax Profit / (1-Tax Rate) Contribution Margin per Unit Sales in units =

The Impact of Taxes The payment of income tax is an important variable in target profit and other CVP decisions.

Assumptions of CVP Analysis Selling price is constant throughout the relevant range. Costs are linear throughout the relevant range. The sales mix used to calculate the weighted average contribution margin is constant. The amount of inventory is constant.

Cost Structure and Operating Leverage Operating Leverage: The measure of the proportion of fixed costs in a company’s cost structure. It is used as an indicator of how sensitive profit is to changes in sales volume.

Cost Structure and Operating Leverage Contribution Margin Net Income Operating Leverage = Operating Leverage X % Increase in Sales = % Increase in Net Income

Cost Structure and Operating Leverage A company operating near the break-even point will have a high level of operating leverage and income will be very sensitive to changes in sales volume.

Variable Costing for Decision Making The only difference between absorption and variable costing is the treatment of fixed overhead. Absorption Costing: Fixed overhead is treated as a product cost and expensed when the product is sold. Variable Costing: Fixed overhead is treated as a period cost and expensed as incurred.

Differences Between Absorption and Variable Costing When units sold equal units produced, net income is the same under both costing methods. When units produced exceed units sold, absorption costing will report higher net income than variable costing. When units sold exceed units produced, variable costing will report higher net income than absorption costing.