McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 4 Short-term Decision Making

4-2 What is the CVP Model? Cost-volume-profit model (short-term) Use to explore relationships among costs, volumes, and profits Assumptions (linearity) Selling price is constant per unit Variable cost is constant per unit Fixed cost is constant in total Number of units produced = number of units sold

4-3 CVP Graph Breakeven point Loss area Profit area Units produced and sold $ Total Revenue Total Cost

4-4 How are the CVP Components Defined Mathematically? Total revenue SP * Q Total cost VC * Q + FC Breakeven (SP * Q – VC * Q) – FC = 0 Where, Q = quantity produced and sold

4-5 CVP Continued Contribution margin SP – VC Breakeven = CM * Q – FC = 0 Target profit before taxes CM * Q – FC = P Target profit after taxes CM * Q – FC = P/(1 – tax rate)

4-6 CVP Continued Change in selling price Increasedecreases breakeven Decreaseincreases breakeven Change in variable cost Increaseincreases breakeven Decreasedecreases breakeven Change in fixed cost Increaseincreases breakeven Decreasedecreases breakeven Change in tax rate No impact on breakeven

4-7 What are Product and Nonproduct Costs? Product costs Incurred in connection with buying or making the product Nonproduct costs Incurred in connection with selling the product and administering (running) the company

4-8 What are the 3 Types of Product Costs? Direct materials Traceable Worth the cost of tracing Direct labor Cost of employees making the product Manufacturing overhead Indirect costs of production (indirect materials, indirect labor, and other manufacturing costs)

4-9 What are the Activity Levels Associated with Costs? Unit-related Vary with units produced or sold Batch-related Vary with batches (groups) regardless of the number of units in the batch Product-sustaining Vary with the number of product lines Facility-sustaining Fixed or capacity costs

4-10 Types and Activity Levels ProductNonproduct Unit-relatedMaterialsCommissions Batch- related Set upsOrdering Product- sustaining Research & development Advertising Facility- sustaining Rental of equipment CEO salary

4-11 What are the 2 Characteristics of a Relevant Variable? Future The variable must occur in the future Different The variable must differ between the alternatives considered

4-12 Relevant Variables Continued Sunk costs Past, irrelevant for decision making Opportunity costs Benefits foregone, relevant for decision making Incremental costs/revenues Additional cost/revenue, relevant if different between alternatives

4-13 What are the Types of Short-Term Decisions Considered? Accept-or-reject decisions Special order Base decision on incremental profit from the order Make-or-buy decisions Outsourcing Base decision on cost comparison between make and buy Keep-or-drop decisions Product mix Base decision on revenues lost versus costs saved