1 Brenda Mallouk Management Accounting One Cost Volume Profit Analysis

2 Brenda Mallouk Variable Cost Behaviour When activity... $ Units

3 Brenda Mallouk Fixed Cost Behaviour When activity.... $ Units

4 Brenda Mallouk Jabot Cosmetics makes and sells scent holders. The company normally produces and sells between 20,000 and 23,000 holders per year. The following cost data were drawn from the company’s accounting records. Number of Units 20,000 21,000 22,000 23,000 Total Costs Incurred Fixed $ 45,000 Variable 100,000 Total Costs $145,000 Cost Per Unit Fixed $ 2.25 Variable 5.00 Total Cost Per Unit $ 7.25

5 Brenda Mallouk Lumpy Costs A cost which shifts upwards when an activity changes by a certain interval or “step”. $ Activity Measure

6 Brenda Mallouk Mixed Costs A cost that has both a variable and a fixed component Does not fluctuate in direct proportion to changes in activity Does not remain constant with changes in activity

7 Brenda Mallouk Mixed Cost Fixed Portion Mixed (Semi-Variable) Expenses Variable Portion $ $ $ Rent a truck -- base cost $145 kilometer charge $ km driven

8 Brenda Mallouk The Pasta Palace is a fast food restaurant that operates a chain of restaurants across the country. Each restaurant employs 8 people. The manager is paid a salary plus a bonus equal to 2 percent of sales. The other employees -- two cooks, one cleaner and four waitstaff are paid salaries. Each manager has a budget of $1,000 per month for advertising cost.

9 Brenda Mallouk Classify each of the following total costs incurred by Pasta Palace as being fixed, variable or mixed: a.The cooks’ salary at a particular location, relative to the number of customers b.The cooks’ salary relative to the number of restaurants c.The cost of cups, plates, spoons, etc. relative to the number of customers d.The cost of cups, plates, spoons, etc. relative to the number of restaurants e.The manager’s compensation relative to the number of customers f.Waitstaff salaries relative to the number of restaurants g.Advertising costs relative to the number of customers for a particular restaurant. h.Advertising costs relative to the number of restaurants.

10 Brenda Mallouk Analyzing Mixed Costs Using the High Low Method Has advantage of objectivity Solely dependent on two observations Simple and fast

11 Brenda Mallouk Steps in Using the High-Low Method 1.Identify the high and low cost-volume points 2.Compute the variable rate by using the following formula: Variable rate = High cost – Low cost High activity – Low activity 3.Compute the fixed rate by using the following formula and inserting the variable rate computed above and either the high activity or the low activity level Total cost = Fixed cost + (Activity level x variable rate)

12 Brenda Mallouk Total Sales (500 units)250,000$ Less: variable expenses150,000 Contribution margin100,000 Less: fixed expenses80,000 Net income20,000$ Jeff's Computers Pentium Five Model Contribution Statement Contribution margin (CM) is the difference between the sales revenue and the variable costs. It is the amount available to cover fixed costs and profit.

13 Brenda Mallouk Contribution Margin Ratio Contribution Margin Ratio = Sales - Variable Costs / Sales = ($250,000 - $150,000) / $250,000 = 40%

14 Brenda Mallouk Determining the Break-Even Point Break-Even Volume in Units = Fixed Costs Contribution Margin Per Unit For Jeff’s Pentium Five model computer the break-even volume in units is: $80,000 $200 = 400 computers Contribution Margin Per Unit $ $300 = $200 The break-even point in units can be determined using the following equation:

15 Brenda Mallouk Estimating the Sales Volume Necessary to Attain a Target Profit Sales Volume in Units = Fixed Costs + Desired Profit Contribution Margin Per Unit

16 Brenda Mallouk Estimating the Effects of Changes in Sales Price The new contribution per unit would be $160 ($460 -$300). Break-Even Volume in Units = Fixed Costs Contribution Margin Per Unit Break-Even Volume in Units = = 500 units Competition is forcing consideration of a drop in selling price. What is the impact on break-even of a drop in selling price from $500 to $460 per unit? $80,000 $160

17 Brenda Mallouk Dollars Cost-Volume-Profit Graph Break-even point Units Profit Area Loss Area

18 Brenda Mallouk Margin of Safety The number of units (or sales dollars) by which actual sales can fall below budgeted sales before a loss is incurred. Margin of safety = Budgeted Sales - Break-even sales Budgeted Sales

19 Brenda Mallouk Operating Leverage A measure of the extent to which fixed costs are being used in an organization.

20 Brenda Mallouk $100,000 $20,000 = 5 Operating Leverage CM Net Income =

21 Brenda Mallouk Short Cut for Changes If sales are increased by 10%, profits will increase by 50% Operating Leverage

22 Brenda Mallouk CVP Limitations  Selling price is constant throughout the entire relevant range.  Costs are linear throughout the entire relevant range.  In multi-product companies, the sales mix is constant.  In manufacturing companies, inventories do not change (units produced = units sold).

23 Brenda Mallouk Income Effects of Alternative Inventory Costing Methods

24 Brenda Mallouk The Effect of Cost Structure on Profit Stability

25 Brenda Mallouk The Effect of Cost Structure on Profit Stability Variable Costs Fixed Costs What happens when the number of units sold increases or increases?

26 Brenda Mallouk The income increase is greater in the All Fixed Company. Increased Sales

27 Brenda Mallouk The income decrease is greater in the All Fixed Company. Decreased Sales

28 Brenda Mallouk Absorption Costing Product Cost Includes Direct Material Direct Labour Manufacturing Overhead Variable Fixed

29 Brenda Mallouk Absorption Costing Direct Material Direct Labour Variable Mfg. O/H Fixed Mfg. O/H Work-in- Process Inventory Finished Goods Inventory Costs are expensed on the income statement as cost of goods sold at the When costs are incurred time of sale of product Asset

30 Brenda Mallouk Variable Costing (Direct) Includes only variable manufacturing costs in work in process and finished goods inventories and in cost of goods sold Expenses all fixed costs in the period in which they are incurred

31 Brenda Mallouk Variable Costing Direct Material Direct Labour Variable Mfg. O/H Work-in Process Inventory Finished Goods Inventory Expense on Income Statement Total Fixed Mfg. O/H When costs are incurred When Sold Asset

32 Brenda Mallouk Net Income Relationships IF # of units produced > # of units sold, then NI under variable costing < NI under absorption costing Why? # of units produced < # units sold, then NI under variable costing > NI under absorption costing Why?

33 Brenda Mallouk Net Income Reconciliation (NI AC - NI VC) = ( I* X FOR) *Inventory

34 Brenda Mallouk Let’s compare absorption and variable costing. The Motive to Overproduce – Absorption Costing

35 Brenda Mallouk The Motive to Overproduce – Absorption Costing Newman Manufacturing Company incurs the following costs to produce 2,000 units of inventory: What happens to costs if Newman increases production.

36 Brenda Mallouk Compute income at the three level of production if Newman sells 2,000 units. The Motive to Overproduce – Absorption Costing 2,000 3,000 4,000

37 Brenda Mallouk The Motive to Overproduce – Absorption Costing

38 Brenda Mallouk Variable Costing Net income is not affected by production increases.

39 Brenda Mallouk Conclusions 1) Under variable costing, income is correlated with sales and not influenced by production 2) Under absorption costing, income is affected by production as well as sales 3) Income is the same when production = sales 4) Production > sales, income is under absorption costing 5) Sales > production, income under variable costing Difference due to inventory levels