Chapter 6 Cost-Volume-Profit Analysis and Relevant Costing

1. How is breakeven point computed and what does it represent? 2. How do costs, revenues, and contribution margin interact with changes in an activity base (volume)? Learning Objectives C6

3. How does cost-volume-profit (CVP) analysis in single-product and multiproduct firms differ? 4. What are the underlying assumptions of CVP analysis and how do these assumptions create a short-run managerial perspective? C6 Continuing... Learning Objectives

5. How do quality decisions affect the components of CVP analysis? 6. What constitutes relevance in a decision-making situation? C6 Continuing... Learning Objectives

7. How can management best utilize a scarce resource? 8. What is the relationship between sales mix and relevant costing problems? Continuing... Learning Objectives C6

9. How can pricing decisions be used to maximize profit? 10. How can product margin be used to determine whether a product line should be retained or eliminated? C6 Continuing... Learning Objectives

11.How are breakeven and profit-volume graphs prepared? (Appendix 1) 12. What are the differences between absorption and variable costing? ( Appendix 2) 13.Why is linear programming a valuable tool for managers? (Appendix 3) C6 Continuing... Learning Objectives

The Breakeven Point (BEP) The level of activity, in units or dollars, at which REVENUES = COSTS

Basic Assumption: Relevant Range Company is operating within the relevant range of activity specified in determining the revenue and cost information used. Total $ Activity Level Relevant Range

Basic Assumption: Revenue Total revenue fluctuates in direct proportion to level of activity or volume. On a per unit basis, the selling price remains constant. Total $ Activity Level

Basic Assumption: Variable Costs Total variable costs fluctuate in direct proportion to level of activity or volume. On a per unit basis, variable costs remain constant. Total $ Activity Level

Basic Assumption: Fixed Costs Total fixed costs remain constant relative to activity level changes. Per-unit fixed costs decrease as volume increases and increase as volume decreases. Total $ Activity Level

Basic Assumption: Mixed Costs Mixed costs must be separated into variable and fixed elements. Total $ Activity Level

Cost Behavior Example

Contribution Margin Per Unit Contribution margin per unit equals selling price per unit less variable cost per unit. sp -vc = cm $40 - $24 = $16

Contribution Margin Ratio Contribution margin ratio is per-unit contribution margin divided by selling price, or total contribution margin divided by total sales dollars. cm/sp=cm% $16 / $40 = 40%

Breakeven Point Breakeven point is the point at which profits are zero because total revenues equal total costs, or Total revenues = Total variable costs + Total fixed costs

Continuing... Breakeven Point Total fixed costs In units= CM per unit Total fixed costs In sales dollars= CM ratio

Continuing... Breakeven Point $120,000 In units= = 7,500 ice buckets $16 $120,000 In sales dollars= = $300,000.40

CVP Analysis: Fixed Amount of Profit Before Taxes (PBT) Total fixed costs + PBT In units= CM per unit Total fixed costs + PBT In sales dollars= CM ratio

CVP Analysis: Fixed Amount of Profit Before Taxes (PBT) $120,000 + $64,000 In units= = 11,500 buckets $16 $120,000 + $64,000 In sales dollars= = $460,000.40

CVP Analysis: Variable Amount of Profit Before Taxes Assume P U BT desired is 25% on sales Therefore, P U BT =.25 ($40) = $10 Total fixed costs Sales in units = CM per unit - P U BT $120,000 Sales in units = = 20,000 ice buckets $16 - $6

CVP Analysis: Variable Amount of Profit Before Taxes Assume P U BT desired is 25% on sales Therefore, P U BT =.25 ($40) = $10 Total fixed costs Sales in $ = CM% - P U BT% $120,000 Sales in $ = = $800,

Income Statement DollarsPercentages Sales$800, % Variable costs 480,000 60% Contribution margin$320,000 40% Fixed costs 120,000 15% Income$200,000 25% ======= ==

CVP Analysis - Multiple Products

Continuing... CVP Analysis - Multiple Products

Total fixed costs BEP in sales dollars= CM ratio per bag ($120,000 + $30,000*) BEP in sales dollars= =$357,995 *$30,000 of additional fixed cost is incurred to produce both units

Scarce Resource -- Machine Hours

Sales Mix Decisions How many of each product?

Relevant Costs in Product Line Decisions Revenues associated with product Variable costs associated with product Avoidable fixed costs Consider product margin Revenues - Variable costs - Avoidable fixed costs

Exhibit 6-12: Partial Product Line Income Statement

Exhibit 6-13: Product Margin for the Electric Skillet Product Line

CVP Graph Total $ Volume Total Costs Total Revenues BE P

Profit-Volume Graph BEP Fixed Costs Volume Profit or Loss Total $

Absorption Costing Also known as full costing Treats costs of all manufacturing components as inventoriable, or product, costs –Direct materials –Direct labor –Variable factory overhead –Fixed factory overhead Presents expenses on income statement according to functional classifications –Cost of goods sold –Selling expenses –Administrative expenses

Variable Costing Also known as direct costing Includes only variable production costs as inventoriable, or product, costs –Direct materials –Direct labor –Variable factory overhead Fixed factory overhead costs treated as period expenses Income statement separates costs by cost behavior –May also present expenses by functional classifications within behavioral categories

Absorption Costing Income Statement SalesXXX Cost of Goods Sold: Beginning inventoryXXX Cost of goods manufacturedXXX Cost of goods availableXXX Ending inventoryXXX Cost of goods soldXXX Gross MarginXXX Operating Expenses: SellingXXX AdministrativeXXXXXX Income before TaxesXXX

Variable Costing Income Statement SalesXXX Cost of Goods Sold: Beginning inventoryXXX Cost of goods manufacturedXXX Cost of goods availableXXX Ending inventoryXXX Variable cost of goods soldXXX Product Contribution MarginXXX Variable Selling ExpenseXXX Total Contribution MarginXXX Fixed Expenses: FactoryXXX SellingXXX AdministrativeXXXXXX Income before TaxesXXX

Absorption Costing vs. Variable Costing Income Statements

Linear Programming Used to solve problems with one objective and multiple limiting factors Objective Constraints –Resource –Demand –Technical product requirements –Non-negativity Optimal solution Simplex