CHAPTER 12 MANAGERIAL ACCOUNTING AND COST-VOLUME- PROFIT RELATIONSHIPS McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 1.What is the managerial planning and control cycle? 2.What are the major differences between financial accounting and managerial accounting? 3.What is the difference between variable and fixed cost behavior patterns, and what simplifying assumptions are made in this classification method? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 4.Why are fixed costs expressed on a per unit of activity basis misleading, and why may this result in faulty decisions? 5.What kinds of costs are likely to have a variable cost behavior pattern, and what kinds of costs are likely to have a fixed costs behavior pattern? 6.How can the high-low method be used to determine the cost formula for a cost that has a mixed behavior pattern? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 7.What is the difference between the traditional income statement format and the contribution statement format? 8.What is the importance of using the contribution margin format to analyze the impact of cost and sales volume changes on operating income? 9.How is the contribution margin ratio calculated, and how can it be used in CVP analysis? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 10.How can changes in sales mix affect the projections using CVP analysis? 11.What are the meaning and significance of the break-even point, and how is the break-even point calculated? 12.What is the concept of operating leverage? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 1 What is the managerial planning and control cycle? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Managerial Accounting Contrasted to Financial Accounting Managerial accounting supports the internal planning decision made by management Financial accounting has more of a score-keeping, historical orientation Planning is a key part of the management process McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Strategic, Operational, and Financial Planning Planning and Control Cycle Performance Analysis: Plans vs. Actual Results (Controlling) Executing Operational Activities (Managing) Revisit Plans Implement Plans Data Collection and Performance Feedback McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Planning and Control The management process consists of planning, organizing, and controlling an entity’s activities Control provides feedback in which actual results are compared to planned results, and if a variance exists, the plan or actions or both are changed McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 2 What are the major differences between financial accounting and managerial accounting? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Managerial Accounting Emphasis is on the future Concerned with units within the organization Reports issued frequently and promptly Relevance more important than reliability No reporting standards Intended to management’s use McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Financial Accounting Intended for external investors and creditors Deals with the past – historical Reports are prepared for the company as a whole Reports are issued monthly – a week or more after the end of the month High accuracy is desired Generally Accepted Accounting Standards are used for reports McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

The Management Accountant Works extensively with people in other functions of the organization Helps develop production standards Helps production people interpret production reports Helps marketing and sales predict future sales Aids in the information system development McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 3 What is the difference between variable and fixed cost behavior patterns, and what simplifying assumptions are made in this classification method? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Cost Classifications Different costs for different purposes: –Relationship between total cost and volume of activity –Relationship to product or activity –For cost accounting purposes –Time frame perspective –Other analytical purposes These classifications are not mutually exclusive McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Relationship of Total Cost to Volume of Activity The relationship of total cost to volume of activity describes the cost behavior pattern A variable cost changes in TOTAL as the volume of activity changes A fixed cost does NOT change in TOTAL as the volume of activity changes Variable cost example is raw materials Fixed cost example is depreciation McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Graphical Representation Variable costsFixed costs Total activity (units) Total costs McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Semivariable Costs Some costs have components of both fixed and variable costs A cost formula for such a cost is: Total cost = Fixed cost + Variable cost or Total cost = Fixed cost + (Variable rate per unit X Activity) McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 4 Why are fixed costs expressed on a per unit of activity basis misleading, and why may this result in faulty decisions? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Fixed Cost Unitization Do NOT unitize fixed expenses because they do not behave on a per unit basis Dividing fixed expenses by activity level will give varying results depending on the activity level McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 5 What kinds of costs are likely to have a variable cost behavior pattern, and what kinds of costs are likely to have a fixed cost behavior pattern? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Cost Behavior Pattern Two assumptions made in determining cost behavior patterns: –The behavior pattern is true only within a relevant range –The behavior pattern is assumed to be linear in the relevant range The relevant range is the level of activity over which a particular pattern exists McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 6 How can the high-low method be used to determine the cost formula for a cost that has a mixed behavior pattern? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

The High-Low Method A cost behavior pattern can be analyzed using a technique that employs a scattergram to identify high and low cost- volume data A scattergram is a graph with total units produced as the horizontal axis and cost as the vertical axis Points are plotted on the graph for various production levels and costs McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

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 McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Steps in Using the High-Low Method 3.Compute the fixed rate by using the following formula and inserting the variable rate computed above and either the high activity level or the low activity level Total cost = Fixed cost + Variable cost Total cost = Fixed cost + (Activity level x Variable rate) McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 7 What is the difference between the traditional income statement format and the contribution statement format? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Modified Income Statement Format Referred to as the contribution margin format Classifies costs according to their behavior Revenues and operating income are the same as under the traditional format of revenues minus cost of goods sold, etc. McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Contribution Margin Format Revenues XX - Variable expenses XX = Contribution margin XX - Fixed expenses XX = Operating income XX McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 8 What is the importance of using the contribution margin format to analyze the impact of cost and sales volume changes on operating income? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Contribution Margin Contribution margin is the amount that is available to cover fixed expenses and operating income The traditional approach does not consider cost behavior patterns The contribution margin approach avoids the errors that may result from viewing fixed costs on a per unit approach McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 9 How is the contribution margin ratio calculated, and how can it be used in CVP analysis? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Contribution Margin Ratio Contribution margin ratio is the ratio of contribution margin to revenues Using either total dollars or dollars per unit, divide the contribution margin by the revenue The result is a percentage McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Contribution Margin Model Per unit X Volume = Total % Revenue$XX Variable expenses XX Contribution margin$XX x XX = $XX X% Fixed expenses XX Operating income $XX McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Using the Contribution Margin Model Steps in using the model are as follows: –Express revenue, variable expense, and contribution on a per unit basis –Multiply the contribution per unit by the volume to get the total contribution margin –Subtract fixed expenses from the total contribution margin to get operating income (Fixed expenses are NOT unitized!) McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Contribution Margin in Action Four relationships to notice as you study: –Revenue - Variable expenses = Contribution margin –Contribution margin / Revenue = Contribution margin ratio –Total contribution margin depends on the volume of activity –Contribution margin must cover fixed expenses before an operating income is earned McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 10 How can changes in sales mix affect the projections using CVP analysis? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Multiple Products and Sales Mix Considerations When using the contribution margin model with more than one product, the sales mix must be considered Sales mix is the relative proportion of total sales accounted for by different products Different products usually have different contribution margins McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 11 What are the meaning and significance of the break-even point, and how is the break- even point calculated? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Break-Even Point Analysis Break-even point is usually expressed as the amount of revenue that must be realized in order to have neither a profit nor a loss Expresses minimum target revenue Use the contribution margin model to determine the break-even point by setting operating income to zero McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Break-Even Point Formulas Total revenues at break-even = Fixed expenses Contribution margin ratio Volume in units at bread-even = Fixed expenses Contribution margin per unit Volume in units at break-even = Total revenues required Revenue per unit McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Target Operating Income The revenues and units necessary may be determined as follows: Total revenues for desired level of operating income = Fixed expenses + Desired operating income Contribution margin ratio Volume in units for desired level of operating income = Fixed expenses + Desired operating income Contribution margin per unit McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Break-Even Graph Loss Profit Break-even point Variable expenses Fixed expense Total expenses Total revenues Sales volume in units $000 McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 12 What is the concept of operating leverage? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Operating Leverage Operating income will change proportionately more than changes in revenues because fixed expenses do not change with changes in volume This magnification effect on operating income due to a change in revenues is called operating leverage McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Operating Leverage Effects The higher a firm’s contribution margin ratio, the greater its operating leverage High operating leverage increases the risk that a small percentage decline in revenues will cause a large percentage decline in operating income McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002