Accounting for Executives Week 8 6/5/2010 (Fri) Lecture 8

Learning Objectives 1. Explain the concept of marginal (variable) costing and absorption (full) costing 2.Use CVP analysis to compute breakeven point 3.Use CVP analysis for profit planning and graph relations 4.Use CVP methods to perform sensitivity analysis

Objective 1 Explain the concept of marginal costing and absorption costing

Marginal Costing (Variable Costing) Marginal cost ( 變動成本 ) is defined as the cost of one unit of product or service which would be avoided if that unit were not produced or provided. The marginal costs consist of the variable costs of production, namely the direct material cost, the direct labor cost, the variable production overhead and the variable costs of selling, distribution and administration. A marginal costing approach attempts to identify the cost of producing one extra unit of output and is defined as the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written off in full against the aggregate contribution.

Absorption Costing (Full Costing) Absorption costing ( 全部成本法 ) is a method of costing that, in addition to direct costs, assigns all, or a proportion of, production overheads costs to cost units by means of one or a number of overhead absorption rates Absorption costing calculates the unit cost of an item taking into account all costs, fixed and variable, direct and indirect. Indirect or fixed costs are allocated to or absorbed by the products made

Marginal costing Example A product manufactured by ABC CO. with a total cost of $20 per unit, which has a selling price in the market $30. Among the total cost 60% is determined to be variable cost. The company has a budgeted production of 20,000 units in the current year and the budgeted overheads for the year are $160,000. Required (a) Calculate the Overhead absorption rate for the product. (b) Calculate the budgeted profit for the company by using absorption costing. (c) Calculate the budgeted profit for the company by using marginal costing.

Marginal Costing Answer (a) OH absorption rate: Budgeted OH  Budgeted Units = $160,000  20,000 = $ 8 per unit Contribution : Selling price - Variable cost =$30 - $20 X 60% =$30 - $12 =$18 per unit

Marginal Costing Answer (continue) (b) Profit under Absorption costing Sales : 20,000 X $30 =$ 600,000 (1) Cost of Sales: 20,000 X $20=$ 400,000 (2) Budgeted Profit (1) - (2) =$ 200,000 (c ) Profit under Marginal costing Sales: 20,000 X $30 =$600,000(4) Cost of Sales: Var. cost $20 X 60% X 20,000=$240,000(5) Fixed cost =$160,000(6) Budgeted Profit (4)- (5)-(6)=$200,000

Marginal vs Absorption Costing Using the above-mentioned example, what will be the profit for ABC Co. under both costing methods if the actual sales turn out to be 16,000 units. Answer (a) Absorption Costing Profit under Absorption costing Sales : 16,000 X $30 =$ 480,000 (1) Cost of Sales: 16,000 X $20=$ 320,000 (2) Adjustment for under absorption=$ 32,000 (3) Budgeted Profit (1) - (2)- (3)=$ 128,000

(b) Profit under Marginal costing Sales: 16,000 X $30 =$480,000(4) Cost of Sales: Var.cost $20X60%X16,000=$192,000(5) Fixed cost =$160,000(6) Budgeted Profit (4)- (5) -(6)=$128,000 Marginal vs Absorption Costing

Comparison between absorption and marginal costing The marginal costing method is based on the assumption that the process of full allocation of costs as exemplified in overhead absorption is a waste of time. It is argued that the only analysis that is required is that for variable and fixed cost. This approach is likely to be easier and less subject to the inaccuracies of the allocation and apportionment process. Proponents of marginal costing argue that full costing is out of date in competitive markets where price is more likely to be determined by consumer demand rather than what the producer believes the product is worth.

Marginal costing presents information in a simple way with analysis mainly restricted to variable costs, with fixed costs dealt with as an additional, unallocated sum. Overhead absorption does involve arbitrary allocation of costs to a product or service but firms need to ensure that in the long term all costs are covered if a firm is to make a profit. Comparison between absorption and marginal costing

Objective 2 Use CVP analysis to compute breakeven point

Assumptions 1.Expenses can be classified as either variable or fixed 2.The only factor that affects costs is change in volume CVP = Cost-Volume-Profit

Breakeven Point Sales level at which operating income is zero Sales above breakeven result in a profit Sales below breakeven result in a loss

Income Statement Approach Contribution Margin Income Statement Sales - Variable Costs Contribution Margin - Fixed Costs Operating Income

Contribution Margin Approach Breakeven units sold = Fixed costs+ target profit Contribution margin per unit

Contribution Margin Ratio Contribution margin ÷ Sales revenue Breakeven sales dollars = Fixed costs + Operating profit = 0 Contribution margin ratio

Example 1 Contribution margin ÷ Sales revenue $187,500 ÷ $312,500 = 60%

Example 2 Aussie Travel Contribution Margin Income Statement Three Months Ended March 31, 2009 Sales revenue $250,000$360,000 Variable Costs (40%)(100,000)(144,000) Contribution Margin (60%)$150,000$216,000 Fixed Costs(170,000)(170,000) Operating Income$(20,000)$46,000

Example 2 Breakeven sales dollars = Fixed costs + Operating income Contribution margin ratio $170,000 + $0.60 $283,333

Example 3 1. Contribution margin = Sales–Variable costs = $ $0.85 = $ Breakeven units sold = Fixed costs + Operating income Contribution margin per unit ($85,000 + $0) / $0.85 = 100,000 units 100,000 units x $1.70 = $170,000

Objective 3 Use CVP analysis for profit planning and graph relations

Plan Profits Example: The following information is available for Conte Company Sale price per unit$30 Variable costs per unit21 Total fixed costs$180,000 Target operating income$90,000 How many units must be sold to meet the targeted operating income?

Plan Profits Sales – variable costs – fixed costs = operating income $30x – $21x - $180,000 = $90,000 $9x = $270,000 x = 30,000 units

Preparing a CVP Chart Step 1:  Choose a sales volume  Plot point for total sales revenue  Draw sales revenue line from origin

Preparing a CVP Chart

Preparing a CVP Chart Step 2: Draw the fixed cost line

Preparing a CVP Chart

Step 3: Draw the total cost line ( fixed plus variable)

Preparing a CVP Chart

Step 4: Identify the breakeven point and the areas of operating income and loss

Preparing a CVP Chart Breakeven point Profit Loss

Profit Breakeven point Revenues Total Costs Fixed Costs

Objective 4 Use CVP methods to perform sensitivity analysis

Sensitivity Analysis “What if” analysis What if the sales price changes? What if costs change?

Example 4 Sale price per student$200 Variable costs per student120 Total fixed costs$50, Contribution margin per unit: $200 – 120 = $80 Breakeven point: $50,000 ÷ $80 = 625 students

Example 4 Sale price per student$180 Variable costs per student120 Total fixed costs$50, Contribution margin per unit: $180 – 120 = $60 Breakeven point: $50,000 ÷ $60 = 833 students

Example 4 Sale price per student$200 Variable costs per student110 Total fixed costs$50, Contribution margin per unit: $200 – 110 = $90 Breakeven point: $50,000 ÷ $90 = 556 students

Example 4 Sale price per student$200 Variable costs per student120 Total fixed costs$40, Contribution margin per unit: $200 – 120 = $80 Breakeven point: $40,000 ÷ $80 = 500 students

Margin of Safety Excess of expected sales over breakeven sales Drop in sales that the company can absorb before incurring a loss

Example 5 Margin of safety = Expected sales – breakeven sales Expected sales: Sales – variable costs – fixed costs = operating income 1x -.70x - $9,000 = $12,000.30x = $21,000 x = $70,000

Example 5 Margin of safety = Expected sales – breakeven sales Breakeven sales: Sales – variable costs – fixed costs = operating income 1x -.70x - $9,000 = $0.30x = $9,000 x = $30,000

Example 5 Margin of safety in dollars = Expected sales – breakeven sales = $70,000 - $30,000 = $40,000 Margin of safety in % = (Expected sales – breakeven sales) ÷ Expected sales × 100%