1. Cost Accounting Traditions and Innovations Barfield, Raiborn, Kinney Chapter 11 Absorption/Variable Costing and Cost-Volume-Profit Analysis

2. Learning Objectives (1 of 2) Explain the different approaches to cost accumulation and cost presentation Contrast absorption and variable costing Describe how changes in sales and/or production levels affect net income under absorption and variable costing Explain how companies use cost-volume- profit analysis

3. Learning Objectives (2 of 2) Explain cost-volume-profit analysis for single-product and multiproduct firms Describe how businesses use margin of safety and operating leverage concepts List the underlying assumptions of cost- volume-profit analysis (Appendix) Construct break-even charts and profit-volume graphs

4. Absorption Vs. Variable Costing Absorption or Full GAAP Classify by Function –Cost of goods sold –Selling expense –Administrative expense Variable or Direct Not GAAP Classify by Behavior –Variable –Fixed

5. Absorption Vs. Variable Costing Absorption or Full Product costs –Direct material –Direct labor –Variable mfg. overhead –Fixed mfg. overhead Period costs –Selling –General –Administrative Variable or Direct Product costs –Direct material –Direct labor –Variable mfg. overhead Period Costs –Fixed mfg. overhead –Selling –General –Administrative

6. Income Statement Absorption Costing Sales Less: Cost of Goods Sold Gross Profit Less: Operating Expenses Net Income Product Costs Direct Material Direct Labor Fixed and Variable Mfg. Overhead Period Costs Selling, General, Administrative

7. Income Statement Variable Costing Sales Less:Variable Cost of Goods Sold Product Contribution Margin Less: Variable Operating Expenses Contribution Margin Less:Fixed Mfg. Overhead Less:Fixed Operating Expenses Net Income Direct Material Direct Labor Variable Mfg. Overhead Selling, General, Administration Selling General Administrative

8. Difference in Income Absorption Vs. Variable No change in inventory level –Absorption Income = Variable Income Increase in inventory level –Absorption Income > Variable Income –Phantom Profits Decrease in inventory level –Absorption Income < Variable Income

9. Cost-Volume-Profit Analysis Relationship of –Revenue –Costs –Volume changes –Taxes –Profits Applies to –Manufacturers –Wholesalers –Retailers –Service Industries

10. Cost-Volume-Profit Analysis Compute the break-even point Calculate the level of sales necessary to achieve a target profit Set sales price Answer “what-if” questions

11. Cost-Volume-Profit Assumptions Company is operating within the relevant range Revenue per unit remains constant Variable costs per unit remain constant Total fixed costs remain constant Mixed costs are separated into variable and fixed elements

12. Equations Break-even point Total Revenues = Total Costs Total Revenues - Total Costs = Zero Profit Contribution Margin (CM) Sales Price - Variable Cost = CM per unit Revenue - Total Variable Costs = CM in total

13. Break-Even Formula - Units Total Fixed Costs Sales Price (per unit) - Variable Cost (per unit) $100,000 12 - 4 = 12,500 units If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is 12,500 units Contribution Margin

14. Break-Even Formula - Dollars Total Fixed Costs Sales Price (per unit) - Variable Cost (per unit) Sales Price (per unit) If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is $150,000 $100,000 12 - 4 = $150,000 12 Contribution Margin Ratio

15. Income Statement Proof Sales LessTotal variable costs Contribution Margin LessTotal fixed costs Profit before taxes $ 150,000 (12,500 * 12) (50,000) (12,500 * 4) $ 100,000 (100,000) -0- If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is 12,500 units

16. Using Cost-Volume-Profit Analysis Setting a target profit –Enter before-tax profit in numerator $100,000 + $30,000 12 - 4 = $195,000 12 If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired before-tax profit is $30,000, the required sales are $195,000

17. Using Cost-Volume-Profit Analysis Setting a target profit –Convert after-tax profit to before-tax profit Before-tax profit = After-tax profit 1 - tax rate $36,000 = 1 - 40% $60,000 At a 40% tax rate, an after-tax profit of $36,000 equals a before-tax profit of $60,000

18. Setting a target profit –Convert after-tax profit to before-tax profit –Enter before-tax profit in numerator If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $36,000, the required sales are $240,000 $100,000 + $60,000 12 - 4 = $240,000 12 Using Cost-Volume-Profit Analysis

19. Income Statement Proof Sales LessTotal variable costs Contribution Margin LessTotal fixed costs Profit before taxes Income taxes Profit after taxes $ 240,000 (20,000 * 12) (80,000) (20,000 * 4) $ 160,000 (100,000) $ 60,000 (24,000) (60,000 * 40%) $ 36,000 If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $36,000, the required sales are $240,000

20. Using Cost-Volume-Profit Analysis Variable profit related to number of units sold X = FC / (CM u - P u BT) Sales Volume Total Fixed Cost Contribution Margin Ratio Variable Amount of Profit Before Tax per Unit

21. Incremental Analysis Changes in revenues, costs, and/or volume Break-even point increases when –fixed costs increase –sales price decreases –variable costs increases

22. Multiproduct Cost-Volume-Profit Analysis Assumes a constant product sales mix Contribution margin is weighted on the quantities of each product included in the “bag” of products Contribution margin of the product making up the largest proportion of the bag has the greatest impact on the average contribution margin of the product mix

23. Multiproduct Cost-Volume-Profit Analysis 3 2 Sales mix Contribution margin per unit $2 $1 FC = $8,000 “The Bag” Three units of spray for every two units of liquid

24. Multiproduct Cost-Volume-Profit Analysis 3 2 Sales mix Contribution margin per unit $2 $1 $8000 3($2) + 2($1) = 1,000 “bags” Breakeven

25. Multiproduct Cost-Volume-Profit Analysis 3 2 Sales mix x 1,000 3,000 x 1,000 2,000 Breakeven “bag” Breakeven units To break even sell 3,000 sprays and 2,000 liquids

26. Margin of Safety Budgeted (or actual) sales after the break-even point Indication of risk

27. Margin of Safety Units Actual units - break-even units Dollars Actual sales dollars - break-even sales dollars Percentage Margin of Safety in units or dollars Break-even units or sales in dollars

28. Operating Leverage Relationship of variable and fixed costs Effect on profits when volume changes Cost structure strongly influences the impact changes in volume have on profits

29. Operating Leverage High Operating Leverage Low variable costs High fixed costs High contribution margin High break-even point Sales after break-even have greater impact on profits Low Operating Leverage High variable costs Low fixed costs Low contribution margin Low break-even point Sales after break-even have lesser impact on profits

30. Degree of Operating Leverage Measures how a percentage change in sales will affect profits Degree of Operating Leverage Contribution Margin Profit Before Taxes When margin of safety is small, the degree of operating leverage is large

31. Cost-Volume-Profit Assumptions Company is operating within the relevant range Revenue and variable cost per unit are constant Total contribution margin increases proportionally with increases in unit sales Total fixed costs remain constant Mixed costs are separated into variable and fixed elements

32. Cost-Volume-Profit Assumptions No change in inventory (production equals sales) No change in capacity Sales mix remains constant Anticipated price level changes included in formulas Labor productivity, production technology, and market conditions remain constant

33. Additional Considerations Are they fixed costs or long-term variable costs? Quality improvements may violate assumptions –increase costs during implementation –increase productivity –decrease costs –adjust sales price

34. Traditional CVP Graph Total $ Activity Level Fixed Costs

35. Traditional CVP Graph Total $ Activity Level Fixed Costs Total Costs

36. Traditional CVP Graph Total $ Activity Level Total Costs Variable Costs

37. Traditional CVP Graph Total $ Activity Level Total Costs Total Revenues

38. Traditional CVP Graph Total $ Activity Level Total Costs Total Revenues BEP Loss Profit

39. Contemporary CVP Graph Total $ Activity Level Variable Costs

40. Contemporary CVP Graph Total $ Activity Level Total Revenues Variable Costs Contribution Margin

41. Contemporary CVP Graph Total $ Activity Level Total Revenues Total Costs Total Variable Costs

42. Contemporary CVP Graph Total $ Activity Level Total Revenues Total Costs Total Variable Costs BEP

43. Profit-Volume Graph $ Activity Level

44. Profit-Volume Graph $ Activity Level Fixed Costs

45. Profit-Volume Graph $ Activity Level Fixed Costs BEP

46. Profit-Volume Graph $ Activity Level Fixed Costs BEP

47. Questions What is the difference between absorption and variable costing? How do companies use cost-volume-profit analysis? What are the underlying assumptions of cost-volume-profit analysis?