2. 4 - 1 © 2005 Accounting 1/e, Terrell/Terrell Planning for and Predicting Performance Chapter 4

3. 4 - 2 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 1 Classify costs by cost objects and cost drivers and describe the characteristics of activity- based cost systems and standard cost systems.

4. 4 - 3 © 2005 Accounting 1/e, Terrell/Terrell Classifying Costs The type of decision management must make determines the type of cost information needed.

5. 4 - 4 © 2005 Accounting 1/e, Terrell/Terrell Cost Objects ActivityProductServiceProject Geographic region Department Cost objects are those entities for which management desires a separate cost measurement.

6. 4 - 5 © 2005 Accounting 1/e, Terrell/Terrell Cost Objects Direct costs Indirect costs (common costs)

7. 4 - 6 © 2005 Accounting 1/e, Terrell/Terrell Activity-Based Costing (ABC) Systems uses that activity as the basis for common cost allocation. A cost driver is the activity that causes the expense to occur. It identifies the specific activity that causes the cost to occur and...

8. 4 - 7 © 2005 Accounting 1/e, Terrell/Terrell Standard Cost Systems Standards are used to evaluate actual performance. A standard is a pre-established benchmark for desirable performance.

9. 4 - 8 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 2 Distinguish between product and period costs.

10. 4 - 9 © 2005 Accounting 1/e, Terrell/Terrell Product Costs Product costs are all costs of acquiring or manufacturing to make them available for sale to customers.

11. 4 - 10 © 2005 Accounting 1/e, Terrell/Terrell Product Costs Manufactured goods: Materials Materials Labor Labor Other plant expenses Other plant expenses Transportation costs Transportation costs Make-ready expense Make-ready expense Purchased goods: Invoice price Invoice price Transportation costs Transportation costs Make-ready expense Make-ready expense Balance sheet Assets: Inventory InventoryWhenpurchasedWhenmanufactured Income statement Cost of goods sold Whensold

12. 4 - 11 © 2005 Accounting 1/e, Terrell/Terrell Period Costs These are the costs of operating a business that are not product costs. Selling costs Administrative costs

13. 4 - 12 © 2005 Accounting 1/e, Terrell/Terrell Income Statement for Family Dollar Stores, Inc. Consolidated Income Statement For the Year Ended August 31, 2002 (in thousands) Net sales$4,162,652 Costs and expenses: Cost of sales 2,766,733 Selling, general, and admin. 1,054,298 Income before income taxes$ 341,621 Income taxes 124,692 Net income$ 216,929 Productcosts Periodcosts

14. 4 - 13 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 3 Differentiate between fixed and variable costs and classify costs by cost behavior.

15. 4 - 14 © 2005 Accounting 1/e, Terrell/Terrell Cost Behavior Variable costs change proportionately with the volume of sales or production. Mixed costs have both a fixed and a variable component. Fixed costs remain the same in total regardless of the volume of sales or production.

16. 4 - 15 © 2005 Accounting 1/e, Terrell/Terrell Graph of Fixed, Variable, and Mixed Costs 0 200 400 600 800 1000 1200 1400 0306090 Production Level $ Costs Fixed costs Variable cost Mixed cost

17. 4 - 16 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 4 Explain the concept of a relevant range and its effect on cost information.

18. 4 - 17 © 2005 Accounting 1/e, Terrell/Terrell Relevant Range It is a range of business activity in which cost behavior patterns remain unchanged.

19. 4 - 18 © 2005 Accounting 1/e, Terrell/Terrell Relevant Ranges of Fixed Costs by Number of Shifts 0 100 200 300 400 500 600 700 Production in Millions of Cases $ Fixed Costs (thousands) Relevantrange 1 shift Relevantrange 2 shifts Relevantrange 3 shifts

20. 4 - 19 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 5 Analyze cost information to construct a total cost formula for a business activity.

21. 4 - 20 © 2005 Accounting 1/e, Terrell/Terrell The Total Cost Formula Variable costs = Unit variable cost × Volume Total cost = Fixed costs + Variable costs

22. 4 - 21 © 2005 Accounting 1/e, Terrell/Terrell The Total Cost Formula Fixedcosts$250,000$350,000$450,000 Unit variable costs per case $12.00$11.75$11.40Number of shifts 123

23. 4 - 22 © 2005 Accounting 1/e, Terrell/Terrell The Total Cost Formula TC = $350,000 + ($11.75 × 6,000,000) TC = $350,000 + $70,500,000 TC = $70,850,000 What is the cost of producing 6 million cases employing 2 shifts of workers?

24. 4 - 23 © 2005 Accounting 1/e, Terrell/Terrell Operating Income Sales revenues$455,000 Cost of goods sold 245,000 Gross profit$210,000 Operating expenses Selling expenses$105,000 Selling expenses$105,000 Administrative expenses 60,000 Administrative expenses 60,000 Total operating expenses 165,000 Total operating expenses 165,000 Operating income$ 45,000 Jason’s Furniture Gallery, Inc. Income Statement For the Year Ended December 31, 2004 Product costs Period costs

25. 4 - 24 © 2005 Accounting 1/e, Terrell/Terrell Contribution Income Statement Sales revenues$455,000 Variable expenses Cost of goods sold$245,000 Cost of goods sold$245,000 Selling expenses 55,000 Selling expenses 55,000 Administrative expenses 9,400 309,400 Administrative expenses 9,400 309,400 Contribution margin$145,600 Fixed expenses Selling expenses$ 50,000 Selling expenses$ 50,000 Administrative expenses 50,600 100,600 Administrative expenses 50,600 100,600 Operating income$ 45,000 Jason’s Furniture Gallery, Inc. Contribution Income Statement For the Year Ended December 31, 2004

26. 4 - 25 © 2005 Accounting 1/e, Terrell/Terrell Contribution Income Statement Example What is the unit selling price? What is the unit variable cost? What is the unit contribution margin? Assume that Jason’s sole product is one style of sofa and that in 2004 he sold 910 sofas.

27. 4 - 26 © 2005 Accounting 1/e, Terrell/Terrell Contribution Income Statement Example SalesS$455,000USP$500 Variable costsVC 309,400UVC 340 Contribution marginCM$145,600UCM$160 Fixed costsFC 100,600 Operating incomeOI$ 45,000 Per unit Total

28. 4 - 27 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 6 Conduct cost-volume-profit analysis to determine breakeven points.

29. 4 - 28 © 2005 Accounting 1/e, Terrell/Terrell Cost-Volume-Profit Analysis Breakeven occurs when a company’s operating income is zero. CVP analysis is the analysis of the relationships between cost and volume, and the effect of those relationships on profit. those relationships on profit.

30. 4 - 29 © 2005 Accounting 1/e, Terrell/Terrell Breakeven Analysis (1) $455,000 – $309,400 – $100,600 = $45,000 (2) Sales – Variable costs = Contribution margin (2) $455,000 – $309,400 = $145,600 (1) Sales – Variable costs – Fixed costs = Operating income

31. 4 - 30 © 2005 Accounting 1/e, Terrell/Terrell Breakeven Analysis (3) $145,600 – $100,600 = $45,000 (4) USP – UVC = UCM $500 – $340 = $160 (5) (USP × V) – (UVC × V) = (UCM × V) (3) Contribution margin – Fixed costs = Operating income

32. 4 - 31 © 2005 Accounting 1/e, Terrell/Terrell Determining Breakeven Units (b) Contribution margin – Fixed costs = 0 (c) Contribution margin = Fixed costs V BE = FC ÷ UCM $100,600 ÷ $160 = 628.75  629 sofas (a) Sales – Variable costs – Fixed costs = 0

33. 4 - 32 © 2005 Accounting 1/e, Terrell/Terrell Determining Breakeven Units V DP = (FC + DP) ÷ UCM ($100,600 + $75,000) ÷ $160 = 1,097.5  1,098 How many units must Jason sell to make a profit of $75,000?

34. 4 - 33 © 2005 Accounting 1/e, Terrell/Terrell Determining Breakeven Sales Dollars SalesS$455,000100.0% Variable costsVC 309,400 68.0% Contribution marginCM$145,600 32.0% Percent of sales Total Contribution margin ratio = Contribution margin ÷ Sales

35. 4 - 34 © 2005 Accounting 1/e, Terrell/Terrell Determining Breakeven Sales Dollars S BE = FC ÷ CMR $100,600 ÷ 0.32 = $314,375 What is the breakeven point in sales dollars?

36. 4 - 35 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 7 Perform sensitivity analysis.

37. 4 - 36 © 2005 Accounting 1/e, Terrell/Terrell Sensitivity Analysis Sensitivity helps us to solve “what if” questions. If Jason raises the selling price of the sofas to $525 and kept the same volume of 910 per year, how much would his profit change? Contribution margin increases by $25 to $185. This is a technique to determine the effect of changes on the CVP relationships.

38. 4 - 37 © 2005 Accounting 1/e, Terrell/Terrell Sensitivity Analysis ($100,600 + $75,000) ÷ $185 = 949.2  950 If Jason decreases the selling price by 10%, what is his new contribution margin? $160 – $50 = $110 How many units must he sell to make a profit of $75,000?

39. 4 - 38 © 2005 Accounting 1/e, Terrell/Terrell Sensitivity Analysis 1.20 × 910 = 1,092 How many units must Jason sell to make a profit of $75,000? ($100,600 + $75,000) ÷ $110 = 1,596.4  1,597 What would sales be with a 20% increase in volume?

40. 4 - 39 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 8 Build initial operating and capital budgets.

41. 4 - 40 © 2005 Accounting 1/e, Terrell/Terrell Building an Initial Budget To launch Elevation Sports, Inc., in a fiscally responsible manner, management needs to spend time and energy preparing budgets to analyze costs, revenues, equipment needs, and financing.

42. 4 - 41 © 2005 Accounting 1/e, Terrell/Terrell Building an Initial Budget Initial budgets focus heavily on cost estimation whereas ongoing budgets begin with revenue estimation.

43. 4 - 42 © 2005 Accounting 1/e, Terrell/Terrell Operating Costs Selling Administrative Manufacturing

44. 4 - 43 © 2005 Accounting 1/e, Terrell/Terrell Operating Costs Example Insurance costs will be $5,000 per year plus $1.00 per snowboard manufactured. Interest expense will be 10% of the long-term debt of the equipment loan, or $6,000 per year. Rent will be $1,500 per month.

45. 4 - 44 © 2005 Accounting 1/e, Terrell/Terrell Operating Costs Example Utilities: Ski shop: $250 per month Plant: $500 per month Administrative space: $75 per month Legal fees: One-time expense: $2,000 Per month: $300 Secure patents, etc.: $12,000

46. 4 - 45 © 2005 Accounting 1/e, Terrell/Terrell Operating Costs Example USSA membership: $600 per year Booth space and travel expenses: $9,000 per year Advertising costs: One-time expense: $3,000 Per month: $1,000

47. 4 - 46 © 2005 Accounting 1/e, Terrell/Terrell Operating Costs Example Variable cost per unit: $46.90 Monthly fixed costs: $14,329 Internet Web site: Initial cost: $500 Monthly cost: $300

48. 4 - 47 © 2005 Accounting 1/e, Terrell/Terrell Summary of Capital Costs and One-Time Expenses Capital items: Factory equipment$75,000 Computers 4,500 Furniture and fixtures down payment 2,000 Patents, trademarks, and copyrights 12,000 Total capital items$93,500 One-time costs: Web site costs$ 500 Legal costs for incorporation 2,000 Initial advertising 3,000 Total one-time costs$ 5,500

49. 4 - 48 © 2005 Accounting 1/e, Terrell/Terrell Breakeven Analysis $135.00 – $46.90 = $88.10 $14,329 ÷ $88.10 = 162.64  163 Assume that the selling price is $135 per snowboard, what is the breakeven point?

50. 4 - 49 © 2005 Accounting 1/e, Terrell/Terrell Initial Monthly Operating Budget for Elevation Sports, Inc. Budgeted sales ($135.00 × 6 × 30)$24,300 Budgeted variable expenses ($46.90 × 6 × 30) 8,442 Budgeted contribution margin (88.10 × 6 × 30)$15,858 Budgeted fixed expenses 14,329 Budgeted operating income$ 1,529 Estimated income taxes (30%) 459 Budgeted net income$ 1,070 Elevation Sports, Inc. Initial Monthly Operating Budget

51. 4 - 50 © 2005 Accounting 1/e, Terrell/Terrell End of Chapter 4