Cost-Volume-Profit Analysis and Relevant Costing

1. Chapter 6 Cost-Volume-Profit Analysis and Relevant Costing

2. Learning Objectives 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)? C6

3. C6 Continuing . . . Learning Objectives 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?

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

5. 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?

6. C6 Continuing . . . Learning Objectives 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?

7. 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)

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

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

10. 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

11. 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

12. 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

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

14. Cost Behavior Example

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

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%

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

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

19. Continuing . . . Breakeven Point $120,000 In units = ----------- = 7,500 ice buckets $16 $120,000 In sales dollars = ----------- = $300,000 .40

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

21. CVP Analysis: Fixed Amount of Profit Before Taxes (PBT) $120,000 + $64,000In units = ------------------------ = 11,500 buckets $16 $120,000 + $64,000In sales dollars = ------------------------ = $460,000 .40

22. CVP Analysis: Variable Amountof Profit Before Taxes Assume PUBT desired is 25% on sales Therefore, PUBT = .25 ($40) = $10 Total fixed costsSales in units = --------------------------- CM per unit - PUBT $120,000Sales in units = --------------- = 20,000 ice buckets$16 - $6

23. CVP Analysis: Variable Amountof Profit Before Taxes Assume PUBT desired is 25% on sales Therefore, PUBT = .25 ($40) = $10 Total fixed costsSales in $ = --------------------- CM% - PUBT% $120,000Sales in $ = ---------------= $800,000 .40 - .25

24. Income Statement DollarsPercentages Sales $800,000 100% Variable costs 480,00060% Contribution margin $320,000 40% Fixed costs 120,000 15% Income $200,000 25% ======= ==

25. CVP Analysis - Multiple Products

26. Continuing . . .CVP Analysis - Multiple Products

27. Continuing . . . CVP Analysis - Multiple Products Total fixed costs BEP in sales dollars = ----------------------- CM ratio per bag ($120,000 + $30,000*) BEP in sales dollars = ---------------------------- .419 = $357,995 *$30,000 of additional fixed cost is incurred to produce both units

28. Scarce Resource -- Machine Hours

29. Sales Mix Decisions How many of each product?

30. Relevant Costs inProduct Line Decisions • Revenues associated with product • Variable costs associated with product • Avoidable fixed costs • Consider product margin Revenues - Variable costs - Avoidable fixed costs

31. Exhibit 6-12: Partial Product Line Income Statement

32. Exhibit 6-13: Product Margin forthe Electric Skillet Product Line

33. CVP Graph Total Revenues BEP Total Costs Total $ Volume

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

35. 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

36. 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

37. Absorption CostingIncome Statement Sales XXX Cost of Goods Sold: Beginning inventory XXX Cost of goods manufactured XXX Cost of goods available XXX Ending inventory XXX Cost of goods sold XXX Gross Margin XXX Operating Expenses: Selling XXX Administrative XXX XXX Income before Taxes XXX

38. Variable CostingIncome Statement Sales XXX Cost of Goods Sold: Beginning inventory XXX Cost of goods manufactured XXX Cost of goods available XXX Ending inventory XXX Variable cost of goods sold XXX Product Contribution MarginXXX Variable Selling Expense XXX Total Contribution MarginXXX Fixed Expenses: Factory XXX Selling XXX Administrative XXX XXX Income before Taxes XXX

39. Absorption Costing vs. Variable Costing Income Statements

40. 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