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CHAPTER 5 COST – VOLUME - PROFIT

CHAPTER 5 COST – VOLUME - PROFIT. Distinguish between variable and fixed costs. Explain the significance of the relevant range. Explain the concept of mixed costs. List the five components of cost-volume-profit analysis. Indicate what contribution margin is and how it can be expressed.

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CHAPTER 5 COST – VOLUME - PROFIT

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  1. CHAPTER 5 COST – VOLUME - PROFIT • Distinguish between variable and fixed costs. • Explain the significance of the relevant range. • Explain the concept of mixed costs. • List the five components of cost-volume-profit analysis. • Indicate what contribution margin is and how it can be expressed. Study Objectives

  2. Study Objectives: Continued Identify the three ways to determine the break-even point. Give the formulas for determining sales required to earn target net income. Define margin of safety, and give the formulas for computing it.

  3. COST BEHAVIOR ANALYSIS • Definition: The study of how specific costs respond to changes in the level of business activity • Some costs change; others remain the same • Helps management plan operations and make decisions • Applies to all types of businesses and entities

  4. COST BEHAVIOR ANALYSISContinued • Starting point is measuring key business activities • Activity levels may be expressed in terms of • Sales dollars (in a retail company) • Miles driven (in a trucking company) • Room occupancy (in a hotel) • Dance classes taught (by a dance studio)

  5. COST BEHAVIOR ANALYSISContinued • Many companies use more than one measurement base • For an activity level to be useful: Changes in the level or volume of activity should be correlated with changes in cost

  6. COST BEHAVIOR ANALYSISContinued • The activity level selected is called the activity (or volume) index • Identifies the activity that causes changes in the behavior of costs • Allows costs to be classified according to their response to changes in activity as: Variable Costs Fixed Costs Mixed Costs

  7. COST BEHAVIOR ANALYSISVARIABLE COSTSStudy Objective 1 • Costs that varyin totaldirectly and proportionately with changes in the activity level • If the activity level increases 10 percent, total variable costs increase 10 percent • If the activity level decreases by 25 percent, total variable costs will decrease by 25 percent

  8. COST BEHAVIOR ANALYSISVARIABLE COSTS - Continued • Variable costs also remain constant per unit at every level of activity • Examples of variable costs include • Direct material and direct labor for a manufacturer • Sales commissions for a merchandiser • Gasoline in airlines and trucking companies

  9. COST BEHAVIOR ANALYSISVARIABLE COSTS - Continued Example • Damon Company manufactures radios that contain a $10 clock • Activity index is the number of radios produced • For each radio produced, the total cost of the clocks increases by $10 • If 2,000 radios are made, the total cost of the clocks is $20,000 (2,000 X $10) • If 10,000 radios are made, the total cost of the clocks is $100,000 (10,000 X $10)

  10. COST BEHAVIOR ANALYSISVARIABLE COSTS - Continued Example: Continued

  11. COST BEHAVIOR ANALYSISFIXED COSTS • Costs that remain the same intotalregardless of changes in the activity level. • Per unit costvariesinverselywith activity: As volume increases, unit cost decline, and vice versa • Examples include • Property taxes • Insurance • Rent • Depreciation on buildings and equipment

  12. COST BEHAVIOR ANALYSISFIXED COSTS - Continued Example • Damon Company leases its productive facilities for $10,000 per month • Total fixed costs of the facilities remain constant at all levels of activity - $10,000 per month • On a per unit basis, the cost of rent decreases as activity increases and vice versa • At 2,000 radios, the unit cost is $5 ($10,000 ÷ 2,000 units) • At 10,000 radios, the unit cost is $1 ($10,000 ÷ 10,000 units)

  13. COST BEHAVIOR ANALYSISFIXED COSTS - Continued Example:Continued

  14. COST BEHAVIOR ANALYSISRELEVANT RANGEStudy Objective 2 • Throughout the range of possible levels of activity, a straight-line relationship usually does not exist for either variable costs or fixed costs • The relationship between variable costs and changes in activity level is often curvilinear • For fixed costs, the relationship is nonlinear – some fixed costs will not change over the entire range of activities, others may

  15. COST BEHAVIOR ANALYSISRELEVANT RANGE - Continued

  16. COST BEHAVIOR ANALYSISRELEVANT RANGE - Continued • Defined as the range of activity over which a company expects to operate during a year • Within this range, a straight-line relationshipusually exists for both variable and fixed costs

  17. COST BEHAVIOR ANALYSISMIXED COSTS Study Objective 3 • Costs that have both a variable cost element and a fixed cost element • Sometimes called semivariable cost • Change in total but not proportionately with changes in activity level

  18. COST BEHAVIOR ANALYSISMIXED COSTS – High-Low Method • Mixed costs must be classified into their fixed and variable elements • One approach to separate the costs is called the high-low method • Uses the total costs incurred at both the high and the low levels of activity to classify mixed costs • The difference in costs between the high and low levels represents variable costs, since only variable costs change as activity levels change

  19. Change in Total Costs High minus Low Activity Level Variable Cost per Unit ÷ = COST BEHAVIOR ANALYSISMIXED COSTS – High-Low Method - Continued Steps in Method • STEP 1:Determine variable cost per unit using the following formula: • STEP 2:Determine the fixed cost by subtracting the total variable cost at either the high or the low activity level from the total cost at that level

  20. MonthJanuaryFebruary Miles Driven20,00040,000 Total Cost$30,000$48,000 MonthMarchApril Miles Driven35,00050,000 Total Cost$49,000$63,000 COST BEHAVIOR ANALYSISMIXED COSTS – High-Low Method - Continued Example Data for Metro Transit Company for the last 4-month period: High Level of Activity:April $63,000 50,000 miles Low Level of Activity: January 30,000 20,000 miles Difference $33,000 30,000 miles Step 1: Using the formula, variable costs per unit are $33,000  30,000 = $1.10 variable cost per mile

  21. Activity Level High $63,000 55,000$ 8,000 Low $30,000 22,000 $ 8,000 Total CostLess: Variable costs (50,000 x $1.10) (20,000 x $1.10)Total fixed costs COST BEHAVIOR ANALYSISMIXED COSTS – High-Low Method - Continued Example: Continued Step 2: Subtract total variable costs at either the high or low activity level from the total cost at that same level

  22. COST BEHAVIOR ANALYSISMIXED COSTS – High-Low Method - Continued Example: Continued • Maintenance costs: $8,000 per month plus $1.10 per mile • To determine maintenance costs at a particular activity level: • multiply the activity level times the variable cost per unit • then add that total to the fixed cost EXAMPLE: If the activity level is 45,000 miles, the estimated maintenance costs would be $8,000 fixed and $49,500 variable ($1.10 X 45,000 miles) for a total of $57,500.

  23. COST-VOLUME-PROFIT ANALYSISStudy Objective 4 • Study of the effects of changes of costs and volume on a company’s profits • A critical factor in management decisions • Important in profit planning

  24. COST-VOLUME-PROFIT ANALYSIS • Considers the interrelationships among the five components of CVP analysis:

  25. ASSUMPTIONS UNDERLYINGCVP ANALYSIS • Behavior of both costs and revenues is linear throughout the relevant range of the activity index • All costs can be classified as either variable or fixed with reasonable accuracy • Changes in activity are the only factors that affect costs • All units produced are sold • When more than one type of product is sold, the sales mix will remain constant

  26. CVP INCOME STATEMENTStudy Objective 5 • A statement for internal use • Classifies costs and expenses as fixed or variable • Reports contribution margin in the body of the statement. • Contribution margin – amount of revenue remaining after deducting variable costs • Reports the same net income as a traditional income statement

  27. CVP INCOME STATEMENT Example • Vargo Video Company produces DVD players. • Relevant data for June 2005: Unit selling price of DVD player $500 Unit variable costs $300 Total monthly fixed costs $200,000 Units sold 1,600

  28. Contribution Margin per Unit Contribution Margin per Unit $200 Unit Selling Price Unit Selling Price $500 Unit Variable Costs Unit Variable Costs $300 – = – = CVP INCOME STATEMENT Contribution Margin Per Unit • Contribution margin is availableto cover fixed costs and to contribute to income • Formula for contribution margin per unit: • Example: Computation for Vargo Video

  29. Contribution Margin per Unit Contribution Margin per Unit S200 Contribution Margin Ratio Contribution Margin Ratio 40% Unit Selling Price Unit Selling Price $500 ÷ = ÷ = CVP INCOME STATEMENTContribution Margin Ratio • Shows the percentage of each sales dollar available to apply toward fixed costs and profits • Example: Computation for Vargo Video

  30. CVP INCOME STATEMENTContribution Margin Ratio - Example Ratio helps to determine the effect of changes in sales on net income

  31. BREAK-EVEN ANALYSISStudy Objective 6 • Process of finding the break-even point • Break-even point • Level of activity at which total revenues equal total costs (both fixed and variable) • Can be computed or derived • from a mathematical equation • by using contribution margin • from a cost-volume-profit (CVP) graph • Expressed either in sales units or in salesdollars

  32. Variable Costs $300 Q Fixed Costs $200,000 Net Income $0 $200 Q $200,000 Q 1000 units BREAK-EVEN ANALYSISMathematical Equation Example using the Vargo Video data: Where: Q = sales volume; $500 = selling price; $300 = variable cost per unit; $200,000 total fixed costs • To find sales dollars required to break-even: 1000 units X $500 = $500,000 (break-even sales dollars) Sales $500 Q = + + = =

  33. Contribution Margin per Unit Break-even Point in Units Contribution Margin Ratio Break-even Point in Dollars ÷ = ÷ = Fixed Costs Fixed Costs BREAK-EVEN ANALYSISContribution Margin Technique • At the break-even point, contribution margin must equal total fixed costs(CM = total revenues – variable costs) • The break-even point can be computed using either contribution margin per unit or contribution margin ratio • When the break even point in units is desired, contribution margin per unit is used in the following formula • When the break even point in dollars is desired, contribution margin ratio is used in the following formula

  34. Contribution Margin per Unit $200 Contribution Margin per Unit 40% Break-even Point in Units 1,000 units Break-even Point in Dollars $500,000 ÷ = ÷ = Fixed Costs $200,000 Fixed Costs $200,000 BREAK-EVEN ANALYSISContribution Margin Technique Example using Vargo Video data:

  35. BREAK-EVEN ANALYSISGraphic Presentation • A cost-volume-profit (CVP) graph shows costs, volume, and profits • Used to visually find the break-even point • To construct a CVP graph, • Plot the total revenue line starting at the zero activity level • Plot the total fixed cost by a horizontal line • Plot the total cost line. (Starts at the fixed cost line at zero activity) • Determine the break-even point from the intersection of the total cost line and the total revenue line

  36. BREAK-EVEN ANALYSISCVP Graph for Vargo Video

  37. BREAK-EVEN ANALYSIS Target Net IncomeStudy Objective 7 • Level of sales necessary to achieve a specified income • Can be determined from each of the approaches used to determine break-even sales/units • May be expressed either in sales dollars or sales units

  38. Fixed Costs + Target Net Income $200,000 + $120,000 Fixed Costs + Target Net Income $200,000 + $120,000 Contribution Margin Ratio 40% Contribution Margin Per Unit $200 ÷ = ÷ = BREAK-EVEN ANALYSIS Target Net Income - Example Using the Contribution Margin Approach and the Vargo Video Data: • Formula forrequired sales in units: • Formula forrequired sales in dollars Required Sales in Units 1,600 units Required Sales in Dollars $800,000

  39. Actual (Expected) Sales S750,000 Break-even Sales $500,000 Margin of Safety in Dollars $250,000 – = BREAK-EVEN ANALYSIS Margin of Safety • Difference between actual or expected sales and sales at the break-even point • May be expressed in dollars or as a ratio • Example - To determine the margin of safety in dollars for Vargo Video assuming that actual (expected) sales are $750,000:

  40. Margin of Safety in Dollars $250,000 Actual (Expected) Sales $750,000 Margin of Safety Ratio 33% ÷ = BREAK-EVEN ANALYSIS Margin of Safety RatioStudy Objective 8 • Computed by dividing the margin of safety in dollars by the actual or expected sales (using Vargo Video data) • Results indicate that Vargo Video’s sales could fall by 33 percent before it would be operating at a loss. • The higher the dollars or the percentage, the greater the margin of safety.

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