### 1B_ch19_inst

```Chapter 19
1
Analyze Costs and identify how changes in
volume affect costs
Use CVP analysis to compute breakeven
points
Use CVP analysis for profit planning, and
graph the CVP relations
Use CVP methods to perform sensitivity
analyses
2
Calculate the breakeven point for multiple
products or services
Distinguish between variable costing and
absorption costing (see Appendix 19A,
located at myaccountinglab.com)
3
1
Analyze Costs and identify how changes in
volume affect costs
4
Standard entry level budgeting process:
\$12,000 annual expense = \$1,000 each month
The \$1,000 is a lousy benchmark for
measuring our cost control performance.
If this is a VOLUME driven expense, what is
wrong with that \$1,000 target in:
Busy months?
Slow months?
Let’s review this worksheet used to plan that budget.
Month
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Totals
6
Sales
2010
orders
shipped
1,400
2,200
2,900
3,200
4,000
4,900
6,000
2,400
2,000
1,300
1,100
900
32,300
Distribution Center Costs
2010
2011
\$\$ Actual
Simple
2011 Volume
Based Budget
Costs
Budget
527
450
1,000 \$
\$
820
650
1,000 \$
\$
1076
1,000
1,000 \$
\$
1186
1,100
1,000 \$
\$
1479
1,300
1,000 \$
\$
1808
1,500
1,000 \$
\$
2211
2,600
1,000 \$
\$
893
1,000
1,000 \$
\$
747
950
1,000 \$
\$
491
550
1,000 \$
\$
417
450
1,000 \$
\$
344
450
1,000 \$
\$
12,000
\$ 12,000 \$ 12,000 \$
The tools we will learn today will allow us to
plan more realistic cost estimates that follow the
cost behaviors we’ll be studying.
Good for budgeting,
Meaningful performance measures
Good for one time decision making too.
Measure revenue changes against more useful cost
estimates.
Defined by the effect of volume of activity on
cost expenditure
Variable costs
Total expenditure increases or decreases in direct
proportion to changes in the volume of activity
Fixed costs
Total expenditure does not change over wide
ranges of volume
Mixed costs
Have both variable and fixed components so they
share behavior of both variable & fixed costs
8
These costs are defined
by their TOTAL cost
behavior.
The cost per unit are
different, but are derived
based from the total cost
behavior
Total Gasoline
Expense \$\$
Your total gasoline expenses are based on
how many miles you drive.
Miles Driven
Per Mile Gas Expense
The gasoline cost per mile is constant regardless
of the number of miles driven.
Miles Driven
Total Gasoline
Expense \$
Per Mile Gas Expense \$
The definition “Variable” is based on the total,
NOT the individual unit cost.
Miles Driven
Miles Driven
Monthly Car
Insurance Bill \$\$
Your monthly Car Insurance bill probably does
not change when you drive more or less in a
given month.
Number of Miles Driven
Monthly Insurance Cost
Per Mile \$\$
The average insurance cost PER MILE decreases
as more miles are driven.
Number of Miles
Driven
Monthly Car
Insurance Bill \$\$
Monthly Insurance Cost
Per Mile \$\$
The definition “Fixed” is based on the total,
NOT the individual unit cost.
Number of Miles Driven
Number of Miles
Driven
Will you be able
to price
competitively if you
sell one car?
What if you sold
10 cars,
or maybe 100
cars……?
Car Lot Rent Per Car Sold
Relate this curve to business volume
\$4,000
\$2,000
\$400
1 2
10
Number of Cars Sold
What would you do to save costs in a
recession?
Which cost situation would you rather have
in a growth boom?
Have both a fixed and variable component
Example:
What fixed costs are involved?
What variable costs are involved?
18
A mixed cost is made of combined fixed and
variable costs
Total Automobile
operation expenses \$
Mixed costs:
Fixed & Variable
combined
Variable costs:
vary with volume
Fixed costs: no
change with
volume
Miles Driven
Fixed
Variable
Mixed
For
the
rest
of
class,
we
At 10
units,
each
unit
Within
the
relevant
range,
Your
store
rent
isin
Bake
one
cupcake,
spend
Within
the
relevant
range,
The
total
COGS
inper
just
The
total
COGS
just
are
going
tomerchandiser
work
on
cost
isany
\$50.
At
20
units,
this
cost
will
not
increase.
\$2,000/month
this
\$0
on
cost
paper
has
cups.
a constant
Bake
any
manufacturer
splitting
this
onespend
up
into the
each
costs
\$25,
At 100
per
900
unit
cupcakes,
cost.
other
cost
types.
units,two
each
costs
\$5.
\$9.00
20
The total mixed cost line can be expressed
as an equation: TC
Y= a
FC
+ +bX
VC*N
Total Automobile
Operation Expenses
Where:
Y
TC = the total mixed cost
FC = the total fixed cost (the
vertical intercept of the line)
VC = the variable cost per unit of
activity (the slope of the line)
N = the level of activity
Variable
Cost
X
Number of miles driven
Fixed Cost
We break mixed costs down into their variable and fixed
components so we can get an equation to work with:
Total mixed cost = (Variable cost per unit x number of units) + Total fixed cost
TC = VC*N + FC
If we know our Fixed Costs (FC) and Variable Costs per unit (VC),
we can predict our Total Cost (TC) at a given Number of units
output (N)
What good is this?
What can the variable unit cost alone tell us?
Identify the highest and lowest levels of activity
over a period of time
STEP 1: Calculate variable cost per unit
Variable cost per unit = Change in total cost ÷ Change in activity volume
STEP 2: Calculate total fixed cost
Total fixed cost = Total mixed cost – Total variable cost
STEP 3: Create and use equation to show the
behavior of a mixed cost
Total mixed cost = (Variable cost per unit X number of units) + Total fixed costs
TC = VC*N + FC
23
Total Cost in
1,000’s of Dollars
Ignore the mid points, and just use the highest and
lowest activity data points
Y
20
10
0
* *
* *
*
*
* *
**
X
0
1
2
3
4
Activity, 1,000’s of Units Produced
Ooh, this looks easier, and somehow more precise.
Why might we still want to plot all the points?
Total Cost in
1,000’s of Dollars
Y
20
10
0
---------------------------
*
*
High-Low cost separation:
VC/unit = ∆ ÷ Δ
FC = TC – total variable cost
Write up useful equation
X
0
1
2
3
4
Activity, 1,000’s of Units Produced
Data
Step 1
Step 2
Step 3
26
(\$2 x 480 event-playing hours) + \$1,000 = \$1,960
OR
(\$2 x 240 event-playing hours) + \$1,000 = \$1,480
27
Consistent: Get the same answer each time!
Arbitrary: Who says the two furthest outlying
numbers are most predictive of future activities?
Misleading precision: See 1 & 2 above.
What happens when fixed costs do change?
How important or fine is your decision?
Month
OccupancyDays
Actual
Electrical
Costs
Predicted
Electrical
Costs
January
1,736 \$
1,889
February
1,904 \$
2,023
March
2,356 \$
2,385
April
2,250 \$
2,300
May
1,500 \$
2,132 \$
1,700
June
744 \$
1,985 \$
1,095
July
2,108 \$
2,186 \$
2,186
August
2,406 \$
2,425
September
840 \$
1,172
October
124 \$
599
November
720 \$
1,076
December
1,364 \$
1,591
Totals
18,052 \$
21,763 \$
Use the high-low method to
equation.
Use that cost equation to find
at each Occupancy volume.
Evaluate actual costs against
expected costs.
When were they skimming?
4,981
Month
OccupancyDays
Actual
Electrical
Costs
Predicted
Electrical
Costs
Use the high-low method to find your predictive cost
equation. High-Low cost separation:
VC/unit = ∆ ÷ Δ
FC = TC – total variable cost
Write up useful equation
January
1,736 \$
1,889 \$
1,889
February
1,904 \$
2,023 \$
2,023
March
2,356 \$
2,385 \$
2,385
April
2,250 \$
2,300 \$
2,300
May
1,500 \$
2,250 \$
1,700
June
744 \$
1,985 \$
1,095
July
2,108 \$
2,186 \$
2,186
August
2,406 \$
2,425 \$
2,425
Evaluate your actual costs against expected costs.
September
840 \$
1,172 \$
1,172
See which actual results differ the most from
October
124 \$
599 \$
599
November
720 \$
1,076 \$
1,076
December
1,364 \$
1,591 \$
1,591
18,052 \$
21,881 \$
20,442
Totals
Use that cost equation to find your expected electrical costs
at each Occupancy volume.
Do this on the grid to the left
When were they skimming?
Month
OccupancyDays
Actual
Electrical
Costs
Expected
Electrical
Costs
January
1,736 \$
1,889 \$
1,889
February
1,904 \$
2,023 \$
2,023
March
2,356 \$
2,385 \$
2,385
April
2,250 \$
2,300 \$
2,300
May
1,500 \$
2,250 \$
1,700
June
744 \$
1,985 \$
1,095
July
2,108 \$
2,186 \$
2,186
August
2,406 \$
2,425 \$
2,425
September
840 \$
1,172 \$
1,172
October
124 \$
599 \$
599
November
720 \$
1,076 \$
1,076
December
1,364 \$
1,591 \$
1,591
18,052 \$
21,881 \$
20,442
Hi-Low:
(\$2,425-\$599) ÷ (2,406-124) = VC/Unit
VC per unit ≈ \$0.80 per Occupancy day
TC=\$2,425=FC + \$0.80*2406
Totals
FC ≈ \$500
Cost equation:
TC = \$500 + \$0.80 * N
Software can be used to fit a
regression line through the data
points.
The cost analysis objective is
the same: Y = a + bx
Or: TC = FC + VC*N
Least-squares regression also provides a statistic,
called R2, that is a measure of the goodness of fit, or
the predictive value* of your cost driver (volume).
* Assuming
aPearson
causal
relationship
Education,
Inc. Publishing as Prentice Hall.
Least-Squares Regression Method
R2 is the percentage of the variation in total cost
explained by the activity.
Y
Total Cost
20
* ** *
**
* *
* * R2 for this relationship is near
10
100% since the data points are
very close to the regression line.
0
0
1
2
3
Activity
4
X
Least-Squares Regression Method
R2 is the percentage of the variation in total cost
explained by the activity.
Y
Total Cost
20
10
0
0
* * *** *
* * * * *
*
* ** *
* * * **
*
*
*
* *
*
** * 2* * *
*
R
for
this
relationship
is near
*
*
*
*
*
0%. It is useless
*
1
2
3
Activity
4
X
Quarter
1st
2nd
3rd
4th
Playing
Hours
3
6
4
5
Total
Maintenance
Costs
\$1,800
\$2,300
\$1,700
\$2,000
Y intercept, Fixed Costs:
\$1,140.00 =INTERCEPT(C2:C5,B2:B5)
Maintenance costs \$1,140 even
if you don't play at all.
Slope, Variable cost per unit:
\$ 180.00 =SLOPE(C2:C5,B2:B5)
One more playing hour will cost
you \$180.00 in maintenance
R Squared, Error:
0.77 =RSQ(C2:C8,B2:B8)
About 3/4 of the variance in cost is explained
by playing hours. There are other factors.
Month
OccupancyDays
Actual
Electrical
Costs
Expected
Electrical
Costs
January
1,736 \$
1,889 \$
1,984
February
1,904 \$
2,023 \$
2,100
March
2,356 \$
2,385 \$
2,412
Regression analysis and
Scattergraph results
\$3,000
April
2,250 \$
2,300 \$
2,339
May
1,500 \$
2,250 \$
1,821
June
744 \$
1,985 \$
1,298
\$1,500
July
2,108 \$
2,186 \$
2,241
\$1,000
August
2,406 \$
2,425 \$
2,447
\$500
September
840 \$
1,172 \$
1,364
October
124 \$
599 \$
870
November
720 \$
1,076 \$
1,281
December
1,364 \$
1,591 \$
1,727
18,052 \$
21,881 \$
21,882
Totals
y = 0.6911x + 783.87
R2 = 0.7783
\$2,500
\$2,000
\$0
500
1,000
1,500
2,000
2,500
3,000
Range of volume:
Where total fixed costs remain constant and variable
cost per unit remains constant
Outside the relevant range, costs can differ
37
2
CVP analysis
44
Since Revenues = SP*N
- Total Costs = - (VC*N + FC)
=
Profits = =Profits
Income Statement
Approach
Contribution Margin
Approach
Where:
These
Target
SP*N – (VC*N) - FC = Profits
Or
(SP – VC)*N – FC = Profits
N = Number of units sold
equations
workprice
for Break Even,
SP = Unit selling
VC = variable
cost perCVP
unit problems.
Profit,
and many
FC = Total fixed Costs
Financial reporting vs. Managerial CVP friendly reporting
Functional income
statement
BCA Cycle Co.
Income Statement
For the Month of June
Total
Sales (500 bikes)
\$ 250,000
Less:COGS
100,000
Gross Margin
150,000
Less: Operating expenses
130,000
Net operating income
\$ 20,000
Arranged by function
Required for GAAP
Poorly suited to internal
CVP decision making
Contribution Margin
income statement
BCA Cycle Co.
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bikes)
\$ 250,000
\$ 500
Less: variable expenses 150,000
300
Contribution margin
100,000
\$ 200
Less: fixed expenses
80,000
Net operating income
\$ 20,000
Arranged by cost behavior
Not GAAP approved
Ideal for CVP decision
making
Using the Contribution Margin
Income Statement
BCA Cycle Co.
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bikes)
\$ 250,000
\$ 500
Less: variable expenses 150,000
300
Contribution margin
100,000
\$ 200
Less: fixed expenses
80,000
Net operating income
\$ 20,000
Interpreting contribution margin dollars: If we
cover fixed cost, all contribution margin dollars
after that go to profits.
Using the Contribution Margin
Income Statement
For each additional cycle that BCA sells, \$200
more in contribution margin will help to cover
fixed expenses and profit.
Total
Sales (500 bikes)
\$ 250,000
Less: variable expenses 150,000
Contribution margin
\$ 100,000
Less: fixed expenses
80,000
Net operating income
\$ 20,000
Per Unit
\$
500
300
\$
200
Percen
100
60
40
How many units must they sell to break even?
Using the Contribution Margin
Income Statement
If BCA sells 400 units in a month, it will be
operating at the break-even point.
BCA Cycle Co.
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (400 bikes)
\$ 200,000
\$ 500
Less: variable expenses
120,000
300
Contribution margin
80,000
\$ 200
Less: fixed expenses
80,000
Net operating income
\$
0
40% of incremental bike sales goes to fixed costs and
profits
How is that fact useful for BCA?
BCA Cycle Co.
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bikes)
\$ 250,000
\$ 500
Less: variable expenses 150,000
300
Contribution margin
100,000
\$ 200
Less: fixed expenses
80,000
Net operating income
\$ 20,000
50
% Sales
100%
60%
40%
What if our unit What if we
variable costs increase sales
increase?
price?
BCA Cycle Co.
huge marketing
Contribution Income Statement
campaign, raise
For the Month of June
our prices and
Total
Per Unit
increases
the
Sales
(500 bikes)
\$ 250,000
\$ 500
sales
Less: variable expenses 150,000
300
commission?!?!?
Contribution margin
100,000
\$ 200
Less: fixed expenses
Net operating income
a huge
marketing
campaign?
80,000
\$ 20,000
Expresses the relationships among costs, volume, and
profit or loss
How many products or services must the company sell to
break even?
What will profits be if sales double?
How will changes in selling price, variable costs, or fixed
costs affect profits?
Assumptions:
Managers can classify each cost as either variable or fixed
Only factor that affects total costs is change in volume,
which increases variable and mixed costs
Fixed costs do not change
52
Breakeven: Sales level at which
operating income is zero
Total revenues equal total costs (expenses)
Target profits
Instead of zero profits, insert desired profits and
repeat exactly like breakeven analysis
Two methods to compute breakeven point:
Either formula method
Create a Contribution Margin Income Statement
53
(SP – VC)*N – FC = Profits
Our hamburger stand plans to capture \$8.00 on the average
sale. The variable cots per order run about \$3.50. Our
monthly fixed costs are \$3,600.
What is out break even volume in orders and Dollars?
(\$8.00 - \$3.50) * N - \$3,600 = \$0
\$4.50 * N - \$3,600 = \$0
+\$3,600 + \$3,600
\$4.50 * N = \$3,600
÷\$4.50
÷\$4.50
N = 800 customers
N = Number of units sold
SP = Unit selling price
VC = variable cost per unit
FC = Total fixed Costs
\$6,400 in revenue = 800 * \$8.00 per customer
(SP – VC)*N – FC = Profits
What will our break even targets be if we increase our cost per
meal to \$3.75 by adding a dessert and raise our average selling
price to \$9.00 per meal? Assume the same \$3,600 fixed costs
(\$9.00 - \$3.75) * N - \$3,600 = \$0
\$5.25 * N - \$3,600 = \$0
+\$3,600 + \$3,600
\$5.25 * N = \$3,600
÷\$5.25
÷\$5.25
N = 686 customers
N = Number of units sold
\$6,171 in revenue = 686 * \$9.00 per customer
SP = Unit selling price
VC = variable cost per unit
FC = Total fixed Costs
(SP – VC)*N – FC = Profits
Our hamburger stand plans to capture \$8.00 on the average
sale. The variable costs per order run about \$3.50. Our
monthly fixed costs are \$3,600.
How many customers will it take to earn \$4,000 per month?
(\$8.00 - \$3.50) * N - \$3,600 = \$4,000
\$4.50 * N - \$3,600 = \$4,000
+\$3,600 + \$3,600
\$4.50 * N = \$7,600
÷\$4.50
÷\$4.50
N = 1,689 customers
N = Number of units sold
\$16,511 in revenue = 1,689 * \$8.00 per customer
SP = Unit selling price
VC = variable cost per unit
FC = Total fixed Costs
(SP – VC)*N – FC = Profits
What sales numbers will achieve our \$4,000 target profit if we
increase our cost per meal to \$3.75 by adding a dessert and raise
our average selling price to \$9.00 per meal? Assume the same
\$3,600 fixed costs
(\$9.00 - \$3.75) * N - \$3,600 = \$4,000
\$5.25 * N - \$3,600 = \$4,000
+\$3,600 + \$3,600
\$5.25 * N = \$7,600
÷\$5.25
÷\$5.25
N = 1,448 customers
N = Number of units sold
\$13,027 in revenue = 1,448 * \$9.00 per customer
SP = Unit selling price
VC = variable cost per unit
FC = Total fixed Costs
Why bother?
Error prevention
Display for decision makers
Helpful in understanding and deriving shortcut
Shortcut method
Time saving, error prone derivatives of statement
BCA Cycle Co.
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bikes)
\$ 250,000
\$ 500
Less: variable expenses 150,000
300
Contribution margin
100,000
\$ 200
Less: fixed expenses
80,000
Net operating income
\$ 20,000
58
%
100%
60%
40%
BCA Cycle Co.
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bikes)
\$ 250,000
\$ 500
Less: variable expenses
Variable COGS
70,000
140
Variable compensation 50,000
100
Variable other expenses 30,000
60
Contribution margin
100,000
\$ 200
Less: fixed expenses
80,000
Fixed COGS
35,000
Fixed compensation
25,000
Fixed other expenses
20,000
Net operating income
\$ 20,000
59
%
100%
28%
20%
12%
40%
To convert from functional
to CM, we must separate
mixed costs, as we did
earlier in the chapter
Note how the statement is
organized by cost behavior,
function.
enables efficient sensitivity
analysis, including break
even
separated the functional
cost areas into variable
and fixed costs.
Prepare a contribution
margin income
statement from the
results of that work
shown:
60
Benson Music, Inc.
Keyboard Division
Information for the Month Ended March 31, 2011
Sales in units
Selling price per unit
Cost information:
COGS
Selling expenses
250
\$800
Variable
Fixed
cost per Costs per
unit
Month
\$450
\$0
\$80
\$20,000
\$15
\$8,000
Here, individual changes
suggestions or altered
realities.
You can do this by hand to
learn it, but really…..
enables efficient sensitivity
analysis, including break
even
Let’s play with Excel
Show break even
Show target profit
Target costing
61
Benson Music, Inc.
Keyboard Division
Contribtion Margin Income Statement
For the Month Ended March 31, 20xx
Sales
Variable Expenses:
COGS
Selling expenses
Contribution Margin
Fixed Expenses
Selling expenses
Net operating income
\$200,000
\$112,500
20,000
3,750
20,000
8,000
136,250
63,750
28,000
\$35,750
Predict how changes in sale prices, cost, or
volume affect profits
“What-if?” analysis
Allows managers to see how various business
strategies affect profits
Changing selling price
Changing variable Costs
Changing fixed Costs
62
You are in a meeting trying to boost company
profits.
Ralph, You’re an
idiot. We should
People are suggesting approaches
that
they
think
raise
prices
and
Great idea Ralph!
will
company profitability.
Let’s maximize
get started
packaging to offset
making second
I
like
You
test their assumptions
instantly
with
CVP.
rate can
stuff right
any pricing caused
peanut
away!
volume decline.
butter.
You can test their assumptions too, but that’s
another subject.
cheaper
materials and
cut price to
grow sales
volume!
Let me punch
in the #’s:
Lower variable
costs 10%,
Lower sales
price 5%,
Boost volume
25%.
Decrease sales price by
10%
Increase unit sales by
20%
Georgia Peach Pies
Contribtion Margin Income Statement
For the Month Ended March 31, 20xx
Volume
2,500
\$/Unit
10
2,500
8
Sales
Variable Expenses:
Combined variable costs
Contribution Margin
Fixed Expenses
Combined fixed costs
Net operating income
6,000
\$25,000
100%
20,000
5,000
80%
20%
6,000
-\$1,000
24%
-4%
\$27,000
100%
24,000
3,000
89%
11%
6,000
-\$3,000
22%
-11%
What suggestion likely
drove those numbers?
What outcome would
you expect on
profitability?
64
Georgia Peach Pies
Contribtion Margin Income Statement
For the Month Ended March 31, 20xx
Volume
3,000
\$/Unit
9
3,000
8
Sales
Variable Expenses:
Combined variable costs
Contribution Margin
Fixed Expenses
Combined fixed costs
Net operating income
6,000
Increase price by 10%
Increase variable costs
5% per unit
Increase fixed costs by
\$1,000
Georgia Peach Pies
Contribtion Margin Income Statement
For the Month Ended March 31, 20xx
Volume
2,500
\$/Unit
10
2,500
8
What suggestion likely
drove those numbers?
What outcome would
you expect on
profitability?
What should we be wary
of ?
65
Sales
Variable Expenses:
Combined variable costs
Contribution Margin
Fixed Expenses
Combined fixed costs
Net operating income
6,000
\$25,000
100%
20,000
5,000
80%
20%
6,000
-\$1,000
24%
-4%
\$27,500
100%
21,000
6,500
76%
24%
7,000
-\$500
25%
-2%
Georgia Peach Pies
Contribtion Margin Income Statement
For the Month Ended March 31, 20xx
Volume
2,500
\$/Unit
11
2,500
8.4
Sales
Variable Expenses:
Combined variable costs
Contribution Margin
Fixed Expenses
Combined fixed costs
Net operating income
7,000
Variable costs increase
by 25%
Increase selling price by
\$2.00
Decrease volume by
10%
Decrease fixed costs by
\$2,000.
What situation likely
drove those numbers?
What outcome would
you expect on
profitability?
66
Georgia Peach Pies
Contribtion Margin Income Statement
For the Month Ended March 31, 20xx
Volume
2,500
\$/Unit
10
2,500
8
Sales
Variable Expenses:
Combined variable costs
Contribution Margin
Fixed Expenses
Combined fixed costs
Net operating income
6,000
\$25,000
100%
20,000
5,000
80%
20%
6,000
-\$1,000
24%
-4%
\$27,000
100%
22,500
4,500
83%
17%
4,000
\$500
15%
2%
Georgia Peach Pies
Contribtion Margin Income Statement
For the Month Ended March 31, 20xx
Volume
2,250
\$/Unit
12
2,250
10
Sales
Variable Expenses:
Combined variable costs
Contribution Margin
Fixed Expenses
Combined fixed costs
Net operating income
4,000
Relate to the
Contribution
margin format
income statement
CM Ratio
Breakeven sales in dollars
Use to solve for
breakeven
Use to solve for
target profits
67
=
Contribution margin dollars
Sales revenue dollars
=
Fixed costs
Contribution margin ratio
Georgia Peach Pies
Contribtion Margin Income Statement
For the Month Ended March 31, 20xx
Volume
2,500
\$/Unit
10
2,500
8
Sales
Variable Expenses:
Combined variable costs
Contribution Margin
Fixed Expenses
Combined fixed costs
Net operating income
6,000
\$25,000
100%
20,000
5,000
80%
20%
6,000
-\$1,000
24%
-4%
Story Park is an entertainment theme park. Story sells
tickets at \$50 per person as a one-day entrance fee.
Variable costs are \$10 per person, and fixed costs are
\$240,000 per month.
1. Compute Story Park’s contribution margin ratio. Carry
your computation to two decimal places.
\$50 - \$10 = \$40
\$40 ÷ \$50 = 0.80 or 80%
2. Use the contribution margin ratio CVP formula to
determine the sales revenue Story Park needs to break
even.
\$240,000 ÷ 0.80 = \$300,000
68
5
CVP with multiple product lines or services
69
Selling prices and variable costs differ for each
product
Different contribution to profits
Weighted-average contribution margin
computed
Sales mix provides weights to make up total
product sales
Weights equal 100% of total product sales
70
To compute breakeven sales in units for multiple
products, complete the following three steps:
STEP 1: Calculate the weighted-average
contribution margin per unit
STEP 2: Calculate the breakeven point in units for
the “package” of products
STEP 3: Calculate the breakeven point in units for
each product and then multiply the “package”
breakeven point in units by each product’s
proportion of the sales mix
71
Calculate the weighted-average contribution
margin per unit:
72
Calculate the breakeven point in units for the
“package” of products:
73
Calculate the breakeven point in units for each
product. Multiply the “package” breakeven
point in units by each product’s proportion of
the sales mix:
74
Prove this breakeven point by preparing a
contribution margin income statement:
75
Assume that management sets an incentive
based on unit sales.
Customers come in to buy cat beds
If two customers are waiting, how will your
sales people maximize their bonus?
Sale price per unit
\$
Variable cost per unit
Contribution margin per unit \$
Sales mix in units
Contribution margin
\$
Weighted average \$CM
76
Cat Beds
44.00
100%
24.00
55%
20.00
45%
3
60.00
Scratching Posts
\$ 100.00
100%
30.00
30%
\$
70.00
70%
2
\$ 140.00
\$
5
200
40.00
We need to increase profits in our
pet store:
We want to sell more of everything.
If pressed for time, sales people will
make decisions that maximize their
bonuses
Assuming equal spiffs, sales of the
easier to sell product will increase
more.
How does CVP analysis
accommodate these issues?
1. Contribution Margin Income Statement
Sales revenue
Variable costs
Contribution margin
Less fixed costs
\$
\$
\$
Cat Beds
26,400
100%
14,400
55%
12,000
45%
Scratching Posts
\$ 40,000
100%
\$ 12,000
30%
\$ 28,000
70%
\$
\$
\$
\$
Total
66,400
26,400
40,000
40,000
-
100%
40%
60%
Note how average CM ratio is calculated.
How will increased Cat bed sales change average
CM?
How can sales incentives be formulated to avoid
this shift?
79
10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
82
100 200 300 400 500 600 700 800 900 1,000
6
Variable costing (Appendix 19A—online at
myaccountinglab.com
83
Variable Costing introduction
Class attack on in-class problem
“I enjoy Challenges” case
The great debate!
CVP analysis tore mixed costs into two pieces for
more effective analysis:
Fixed costs
Variable costs
Variable costing tracks product costs consistent with
that emphasis on cost behavior
Stresses the fact that fixed production costs are really
incurred in a period no matter the output, so treats them as
period costs
Fits perfectly into contribution margin income statements
It is only a PRODUCT costing technique
The only new thing:
Fixed manufacturing overhead is NOT assigned to
WIP, and is NOT part of the product cost.
Fixed manufacturing overhead is treated as a period
cost.
How are period costs treated?
So what? This one change removes an
uncomfortable incentive inherent in GAAP
approved absorption costing.
Reminiscing: Cost Flow
Costs
Material Purchases
Balance Sheet
Inventories
Raw Materials
Income
Statement
Expenses
Direct Labor
Variable
Manufacturing
Fixed
Manufacturing
Selling and
Work in
Process
Finished
Goods
Variable
Cost of
Goods
Sold
Fixed MOH
Period Costs
Selling and
when production exceeds sales
\$100,000
\$75,000
Variable Costing
\$50,000
Absorption Costing
\$25,000
\$0
Inventoried
Expensed
Raw Materials
400
400 b
0
b
c
e
subtotal
EB
Work In Process
400
300
100
800
800 f
0
f
EB
Finished Goods
800
600 g
200
g
COGS
600
g
COGS
525
Wages Payable
300 c
Manufacturing
100
100 e
0
Raw Materials
400
400 b
0
b
Work In Process
400
300
f
Finished Goods
700
525 g
175
Above is our airplane cost flow work:
c
700 3 sold
700 f
\$100 DM per0 plane
Wages Payable
\$75
DL per plane
300 c
\$100 total fixed MOH
Manufacturing
EB
subtotal
EB
Fixed Manufacturing
Expense
100
Note ending inventory contains fixed MOH
e
Stainless Chef Tools
Selected financial information
For the year ended December 31, 2010
Units sold
Units produced
Sales price
Direct materials per unit
Direct labor per unit
Variable selling costs per unit sold
90
5,000
8,000
100
30
10
5
16
48,000
150,000
Prepare unit product
costs under
Absorption costing
Variable costing
Product costs per unit
Absorption Variable
DM
\$
30 \$
30
DL
10
10
VMOH
5
5
FMOH
6
Total
\$
51 \$
45
Stainless Chef Tools
Income Statement
Absorption Costing
Year ended Dec. 31, 2010
Stainless Chef Tools
Income Statement
Variable Costing
Year ended Dec. 31, 2010
Prepare income
statements using
Absorption\$ costing
Sales
500,000
Less COGS
255,000
Variable costing
Gross margin
Less SG&A
Net Operating Income
\$
245,000
230,000
15,000
Stainless Chef Tools
Selected financial information
For the year ended December 31, 2010
Units sold
Units produced
Sales price
Direct materials per unit
Direct labor per unit
Variable selling costs per unit sold
91
Fixed Selling,
5,000
8,000
100
Sales
Less Variable costs
VCOGS
VSG&A
Contribution Margin
Less Fixed costs
FMOH
FSG&A
Net Operating Income
\$
500,000
225,000
80,000
195,000
\$
48,000
150,000
(3,000)
Product costs per unit
Absorption Variable
DM
\$
30 \$
30
DL
10
10
VMOH
5
5
FMOH
6
Total
\$
51 \$
45
30
10
5
16
48,000
I Enjoy Challenges
Kelly company is unprofitable
Superman(ager) is hired to turn that around
He accomplishes his profitability goal and leaves
with an overflowing briefcase to excitedly pursue
his next challenge
What do we do?
What we do?
Prepare a variable costing contribution margin
income statement.
Reconcile it with the supplied Absorption costing
income statement.
Would you like a quick once-over of the case
financial statement formatting?
Kelly Company
Income Statement
for the Year Ending December 31, 2009
Sales (10,000,000 units @ \$3 ea)
Less Cost of Goods Sold:
Variable (10,000,000 units @ \$1 ea)
Fixed Manufacturing Costs
Gross Margin
costs (all fixed)
Operating Profit (loss)
\$30,000,000
\$10,000,000
24,000,000
\$34,000,000
(\$4,000,000)
5,000,000
(\$9,000,000)
Kelly Company
Income Statement
for the Year Ending December 31, 2010
Sales (10,000,000 units each \$3.00)
Less Cost of Goods Sold:
Beginning inventory
Variable (30,000,000 units @ \$1 ea)
Fixed
Cost of Goods Manufactured
Less Ending Inventory:
Variable (20,000,000 units @ \$1 ea)
Fixed (20m/30m x \$24,000,000)
Total Ending Inventory
Cost of Goods Sold
Gross Margin
costs (all fixed)
Operating Profit Before Bonus
Less Bonus
Operating Profit after Bonus
\$30,000,000
0
\$30,000,000
24,000,000
\$54,000,000
\$20,000,000
16,000,000
\$36,000,000
18,000,000
\$12,000,000
5,000,000
\$7,000,000
700,000
\$6,300,000
Kelly Company
Variable Costing Income Statement
for the Year Ending December 31, 2010
Sales (10,000,000 units each \$3.00)
\$30,000,000
Less cost of goods sold:
Made 30m units @\$1 variable cost ea\$30,000,000
Less ending inventory
20,000,000
Variable COGS
\$10,000,000
Contribution margin
\$20,000,000
Less fixed costs
24,000,000
\$5,000,000
Total fixed costs
29,000,000
Income before bonus
(\$9,000,000)
Bonus
700,000
Net operating income
(9,700,000)
as Prentice Hall.
Kelly Company
Variable Costing to Absorption Reconciliation
for the Year Ending December 31, 2010
Net operating income, absorption
Less fixed costs deferred in inventory
2/3 * 24,000,000
Net operating income, variable
\$6,300,000
(\$16,000,000)
(\$9,700,000)
Unneeded production increases don’t
result in false perceived profits
Increases in sales bring increases in
profits, aligning reporting with performing
Unit cost becomes a truly variable figure
so your CVP analysis works right
Know it, so you don’t fall for illusion
created by the income statement!
All manufacturing
costs must be assigned
to products to properly
match revenues and
costs.
Absorption
Costing
Fixed costs are
not really the costs
of any particular
product.
Variable
Costing
The Real Debate!
Depreciation,
taxes, insurance and
salaries are just as
essential to products
as variable costs.
Absorption
Costing
These are capacity
costs and will be
incurred even if nothing
is produced.
Variable
Costing
They are the
numbers that
appear on our
external reports!
Absorption
costing product costs
decision making.
Censored
Absorption
Costing
Variable
Costing
Both absorption and variable costing are valid
approaches to cost accounting and, believe it
or not, they can coexist peacefully.
Type of Cost
Absorption Costing
Product Costs
(capitalized as Inventory
until expensed as Cost of
goods sold)
Direct materials
Direct labor
Variable manufacturing
Direct materials
Direct labor
Variable manufacturing
Period Costs (expensed
in period incurred)
Variable nonmanufacturing
costs
Fixed nonmanufacturing costs
Fixed manufacturing
Variable nonmanufacturing
costs
Fixed nonmanufacturing
costs
Income Statement
Format
Conventional income
statement
Contribution margin
income statement
103
Variable Costing
Variable costs are those costs that increase or
decrease in total as the volume of activity
increases or decreases. Fixed costs are costs that
do not change over wide ranges of volume. Costs
that have both variable and fixed components are
called mixed costs.
The high-low method is an easy way to separate
mixed costs into variable and fixed components
by requiring you to identify the highest and
lowest levels of activity over a period of time.
The relevant range is the range of activity where
total fixed cost stays the same and variable cost
per unit stays the same.
104
The breakeven point is the sales level at which
operating income is zero—total revenues equal
total costs. The breakeven point can be found by
using the income statement approach, using zero
for operating income. The breakeven point can
also be found by dividing total fixed cost by the
contribution margin per unit (sales price per unit –
variable cost per unit).
Breakeven analysis can be used to calculate the
sales volume needed to earn a certain amount of
profit, called target profit. Target profit is the
operating income that results when sales revenue
minus variable costs and minus fixed costs equals
management’s
profit goal.
105
Graphing various activity levels and costs gives a
visual representation of operating levels that
generate net income and operating levels that
result in net loss.
Sensitivity analysis is a “what if” technique that
asks what results are likely if selling price or
costs change or if an underlying assumption
changes. The income statement approach to
breakeven is just adjusted for the new proposed
values.
The margin of safety is the “cushion” or drop in
sales that the company can absorb before
incurring a loss.
106
Most companies sell more than one product.
Selling price and variable costs differ for each
product, so each product makes a different
contribution to profits. To calculate break even for
each product, we compute the weighted-average
contribution margin of all the company’s products.
The combination of products that make up total
sales, called the sales mix (or product mix),
provides the weights that make up total product
sales.
107
Variable costing assigns only variable
manufacturing costs to products. Fixed
manufacturing costs are considered period costs
and are expensed immediately because the
company incurs these fixed costs whether or not it
produces any products or services.
In variable costing, fixed manufacturing costs are
not treated as product costs. Management
accountants often prefer variable costing because
contribution margin is readily apparent on the
variable costing income statement.
108