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Financial and Managerial Accounting Wild, Shaw, and Chiappetta Fourth Edition McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 18 Cost Behavior and Cost-Volume-Profit Analysis Conceptual Learning Objectives C1: Describe different types of cost behavior in relation to production and sales volume. C2: Describe several applications of costvolume-profit analysis. 18-3 Analytical Learning Objectives A1: Compute the contribution margin and describe what it reveals about a company’s cost structure. A2: Analyze changes in sales using the degree of operating leverage. 18-4 Procedural Learning Objectives P1: Determine cost estimates using the scatter diagram, high-low, and regression methods of estimating costs. P2: Compute the break-even point for a single product company. P3: Graph costs and sales for a single product company. P4: Compute the break-even point for a multiproduct company. 18-5 C2 Questions Addressed by Cost-Volume-Profit Analysis CVP analysis is used to answer questions such as: What sales volume is needed to earn a target income? What is the change in income if selling prices decline and sales volume increases? How much does income increase if we install a new machine to reduce labor costs? What is the income effect if we change the sales mix of our products or services? 18-6 C1 Total Fixed Cost Monthly Basic Telephone Bill Total fixed costs remain unchanged when activity changes. Number of Local Calls Your monthly basic telephone bill probably does not change when you make more local calls. 18-7 C1 Fixed Cost Per Unit Your average cost per local call decreases as more local calls are made. Monthly Basic Telephone Bill per Local Call Fixed costs per unit decline as activity increases. Number of Local Calls 18-8 C1 Total Variable Cost Total Long Distance Telephone Bill Total variable costs change when activity changes. Minutes Talked Your total long distance telephone bill is based on how many minutes you talk. 18-9 C1 Variable Cost Per Unit The cost per long distance minute talked is constant. For example, 7 cents per minute. Per Minute Telephone Charge Variable costs per unit do not change as activity increases. Minutes Talked 18-10 C1 Cost Behavior Summary Summary of Variable and Fixed Cost Behavior Cost In Total Per Unit Variable Changes as activity level changes. Remains the same over wide ranges of activity. Fixed Remains the same even when activity level changes. Dereases as activity level increases. 18-11 C1 Mixed Costs Mixed costs contain a fixed portion that is incurred even when the facility is unused, and a variable portion that increases with usage. Example: monthly electric utility charge Fixed service fee Variable charge per kilowatt hour used 18-12 C1 Step-Wise Costs Cost Total cost remains constant within a narrow range of activity. Activity 18-13 P1 Identifying and Measuring Cost Behavior The objective is to classify all costs as either fixed or variable. 18-14 P1 Scatter Diagram Total Cost in 1,000’s of Dollars Unit Variable Cost = Slope = 20 10 * * * * Δ Δ in cost in units * ** * ** Vertical distance is the change in cost. Horizontal distance is the change in activity. 0 0 1 2 3 4 Activity, 1,000’s of Units Produced 18-15 P1 The High-Low Method The following relationships between units produced and costs are observed: High activity level Low activity level Change Units 67,500 17,500 50,000 Cost $ 29,000 20,500 $ 8,500 Using these two levels of activity, compute: the variable cost per unit. the total fixed cost. 18-16 P1 The High-Low Method High activity level Low activity level Change Units 67,500 17,500 50,000 Cost $ 29,000 20,500 $ 8,500 Δ Unit variable cost = Δ Fixed cost = Total cost – Total variable cost $8,500 in cost = = $0.17 /unit in units $50,000 Fixed cost = $29,000 – ($0.17 per unit × $67,500) Fixed cost = $29,000 – $11,475 = $17,525 18-17 P1 Least-Squares Regression Least-squares regression is usually covered in advanced cost accounting courses. It is commonly used with spreadsheet programs or calculators. The objective of the cost analysis remains the same: determination of total fixed cost and the variable unit cost. 18-18 P2 Computing The Break-Even Point The break-even point (expressed in units of product or dollars of sales) is the sales level at which a company earns neither a profit nor incurs a loss. 18-19 A1 Computing The Break-Even Point Sales Revenue (2,000 units) Less: Variable costs Contribution margin Less: Fixed costs Net income Total $ 200,000 140,000 $ 60,000 24,000 $ 36,000 Unit $ 100 70 $ 30 Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue. 18-20 A1 Understanding the Contribution Margin Sales Revenue (2,000 units) Less: Variable costs Contribution margin Less: Fixed costs Net income Total $ 200,000 140,000 $ 60,000 24,000 $ 36,000 Unit $ 100 70 $ 30 How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $24,000 18-21 P2 Computing The Break-Even Point Sales Revenue (2,000 units) Less: Variable costs Contribution margin Less: Fixed costs Net income Total $ 200,000 140,000 $ 60,000 24,000 $ 36,000 Unit $ 100 70 $ 30 How many units must this company sell to cover its fixed costs (break even)? Answer: $24,000 ÷ $30 per unit = 800 units 18-22 P2 Computing The Break-Even Point We have just seen one of the basic CVP relationships – the break-even computation. Break-even point in units = Fixed costs Contribution margin per unit Unit sales price less unit variable cost ($30 in previous example) 18-23 P2 Computing The Break-Even Point The break-even formula may also be expressed in sales dollars. Break-even point in dollars = Fixed costs Contribution margin ratio Unit contribution margin Unit sales price 18-24 P3 Preparing a CVP Chart Costs and Revenue in Dollars Plot total fixed costs on the vertical axis. Total fixed costs Total costs Draw the total cost line with a slope equal to the unit variable cost. Volume in Units 18-25 P3 Preparing a CVP Chart Starting at the origin, draw the sales line Sales Costs and Revenue in Dollars with a slope equal to the unit sales price. Total fixed costs Total costs Breakeven Point Volume in Units 18-26 C1 Assumptions of CVP Analysis A limited range of activity called the relevant range, where CVP relationships are linear. Unit selling price remains constant. Unit variable costs remain constant. Total fixed costs remain constant. Production = sales (no inventory changes). 18-27 C2 Computing Income from Expected Sales Income (pretax) = Sales – Variable costs – Fixed costs 18-28 C2 Computing Sales for a Target Income Break-even formulas may be adjusted to show the sales volume needed to earn any amount of income. Unit sales = Fixed costs + Target income Contribution margin per unit Fixed costs + Target income Dollar sales = Contribution margin ratio 18-29 C2 Computing Sales (Dollars) for a Target Net Income Target net income is income after income tax. But we can use target income before tax in our calculations. Dollar sales = Fixed + Target income costs before tax Contribution margin ratio 18-30 C2 Computing Sales (Dollars) for a Target Net Income To convert target net income to before-tax income, use the following formula: Target net income Before-tax income = 1 - tax rate 18-31 C2 Computing the Margin of Safety Margin of safety is the amount by which sales can drop before the company incurs a loss. Margin of safety may be expressed as a percentage of expected sales. Margin of safety percentage = Expected sales - Break-even sales Expected sales 18-32 C2 Sensitivity Analysis The basic CVP relationships may be used to analyze a number of situations such as changing sales price, changing variable cost, or changing fixed cost. Continue 18-33 P4 Computing Multiproduct Break-Even Point The CVP formulas may be modified for use when a company sells more than one product. The unit contribution margin is replaced with the contribution margin for a composite unit. A composite unit is composed of specific numbers of each product in proportion to the product sales mix. Sales mix is the ratio of the volumes of the various products. 18-34 P4 Computing Multiproduct Break-Even Point The resulting break-even formula for composite unit sales is: Break-even point in composite units = Fixed costs Contribution margin per composite unit 18-35 A2 Operating Leverage A measure of the extent to which fixed costs are being used in an organization. A measure of how a percentage change in sales will affect profits. Contribution margin Pretax income = Degree of operating leverage 18-36 End of Chapter 18 18-37