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Management Accounting One

Cost Volume Profit Analysis

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Variable Cost Behaviour

Increases Decreases

Total Variable Cost

Increases Proportionately

Decreases Proportionately

Variable Cost Per Unit

Remains Constant Remains Constant

When activity . . .

$

Units

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Fixed Cost Behaviour

Increases Decreases

Total Fixed Cost Remains constant Remains Constant

Fixed Cost Per Unit Decreases Increases

When activity . . . .

$

Units

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Jabot Cosmetics makes and sells scent holders. The company normally produces and sells between 20,000 and 23,000 holders per year. The following cost data were drawn from the company’s accounting records.

Number of Units 20,000 21,000 22,000 23,000

Total Costs Incurred Fixed $ 45,000 Variable 100,000 Total Costs $145,000 Cost Per Unit Fixed $ 2.25 Variable 5.00 Total Cost Per Unit $ 7.25

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Lumpy Costs

A cost which shifts upwards when an activitychanges by a certain interval or “step”.

$

Activity Measure

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Mixed Costs

A cost that has both a variable and a fixed component

Does not fluctuate in direct proportion to changes in activity

Does not remain constant with changes inactivity

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Mixed Cost

FixedPortion

Mixed(Semi-Variable)Expenses

VariablePortion

$145.00

$217.00

$ 72.00

Rent a truck -- base cost $145 kilometer charge $0.12 600 km driven

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The Pasta Palace is a fast food restaurant that operates a chain of restaurants across the country. Each restaurant employs 8 people. The manager is paid a salary plus a bonus equal to 2 percent of sales. The other employees -- two cooks, one cleaner and four waitstaff are paid salaries. Each manager has a budget of $1,000 per month for advertising cost.

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Classify each of the following total costs incurred by PastaPalace as being fixed, variable or mixed:

a. The cooks’ salary at a particular location, relative tothe number of customers

b. The cooks’ salary relative to the number of restaurantsc. The cost of cups, plates, spoons, etc. relative to the

number of customersd. The cost of cups, plates, spoons, etc. relative to the

number of restaurantse. The manager’s compensation relative to the number of

customersf. Waitstaff salaries relative to the number of restaurantsg. Advertising costs relative to the number of customers

for a particular restaurant.h. Advertising costs relative to the number of

restaurants.

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Analyzing Mixed Costs Using the High Low

Method

Has advantage of objectivity

Solely dependent on two observations

Simple and fast

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Steps in Using the High-Low Method

1. Identify the high and low cost-volume points

2. Compute the variable rate by using the followingformula:

Variable rate = High cost – Low cost High activity – Low activity

3. Compute the fixed rate by using the followingformula and inserting the variable rate computedabove and either the high activity or the low activity level

Total cost = Fixed cost + (Activity level x variable rate)

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TotalSales (500 units) 250,000$ Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Net income 20,000$

Jeff's Computers

Pentium Five Model

Contribution Statement

Contribution margin (CM) is the difference between the sales revenue and the variable costs. It is the amount

available to cover fixed costs and profit.

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Contribution Margin Ratio

ContributionMargin Ratio

= Sales - Variable Costs / Sales

= ($250,000 - $150,000) / $250,000

= 40%

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Determining the Break-Even Point

Break-Even Volumein Units

= Fixed Costs Contribution Margin Per Unit

For Jeff’s Pentium Five model computer the break-even volume in

units is:$80,000 $200

= 400 computers

Contribution Margin Per Unit $ 500 - $300 = $200

The break-even point in units can be determined using the following equation:

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Estimating the Sales Volume Necessary to Attain a Target

Profit

Sales Volumein Units

= Fixed Costs + Desired Profit Contribution Margin Per Unit

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Estimating the Effects of Changes in Sales Price

The new contribution per unit would be $160 ($460 -$300).

Break-Even Volumein Units =

Fixed Costs

Contribution Margin Per Unit

Break-Even Volumein Units =

Break-Even Volumein Units = 500 units

Competition is forcing consideration of a drop in selling price. What is the impact on break-even of a drop in selling price from $500 to $460 per unit?

$80,000

$160

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Dollars

Cost-Volume-Profit Graph

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

- 100 200 300 400 500 600 700 800

Break-even point

Units

Profit Area

Loss Area

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Margin of Safety

The number of units (or sales dollars) by which actual sales can fall below budgeted sales before a loss is incurred.

Margin of safety =Budgeted Sales - Break-even sales

Budgeted Sales

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Operating Leverage

A measure of the extent to which fixed

costs are being used in an organization.

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$100,000 $20,000

= 5

Operating Leverage

CM Net Income =

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Short Cut for ChangesShort Cut for Changes

If sales are increased by 10%, profits If sales are increased by 10%, profits will increase by 50%will increase by 50%

Operating Leverage

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CVP LimitationsSelling price is constant

throughout the entire relevant range.

Costs are linear throughout the entire relevant range.

In multi-product companies, the sales mix is constant.

In manufacturing companies, inventories do not change (units produced = units sold).

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Income Effects of Alternative Inventory Costing Methods

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The Effect of Cost Structureon Profit Stability

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The Effect of Cost Structureon Profit Stability

VariableCosts

FixedCosts

What happenswhen the

number of unitssold increases or increases?

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The income increase is greaterin the All Fixed Company.

Increased Sales

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The income decrease is greaterin the All Fixed Company.

Decreased Sales

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Absorption Costing

Product Cost Includes

• Direct Material• Direct Labour• Manufacturing Overhead

Variable

Fixed

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Absorption Costing

Direct MaterialDirect LabourVariable Mfg. O/HFixed Mfg. O/H

Work-in-ProcessInventory

Finished Goods Inventory

Costs are expensed on the income

statement as cost of goods sold at the

When costs are incurred

time of sale of product

Asset

Asset

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Variable Costing (Direct)

Includes only variable manufacturing costs inwork in process and finished goods inventories and in cost of goods sold

Expenses all fixed costs in the period in which they are incurred

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Variable Costing

Direct MaterialDirect LabourVariable Mfg. O/H

Work-in Process Inventory

Finished Goods Inventory

Expense on Income Statement

Total FixedMfg. O/H

When costs are incurred

When Sold

Asset Asset

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Net Income RelationshipsIF

# of units produced > # of units sold, then NI under variable costing < NI under absorption costing Why?

# of units produced < # units sold, then NIunder variable costing > NI under absorption costing

Why?

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Net Income Reconciliation

(NI AC - NI VC) = ( I* X FOR)

*Inventory

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Let’s compare absorption and

variable costing.

The Motive to Overproduce – Absorption Costing

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The Motive to Overproduce – Absorption Costing

Newman Manufacturing Company incurs the followingcosts to produce 2,000 units of inventory:

Newman Manufacturing Company incurs the followingcosts to produce 2,000 units of inventory:

What happens to costsif Newman increases production.

What happens to costsif Newman increases production.

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Compute income at the three levelof production if Newman sells 2,000 units.

Compute income at the three levelof production if Newman sells 2,000 units.

The Motive to Overproduce – Absorption Costing

2,000 3,000 4,000

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The Motive to Overproduce – Absorption Costing

Level of Production 2000 3000 4000Sales @ $20 per unit × 2,000 units 40,000$ 40,000$ 40,000$ Cost of Goods Sold $15 per unit × 2,000 units 30,000 $13 per unit × 2,000 units 26,000 $12 per unit × 2,000 units 24,000 Gross Margin 10,000$ 14,000$ 16,000$

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Variable Costing

Net income is not affected by production increases.Net income is not affected by production increases.

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Conclusions

1) Under variable costing, income is correlatedwith sales and not influenced by production

2) Under absorption costing, income is affected byproduction as well as sales

3) Income is the same when production = sales4) Production > sales, income is under

absorption costing

5) Sales > production, income under variable costing

Difference due to inventory levels