Cost Accounting Traditions and Innovations Barfield, Raiborn, Kinney Chapter 11 Absorption/Variable...

Cost AccountingTraditions and Innovations

Barfield, Raiborn, Kinney

Chapter 11

Absorption/Variable Costing and

Cost-Volume-Profit Analysis

Learning Objectives (1 of 2)

• Explain the different approaches to cost accumulation and cost presentation

• Contrast absorption and variable costing

• Describe how changes in sales and/or production levels affect net income under absorption and variable costing

• Explain how companies use cost-volume-profit analysis

Learning Objectives (2 of 2)

• Explain cost-volume-profit analysis for single-product and multiproduct firms

• Describe how businesses use margin of safety and operating leverage concepts

• List the underlying assumptions of cost-volume-profit analysis

• (Appendix) Construct break-even charts and profit-volume graphs

Absorption Vs. Variable CostingAbsorption or Full• GAAP• Classify by Function

– Cost of goods sold– Selling expense– Administrative

expense

Variable or Direct• Not GAAP• Classify by Behavior

– Variable– Fixed

Absorption Vs. Variable CostingAbsorption or Full• Product costs

– Direct material– Direct labor– Variable mfg. overhead– Fixed mfg. overhead

• Period costs – Selling– General– Administrative

Variable or Direct• Product costs

– Direct material– Direct labor– Variable mfg. overhead

• Period Costs– Fixed mfg. overhead– Selling– General– Administrative

Income Statement Absorption Costing

Sales

Less: Cost of Goods Sold

Gross Profit

Less: Operating Expenses

Net Income

Product CostsDirect MaterialDirect Labor

Fixed and Variable Mfg. Overhead

Period CostsSelling, General,

Administrative

Income StatementVariable Costing

Sales

Less: Variable Cost of Goods Sold

Product Contribution Margin

Less: Variable Operating Expenses

Contribution Margin

Less: Fixed Mfg. Overhead

Less: Fixed Operating Expenses

Net Income

Direct MaterialDirect Labor

Variable Mfg. Overhead

Selling, General,

Administration

Selling General

Administrative

Difference in Income Absorption Vs. Variable

• No change in inventory level– Absorption Income = Variable Income

• Increase in inventory level– Absorption Income > Variable Income– Phantom Profits

• Decrease in inventory level– Absorption Income < Variable Income


• Relationship of– Revenue– Costs– Volume changes– Taxes– Profits

• Applies to– Manufacturers– Wholesalers– Retailers– Service Industries


• Compute the break-even point

• Calculate the level of sales necessary to achieve a target profit

• Set sales price

• Answer “what-if” questions

Cost-Volume-Profit Assumptions

• Company is operating within the relevant range

• Revenue per unit remains constant

• Variable costs per unit remain constant

• Total fixed costs remain constant

• Mixed costs are separated into variable and fixed elements

Equations

• Break-even point

Total Revenues = Total CostsTotal Revenues - Total Costs = Zero Profit

• Contribution Margin (CM)Sales Price - Variable Cost = CM per unit

Revenue - Total Variable Costs = CM in total

Break-Even Formula - Units

Total Fixed Costs

Sales Price (per unit) - Variable Cost (per unit)

$100,000 12 - 4 = 12,500 units

If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is 12,500 units

ContributionMargin

Break-Even Formula - DollarsTotal Fixed Costs

Sales Price (per unit) - Variable Cost (per unit)

Sales Price (per unit)

If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is $150,000

$100,000 12 - 4 = $150,000 12

ContributionMargin Ratio

Income Statement Proof

Sales

Less Total variable costs

Contribution Margin

Less Total fixed costs

Profit before taxes

$ 150,000 (12,500 * 12)

(50,000) (12,500 * 4)

$ 100,000

(100,000)

-0-

If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is 12,500 units

Using Cost-Volume-Profit Analysis

• Setting a target profit– Enter before-tax profit in numerator

$100,000 + $30,000 12 - 4 = $195,000 12

If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired before-tax profit is $30,000, the required sales are $195,000

Using Cost-Volume-Profit Analysis• Setting a target profit

– Convert after-tax profit to before-tax profit

Before-tax profit = After-tax profit

1 - tax rate

$36,000 = 1 - 40%$60,000

At a 40% tax rate, an after-tax profit of $36,000 equals a before-tax profit of $60,000

• Setting a target profit– Convert after-tax profit to before-tax profit – Enter before-tax profit in numerator

If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $36,000, the required sales are $240,000

$100,000 + $60,000 12 - 4 = $240,000 12

Using Cost-Volume-Profit Analysis

Income Statement ProofSales

Less Total variable costs

Contribution Margin

Less Total fixed costs

Profit before taxes

Income taxes

Profit after taxes

$ 240,000 (20,000 * 12)

(80,000) (20,000 * 4)

$ 160,000

(100,000)

$ 60,000

(24,000) (60,000 * 40%)

$ 36,000

If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $36,000, the required sales are $240,000

Using Cost-Volume-Profit Analysis• Variable profit related to number of units sold

• X = FC / (CMu - PuBT)

Sales Volume

TotalFixedCost

ContributionMarginRatio

Variable Amountof Profit Before

Tax per Unit

Incremental Analysis

• Changes in revenues, costs, and/or volume

• Break-even point increases when– fixed costs increase– sales price decreases– variable costs increases

Multiproduct Cost-Volume-Profit Analysis

• Assumes a constant product sales mix

• Contribution margin is weighted on the quantities of each product included in the “bag” of products

• Contribution margin of the product making up the largest proportion of the bag has the greatest impact on the average contribution margin of the product mix



3 2Sales mix

Contribution

margin per unit$2 $1

FC = $8,000

“The Bag”Three units of spray for every two units of liquid



3 2Sales mix

Contribution

margin per unit$2 $1

$80003($2) + 2($1) = 1,000 “bags”

Breakeven



3 2Sales mix

x 1,000 3,000

x 1,000 2,000

Breakeven “bag”Breakeven units

To break evensell 3,000 sprays and 2,000 liquids

Margin of Safety

• Budgeted (or actual) sales after the break-even point

• Indication of risk

Margin of Safety

• Units

Actual units - break-even units• Dollars

Actual sales dollars - break-even sales dollars• Percentage

Margin of Safety in units or dollarsBreak-even units or sales in dollars

Operating Leverage

• Relationship of variable and fixed costs

• Effect on profits when volume changes

• Cost structure strongly influences the impact changes in volume have on profits

Operating Leverage

High Operating Leverage• Low variable costs• High fixed costs• High contribution margin • High break-even point• Sales after break-even

have greater impact on profits

Low Operating Leverage• High variable costs• Low fixed costs• Low contribution margin• Low break-even point• Sales after break-even

have lesser impact on profits

Degree of Operating Leverage

• Measures how a percentage change in sales will affect profits

• Degree of Operating Leverage

Contribution Margin

Profit Before Taxes

• When margin of safety is small, the degree of operating leverage is large

Cost-Volume-Profit Assumptions• Company is operating within the relevant range

• Revenue and variable cost per unit are constant

• Total contribution margin increases proportionally with increases in unit sales

• Total fixed costs remain constant

• Mixed costs are separated into variable and fixed elements

Cost-Volume-Profit Assumptions

• No change in inventory (production equals sales)

• No change in capacity

• Sales mix remains constant

• Anticipated price level changes included in formulas

• Labor productivity, production technology, and market conditions remain constant

Additional Considerations

• Are they fixed costs or long-term variable costs?

• Quality improvements may violate assumptions– increase costs during implementation– increase productivity– decrease costs– adjust sales price

Traditional CVP Graph

Total$

Activity Level

Fixed Costs


Total$

Activity Level

Fixed Costs

Total Costs


Total$

Activity Level

Total Costs

Variable Costs


Total$

Activity Level

Total Costs

Total Revenues


Total$

Activity Level

Total Costs

Total Revenues

BEP

Loss

Profit

Contemporary CVP Graph

Total$

Activity Level

Variable Costs


Total

$

Activity Level

Total Revenues

Variable Costs

Contribution Margin


Total$

Activity Level

Total Revenues

Total Costs

Total Variable Costs


Total$

Activity Level

Total Revenues

Total Costs

Total Variable CostsBEP

Profit-Volume Graph

$

Activity Level

Profit-Volume Graph

$

Activity Level

Fixed Costs

Profit-Volume Graph

$

Activity Level

Fixed Costs

BEP

Questions

• What is the difference between absorption and variable costing?

• How do companies use cost-volume-profit analysis?

• What are the underlying assumptions of cost-volume-profit analysis?

Cost Accounting Traditions and Innovations Barfield, Raiborn, Kinney Chapter 11 Absorption/Variable...

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