Unformatted text preview: CHAPTER 5 CHAPTER COST  VOLUME COST PROFIT PROFIT
Managerial Accounting, Fourth Edition
Chapter 5 1 Preview of Chapter
To manage any business, you must understand: How costs respond to changes in sales volume and The effect of costs and revenues on profit To understand costvolumeprofit (CVP), you must know how costs behave Chapter 5 2 Cost Behavior Analysis
Cost Behavior Analysis is the study of how specific costs respond to the changes in the level of business activity. changes Some costs change; others remain the same Chapter 5 3 LO 1: Distinguish between variable and fixed costs. Variable Costs
Variable costs are costs that vary in total directly and proportionately with changes in the activity level Example: If the activity level increases 10 percent, total variable costs will increase 10 percent Example: If the activity level decreases by 25 percent, total variable costs will decrease by 25 percent Variable costs remain the same per unit at every level remain per of activity. of Chapter 5 4 LO 1: Distinguish between variable and fixed costs. Variable Costs – Example
Damon Company manufactures radios that contain a $10 digital clock The 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 produced, the total cost of the clocks is $20,000 (2,000 X $10) If 10,000 radios are produced, the total cost of the clocks is $100,000 (10,000 X $10) Chapter 5 5 LO 1: Distinguish between variable and fixed costs. Variable Costs – Graphs Chapter 5 6 LO 1: Distinguish between variable and fixed costs. Fixed Costs
Fixed costs are costs that remain the same in total regardless of changes in the activity level. Fixed costs per unit cost vary inversely with activity: with activity: As volume increases, unit cost declines, and vice versa Examples include: Depreciation on buildings and equipment Property taxes Insurance Rent Chapter 5 7 LO 1: Distinguish between variable and fixed costs. Fixed Costs  Example
Damon Company leases its productive facilities at a cost of $10,000 per month Total fixed costs of the facilities remain constant at every level of activity $10,000 per month Fixed costs on a per unit basis vary inversely with activity as activity increases, unit cost declines and vice versa.
At 2,000 radios, the unit cost is $5 ($10,000 ÷ 2,000 units) $5 ($10,000 At 10,000 radios, the unit cost is $1 ($10,000 ÷ 10,000 units) Chapter 5 8 LO 1: Distinguish between variable and fixed costs. Fixed Costs  Graphs Chapter 5 9 LO 1: Distinguish between variable and fixed costs. Let’s Review
Variable costs are costs that:
a. Vary in total directly and proportionately with changes in the activity level. b. Remain the same per unit at every activity level. c. Neither of the above. d. Both (a) and (b) above. Chapter 510 LO 1: Distinguish between variable and fixed costs. LO Distinguish Relevant Range
Throughout the range of possible levels of activity, a straightline 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 also nonlinear – some fixed costs will not change over the entire range of activities while other fixed costs may change Chapter 511 LO 2: Explain the significance of the relevant range. Relevant Range  Graphs Chapter 512 LO 2: Explain the significance of the relevant range. Relevant Range Relevant
Defined as the range of activity over which a company expects to Defined as the range of activity over which a company operate during a year Within this range, a straightline relationship usually exists for both variable and fixed costs Chapter 513 LO 2: Explain the significance of the relevant range. Let’s Review
The relevant range is:
a. The range of activity in which variable costs will be curvilinear. b. The range of activity in which fixed costs will be curvilinear. c. The range over which the company expects to operate during a year. d. Usually from zero to 100% of operating capacity. Chapter 514 LO 2: Explain the significance of the relevant range. Mixed Costs
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
Chapter 515 LO 3: Explain the concept of mixed costs. Mixed Costs: High–Low Method
For purposes of CVP analysis, mixed costs must be classified into their fixed and variable elements and One approach to separate the costs is called the highlow method Uses the total costs incurred at the high and low levels of activity to classify mixed costs into fixed and variable components Chapter 516 LO 3: Explain the concept of mixed costs. Mixed Costs: Mixed Steps in High–LowMethod
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
Chapter 517 LO 3: Explain the concept of mixed costs. Mixed Costs: Mixed High–Low Method Example High–Low
Data for Metro Transit Company for 4 month period: High Level of Activity: April $63,000 50,000 miles 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 Chapter 518 $33,000 ÷ 30,000 = $1.10 variable cost per mile
LO 3: Explain the concept of mixed costs. Mixed Costs: Mixed High–LowMethod Example High–LowMethod
Step 2: Determine the fixed costs by subtracting total variable costs at either the high or low activity from the total cost at that same level level Chapter 519 LO 3: Explain the concept of mixed costs. Mixed Costs: High–LowMethod Example
Maintenance costs: $8,000 per month plus $1.10 per mile To determine maintenance costs at a particular activity level: 1. multiply the activity level times the variable cost per unit 2. 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 costs and $49,500 variable ($1.10 X 45,000 miles) for a total of $57,500.
Chapter 520 LO 3: Explain the concept of mixed costs. CostVolumeProfit Analysis
CVP Analysis the study of the effects of changes in costs and volume on a company’s profits Important in profit planning A critical factor in setting selling prices, determining product mix, and maximizing use of production facilities Chapter 521 LO 4: List the five components of costvolumeprofit analysis. CVP Income Statement
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 all variable costs Reports the same net income as a traditional income statement A statement for internal use only Chapter 522 LO 5: Indicate what contribution margin is and how it can be expressed. CVP Income Statement  Example
Vargo Video Company produces a DVD player/recorder. Relevant data for June 2008: Chapter 523 LO 5: Indicate what contribution margin is and how it can be expressed. Contribution Margin Per Unit
Contribution margin is the amount available to cover fixed costs and to contribute to income The formula for contribution margin per unit and the computation of and the computation of the contribution margin per unit for Vargo Video are: Thus, for every DVD player sold, Vargo Company has $200 to cover fixed costs and contribute to net income Chapter 524 LO 5: Indicate what contribution margin is and how it can be expressed. BreakEven Analysis
A key relationship in CVP analysis is the level of activity at which total revenue equals total costs (both fixed and variable) This level of activity is called the breakeven point At this volume of sales, the company will realize no income, but will also suffer no loss Can be computed or derived: from a mathematical equation, by using contribution margin, or from a costvolume profit (CVP) graph The breakeven point can be expressed either in sales units or in sales dollars Chapter 525 LO 6: Identify the three ways to determine the breakeven point. BreakEven Analysis: Mathematical Equation
Breakeven occurs where total sales equal variable costs plus fixed costs; i.e., net income is zero. The formula for the breakeven point in units and the in The formula for the and the computation for Vargo Video are: To find sales dollars required to breakeven:
Chapter 526 1,000 units X $500 = $500,000 (breakeven sales dollars)
LO 6: Identify the three ways to determine the breakeven point. CVP Income Statement – Contribution Margin Effect
Since Vargo Company has fixed costs of $200,000, it must sell 1,000 DVD players ($200,000 ÷ $200) before it can earn any net income Vargo’s CVP income statement, assuming a zero net income is: Chapter 527 LO 5: Indicate what contribution margin is and how it can be expressed. Contribution Margin Ratio
Shows the percentage of each sales dollar available to apply toward fixed costs and profits The contribution margin ratio is the contribution margin per unit divided by the unit selling price. For Vargo Company, the computation is: In this case, the contribution margin ratio of 40% means that $ .40 of each sales dollar is available to apply to fixed costs and contribute to net income Chapter 528 LO 5: Indicate what contribution margin is and how it can be expressed. BreakEven Analysis: Contribution Margin Technique
At the breakeven point, contribution margin must equal total fixed costs (Contribution Margin = total revenues – variable costs) The breakeven point (BEP) can be computed using either contribution margin per unit or contribution margin ratio. Chapter 529 LO 6: Identify the three ways to determine the breakeven point. Contribution Margin Technique
When the contribution margin per unit is used, the formula to compute the BEP in units for Vargo Video is: When the BEP in dollars is desired, contribution margin ratio is used in the following formula for Vargo Video: Chapter 530 LO 6: Identify the three ways to determine the breakeven point. CVP Income Statement – Contribution Margin Effect
For every DVD player that Vargo sells above 1,000 units, net income increases by the amount of the contribution margin, $200 Vargo’s CVP income statement, assuming 1001 units sold is: Chapter 531 LO 5: Indicate what contribution margin is and how it can be expressed. Contribution Margin Ratio
As shown below, the contribution margin ratio helps to determine the effect of changes in sales on net income Chapter 532 LO 5: Indicate what contribution margin is and how it can be expressed. LO Let’s Review
Contribution margin:
a. Is revenue remaining after deducting variable costs. b. May be expressed as contribution margin per unit. c. Is selling price less cost of goods sold. d. Both (a) and (b) above. Chapter 533 LO 5: Indicate what contribution margin is and how it can be expressed. BreakEven Analysis: Graphic Presentation
A costvolume profit (CVP) graph shows the relationships between costs, volume and profits. To construct a CVP graph: Plot the totalsales line starting at the zero activity level Plot the total fixed cost using a line Plot the totalcost line (starts at the line at zero activity) horizontal fixedcost Determine the breakeven point from the intersection of the totalcost line and the totalsales line Chapter 534 LO 6: Identify the three ways to determine the breakeven point. LO BreakEven Analysis: Graphic Presentation Chapter 535 LO 6: Identify the three ways to determine the breakeven point. Let’s Review
Gossen Company is planning to sell 200,000 pliers for $4 per unit. The contribution margin ratio is 25%. If Gossen will break even at this level of sales, what are the fixed costs?
a. $100,000. b. $160,000. c. $200,000. d. $300,000. Chapter 536 LO 6: Identify the three ways to determine the breakeven point. BreakEven Analysis: Target Net Income
Rather than just breaking even, management usually sets an income objective called “target net income” Indicates sales or units necessary to achieve this specified level of income Can be determined from each of the approaches used to determine break even sales/units: from a mathematical equation, by using contribution margin, or from a costvolume profit (CVP) graph Expressed either in sales units or in sales dollars
Chapter 537 LO 7: Give the formulas for determining sales required to LO earn target net income. earn BreakEven Analysis: Target Net Income
Mathematical Equation Using the basic formula for the breakeven point, simply include the desired net income as a factor. The computation for The computation for Vargo Video is as follows: Chapter 538 LO 7: Give the formulas for determining sales required to LO earn target net income. earn BreakEven Analysis: Target Net Income
Contribution Margin Technique To determine the required sales in units for Vargo Video: To determine the required sales in dollars for Vargo Video: Chapter 539 LO 7: Give the formulas for determining sales required to LO earn target net income. earn Let’s Review
The mathematical equation for computing required sales to obtain target net income is: Required sales = ?
a. Variable costs + Target net income. b. Variable costs + Fixed costs + Target net income. c. Fixed costs + Target net income. d. No correct answer is given. Chapter 540 LO 7: Give the formulas for determining sales required to earn LO target net income. target BreakEven Analysis: Margin of Safety
Difference between actual or expected sales and sales at the breakeven point Measures the “cushion” that management has, allowing it to break even even if expected sales fail to materialize May be expressed in dollars or as a ratio To determine the margin of safety in dollars for Vargo Video assuming that actual/expected sales are $750,000: Chapter 541 LO 8: Define margin of safety, and give the formulas for computing it. BreakEven Analysis: Margin of Safety
Margin of Safety Ratio Computed by dividing the margin of safety in dollars by the actual or expected sales To determine the margin of safety ratio for Vargo Video assuming that actual/expected sales are $750,000: The higher the dollars or the percentage, the greater the margin of safety Chapter 542 LO 8: Define margin of safety, and give the formulas for computing it. Let’s Review
Marshall Company had actual sales of $600,000 when breakeven sales were $420,000. What is the margin of safety ratio?
a. 25%. b. 30%. c. 33 1/3%. d. 45%. Chapter 543 LO 8: Define margin of safety, and give the formulas for LO computing it. computing All About You About
A Hybrid Dilemma
Hybrid vehicles typically cost $3,000 to $5,000 more than conventional vehicles The most fuel efficient hybrids can save about $660 per year in fuel costs Each gallon of gas not burned reduces carbon dioxide emissions by 19 pounds Chapter 544 Chapter Review  Brief Exercise 54 Chapter
Deines Company accumulates the following data concerning a mixed cost, using miles Deines Company accumulates the following data concerning a mixed cost, using miles as the activity level. January February Miles Total Driven Cost 8,000 7,500 $14,150 March $13,600 April 8,500 8,200 Miles Driven $15,000 $14,490 Total Cost Compute the variable and fixed cost elements using the highlow method. Chapter 545 Chapter Review  Brief Exercise 54 Chapter
High Level of Activity: March $15,000 8,500 miles High Level of Activity: March $15,000 8,500 miles Low Level of Activity: February 13,600 7,500 miles Difference $ 1,400 1,000 miles Step 1: Variable Cost per Unit = $1,400 ÷ 1,000 miles = $1.40 variable cost per mile Step 2: Total Cost: Variable Cost: 8,500 X $1.40 7,500 X $1.40 Total Fixed Costs
Chapter 546 High Low $15,000 $13,600 $15,000 $13,600 11,900 10,500 $ 3,100 $ 3,100 ...
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 Contribution Margin

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