CHAPTER E5-8 - COST VOLUME PROFIT Richard E. McDermott...

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COST VOLUME PROFIT Richard E. McDermott Ph.D.
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Costs Volume Profit In this chapter we study what happens to both cost and profit as volume changes. The tools we will use will be helpful in the development of flexible budgets. I am going to begin by giving you some basic definitions. I will then give you what I feel are the best formulas to use in working the problems you will be assigned.
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Definitions Variable Costs : Costs that vary in total, directly and proportionately, with changes in production (also called activity level). If the activity level increases by 50%, variable costs increase by 50%.
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Examples of Variable Costs Direct labor Direct materials Variable overhead
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Definitions Mixed Costs : costs that contain both a fixed and a variable element. Mixed cost change in total, but not proportionately, with changes in the activity level. An example of a mixed cost might be maintenance cost on a taxi. Maintenance costs increase as miles increase. Even if the truck is never driven, however, it is a good idea to change the oil every three months to keep it from degenerating.
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Separating Fixed and Variable Costs If you will look at a general ledger, you will never find accounts labeled “variable labor” or “fixed labor” or “variable overhead” or “fixed overhead.” In order to perform cost volume profit analysis, therefore, it is usually necessary to separate fixed and variable costs. There are three methods to do this: Scatter graph method High-low method Least squares method The bes t method is the leas t s quares method, but s ince the author does not teach it we will not cover it either.
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Definitions Fixed Costs : Costs that do not change with increases or decreases in production volume. It is important to add, there is usually a relevant range. For example, a plant may be built to manufacture 1 to 10,000 shoes per month. Fixed costs would not change within this “relevant range.” If a company wanted to manufacture 12,000 shoes per month, however, there of course would be a new relevant range and the fixed costs might increase.
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Examples of Fixed Costs Rent on a factory Depreciation – straight-line method Heating and air-conditioning expense Housekeeping It is important to emphasize that what might be a fixed cost in one factory, could be a variable cost in another, depending upon the way the firm does business.
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Other Definitions Contribution Margin : Revenue (or unit price) minus total variable costs (or unit variable costs). Example: Contribution Margin Income Statement Sales $100,000 Less variable costs 60,000 Contribution margin $40,000 Less fixed costs 30,000 Income from operations $10,000 Note that contribution margin is what is left after paying variable costs.
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Contribution Margin Income Statement Sales $100,000 Less variable costs 60,000 Contribution margin $40,000 Less fixed costs 30,000
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CHAPTER E5-8 - COST VOLUME PROFIT Richard E. McDermott...

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