23-1 Copyright Houghton Mifflin Company. All rights reserved. Chapter 23 Cost-Volume-Profit Analysis and Variable Costing Belverd E. Needles, Jr. Marian

23-23-11Copyright Houghton Mifflin Company. All rights reserved.

Chapter 23Chapter 23Cost-Volume-Profit Analysis Cost-Volume-Profit Analysis

and Variable Costingand Variable Costing

Belverd E. Needles, Jr.Belverd E. Needles, Jr.

Marian PowersMarian Powers

Sherry K. MillsSherry K. Mills

Henry R. AndersonHenry R. Anderson- - - - - - - - - - -- - - - - - - - - - -

Multimedia Slides by:Multimedia Slides by:

Dr. Paul J. RobertsonDr. Paul J. RobertsonNew Mexico State UniversityNew Mexico State University

Steve LeaskSteve LeaskNew Mexico State UniversityNew Mexico State University


1.1. DefineDefine cost behaviour cost behaviour and explain how and explain how managers make use of this concept in the managers make use of this concept in the management cycle.management cycle.

2.2. Identify specific types of variable and Identify specific types of variable and fixed cost behaviour, and define and fixed cost behaviour, and define and discuss the relationships of operating discuss the relationships of operating capacity and relevant range to cost capacity and relevant range to cost behaviour.behaviour.

3.3. Define Define mixed cost,mixed cost, and use the high-low and use the high-low method to separate the variable and fixed method to separate the variable and fixed components of a mixed cost.components of a mixed cost.

LEARNING OBJECTIVESLEARNING OBJECTIVES


4.4. Define Define cost-volume-profit analysiscost-volume-profit analysis and and discuss how managers use this analysis.discuss how managers use this analysis.

5.5. Compute a breakeven point in units of Compute a breakeven point in units of output and in sales dollars, and prepare a output and in sales dollars, and prepare a breakeven graph.breakeven graph.

6.6. Define Define contribution margincontribution margin and use the and use the concept to determine a company’s concept to determine a company’s breakeven point for a single product and breakeven point for a single product and for multiple products.for multiple products.



7.7. Apply cost-volume-profit analysis to Apply cost-volume-profit analysis to estimated levels of future sales and to estimated levels of future sales and to changes in costs and selling prices.changes in costs and selling prices.

8.8. Apply cost-volume-profit analysis to a Apply cost-volume-profit analysis to a service business.service business.



Cost Behaviour PatternsCost Behaviour Patterns

OBJECTIVE 1OBJECTIVE 1

Define Define cost behaviourcost behaviour and and

explain how managers make explain how managers make

use of this concept in the use of this concept in the

management cycle.management cycle.


The Use of Cost Behaviour The Use of Cost Behaviour in the Management Cyclein the Management Cycle

Determine how many units need to be sold to obtain the desired net income. Determine how changes in planned operating, investing, or financial activities will affect income.

Determine how decisions about current operating, investing, or financing activities affect income.

Report the budgeted net income.Determine the best alternative.


Cost BehaviourCost Behaviour» Cost behaviour refers to how costs Cost behaviour refers to how costs

change in relation to volume or change in relation to volume or activity.activity. Some costs vary with volume or Some costs vary with volume or

operating activity.operating activity.

Others remain fixed as volume Others remain fixed as volume changes.changes.

Some costs exhibit characteristics Some costs exhibit characteristics between these two extremes.between these two extremes.


The Management CycleThe Management Cycle Managers use their knowledge of cost Managers use their knowledge of cost

behaviour to estimate future costs and behaviour to estimate future costs and impact of operational changes on future impact of operational changes on future profitability.profitability.

Managers use assumptions about cost Managers use assumptions about cost behaviour in almost every decision they behaviour in almost every decision they make.make.

Managers must understand cost behaviour Managers must understand cost behaviour patterns to anticipate cost ramifications of patterns to anticipate cost ramifications of alternatives in order to decide correctly.alternatives in order to decide correctly.


A.A. 1.1. Some costs vary with volume Some costs vary with volume or or operating activity.operating activity.

2.2. Others remain fixed as Others remain fixed as volume volume changes.changes.

Discussion Discussion

Q.Q. What are the two extremes What are the two extremes concerning cost behaviour concerning cost behaviour discussed in this chapter?discussed in this chapter?


The Behaviour of The Behaviour of Variable CostsVariable Costs


Identify specific types of variable and Identify specific types of variable and fixed cost behaviour, and define and fixed cost behaviour, and define and discuss the relationships of operating discuss the relationships of operating capacity and relevant range to cost capacity and relevant range to cost behaviour.behaviour.


Variable CostsVariable Costs

» Total costs that change in direct Total costs that change in direct

proportion to changes in productive proportion to changes in productive

output are called output are called variable costs.variable costs.

On a per unit basis, however, variable On a per unit basis, however, variable

costs remain constant as volume costs remain constant as volume

changes.changes.


Variable CostsVariable Costs

Examples of variable costs:Examples of variable costs:

Direct materials.Direct materials.

Direct and indirect labour Direct and indirect labour (hourly).(hourly).

Operating supplies.Operating supplies.

Sales commissions.Sales commissions.


Examples of Variable, Examples of Variable, Fixed, and Mixed CostsFixed, and Mixed Costs

Manufacturing CompanyDesk Manufacturer

VariableCost

FixedCost

MixedCost

Direct materialsDirect labor (hourly)Indirect labor (hourly)Operating suppliesSmall tools

Depreciation, machinery & buildingInsurance premiumsLabor (salaried)Supervisory salariesProperty taxes

Electrical powerTelephoneHeat



Service CompanyBank

VariableCost

FixedCost

MixedCost

Computer equipmentleasing (based onusage)Computer operators(hourly)Operating suppliesData storage disks

Depreciation, furniture & fixturesInsurance premiumsSalaries: Programmers Systems designers Bank administratorsRent, buildings




Merchandising CompanyDepartment Store

VariableCost

FixedCost

MixedCost

Merchandise to sellSales commissionsShelf stockers(hourly)

Depreciation, buildingInsurance premiumsBuyers (salaried)Supervisory salariesProperty taxes (onequipment & building)



CapacityCapacity

» Capacity can be expressed in Capacity can be expressed in

several ways, including:several ways, including:

Total labour hours.Total labour hours.

Total machine hours.Total machine hours.

Total units of output.Total units of output.


CapacityCapacity» Operating CapacityOperating Capacity: Maximum : Maximum

productive output and related costs, productive output and related costs, given existing resources.given existing resources.

» Theoretical Capacity:Theoretical Capacity: Maximum Maximum productive output possible over a productive output possible over a given period of time. given period of time.

» Practical Capacity:Practical Capacity: Theoretical Theoretical capacity reduced by normal, capacity reduced by normal, expected work stoppages.expected work stoppages.


CapacityCapacity» Excess Capacity:Excess Capacity: Extra machinery Extra machinery

and equipment available when and equipment available when regular facilities are being repaired regular facilities are being repaired or when expected volume is greater.or when expected volume is greater.

» Normal Capacity:Normal Capacity: Average annual Average annual operating capacity needed to satisfy operating capacity needed to satisfy expected sales demand. expected sales demand.


Measures of CapacityMeasures of Capacity

» Each variable cost should be Each variable cost should be

related to an appropriate measure related to an appropriate measure

of capacity, but often more than of capacity, but often more than

one measure of capacity applies.one measure of capacity applies.


Measures of CapacityMeasures of Capacity Management accountants must Management accountants must

aggregate variable costs that have aggregate variable costs that have the same activity base to facilitate the same activity base to facilitate estimation of future costs.estimation of future costs.

The traditional definition of variable The traditional definition of variable costs assumes a linear relationship costs assumes a linear relationship exists between costs and the exists between costs and the measure of capacity chosen.measure of capacity chosen.


A Common Variable-Cost Behaviour Pattern: Linear Relationship

A Common Variable-Cost Behaviour Pattern: Linear Relationship

Lab

ou

r C

ost

Units

$2.50 per unit$2.50 per unit

$5

0

$10

$15

$20

0 1 2 3 4 5 6 7 8


Nonlinear Variable CostsNonlinear Variable Costs» Many costs vary with operating Many costs vary with operating

activity in a nonlinear fashion. activity in a nonlinear fashion. Costs of computer usage.Costs of computer usage.

Costs of power consumption.Costs of power consumption.

» Cost behaviour of nonlinear costs can Cost behaviour of nonlinear costs can be approximated within the relevant be approximated within the relevant range using a linear approximation range using a linear approximation technique.technique.


Relevant RangeRelevant Range

» The relevant range is the volume The relevant range is the volume

range within which actual range within which actual

operations are likely to occur.operations are likely to occur.


The Relevant Range and Linear Approximation

The Relevant Range and Linear Approximation

TotalCost

Volume

$ LinearApproximation

True BehaviourPattern

RelevantRelevantRangeRange

0


Fixed CostsFixed Costs» Fixed costs are costs that remain Fixed costs are costs that remain

constant within a relevant range of constant within a relevant range of volume or activity. Examples of fixed volume or activity. Examples of fixed costs are:costs are: Depreciation.Depreciation. Rent.Rent. Supervisory salaries.Supervisory salaries. Property taxes.Property taxes.

» Unit fixed costs vary inversely with Unit fixed costs vary inversely with changes in volume.changes in volume.


A Common Fixed-Cost Behaviour Pattern

A Common Fixed-Cost Behaviour Pattern

Units of Output

$2,000

0

$4,000

$6,000

$8,000

0 200,000 400,000 600,000 800,000

Original RelevantRange

New RelevantRange

Fix

ed O

verh

ead

Co

st

Fixed CostPattern


A.A. 1. Direct materials.1. Direct materials.

2. Direct and indirect labour (hourly).2. Direct and indirect labour (hourly).

3. Operating supplies.3. Operating supplies.

4. Sales commissions.4. Sales commissions.


Q.Q. What are examples of variable What are examples of variable costs?costs?


Mixed CostsMixed Costs


Define Define mixed cost,mixed cost, and use the and use the

high-low method to separate the high-low method to separate the

variable and fixed components variable and fixed components

of a mixed cost.of a mixed cost.


Mixed CostsMixed Costs

» Mixed costs have both variable and Mixed costs have both variable and fixed cost components.fixed cost components.

» Part of the cost changes with Part of the cost changes with volume or usage, and part of the volume or usage, and part of the cost is fixed over time.cost is fixed over time.


To

tal T

ele

ph

on

e C

os

t

Long Distance Calls

$

Behaviour Patterns of Mixed Behaviour Patterns of Mixed Costs: Telephone CostsCosts: Telephone Costs


To

tal M

ain

ten

an

ce C

ost

Maintenance Hours

$

Behaviour Patterns of Mixed Behaviour Patterns of Mixed Costs: Maintenance CostsCosts: Maintenance Costs


High-Low MethodHigh-Low Method

» A scatter diagram is a chart of A scatter diagram is a chart of

plotted points that helps determine plotted points that helps determine

if there is a linear relationship if there is a linear relationship

between a cost item and its related between a cost item and its related

activity measure.activity measure.


A.A. 1.1. Part of the cost changes Part of the cost changes with with volume or usage.volume or usage.

2.2. Part of the cost is fixed over Part of the cost is fixed over the period.the period.


Q.Q. What are the characteristics of a What are the characteristics of a mixed cost?mixed cost?


Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis


Define Define cost-volume-profit analysiscost-volume-profit analysis

and discuss how managers use and discuss how managers use

this analysis.this analysis.


Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis» Cost-volume-profit analysis is used Cost-volume-profit analysis is used

primarily as a planning and control primarily as a planning and control tool.tool. Projecting net income at different activity Projecting net income at different activity

levels.levels.

Measuring the performance of a Measuring the performance of a department within a company.department within a company.

Assisting in the analysis of decision Assisting in the analysis of decision alternatives.alternatives.


Cost-Volume-Profit AnalysisCost-Volume-Profit Analysis

The C-V-P FormulaThe C-V-P Formula

Sales Revenue

Fixed Costs

Total Variable Costs

S

VC

FC

S = VC + FC + Net IncomeS = VC + FC + Net Income


A.A. 1.1. Projecting net income.Projecting net income.

2.2. Measuring departmental Measuring departmental performance.performance.

3.3. Analysis of decision alternatives.Analysis of decision alternatives.


Q.Q. What are the management uses of What are the management uses of

cost-volume-profit analysis?cost-volume-profit analysis?


Breakeven AnalysisBreakeven Analysis


Compute a breakeven point in Compute a breakeven point in

units of output and in sales units of output and in sales

dollars, and prepare a dollars, and prepare a

breakeven graph.breakeven graph.


The Breakeven PointThe Breakeven Point» The breakeven point is the point of The breakeven point is the point of

zero profit.zero profit.

Breakeven units equal fixed costs Breakeven units equal fixed costs

divided by contribution margin per unit.divided by contribution margin per unit.

Breakeven dollars equal breakeven units Breakeven dollars equal breakeven units

times the selling price per unit.times the selling price per unit.


The Breakeven GraphThe Breakeven Graph» A standard breakeven graph has A standard breakeven graph has

five components.five components.

The horizontal axis (volume).The horizontal axis (volume).

The vertical axis (dollars).The vertical axis (dollars).

The fixed cost line.The fixed cost line.

The total cost line.The total cost line.

The total revenue line.The total revenue line.


The Breakeven GraphThe Breakeven Graph

» Normally, a loss area, profit area, Normally, a loss area, profit area,

and breakeven point will result.and breakeven point will result.

» At zero volume, net loss equals At zero volume, net loss equals

fixed costs.fixed costs.


Graphic Breakeven Analysis: Graphic Breakeven Analysis: Dakota Products, Inc.Dakota Products, Inc.

$60

$10

$20

$50

$40

$30

0 200 600400

Do

llar

s (i

n t

ho

usa

nd

s)

Units of Output

Fixed CostsUnit Breakeven

Sales Breakeven

Total RevenueLine

Total Cost Line

Loss Area

Net Income

Area

Variable Costs


A.A. 1.1. Breakeven units equal fixed costs Breakeven units equal fixed costs divided by contribution margin per divided by contribution margin per unit.unit.

2.2. Breakeven dollars equal Breakeven dollars equal breakeven units times the selling breakeven units times the selling price per unit.price per unit.


Q.Q. What are the formulas for breakeven What are the formulas for breakeven units and breakeven dollars?units and breakeven dollars?


Contribution MarginContribution Margin


Define Define contribution margincontribution margin and and

use the concept to determine a use the concept to determine a

company’s breakeven point for company’s breakeven point for

a single product and for a single product and for

multiple products.multiple products.


Contribution MarginContribution Margin

» Contribution margin equals sales Contribution margin equals sales

minus total variable costs.minus total variable costs.

CM = S - VCCM = S - VC

» Contribution margin per unit equals Contribution margin per unit equals

selling price minus variable cost per selling price minus variable cost per

unit.unit.


Contribution MarginContribution Margin» The breakeven point (in units) The breakeven point (in units)

equals fixed costs divided by the equals fixed costs divided by the contribution margin per unit.contribution margin per unit.

BE units = FC / CM per unitBE units = FC / CM per unit

» A sales mix is used to calculate the A sales mix is used to calculate the breakeven point for each product breakeven point for each product when an organization sells more when an organization sells more than one product.than one product.


A.A. Sales - Variable costsSales - Variable costs= Contribution margin= Contribution margin- Fixed costs- Fixed costs= Net income (loss)= Net income (loss)


Q.Q. What is the calculation of net What is the calculation of net income when using the income when using the contribution format?contribution format?


Planning Future SalesPlanning Future Sales


Apply cost-volume-profit analysis Apply cost-volume-profit analysis

to estimated levels of future sales to estimated levels of future sales

and to changes in costs and and to changes in costs and

selling prices.selling prices.


Cost-Volume-Profit Cost-Volume-Profit » The contribution approach is The contribution approach is

extremely useful for profit planning.extremely useful for profit planning.

» Target sales in units = (FC + NI) / Target sales in units = (FC + NI) / (CM per unit).(CM per unit).

» Projected net income can be Projected net income can be calculated, assuming changes in calculated, assuming changes in volume, selling price, and/or costs.volume, selling price, and/or costs.


Assumptions Assumptions Underlying C-V-P AnalysisUnderlying C-V-P Analysis

1.1. The behaviour of variable and fixed The behaviour of variable and fixed costs can be measured accurately.costs can be measured accurately.

2.2. Costs and revenues have a close Costs and revenues have a close linear approximation.linear approximation.

3.3. Efficiency and productivity hold Efficiency and productivity hold steady within the relevant range of steady within the relevant range of activity.activity.


Assumptions Assumptions Underlying C-V-P AnalysisUnderlying C-V-P Analysis4.4. Cost and price variables hold Cost and price variables hold

steady during the period being steady during the period being planned.planned.

5.5. The product sales mix does not The product sales mix does not change during the period being change during the period being planned. planned.

6.6. Production and sales volume are Production and sales volume are roughly equal. roughly equal.


A.A. Target Sales Units = (FC + NI) / Target Sales Units = (FC + NI) / CM per unitCM per unit


Q.Q. The contribution margin approach The contribution margin approach can be used for profit planning. can be used for profit planning. What is the calculation to What is the calculation to determine target sales units?determine target sales units?


Applying C-V-P Analysis Applying C-V-P Analysis to a Service Businessto a Service Business


Apply cost-volume-profit analysis Apply cost-volume-profit analysis

to a service business.to a service business.


Cost-Volume-Profit Cost-Volume-Profit » A service concern does not A service concern does not

manufacture a physical product.manufacture a physical product.

» The cost per service rendered includes The cost per service rendered includes the following:the following:

Professional (direct) labour costs.Professional (direct) labour costs.

Service overhead costs (may be fixed Service overhead costs (may be fixed or variable).or variable).


Cost-Volume-Profit Cost-Volume-Profit » A service business can separate A service business can separate

mixed costs into their variable and mixed costs into their variable and fixed portions in order to:fixed portions in order to:

1.1. Calculate a breakeven point.Calculate a breakeven point.

2.2. Plan net income when changes Plan net income when changes in in cost, volume, or price occur.cost, volume, or price occur.


A.A. 1.1. Separate mixed costs into their Separate mixed costs into their variable and fixed portions.variable and fixed portions.

2.2. Calculate a breakeven point.Calculate a breakeven point.

3.3. Plan net income when changes in Plan net income when changes in cost, volume, or price occur.cost, volume, or price occur.


Q.Q. How can a service business use How can a service business use

cost-volume-profit analysis?cost-volume-profit analysis?


1. Define cost behaviour and explain how managers make use of this concept in the management cycle.

2. Identify specific types of variable and fixed cost behaviour, and define and discuss the relationships of operating capacity and relevant range to cost behaviour.

3. Define mixed cost, and use the high-low method to separate the variable and fixed components of a mixed cost.

OK, LET’S REVIEW . . .


4. Define cost-volume-profit analysis and discuss how managers use this analysis.

5. Compute a breakeven point in units of output and in sales dollars, and prepare a breakeven graph.

6. Define contribution margin and use the concept to determine a company’s breakeven point for a single product and for multiple products.

CONTINUING OUR REVIEW . . .


7. Apply cost-volume-profit analysis to estimated levels of future sales and to changes in costs and selling prices.

8. Apply cost-volume-profit analysis to a service business.

AND FINALLY . . .

Documents

23-1 Copyright Houghton Mifflin Company. All rights reserved. Chapter 23 Cost-Volume-Profit Analysis and Variable Costing Belverd E. Needles, Jr. Marian