Accounting for Executives

Week 8 6/5/2010 (Fri)

Lecture 8

Learning Objectives

1. Explain the concept of marginal (variable) costing and absorption (full) costing

2. Use CVP analysis to compute breakeven point3. Use CVP analysis for profit planning and graph relations4. Use CVP methods to perform sensitivity analysis

Objective 1

Explain the concept of marginal costing and absorption costing

Marginal Costing (Variable Costing) Marginal cost (變動成本 ) is defined as the cost of one

unit of product or service which would be avoided if that unit were not produced or provided.

The marginal costs consist of the variable costs of production, namely the direct material cost, the direct labor cost, the variable production overhead and the variable costs of selling, distribution and administration.

A marginal costing approach attempts to identify the cost of producing one extra unit of output and is defined as the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written off in full against the aggregate contribution.

Absorption Costing (Full Costing) Absorption costing (全部成本法 ) is a method of

costing that, in addition to direct costs, assigns all, or a proportion of, production overheads costs to cost units by means of one or a number of overhead absorption rates

Absorption costing calculates the unit cost of an item taking into account all costs, fixed and variable, direct and indirect.

Indirect or fixed costs are allocated to or absorbed by the products made

Marginal costing

Example A product manufactured by ABC CO. with a total cost of $20 per unit, which has a selling price in the market $30. Among the total cost 60% is determined to be variable cost. The company has a budgeted production of 20,000 units in the current year and the budgeted overheads for the year are $160,000. Required(a) Calculate the Overhead absorption rate for the product.(b) Calculate the budgeted profit for the company by using absorption costing.(c) Calculate the budgeted profit for the company by using marginal costing.

Marginal Costing

Answer

(a) OH absorption rate: Budgeted OH Budgeted Units

= $160,000 20,000= $ 8 per unit

Contribution : Selling price - Variable cost=$30 - $20 X 60%=$30 - $12=$18 per unit

Marginal Costing

Answer (continue)(b) Profit under Absorption costingSales : 20,000 X $30 =$ 600,000 (1)Cost of Sales: 20,000 X $20 =$ 400,000 (2)Budgeted Profit (1) - (2) =$ 200,000

(c ) Profit under Marginal costingSales: 20,000 X $30 =$600,000(4) Cost of Sales: Var. cost $20 X 60% X 20,000

=$240,000(5)Fixed cost =$160,000(6)

Budgeted Profit (4)- (5)-(6) =$200,000

Marginal vs Absorption Costing

Using the above-mentioned example, what will be the profit for ABC Co. under both costing methods if the actual sales turn out to be 16,000 units.

Answer(a) Absorption CostingProfit under Absorption costingSales : 16,000 X $30 =$ 480,000 (1)Cost of Sales: 16,000 X $20 =$ 320,000 (2)Adjustment for under absorption =$ 32,000 (3)Budgeted Profit (1) - (2)- (3) =$ 128,000

(b) Profit under Marginal costingSales: 16,000 X $30 =$480,000(4) Cost of Sales: Var.cost $20X60%X16,000 =$192,000(5)

Fixed cost =$160,000(6)Budgeted Profit (4)- (5) -(6) =$128,000

Marginal vs Absorption Costing

Comparison between absorption and marginal costing The marginal costing method is based on the

assumption that the process of full allocation of costs as exemplified in overhead absorption is a waste of time.

It is argued that the only analysis that is required is that for variable and fixed cost. This approach is likely to be easier and less subject to the inaccuracies of the allocation and apportionment process.

Proponents of marginal costing argue that full costing is out of date in competitive markets where price is more likely to be determined by consumer demand rather than what the producer believes the product is worth.

Marginal costing presents information in a simple way with analysis mainly restricted to variable costs, with fixed costs dealt with as an additional, unallocated sum.

Overhead absorption does involve arbitrary allocation of costs to a product or service but firms need to ensure that in the long term all costs are covered if a firm is to make a profit.

Comparison between absorption and marginal costing

Objective 2

Use CVP analysis to compute breakeven point

Assumptions

1. Expenses can be classified as either variable or fixed

2. The only factor that affects costs is change in volume

CVP = Cost-Volume-Profit

Breakeven Point

Sales level at which operating income is zeroSales above breakeven result in a profitSales below breakeven result in a loss

Income Statement Approach

Contribution Margin Income Statement Sales- Variable Costs Contribution Margin- Fixed Costs Operating Income

Contribution Margin Approach

Breakeven units sold = Fixed costs+ target profitContribution margin per unit

Contribution Margin Ratio

Contribution margin ÷ Sales revenue

Breakeven sales dollars =Fixed costs + Operating profit = 0Contribution margin ratio

Example 1

Contribution margin ÷ Sales revenue

$187,500 ÷ $312,500 = 60%

Example 2

Aussie TravelContribution Margin Income StatementThree Months Ended March 31, 2009

Sales revenue $250,000$360,000

Variable Costs (40%) (100,000)(144,000)

Contribution Margin (60%) $150,000$216,000

Fixed Costs (170,000)(170,000)

Operating Income $(20,000)$46,000

Example 2

Breakeven sales dollars =Fixed costs + Operating incomeContribution margin ratio

$170,000 + $0 .60

$283,333

Example 3

1. Contribution margin = Sales–Variable costs= $1.70 - $0.85= $0.85

2. Breakeven units sold = Fixed costs + Operating incomeContribution margin per unit

($85,000 + $0) / $0.85 = 100,000 units100,000 units x $1.70 = $170,000

Objective 3

Use CVP analysis for profit planning and graph relations

Plan Profits

Example: The following information is available for Conte Company

Sale price per unit $30Variable costs per unit 21Total fixed costs $180,000Target operating income $90,000

How many units must be sold to meet the targeted operating income?

Plan Profits

Sales – variable costs – fixed costs = operating income

$30x – $21x - $180,000 = $90,000$9x = $270,000x = 30,000 units

Preparing a CVP Chart

Step 1: Choose a sales volume Plot point for total sales revenue Draw sales revenue line from origin

Preparing a CVP Chart

$0

$5,000

$10,000

$15,000

$20,000

0 500 1,000 1,500

Volume of Units

Dol

lars

Revenues•

Preparing a CVP Chart

Step 2: Draw the fixed cost line

Preparing a CVP Chart

$0

$5,000

$10,000

$15,000

$20,000

0 500 1,000 1,500

Volume of Units

Dol

lars

RevenuesFixed costs

Preparing a CVP Chart

Step 3: Draw the total cost line ( fixed plus variable)

Preparing a CVP Chart

$0

$5,000

$10,000

$15,000

$20,000

0 500 1,000 1,500

Volume of Units

Dol

lars Revenues

Fixed costsTotal cost

Preparing a CVP Chart

Step 4: Identify the breakeven point and the areas of operating income and loss

Preparing a CVP Chart

$0

$5,000

$10,000

$15,000

$20,000

0 500 1,000 1,500

Volume of Units

Dol

lars

Breakeven point

Profit

Loss

$0$10,000$20,000$30,000$40,000$50,000$60,000$70,000

0 100 200 300 400 500 600 700

Volume of Units

Dol

lars

ProfitProfit

Breakeven point

Revenues

Total Costs

Fixed Costs

Objective 4

Use CVP methods to perform sensitivity analysis

Sensitivity Analysis

“What if” analysisWhat if the sales price changes?What if costs change?

Example 4

Sale price per student $200Variable costs per student 120Total fixed costs $50,000

1. Contribution margin per unit: $200 – 120 = $80

Breakeven point: $50,000 ÷ $80 = 625 students

Example 4

Sale price per student $180Variable costs per student 120Total fixed costs $50,000

2. Contribution margin per unit: $180 – 120 = $60

Breakeven point: $50,000 ÷ $60 = 833 students

Example 4

Sale price per student $200Variable costs per student 110Total fixed costs $50,000

2. Contribution margin per unit: $200 – 110 = $90

Breakeven point: $50,000 ÷ $90 = 556 students

Example 4

Sale price per student $200Variable costs per student 120Total fixed costs $40,000

1. Contribution margin per unit: $200 – 120 = $80

Breakeven point: $40,000 ÷ $80 = 500 students

Margin of Safety

Excess of expected sales over breakeven salesDrop in sales that the company can absorb before

incurring a loss

Example 5

Margin of safety = Expected sales – breakeven sales

Expected sales: Sales – variable costs – fixed costs = operating income1x - .70x - $9,000 = $12,000.30x = $21,000x = $70,000

Example 5

Margin of safety = Expected sales – breakeven sales

Breakeven sales: Sales – variable costs – fixed costs = operating income1x - .70x - $9,000 = $0.30x = $9,000x = $30,000

Example 5

Margin of safety in dollars = Expected sales – breakeven sales = $70,000 - $30,000 = $40,000

Margin of safety in % = (Expected sales – breakeven sales) ÷ Expected sales × 100%