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CHAPTER 5 COST VOLUME - PROFIT

Study Objectives

- Distinguish between variable and fixed costs.
- Explain the significance of the relevant range.
- Explain the concept of mixed costs.
- List the five components of cost-volume-profit

analysis. - Indicate what contribution margin is and how it

can be expressed.

- Study Objectives Continued
- Identify the three ways to determine the

break-even point. - Give the formulas for determining sales required

to earn target net income. - Define margin of safety, and give the formulas

for computing it.

COST BEHAVIOR ANALYSIS

- Definition The study of how specific costs

respond to changes in the level of business

activity - Some costs change others remain the same
- Helps management plan operations and make

decisions - Applies to all types of businesses and entities

COST BEHAVIOR ANALYSISContinued

- Starting point is measuring key business

activities - Activity levels may be expressed in terms of
- Sales dollars (in a retail company)
- Miles driven (in a trucking company)
- Room occupancy (in a hotel)
- Dance classes taught (by a dance studio)

COST BEHAVIOR ANALYSIS Continued

- Many companies use more
- than one measurement base
- For an activity level
- to be useful
- Changes in the level or volume of activity

should be correlated with changes in cost

COST BEHAVIOR ANALYSISContinued

- The activity level selected is called the

activity (or volume) index - Identifies the activity that causes changes in

the behavior of costs - Allows costs to be classified according to their

response to changes in activity as - Variable Costs
- Fixed Costs
- Mixed Costs

COST BEHAVIOR ANALYSISVARIABLE COSTSStudy

Objective 1

- Costs that vary in total directly and

proportionately with changes in the activity

level - If the activity level increases 10 percent, total

variable costs increase 10 percent - If the activity level decreases by 25 percent,

total variable costs will decrease by 25 percent

COST BEHAVIOR ANALYSISVARIABLE COSTS - Continued

- Variable costs also remain constant per unit at

every level of activity - Examples of variable costs include
- Direct material and direct labor for a

manufacturer - Sales commissions for a merchandiser
- Gasoline in airlines and trucking companies

COST BEHAVIOR ANALYSISVARIABLE COSTS - Continued

- Example
- Damon Company manufactures radios that contain a

10 clock - 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 made, the total cost of the

clocks is 20,000 (2,000 X 10) - If 10,000 radios are made, the total cost of the

clocks is 100,000 (10,000 X 10)

COST BEHAVIOR ANALYSIS VARIABLE COSTS -

Continued

- Example Continued

COST BEHAVIOR ANALYSISFIXED COSTS

- Costs that remain the same in total regardless of

changes in the activity level. - Per unit cost varies inversely with activity
- As volume increases,
- unit cost decline, and vice versa
- Examples include
- Property taxes
- Insurance
- Rent
- Depreciation on buildings and equipment

COST BEHAVIOR ANALYSISFIXED COSTS - Continued

- Example
- Damon Company leases its productive facilities

for 10,000 per month - Total fixed costs of the facilities remain

constant at all levels of activity - 10,000 per

month - On a per unit basis, the cost of rent decreases

as activity increases and vice versa - At 2,000 radios, the unit cost is 5 (10,000

2,000 units) - At 10,000 radios, the unit cost is 1 (10,000

10,000 units)

COST BEHAVIOR ANALYSISFIXED COSTS - Continued

- Example Continued

COST BEHAVIOR ANALYSISRELEVANT RANGEStudy

Objective 2

- Throughout the range of possible levels of

activity, a straight-line 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 nonlinear

some fixed costs will not change over the entire

range of activities, others may

COST BEHAVIOR ANALYSISRELEVANT RANGE - Continued

COST BEHAVIOR ANALYSISRELEVANT RANGE - Continued

- Defined as the range of activity over which a

company expects to operate during a year - Within this range, a straight-line relationship

usually exists for both variable and fixed costs

COST BEHAVIOR ANALYSISMIXED COSTS Study

Objective 3

- 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

COST BEHAVIOR ANALYSISMIXED COSTS High-Low

Method

- Mixed costs must be classified into their fixed

and variable elements - One approach to separate the costs is called the

high-low method - Uses the total costs incurred at both the high

and the low levels of activity to classify mixed

costs - The difference in costs between the high and low

levels represents variable costs, since only

variable costs change as activity levels change

COST BEHAVIOR ANALYSISMIXED COSTS High-Low

Method - Continued

- Steps in Method
- 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

COST BEHAVIOR ANALYSISMIXED COSTS High-Low

Method - Continued

- Example
- Data for Metro Transit Company
- for the last 4-month period
- High Level of Activity 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 - 33,000 ? 30,000 1.10 variable cost per mile

COST BEHAVIOR ANALYSISMIXED COSTS High-Low

Method - Continued

- Example Continued
- Step 2 Subtract total variable costs at either

the high or low activity level from the total

cost at that same level

COST BEHAVIOR ANALYSISMIXED COSTS High-Low

Method - Continued

- Example Continued
- Maintenance costs 8,000 per month plus 1.10

per mile - To determine maintenance costs at a particular

activity level - multiply the activity level times the variable

cost per unit - 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 and 49,500 variable (1.10 X 45,000 miles)

for a total of 57,500.

COST-VOLUME-PROFIT ANALYSISStudy Objective 4

- Study of the effects of changes of costs and

volume on a companys profits - A critical factor in management decisions
- Important in profit planning

COST-VOLUME-PROFIT ANALYSIS

- Considers the interrelationships among the five

components of CVP analysis

ASSUMPTIONS UNDERLYINGCVP ANALYSIS

- Behavior of both costs and revenues is linear

throughout the relevant range of the activity

index - All costs can be classified as either variable or

fixed with reasonable accuracy - Changes in activity are the only factors that

affect costs - All units produced are sold
- When more than one type of product is sold, the

sales mix will remain constant

CVP INCOME STATEMENTStudy Objective 5

- A statement for internal use
- 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 variable costs
- Reports the same net
- income as a traditional
- income statement

CVP INCOME STATEMENT

- Example
- Vargo Video Company produces DVD players.
- Relevant data for June 2005
- Unit selling price of DVD player 500
- Unit variable costs 300
- Total monthly fixed costs 200,000
- Units sold 1,600

CVP INCOME STATEMENT Contribution Margin Per Unit

- Contribution margin is available to cover fixed

costs and to contribute to income - Formula for contribution margin per unit
- Example Computation for Vargo Video

CVP INCOME STATEMENT Contribution Margin Ratio

- Shows the percentage of each sales dollar

available to apply toward fixed costs and profits - Example Computation for Vargo Video

CVP INCOME STATEMENT Contribution Margin Ratio -

Example

- Ratio helps to determine the effect of changes in

sales on net income

BREAK-EVEN ANALYSISStudy Objective 6

- Process of finding the break-even point
- Break-even point
- Level of activity at which total revenues equal

total costs (both fixed and variable) - Can be computed or derived
- from a mathematical equation
- by using contribution margin
- from a cost-volume-profit (CVP) graph
- Expressed either in sales units or in sales

dollars

BREAK-EVEN ANALYSIS Mathematical Equation

- Example using the Vargo Video data
- Where
- Q sales volume 500 selling price 300

variable cost per unit 200,000 total fixed

costs - To find sales dollars required to break-even
- 1000 units X 500 500,000 (break-even sales

dollars)

Sales 500 Q

BREAK-EVEN ANALYSIS Contribution Margin

Technique

- At the break-even point, contribution margin must

equal total fixed costs (CM total revenues

variable costs) - The break-even point can be computed using either

contribution margin per unit or contribution

margin ratio - When the break even point in units is desired,

contribution margin per unit is used in the

following formula - When the break even point in dollars is desired,

contribution margin ratio is used in the

following formula

BREAK-EVEN ANALYSIS Contribution Margin Technique

- Example using Vargo Video data

BREAK-EVEN ANALYSISGraphic Presentation

- A cost-volume-profit (CVP) graph shows costs,

volume, and profits - Used to visually find the break-even point
- To construct a CVP graph,
- Plot the total revenue line
- starting at the zero activity level
- Plot the total fixed cost
- by a horizontal line
- Plot the total cost line.
- (Starts at the fixed cost line
- at zero activity)
- Determine the break-even point from the

intersection of the total cost line and the total

revenue line

BREAK-EVEN ANALYSIS CVP Graph for Vargo Video

BREAK-EVEN ANALYSIS Target Net IncomeStudy

Objective 7

- Level of sales necessary to achieve a specified

income - Can be determined from each of the approaches

used to determine break-even sales/units - May be expressed either in sales dollars or sales

units

BREAK-EVEN ANALYSIS Target Net Income - Example

- Using the Contribution Margin Approach
- and the Vargo Video Data
- Formula for required sales in units
- Formula for required sales in dollars

Required Sales in Units 1,600 units

Required Sales in Dollars 800,000

BREAK-EVEN ANALYSIS Margin of Safety

- Difference between actual or expected sales and

sales at the break-even point - May be expressed in dollars or as a ratio
- Example -
- To determine the margin of safety in dollars for

Vargo Video assuming that actual (expected) sales

are 750,000

BREAK-EVEN ANALYSIS Margin of Safety RatioStudy

Objective 8

- Computed by dividing the margin of safety in

dollars by the actual or expected sales (using

Vargo Video data) - Results indicate that Vargo Videos sales could

fall by 33 percent before it would be operating

at a loss. - The higher the dollars or the percentage, the

greater the margin of safety.

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