Cost Behavior and Decision Making: Cost, Volume, Profit Analysis

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Chapter 6

• Cost Behavior and Decision Making Cost, Volume,
  Profit Analysis

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Topics
Introduction The Contribution Margin Income
Statement The Contribution Margin and Its Uses
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Introduction
Cost-Volume-Profit Analysis (CVP) focuses on the
following factors The prices of products or
services The volume of products or services
produced and sold The per-unit variable costs The
total fixed costs The mix of products or services
produced
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The Contribution Margin Income Statement
The Contribution Margin Income Statement is
structured by behavior rather than by
function. Sales - All Variable Costs
Contribution Margin Contribution Margin - All
Fixed Costs Net Income
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Income Statements
CONTRIBUTION MARGIN
TRADITIONAL
Sales Less Cost of Goods Sold Variable
Costs Fixed Costs Total Costs of Goods
Sold Gross Profit Less SA Costs Variable
Costs Fixed Costs Total SA Costs Net Income
Sales Less Variable Costs Manuf. Costs SA
Costs Total Variable Costs Contribution
Margin Less Fixed Costs Manuf. Costs SA
Costs Total Fixed Costs Net Income
1,000 350 150 500 500 50 250 300 200
1,000 350 50 400 600 150 250 400 200
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The Contribution Margin Income Statement
Key Concept The contribution margin income
statement is structured to emphasize cost
behavior as opposed to cost function.
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Contribution Margin Per Unit
Sales (100,000 units) Less Variable Costs
Contribution Margin Less Fixed Costs Net
Income
Total 200,000 80,000 120,000 40,000 80,000
Per Unit 2.00 .80 1.20
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Contribution Margin Per Unit
What if HD Inc. sold one more unit?
Sales (100,001 units) Less Variable Costs
Contribution Margin Less Fixed Costs Net
Income
Total 200,002.00 80,000.80 120,001.20 40,000.00
80,001.20
Per Unit 2.00 .80 1.20
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Contribution Margin Per Unit
Key Concept For every unit in change in sales,
contribution margin will increase or decrease by
the contribution margin per unit multiplied by
the increase or decrease in sales volume.
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Contribution Margin Ratio
Contribution Margin Ratio Contribution Margin
(in ) Sale (in )
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Contribution Margin Ratio
Sales (100,000 units) Less Variable Costs
Contribution Margin Less Fixed Costs Net
Income
Total 200,000 80,000 120,000 40,000 80,000
Percent 100 40 60
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Contribution Margin Ratio
Key Concept The contribution margin per unit and
the contribution margin ration will remain
constant as long as sales vary in direct
proportion with volume.
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Contribution Margin Ratio
Pause and reflect Go back and calculate the
contribution margin ratio in the HD Inc. income
statements presented in your text. Make sure you
understand the calculations. You will see that it
is always 60 percent.
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Contribution Margin Ratio
Key Concept For every dollar change in sales,
contribution margin will increase or decrease by
the contribution margin ratio multiplied by the
increase or decrease in sales dollars.
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Contribution Margin Ratio
Using either contribution margin per unit or
contribution margin ratio, calculate HD Inc.s
net income (loss) when sales are 25,000 units or
50,000. Answer 25,000 units x 1.20 cm
30,000 or 50,000 x 60 30,000
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The Contribution Margin and Its Uses
What would happen if sales increase? Use the CM
to determine the increase of net income. Then
consider what must happen before sales increase.
Lower sales price? Increase incentives for sales
staff? Improve quality of product? Increase
advertising budget?
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What-If Decisions Using CVP
Step 1 Define the Problem Contribution margin is
not sufficient to cover fixed costs.
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What-If Decisions Using CVP
Step 2 Identify Objectives 1. Increase net
income 2. Maintain a high-quality product
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What-If Decisions Using CVP
Step 3Identify and analyze available options
1. Reduce variable costs of manufacturing the
product 2.Increase sales through a change in the
sales incentive structure or commissions (a
variable cost) 3. Increase sales through
increasing advertising (a fixed cost)
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What-If Options Using CVP
Option 1 When variable costs are reduced,
contribution margin will increase. Find less
expensive supplier of raw material Reduce the
amount of labor used Use lower-wage
employees What would be the consequences of each?
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What-If Options Using CVP
Sales Less Variable Costs
Contribution Margin Less Fixed Costs Net Income
(Loss)
Total 100,000 72,000 28,000 35,000 (7,000)
Option 1 100,000 64,800 35,200 35,000 200
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What-If Options Using CVP
Option 2 Raise sales commissions on all sales
above the present level by 10 percent. Sales will
increase by 30,000 or 2,400 games. Additional
sales commission will be 3,000.
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What-If Options Using CVP
Impact of increasing Sales Incentives, Sales
130,000
Sales Less Variable Costs
Contribution Margin Less Fixed Costs Net Income
(Loss)
Total 100,000 72,000 28,000 35,000 (7,000)
Option 1 130,000 96,600 33,400 35,000 (1,600)
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What-If Options Using CVP
Option 2A Increase net income by 5,400 by
increasing the sales commission by 10 percent on
all sales of more than 100,000. The new
variable costs 72 of sales up to 100,000 and
82 on all sales over 100,000.
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What-If Options Using CVP
Option 3 Spending an additional 10,000 on
advertising will increase sales by 40,000 or
3,200 games.
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What-If Options Using CVP
Impact of increasing Sales Incentives, Sales
140,000
Sales Less Variable Costs
Contribution Margin Less Fixed Costs Net Income
(Loss)
Total 100,000 72,000 28,000 35,000 (7,000)
Option 3 140,000 100,800 39,200 45,000 (5800)
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What-If Options Using CVP
Step 4 Select the best option Option 1, NI
200 Option 2, NI (1,600) Option 2a, NI
200 Option 3, NI (5,800) Assess risk inherent
in each option Assess sensitivity of a decision
to changes in key assumptions
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More Topics
Change in Price and Volume Changes in Cost, Price
and Volume Break-Even Analysis Target Income
Analysis The Impact of Income Taxes Operating
Leverage Variable Costing for Decision Making
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Changes in Price and Volume
If the manager changes the sales price resulting
in a change in sales volume, what will be the
impact on net income? Raising the sales price may
decrease sales volume but the impact on total
sales revenue may be offset by the increase in
sales price. Decreasing the sales price may
increase the sales volume without increasing
total sales revenue.
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Changes in Price and Volume
These business strategies decisions involve
individuals in many areas of an organization,
such as marketing, sales, production management,
and even human resources personnel for hiring
decisions. The implications of a bad decision in
this area can affect the firms bottom line.
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Changes in Cost, Price and Volume
Changes can be made to cost, price and volume at
the same time. Changes in one almost always
impact one or both of the other variables.
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Break-Even Analysis
Break-Even Point the level of sales where
contribution margin just covers fixed costs and
consequently net income is equal to zero.
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Break-Even Analysis
Fixed Costs Contribution Margin Per Unit
Break-Even (units)


Break-Even (Sales )
Fixed Costs Contribution Margin Per Unit

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Break-Even Graph
Revenue
Break-Even Point
Income
Total Cost

Loss
Break-Even Point in
Break-Even Point in Volume
Volume
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Break-Even Calculations with Multiple Products
The calculation of average contribution margin
is really a weighted average.
Fixed Costs Weighted Average Contribution Margin
Per Unit
Break-Even Point
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Break-Even Calculations with Multiple Products
Pause and Reflect Imagine how difficult it is for
large retail stores such as Wal-Mart or JCPenney
to compute a break-even point for the entire
store or company.
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Break-Even Calculations with Multiple Products
When using ABC, costs are classified as unit,
batch, product, or facility level instead of
variable or fixed.
Break-Even (units)
Fixed Costs Batch-level costs Product-level
costs Contribution Margin Per Unit
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Target Profit Analysis(Before and After Tax)
To determine the sales units required to achieve
a Target Profit before taxes
Sales (units)
Fixed Costs Target Profit (before
taxes) Contribution Margin Per Unit
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Target Profit Analysis(Before and After Tax)
Multiple Product formula to reach a Target Profit
Sales (units)
Fixed Costs Target Profit Weighted Average
Contribution Margin Per Unit
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Target Profit Analysis(Before and After Tax)
ABC Formula to reach a Target Income
Sales (units)
Fixed Costs Batch-level Costs Product-level
Costs Target Profit Contribution Margin Per Unit
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The Impact of Taxes
If After-Tax Profit Before-Tax Profit (1-tax
rate) then Before-Tax Profit After-Tax Profit
/ (1-tax rate) Therefore, to determine after-tax
Target Income
Fixed costs After-Tax Profit / (1-tax
rate) Contribution Margin per unit
Sales in units
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The Impact of Taxes
Key Concept The payment of income tax is an
important variable in target profit and other CVP
decisions.
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The Impact of Taxes
Pause and reflect What impact do income taxes
have on the calculation of the break-even point?
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Assumptions of CVP Analysis
Selling price is constant throughout the relevant
range. Costs are linear throughout the relevant
range. The sales mix used to calculate the
weighted average contribution margin is
constant. The amount of inventory is constant.
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Cost Structure and Operating Leverage
Operating Leverage The measure of the proportion
of fixed costs in a companys cost structure. It
is used as an indicator of how sensitive profit
is to changes in sales volume.
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Cost Structure and Operating Leverage
Contribution Margin Net Income
Operating Leverage
Multiply OL x increase in Sales increase in
Net Income
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Cost Structure and Operating Leverage
Company A B C
Sales Cont. Margin Net Income
100,000 60,000 20,000
200,000 120,000 80,000
400,000 240,000 200,000
Operating Leverage
60,000 20,000
120,000 80,000
240,000 200,000
3.0 1.5 1.2
10 Inc Sales 30 15 12
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Cost Structure and Operating Leverage
Pause and Reflect Unlike measures of contribution
margin, operating leverage changes as sales
change.
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Cost Structure and Operating Leverage
Key Concept A company operating near the
break-even point will have a high level of
operating leverage and income will be very
sensitive to changes in sales volume.
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Variable Costing for Decision Making
The only difference between absorption and
variable costing is the treatment of fixed
overhead. Absorption Costing FO is treated as a
product cost, and expensed when the product is
sold. Variable Costing FO is treated as a period
cost and expensed as incurred.
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Variable Costing for Decision Making
Variable Costing
Absorption Costing
Sales Less Cost of Goods Sold Variable
Costs Fixed Costs Total Costs of Goods
Sold Gross Profit Less SA Costs Variable
Costs Fixed Costs Total SA Costs Net Income
Sales Less Variable Costs Manuf. Costs SA
Costs Total Variable Costs Contribution
Margin Less Fixed Costs Manuf. Costs SA
Costs Total Fixed Costs Net Income
1,000 350 150 500 500 50 250 300 200
1,000 350 50 400 600 150 250 400 200
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Variable Costing for Decision Making
Variable Costing
Absorption Costing
Product Cost Direct Material Direct
Labor Variable Overhead Fixed Overhead
Period Cost Sell. Adm.
Product Cost Direct Material Direct
Labor Variable Overhead Fixed Overhead
Period Cost Fixed OH Sell. Adm.
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Variable Costing for Decision Making
Product Costs
Variable Costing
Absorption Costing
Direct Material Direct Labor Variable
Overhead Fixed Overhead Total per unit
.30 .35 .10 .30 1.05
Direct Material Direct Labor Variable
Overhead Total per unit
.30 .35 .10 .75
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Differences Between Absorption and Variable
Costing
When units sold equal units produced, net income
is the same under both costing methods. When
units produced exceed units sold, absorption
costing will report higher net income than
variable costing. When units sold exceeds units
produced, variable costing will report higher net
income than absorption costing.
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Variable Costing for Decision Making
Key Concept Variable costing is consistent with
CVPs focus on differentiating fixed from
variable costs, and provides useful information
for decision making that is often not apparent
when using absorption costing.
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Variable Costing for Decision Making
Im ready! Bring on the costs!