Chapter 6

Cost-Volume-Profit Analysis and Relevant Costing

Learning Objectives

1. How is breakeven point computed and what does it represent?

2. How do costs, revenues, and contribution

margin interact with changes in an activity base (volume)?

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Continuing . . . Learning Objectives

3. How does cost-volume-profit (CVP) analysis in single-product and multiproduct firms differ?

4. What are the underlying assumptions of CVP

analysis and how do these assumptions create a short-run managerial perspective?

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Continuing . . . Learning Objectives

5. How do quality decisions affect the components of CVP analysis?

6. What constitutes relevance in a decision-making

situation?

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Continuing . . . Learning Objectives

7. How can management best utilize a scarce resource?

8. What is the relationship between sales mix and

relevant costing problems?

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Continuing . . . Learning Objectives

9. How can pricing decisions be used to maximize profit?

10. How can product margin be used to

determine whether a product line should be retained or eliminated?

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Continuing . . . Learning Objectives

11. How are breakeven and profit-volume graphs prepared? (Appendix 1) 12. What are the differences between absorption

and variable costing? ( Appendix 2)

13. Why is linear programming a valuable tool for managers? (Appendix 3)

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The Breakeven Point (BEP)

The level of activity, in units or dollars, at which REVENUES = COSTS

Basic Assumption: Relevant Range

Company is operating within the relevant range of activity specified in determining the revenue and cost information used.

Total $

Relevant Range Activity Level

Basic Assumption: Revenue

Total revenue fluctuates in direct proportion to level of activity or volume. On a per unit basis, the selling price remains constant.

Total $ Activity Level

Basic Assumption: Variable Costs

Total variable costs fluctuate in direct proportion to level of activity or volume. On a per unit basis, variable costs remain constant.

Total $ Activity Level

Basic Assumption: Fixed Costs

Total fixed costs remain constant relative to activity level changes. Per-unit fixed costs decrease as volume increases and increase as volume decreases.

Total $ Activity Level

Basic Assumption: Mixed Costs

Mixed costs must be separated into variable and fixed elements.

Total $

Activity Level

Cost Behavior Example

Selling price per ice bucket Variable production cost per ice bucket Variable selling cost per ice bucket Total variable cost per ice bucket Fixed production costs Fixed selling and administrative costs $40 $20 4 $24 $100,000 20,000

Contribution Margin Per Unit

Contribution margin per unit equals selling price per unit less variable cost per unit.

sp -vc = cm $40 - $24 = $16

Contribution Margin Ratio

Contribution margin ratio is per-unit contribution margin divided by selling price, or total contribution margin divided by total sales dollars. cm/sp=cm% $16 / $40 = 40%

Breakeven Point
Breakeven point is the point at which profits are zero because total revenues equal total costs, or
Total revenues = Total variable costs + Total fixed costs

Continuing . . . Breakeven Point

Total fixed costs --------------------CM per unit Total fixed costs --------------------CM ratio

In units

In sales dollars

Continuing . . . Breakeven Point

$120,000 ----------- = 7,500 ice buckets $16 $120,000 ----------- = $300,000 .40

In units

In sales dollars

CVP Analysis: Fixed Amount of Profit Before Taxes (PBT)

In units

Total fixed costs + PBT -----------------------------CM per unit Total fixed costs + PBT -----------------------------CM ratio

In sales dollars

CVP Analysis: Fixed Amount of Profit Before Taxes (PBT)

In units

$120,000 + $64,000 ------------------------ = 11,500 buckets $16 $120,000 + $64,000 ------------------------ = $460,000 .40

In sales dollars

CVP Analysis: Variable Amount of Profit Before Taxes

Assume PUBT desired is 25% on sales Therefore, PUBT = .25 ($40) = $10 Total fixed costs Sales in units = --------------------------CM per unit - PUBT

Sales in units =

$120,000 --------------- = 20,000 ice buckets $16 - $6

CVP Analysis: Variable Amount of Profit Before Taxes

Assume PUBT desired is 25% on sales Therefore, PUBT = .25 ($40) = $10 Total fixed costs --------------------CM% - PUBT%

Sales in $

Sales in $

$120,000 --------------- = $800,000 .40 - .25

Income Statement
Dollars
Sales Variable costs Contribution margin Fixed costs $800,000 480,000 $320,000 120,000

Percentages
100% 60% 40% 15%

Income

$200,000 =======

25% ==

CVP Analysis - Multiple Products

Ice Serving Buckets Sets $40 $24 24 12 $16 $12 40.0% 80.6% 50.0% 19.4%

Selling price Variable cost Contribution margin Contribution margin ratio Sales mix* *5:2 ratio

Continuing . . . CVP Analysis Multiple Products

Ice Buckets 40.0% 80.6% 32.2% 41.9% Serving Sets 50.0% 19.4% 9.7%

Contribution margin ratio Sales mix* Weighted contribution margin

Contribution margin ratio per bag *5:2 ratio

Continuing . . . CVP Analysis Multiple Products

BEP in sales dollars =

Total fixed costs ----------------------CM ratio per bag ($120,000 + $30,000*) ---------------------------.419 $357,995

BEP in sales dollars =

*$30,000 of additional fixed cost is incurred to produce both units

Scarce Resource -- Machine Hours

Ice Crushers $15 $3 4 3 10 $5 30 $150 $3 2 1 6 $6 20 $120 Juice Extractors $12

Selling price per unit Variable production cost per unit: Direct materials Direct labor Variable overhead Total variable cost Unit contribution margin Units of output per machine hour Contribution margin per machine hour

Sales Mix Decisions

How many of each product?

Relevant Costs in Product Line Decisions

Revenues associated with product Variable costs associated with product Avoidable fixed costs Consider product margin
Revenues - Variable costs - Avoidable fixed costs

Exhibit 6-12: Partial Product Line Income Statement

Electric Skillet $75,000 43,750 $31,250 39,500 ($8,250)

Sales Total direct variable expenses Total contribution margin Total fixed expenses* Net loss *Fixed expenses: Avoidable fixed expenses Unavoidable fixed expenses Allocated common costs Total

$25,000 4,500 10,000 $39,500

Exhibit 6-13: Product Margin for the Electric Skillet Product Line
Electric Skillet Sales Total direct variable expenses Total contribution margin Avoidable fixed expenses Product margin $75,000 43,750 $31,250 25,000 $6,250

CVP Graph
BE P
Total $ Volume Total Revenues Total Costs

Profit-Volume Graph

BEP Total $

Profit or Loss
Volume

Fixed Costs

Absorption Costing
Also known as full costing Treats costs of all manufacturing components as inventoriable, or product, costs
Direct materials Direct labor Variable factory overhead Fixed factory overhead

Presents expenses on income statement according to functional classifications

Cost of goods sold Selling expenses Administrative expenses

Variable Costing
Also known as direct costing Includes only variable production costs as inventoriable, or product, costs
Direct materials Direct labor Variable factory overhead

Fixed factory overhead costs treated as period expenses Income statement separates costs by cost behavior
May also present expenses by functional classifications within behavioral categories

Absorption Costing Income Statement

Sales Cost of Goods Sold: Beginning inventory Cost of goods manufactured Cost of goods available Ending inventory Cost of goods sold Gross Margin Operating Expenses: Selling Administrative Income before Taxes XXX XXX XXX XXX XXX XXX XXX XXX XXX

XXX XXX

Variable Costing Income Statement

Sales Cost of Goods Sold: Beginning inventory Cost of goods manufactured Cost of goods available Ending inventory Variable cost of goods sold Product Contribution Margin Variable Selling Expense Total Contribution Margin Fixed Expenses: Factory Selling Administrative Income before Taxes XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX

XXX XXX

Absorption Costing vs. Variable Costing Income Statements

Absorption Costing Sales Cost of sales Gross profit Operating expenses: Variable Fixed Total operating expenses Income $6,000 20,000 $26,000 $4,000 $60,000 30,000 $30,000 Variable Costing: Sales Variable costs: Cost of sales Operating expenses Total variable costs Contribution margin: Fixed costs Income 30,000 6,000 $36,000 $24,000 20,000 $4,000 $60,000