ESSENTIALS OF ACCOUNTING Tools for Business Decision Making, 2 nd . ED

1. ESSENTIALS OF ACCOUNTINGTools for Business Decision Making, 2nd. ED ELS Kimmel, Weygandt, Kieso

2. Cost-Volume-Profit Relationships CHAPTER 6

3. Cost-Volume-Profit Relationships T o manage any size business you must understand: • how costs respond to changes in sales volume • the effect of costs and revenues on profits.

4. Cost Behavior Analysis The study of how specific costs respond to changes in the level of business activity.

5. Activity (Volume) Index The activity that causes changes in the behavior of costs. Examples: • Sales dollars in retail company • Miles driven in trucking company • Room occupancy in hotel • Classes taught at college

6. Activity (Volume) Index Changes in level or volume of activity should be correlated with changes in costs.

7. Three Categories of Costs • Variable • Fixed • Mixed

8. Illustration 6-1 Variable Costs - in Total Costs that vary in total directly and proportionately with changes in the activity level. • Variable Cost= $10 per unit • 0 units = $ 0= total • 2 units = $ 20= total • 4 units = $ 40= total • 6 units = $ 60=total • 8 units = $ 80=total • 10units = $100=total

9. Illustration 6-1 Variable Costs - per Unit Costs that remain the same per unit at every level of activity. • Variable Cost= $10 per unit • 0 units = $ 0 per unit • 2 units = $ 10 per unit • 4 units = $ 10 per unit • 6 units = $ 10 per unit • 8 units = $ 10 per unit • 10units = $ 10 per unit

10. Fixed Costs - in Total Costs that remain the same in total regardless of changes in the activity level. • Property Taxes • Insurance • Rent • Supervisory Salaries • Depreciation on building, equipment

11. Illustration 6-2 Fixed Cost - in Total Costs that remain the same in total regardless of changes in the activity level. Total Fixed Costs= $ 10,000 2 units = $ 10,000 per month 4 units = $ 10,000 per month 6 units = $ 10,000 per month 8 units = $ 10,000 per month 10units = $ 10,000 per month

12. Illustration 6-2 Fixed Cost - per Unit Costs that very inversely with activity. As volume increases, unit cost declines. Total Fixed Costs= $ 10,000 2 units = $ 5,000 per unit 4 units = $ 2,500 per unit 6 units = $ 1,667 per unit 8 units = $ 1,250 per unit 10units = $ 1,000 per unit

13. Often between 40-80 % of Capacity Relevant Range The range of activity index over which the company expects to operate during the year.

14. Mixed Costs Costs that contain both a variable and a fixed cost element and change in total but not proportionately with changes in the activity level. Rental of U-haul Truck • $50 a day (Fixed Amount) + • $.50 a mile (Variable Cost)

15. Illustration 6-5 Behavior of a Mixed Costs

16. High-Low Method A mathematical method that uses the total costs incurred at the high and low levels of activity.

17. MonthJanuaryFebruary Miles Driven20,00040,000 Total Cost$30,000$48,000 MonthMarchApril Miles Driven35,00050,000 Total Cost$49,000$63,000 Illustration 6-7 High-Low Method Metro Transit Company has the following maintenance costs and mileage data for its fleet of buses over a 4-month period: April $63,000 50,000 January 30,000 20,000 Difference $33,000 30,000 $33,000  30,000 = $1.10 variable costs per mile

18. Activity Level High $63,000 55,000$ 8,000 Low $30,000 22,000$ 8,000 Total CostLess: Variable costs (50,000 x $1.10) (20,000 x $1.10)Total fixed costs Illustration 6-8 High-Low Method Metro Transit Company would compute the fixed portion as: Maintenance costs are $8,000 per month fixed plus $1.10 per mile. For example at 45,000 miles, estimated maintenance costs would be $49,500 = variable (45,000 x $1.10), and $8,000 fixed.

19. High-Low Method The high-low method generally produces a reasonable (not a precise) estimate for analysis.

20. Illustration 6-9 Cost-Volume-Profit (CVP) Analysis The study of the effects of changes in costs and volume on a company’s profits.

21. CVP Income Statement A statement for internal use that classifies costs and expenses as fixed or variable and reports contribution margin in the body of the statement.

22. Traditional Format CVP Format Sales $ 800,000 Sales $ 800,000 Cost of goods sold 520,000 Variable expenses Cost of goods sold $ 400,000 Gross profit 280,000 Selling expenses 60,000 Operating expenses Administrative expenses 20,000 Selling expenses $ 100,000 Administrative expenses 60,000 Total variable expenses 480,000 Total operating expenses 160,000 320,000 Contribution Margin Fixed expenses Net income $ 120,000 Cost of goods sold 120,000 Selling expenses 40,000 Administrative expenses 40,000 Total fixed expenses 200,000 Net income $ 120,000 Illustration 6-31 CVP Income Statement

23. Contribution Margin (CM) The amount of revenue remaining after deducting variable costs.

24. Contribution Margin Per Unit The amount of revenue remaining per unit after deducting variable costs; calculated as unit selling price minus unit variable cost.

25. Contribution Margin Ratio The percentage of each dollar of sales that is available to contribute to net income; calculated as contribution margin per unit divided by unit selling price.

26. CVP Graph A graph showing the relationship between costs, volume, and profits.

27. TargetNet Income The income objective for individual product lines.

28. Break-Even Point The level of activity at which total revenues equal total costs.

29. Break-Even Point • Is the level of activity where total revenues equals total costs, both fixed and variable. • Can be expressed in sales dollars or sales units. • Is useful to management in deciding whether: • To add new product lines • Change sales prices on current products • To enter new markets

30. Break-Even Point

31. Margin of Safety The difference between actual or expected sales and sales at the break-even point.