978-1337119207 Chapter 19 Part 1

Unlock access to all the studying documents.

View Full Document

355

chapter

19(5)

Cost-Volume-Profit

Analysis

______________________________________________

OPENING COMMENTS

Cost-volume-profit analysis is conducted using both a formula-based mathematical approach and a

graphic approach. It is applied to single-product and multiple-product companies. The chapter concludes

with an appendix that discusses variable costing.

1. Classify costs as variable costs, fixed costs, or mixed costs.

2. Compute the contribution margin, the contribution margin ratio, and the unit contribution margin.

3. Determine the break-even point and sales necessary to achieve a target profit.

necessary to achieve a target profit.

5. Compute the break-even point for a company selling more than one product, the operating leverage,

and the margin of safety.

ADM: Describe and illustrate the use of cost-volume-profit analysis for decision making in a service

business.

KEY TERMS

activity bases (drivers)

break-even point

Chapter 19(5) Cost-Volume-Profit Analysis 356

contribution margin

contribution margin ratio

cost behavior

cost-volume-profit analysis

cost-volume-profit chart

fixed costs

high-low method

margin of safety

mixed costs

operating leverage

profit-volume chart

relevant range

sales mix

unit contribution margin

variable costing

variable costs

STUDENT FAQS

 Why does variable cost per unit stay the same but total cost varies with the number of units you

produce?

 How do you choose what activity base to use?

 Why does fixed cost remain the same in total dollar amount but increase or decrease per unit as the

level of activity changes?

 What do increases in fixed cost do to break-even analysis?

 What do increases in variable cost do to break-even analysis?

OBJECTIVE 1

Classify costs as variable costs, fixed costs, or mixed costs.

SYNOPSIS

Cost behavior is the manner in which a cost changes as activity changes. Managers find this relationship

useful as it allows managers to predict profits as sales and production volume change. Activity bases are

the things that cause cost to change, and the range over which the changes are of interest is called the

relevant range. Costs are classified as variable, fixed, or mixed costs. Variable costs are those that change

directly in proportion to changes in production volume. Direct materials and direct labor are usually

variable costs. Variable costs have certain characteristics, such as the cost per unit remains the same and

total cost varies in proportion to the activity base. Exhibit 1 shows a graphical representation of variable

cost per unit and variable total cost. Fixed costs are those that remain the same in total over the relevant

range. Straight-line depreciation is an example of a fixed cost. Although total cost remains the same, fixed

cost per unit decreases as production increases. Mixed costs have characteristics of both a variable and

fixed cost. They are also called semivariable or semifixed costs. An example might be a rental car that has

a fixed component (charge per day) and also charges per mile driven. For purposes of analysis, mixed

Chapter 19(5) Cost-Volume-Profit Analysis 357

costs are usually separated into their fixed and variable components. The high-low method is a cost

estimation tool that is used to calculate mixed costs. To calculate, you must have several periods of

historical data, including units produced and total costs. Subtract the lowest levels of production from the

highest levels of production computed as: variable cost per unit = difference in total cost/difference in

units produced. The fixed cost is then estimated by subtracting the total variable costs from the total fixed

costs, as follows: fixed cost = total costs—(variable cost per unit × units produced). Mixed costs contain a

fixed component even if nothing is produced.

Key Terms and Definitions

 Activity Base (Driver)—A measure of activity that is related to changes in cost. Used in

analyzing and classifying cost behavior. Activity bases are also used in the denominator in

calculating the predetermined factory overhead rate to assign overhead costs to cost objects.

 Cost Behavior—The manner in which a cost changes in relation to its activity base (driver).

 Fixed Costs—Costs that tend to remain the same in amount, regardless of variations in the level

of activity.

 High-Low Method—A technique that uses the highest and lowest total costs as a basis for

estimating the variable cost per unit and the fixed cost component of a mixed cost.

 Mixed Costs—Costs with both variable and fixed characteristics, sometimes called semivariable

or semifixed costs.

 Relevant Range—The range of activity over which changes in cost are of interest to

management.

 Variable Costing—The concept that considers the cost of products manufactured to be

composed only of those manufacturing costs that increase or decrease as the volume of

production rises or falls (direct materials, direct labor, and variable factory overhead).

 Variable Costs—Costs that vary in total dollar amount as the level of activity changes.

Relevant Check Up Corner and Exhibits

 Exhibit 1—Variable Cost Graphs

 Exhibit 2—Variable Costs and Their Activity Bases

 Exhibit 3—Fixed Cost Graphs

 Exhibit 4—Fixed Costs and Their Activity Bases

 Exhibit 5—Mixed Costs

 Exhibit 6—Variable and Fixed Cost Behavior

 Exhibit 7—Variable, Fixed, and Mixed Cost

 Check Up Cornier 19(5)-1 – Cost Behavior

SUGGESTED APPROACH

Knowing how costs behave enables management to estimate costs when evaluating alternative operating

proposals. Begin your coverage of this objective by reviewing the definitions of variable, fixed, and

mixed costs. Be sure to point out the behavior of both total and unit costs. For example, variable costs are

illustrated in text Exhibit 1. When reviewing this illustration, stress that as the number of units produced

increases, the total direct materials cost increases but the unit cost remains constant.

Chapter 19(5) Cost-Volume-Profit Analysis 358

Fixed costs are shown in text Exhibit 3. This illustration compares the supervisor’s salary in a plant that

makes perfume to the number of perfume bottles produced. The total salary is constant at all production

levels. As a result, the per-unit cost decreases as production increases.

Mixed costs have both a fixed and a variable component. An example of a mixed cost is the price paid to

rent a moving van if that price includes a fixed fee plus a charge per mile (i.e., $50 plus $0.30 per mile).

In addition to understanding how costs behave, managers need to know what activities create costs. These

activities are called activity bases (or activity drivers). Ask your students to identify the activity base that

drives their textbook expenditures. (Answer: the number of courses taken)

GROUP LEARNING ACTIVITY—Variable, Fixed, and Mixed Costs

Divide your class into small groups. Ask them to list examples of fixed, variable, and mixed costs

incurred by a McDonald’s restaurant. Encourage them to list as many examples as they can. Also instruct

them to identify the activity base (driver) for each variable cost on their list.

Possible response: McDonald’s variable costs could include all the food and drinks, hourly labor, food

containers, and condiments. Fixed costs could include rent or mortgage, managers’ salaries, insurance,

and franchise fees. Mixed costs could include utilities, advertising, and maintenance costs.

DEMONSTRATION PROBLEM—High-Low Method

For most business analysis, mixed costs must be separated into their fixed and variable components. Use

the following problem to demonstrate the high-low method.

The power costs of Jones Manufacturing behave as a mixed cost. The activity that creates most of the

power costs is machine usage. Therefore, power costs will be analyzed in relation to machine hours.

Machine hours and power costs for the past six months are presented on Transparency Master (TM)

19(5)-1. Ask students to identify the highest and lowest levels of power usage (August and July

respectively). Next, ask them to compute the difference in machine hours and power costs and record

these numbers in their notes.

Once the high and low points have been identified, the variable portion of the cost is determined using the

following equation:

Difference in Total Cost

Variable Cost/Unit Difference in Machine Hours

$300

Variable Cost/Unit $0.05/hour

6,000 hours





The fixed portion can be determined using data from either the high or the low power-usage points and

the following equation:

Chapter 19(5) Cost-Volume-Profit Analysis 359

Total Cost = (Variable Cost/Unit  No. of Units) + Fixed Costs

Chapter 19(5) Cost-Volume-Profit Analysis 360

Using data from July:

$1,900 = ($0.05/unit  14,000) + Fixed Costs

$1,900 – $700 = Fixed Costs

$1,200 = Fixed Costs

OBJECTIVE 2

Compute the contribution margin, the contribution margin ratio, and the unit contribution

margin.

SYNOPSIS

Cost-volume-profit analysis is useful for managerial decision making. The analysis may be used to

analyze the following: the effects of changes in selling price on profits, the effects of changes in costs of

profits, the effects of changes in volume on profits, how to set prices, how to select the mix of products to

sell, and how to choose marketing strategy. The contribution margin provides insights in to the profit

potential and is calculated as: contribution margin = sales—variable costs. The contribution margin can

also be expressed as a percentage; this ratio is calculated as: contribution margin ratio = contribution

margin/sales. This ratio is most useful when the increase or decrease in sales volume is measured in sales

dollars. The contribution margin can also be computed per unit as: unit contribution margin = sales price

per unit—variable cost per unit.

Key Terms and Definitions

 Contribution Margin—Sales less variable costs and variable selling and administrative

expenses.

 Contribution Margin Ratio—The percentage of each sales dollar that is available to cover the

fixed costs and provide an operating income.

 Cost-Volume-Profit Analysis—The systematic examination of the relationships among selling

prices, volume of sales and production, costs, expenses, and profits.

 Unit Contribution Margin—The dollars available from each unit of sales to cover fixed costs

and provide operating profits.

Relevant Check Up Corner and Exhibits

 Exhibit 8—Contribution Margin Income Statement Format

 Check Up Corner 19(5)-2) – Contribution Margin

SUGGESTED APPROACH

Give students the following formulas related to contribution margin (CM):

CM = Sales—Variable Costs

CM Ratio = CM/Sales

Chapter 19(5) Cost-Volume-Profit Analysis 361

Stress that contribution margin is the amount of funds left from a sale after the variable costs have been

paid. Contribution margin is used to pay the fixed costs of the business. Once all fixed costs have been

covered, any contribution margin left represents profit.

The contribution margin ratio tells what percent of each sales dollar is contribution margin. Once again, if

sales are above break-even, this percentage represents profit.

GROUP LEARNING ACTIVITY—Contribution Margin

Give your students the following sales and cost data for Van Buren Company. The total sales and cost

information is based on the sale of 20,000 units.

Total Per Unit

Sales $570,000 $28.50

Variable costs $387,600 $19.38

Fixed costs $140,000

Divide the class into small groups. Ask students to compute the total contribution margin, contribution

margin ratio, and unit contribution margin for this company. Also instruct them to compute the increase

in net income that will result from a $50,000 increase in sales and a 1,000-unit increase in sales.

The answers to this exercise are as follows:

1. Total contribution margin: $182,400

2. Contribution margin ratio: 32 percent

3. Unit contribution margin: $9.12

4. Increase in net income from $50,000 increase in sales: $50,000  32% = $16,000

5. Increase in net income from 1,000-unit increase in sales: 1,000  $9.12 = $9,120

OBJECTIVE 3

Determine the break-even point and sales necessary to achieve a target profit.

SYNOPSIS

of activity; however, unit variable costs may be affected by changes in the price of materials, labor, or

sales. An increase in unit variable costs increases the break-even point, and decreases in variable costs

decrease the break-even point. If the selling price changes, this also changes the break-even point in the

Chapter 19(5) Cost-Volume-Profit Analysis 362

opposite direction. If the sales price increases, the break-even point decreases, and if the sales price

decreases, the break-even point increases. A summary of the effects is shown in Exhibit 13. By modifying

the break-even equation, a business can determine what sales are necessary to achieve a target profit. The

equation is: sales (units) = (fixed costs + target profit)/unit contribution margin.

Key Terms and Definitions

 Break-Even Point—The level of business operations at which revenues and expired costs are

equal.

Relevant Check Up Corner and Exhibits

 Exhibit 9—Break-Even Point

SUGGESTED APPROACH

Under this objective, the text presents formulas to calculate the break-even point in units and the unit

sales necessary to achieve a target profit. Use the following lecture notes to explain these formulas.

LECTURE NOTES—Break–Even Point and Target Profit

Fixed Costs + Target Profit

Sales (units) Unit Contribution Margin



formula can be derived as follows:

Sales Price (X) – Variable Cost (X) – Fixed Costs = Income from Operations

where: X = No. of units sold

also note: sales price and variable cost are per-unit amounts