1. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 19 1

2. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 Identify how changes in volume affect costs Use CVP analysis to compute breakeven points Use CVP analysis for profit planning, and graph the CVP relations Use CVP methods to perform sensitivity analyses

3. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 3 Calculate the breakeven point for multiple products or services Distinguish between variable costing and absorption costing (see Appendix 19A, located at myaccountinglab.com)

4. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Identify how changes in volume affect costs 4 1 1

5. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The effect of volume of activity on costs Variable costs Increase or decrease in total in direct proportion to changes in the volume of activity Fixed costs Do not change over wide ranges of volume Mixed costs Have both variable and fixed components 5

6. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Total variable costs change in direct proportion to changes in the volume of activity If activity increases, so does the cost Unit variable cost remains constant Volume can be measured in many different ways: Number of units sold Number of units produced Number of miles driven by a delivery vehicle Number of phone calls placed 6

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8. Tend to remain the same in amount, regardless of variations in level of activity Examples: Straight-line depreciation Salaries Part-time manager’s salary Total fixed costs do not change, but the fixed cost per event depends on the number of events The more activity, the less the fixed cost per unit 8

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10. Have both a fixed and variable component Example: Utilities that charge a set fee per month, plus a charge for usage 10

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12. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Method to separate mixed costs into variable and fixed components Identify the highest and lowest levels of activity over a period of time STEP 1: Calculate variable cost per unit STEP 2: Calculate total fixed cost STEP 3: Create and use equation to show the behavior of a mixed cost 12 Variable cost per unit = Change in total cost ÷ Change in activity volume Total fixed cost = Total mixed cost – Total variable cost Total mixed cost = (Variable cost per unit X number of units) + Total fixed costs

13. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Data Step 1 Step 2 13

14. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 14 ($2 x 400 event-playing hours) + $1,000 = $1,800 Now check your formula against the original data

15. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Range of volume: Where total fixed costs remain constant and variable cost per unit remains constant Outside the relevant range, costs can differ 15

16. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Philadelphia Acoustics builds innovative speakers for music and home theater systems. Consider the following costs. Identify the costs as variable (V), fixed (F), or mixed (M). 16 1. Units of production depreciation on routers used to cut wood enclosures 2. Wood for speaker enclosures 3. Patents on crossover relays 4. Total compensation to salesperson, who receives a salary plus a commission based on meeting sales goals 5. Crossover relays V V F M V

17. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Philadelphia Acoustics builds innovative speakers for music and home theater systems. Consider the following costs. Identify the costs as variable (V), fixed (F), or mixed (M). 17 6. Straight-line depreciation on manufacturing plant 7. Grill cloth 8. Cell phone costs of salesperson (plan includes 1,200 minutes; overseas calls are charged at an average of $0.15 per minute) 9. Glue 10. Quality inspector’s salary F V M V F

18. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Martin owns a machine shop. In reviewing his utility bill for the last 12 months, he found that his highest bill of $2,800 occurred in August when his machines worked 1,400 machine hours. His lowest utility bill of $2,600 occurred in December when his machines worked 900 machine hours. 1.Calculate (a) the variable rate per machine hour and (b) Martin’s total fixed utility cost. Variable cost per unit = Change in total cost ÷ Change in activity volume 18 a. Variable cost per unit = ($2,800 - $2,600) ÷ (1,400 – 900) Variable cost per unit = $200 ÷ 500 + 0.40 per machine hour b. Total fixed cost = Total mixed cost – Total variable cost Total fixed cost = $2,800 – (0.40 X 1,400) Total fixed cost = $2,800 - $560 Total fixed cost = $2,240

19. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Martin owns a machine shop. In reviewing his utility bill for the last 12 months, he found that his highest bill of $2,800 occurred in August when his machines worked 1,400 machine hours. His lowest utility bill of $2,600 occurred in December when his machines worked 900 machine hours. 2. Show the equation for determining the total utility cost for Martin’s. $ 0.40 per machine hour + $2,240 19

20. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Martin owns a machine shop. In reviewing his utility bill for the last 12 months, he found that his highest bill of $2,800 occurred in August when his machines worked 1,400 machine hours. His lowest utility bill of $2,600 occurred in December when his machines worked 900 machine hours. 3. If Martin’s anticipates using 1,200 machine hours in January, predict his total utility bill using the equation from Requirement 2. ($ 0.40 per machine hour x 1.200 machine hours) + $2,240 $480 +$2,240 = $2,720 20

21. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Martin owns a machine shop. In reviewing his utility bill for the last 12 months, he found that his highest bill of $2,800 occurred in August when his machines worked 1,400 machine hours. His lowest utility bill of $2,600 occurred in December when his machines worked 900 machine hours. 4. Draw a graph illustrating your total cost under this plan. Label the axes, and show your costs at 900, 1,200, and 1,400 machine hours. 21

22. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use CVP analysis to compute breakeven points 22 2 2

23. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Expresses the relationships among costs, volume, and profit or loss Answers: How many products or services must the company sell to break even? What will profits be if sales double? How will changes in selling price, variable costs, or fixed costs affect profits? Assumptions: Managers can classify each cost as either variable or fixed Only factor that affects total costs is change in volume, which increases variable and mixed costs Fixed costs do not change 23

24. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Sales level at which operating income is zero: Total revenues equal total costs (expenses) Sales above breakeven result in a profit Sales below breakeven result in a loss Two methods to compute breakeven point: Income statement approach Sales revenue − Total costs = Operating income Contribution margin approach Sales revenue – Variable costs = Contribution margin – Fixed costs = Operating income 24

25. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Express income in equation form and then break it down into its components: 25

26. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Shortcut method The contribution margin is sales revenue minus variable costs (expenses) Called contribution margin because the excess of sales revenue over variable costs contributes to covering fixed costs 26

27. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Rearrange the income statement—use the contribution margin to develop a shortcut method Shortcut equation: 27

28. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Given fixed costs total $12,000. The contribution margin per event is $120 ($200 sale price – $80 variable cost) Check your answer 28

29. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Ratio of contribution margin to sales revenue Used to compute the breakeven point in terms of sales dollars Contribution margin is equal to: Sales price – variable cost Contribution margin divided by sales revenue yields a percentage Percentage of each dollar of sales revenue that contributes toward fixed costs and profit 29

30. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Formula: Example: Yields the same breakeven as the contribution margin approach earlier 30

31. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1. Compute the number of tickets Story must sell to break even. Perform a numerical proof to show that your answer is correct. 31 Units sold = ($240,000 + 0) ÷ ($50 - $10) Units sold = $240,000 ÷ $40 = 6,000 units to breakeven

32. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1. Compute the number of tickets Story must sell to break even. Perform a numerical proof to show that your answer is correct. 32 Total sales revenue $300,000 -Variable cost 60,000 Contribution margin $240,000 - Fixed cost 240,000 Operating income $ 0

33. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1. Compute Story Park’s contribution margin ratio. Carry your computation to two decimal places. 33 $50 - $10 = $40 $40 ÷ $50 = 0.80 or 80%

34. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 2. Use the contribution margin ratio CVP formula to determine the sales revenue Story Park needs to break even. 34 $240,000 ÷ 0.80 = $300,000

35. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use CVP analysis for profit planning, and graph the CVP relations 35 3 3

36. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Managers more interested in: Sales level needed to earn a target profit Profits they can expect to earn How many products or service events must be sold to earn a specific operating profit Use either method Set operating profit equal to desired profit 36

37. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Graph provides a picture that shows how changes in the levels of sales will affect profits Four steps: 1.Choose a sales volume and plot the point for total sales revenue at that volume 2.Draw the fixed cost line 3.Draw the total cost line (total costs are the sum of variable costs plus fixed costs) 4.Identify the breakeven point and the areas of operating income and loss 37

38. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 38

39. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider the following facts: 39 ABC Number of units1,3003,6007.500 Sale price per unit$100$40$125 Variable costs per unit4010100 Total fixed costs72,00060,00040,000 Target operating income180,00075,000100,000 Calculate: Contribution margin per unit Contribution margin ratio Breakeven points in units Breakeven point in sales dollars Units to achieve target operating income

40. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Consider the following facts: 40 ABC Number of units1,3003,6007.,00 Sale price per unit$100$40$125 Variable costs per unit4010100 Total fixed costs72,00060,00040,000 Target operating income180,00075,000100,000 Calculate: Contribution margin per unit$60$30$25 Contribution margin ratio60%75%20% Breakeven points in units1,2002,0001,600 Breakeven point in sales dollars$120,000$80,000$200,000 Units to achieve target operating income4,2004,5005,600

41. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. John Kyler is considering starting a Web-based educational business, e-Prep MBA. He plans to offer a short-course review of accounting for students entering MBA programs. The materials would be available on a password-protected Web site; students would complete the course through self-study. Kyler would have to grade the course assignments, but most of the work is in developing the course materials, setting up the site, and marketing. Unfortunately, Kyler’s hard drive crashed before he finished his financial analysis. However, he did recover the following partial CVP chart: 1. Label each axis, the sales revenue line, the total costs line, the fixed costs, the operating income area, and the breakeven point. 2. If Kyler attracts 300 students to take the course, will the venture be profitable? 3. What are the breakeven sales in students and dollars? 41

42. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1.Label each axis, the sales revenue line, the total costs line, the fixed costs, the operating income area, and the breakeven point. 2. If Kyler attracts 300 students to take the course, will the venture be profitable? 3. What are the breakeven sales in students and dollars? 42 Sales Revenue Total Cost Fixed Cost Operating income Breakeven Will not be profitable. Possible loss of $8,000 Breakeven at 400 students, $40,000 in sales

43. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use CVP methods to perform sensitivity analysis 43 4 4

44. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Predict how changes in sale prices, cost, or volume affect profits “What-if?” analysis Allows managers to see how various business strategies affect profits Changing selling price Changing variable Costs Changing fixed Costs 44

45. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How will the lower sale price affect the breakeven point? Lower price yields higher unit sales to breakeven Higher prices yields lower unit sales to breakeven 45

46. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How will increased costs affect the breakeven point? Higher cost yields higher unit sales to breakeven Lower cost yields lower unit sales to breakeven 46

47. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. How will the increased fixed costs affect the breakeven point? Higher fixed costs yields higher unit sales to breakeven Lower fixed costs yields lower unit sales to breakeven 47

48. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Exhibit 19-6 48

49. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Excess of expected sales over breakeven sales Cushion, drop in sales, a company can absorb without incurring a loss Margin of safety in units Margin of safety in dollars 49

50. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1. Suppose Story Park cuts its ticket price from $50 to $40 to increase the number of tickets sold. Compute the new breakeven point in tickets and in sales dollars. 50 Units sold = ($240,000 + 0) ÷ ($40 - $10) Units sold = $240,000 ÷ $30 = 8,000 units to breakeven $320,000 sales dollars to breakeven

51. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 2. Ignore the information in Requirement 1. Instead, assume that Story Park increases the variable cost from $10 to $20 per ticket. Compute the new breakeven point in tickets and in sales dollars. 51 Units sold = ($240,000 + 0) ÷ ($50 - $20) Units sold = $240,000 ÷ $30 = 8,000 units to breakeven = $400,000 in sales dollars

52. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Story Park competes with Splash World by providing a variety of rides. Story sells tickets at $50 per person as a one-day entrance fee. Variable costs are $10 per person, and fixed costs are $240,000 per month. 1. If Story Park expects to sell 6,200 tickets, compute the margin of safety in tickets and in sales dollars. 52 Expected sales - Breakeven sales = Margin of safety in units 6,200 – 6,000 = 200 in units Margin of safety in units x Sales price = Margin of safety in dollars 200 units x $50 = $10,000

53. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculate the breakeven point for multiple product lines or services 53 5 5

54. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Selling prices and variable costs differ for each product Different contribution to profits Weighted-average contribution margin computed Sales mix provides weights to make up total product sales Weights equal 100% of total product sales 54

55. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. To compute breakeven sales in units for multiple products, complete the following three steps: STEP 1: Calculate the weighted-average contribution margin per unit STEP 2: Calculate the breakeven point in units for the “package” of products STEP 3: Calculate the breakeven point in units for each product and then multiply the “package” breakeven point in units by each product’s proportion of the sales mix 55

56. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculate the weighted-average contribution margin per unit: 56

57. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculate the breakeven point in units for the “package” of products: 57

58. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Calculate the breakeven point in units for each product. Multiply the “package” breakeven point in units by each product’s proportion of the sales mix: 58

59. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Prove this breakeven point by preparing a contribution margin income statement: 59

60. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Wet Weekend Swim Park sells individual and family tickets, which include a meal, three beverages, and unlimited use of the swimming pools. Wet Weekend has the following ticket prices and variable costs for 2012: Wet Weekend expects to sell two individual tickets for every four family tickets. Wet Weekend’s total fixed costs are $75,000. 1. Compute the weighted-average contribution margin per ticket. 2. Calculate the total number of tickets Wet Weekend must sell to break even. 3. Calculate the number of individual tickets and the number of family tickets the company must sell to break even. 60 IndividualFamily Sale price per ticket3090 Variable cost per ticket1560

61. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Wet Weekend expects to sell two individual tickets for every four family tickets. Wet Weekend’s total fixed costs are $75,000. 1. Compute the weighted-average contribution margin per ticket. 61 IndividualFamilyTotal Sale price per ticket$ 30$ 90 Variable cost per ticket 15 60 Contribution margin per unit 15 30 Sales mix in units 2 46 Contribution margin$30$120150 Weighted-average contribution margin per unit $25

62. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2. Calculate the total number of tickets Wet Weekend must sell to break even. 3. Calculate the number of individual tickets and the number of family tickets the company must sell to break even. 62 IndividualFamilyTotal Sale price per ticket$ 30$ 90 Variable cost per ticket 15 60 Contribution margin per unit 15 30 Sales mix in units 2 46 Contribution margin$30$120150 Weighted-average contribution margin per unit $25 $75,000 ÷ $25 = 3,000 total tickets 3,000 total tickets x 2/6 = 1,000 individual tickets 3,000 total tickets x 4/6 = 2,000 family tickets

63. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Distinguish between variable costing and absorption costing (Appendix 19A—online at myaccountinglab.com 63 6 6

64. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Absorption costing: Considers fixed manufacturing costs as inventoriable product costs Variable costing: Considers fixed manufacturing costs as period costs (expenses) 64

65. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Type of CostAbsorption CostingVariable Costing Product Costs (capitalized as Inventory until expensed as Cost of goods sold) Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Direct materials Direct labor Variable manufacturing overhead Period Costs (expensed in period incurred) Variable nonmanufacturing costs Fixed nonmanufacturing costs Fixed manufacturing overhead Variable nonmanufacturing costs Fixed nonmanufacturing costs Income Statement Format Conventional income statement Contribution margin income statement 65

66. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Variable costs are those costs that increase or decrease in total as the volume of activity increases or decreases. Fixed costs are costs that do not change over wide ranges of volume. Costs that have both variable and fixed components are called mixed costs. The high-low method is an easy way to separate mixed costs into variable and fixed components by requiring you to identify the highest and lowest levels of activity over a period of time. The relevant range is the range of activity where total fixed cost stays the same and variable cost per unit stays the same. 66

67. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The breakeven point is the sales level at which operating income is zero—total revenues equal total costs. The breakeven point can be found by using the income statement approach, using zero for operating income. The breakeven point can also be found by dividing total fixed cost by the contribution margin per unit (sales price per unit – variable cost per unit). Breakeven analysis can be used to calculate the sales volume needed to earn a certain amount of profit, called target profit. Target profit is the operating income that results when sales revenue minus variable costs and minus fixed costs equals management’s profit goal. 67

68. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Graphing various activity levels and costs gives a visual representation of operating levels that generate net income and operating levels that result in net loss. Sensitivity analysis is a “what if” technique that asks what results are likely if selling price or costs change or if an underlying assumption changes. The income statement approach to breakeven is just adjusted for the new proposed values. The margin of safety is the “cushion” or drop in sales that the company can absorb before incurring a loss. 68

69. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Most companies sell more than one product. Selling price and variable costs differ for each product, so each product makes a different contribution to profits. To calculate break even for each product, we compute the weighted-average contribution margin of all the company’s products. The combination of products that make up total sales, called the sales mix (or product mix), provides the weights that make up total product sales. 69

70. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Variable costing assigns only variable manufacturing costs to products. Fixed manufacturing costs are considered period costs and are expensed immediately because the company incurs these fixed costs whether or not it produces any products or services. In variable costing, fixed manufacturing costs are not treated as product costs. Management accountants often prefer variable costing because contribution margin is readily apparent on the variable costing income statement. 70

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72. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 72 Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.