ACCOUNTING PRINCIPLES Third Canadian Edition Prepared by: Keri Norrie, Camosun College

COST-VOLUME-PROFIT RELATIONSHIPS CHAPTER 20

COST- BEHAVIOUR ANALYSIS Cost behaviour analysis: is the study of how specific costs respond to changes in the level of activity within a company.is the study of how specific costs respond to changes in the level of activity within a company. helps management plan operations and choose between alternative courses of action.helps management plan operations and choose between alternative courses of action. classifies the behaviour of costs in response to changes in activity levels into three categories: variable, fixed, or mixed.classifies the behaviour of costs in response to changes in activity levels into three categories: variable, fixed, or mixed.

COST- BEHAVIOUR ANALYSIS Variable Costs COST- BEHAVIOUR ANALYSIS Variable Costs Variable costs are costs that vary in total directly and proportionately with changes in the activity level.Variable costs are costs that vary in total directly and proportionately with changes in the activity level. The relevant activity depends on the company, for instance sales dollars (in a retail company), room occupancy (in a hotel), and kilometres driven (in a trucking company).The relevant activity depends on the company, for instance sales dollars (in a retail company), room occupancy (in a hotel), and kilometres driven (in a trucking company). Examples:Examples: Direct material and direct labour for a manufacturing companyDirect material and direct labour for a manufacturing company Sales commissions, and delivery costs for a merchandising company.Sales commissions, and delivery costs for a merchandising company.

$ Cost (000) Radios produced in (000) 0 5 $ Cost (per unit) Radios produced in (000) (a) Total Variable Costs (Digital Clocks) (b) Unit Variable Costs (Digital Clocks) ILLUSTRATION 20-1 COST- BEHAVIOUR ANALYSIS Variable Costs ILLUSTRATION 20-1 COST- BEHAVIOUR ANALYSIS Variable Costs Variable costs can also be defined as a cost that remains the same per unit at every activity level. For example, Damon Corp. manufactures radios that contain a $10 digital clock. The variable cost is $10 per radio with total costs increasing with more radios produced.

COST- BEHAVIOUR ANALYSIS Fixed Costs COST- BEHAVIOUR ANALYSIS Fixed Costs Fixed costs are costs that remain the same in total regardless of changes in the activity level.Fixed costs are costs that remain the same in total regardless of changes in the activity level. Examples: Property taxes, insurance, rent, supervisory salaries, and amortization on property, plant, and equipment.Examples: Property taxes, insurance, rent, supervisory salaries, and amortization on property, plant, and equipment. Since total fixed costs remain the same at any activity level, fixed cost per unit varies inversely with activity.Since total fixed costs remain the same at any activity level, fixed cost per unit varies inversely with activity.

ILLUSTRATION 20-2 COST- BEHAVIOUR ANALYSIS Fixed Costs ILLUSTRATION 20-2 COST- BEHAVIOUR ANALYSIS Fixed Costs $ Cost (000) Radios produced in (000) (a) Total Fixed Costs (Rent Expense) 0 1 $ Cost (per unit) Radios produced in (000) (b) Fixed Costs Per Unit (Rent Expense) Damon Corp. leases its production facilities at a cost of $10,000 per month. The total fixed cost of the facilities remains constant at every level of activity (see (a)). On a per unit basis the cost of rent will decline as activity increases (see (b)).

ILLUSTRATION 20-4 COST- BEHAVIOUR ANALYSIS Relevant Range ILLUSTRATION 20-4 COST- BEHAVIOUR ANALYSIS Relevant Range Cost ($) 0 (b)Total Fixed Costs Nonlinear Activity level (%) Relevant Range Cost ($) Activity level (%) (a) Total Variable Costs Curvilinear Relevant Range In practice, variable and fixed costs do not have a perfect linear relationship throughout the entire range of activity. However, at the level of activity over which a company expects to operate, referred to as the relevant range, a straight- line relationship to activity generally exists.

COST- BEHAVIOUR ANALYSIS Mixed Costs COST- BEHAVIOUR ANALYSIS Mixed Costs Mixed costs contain a variable and fixed cost element.Mixed costs contain a variable and fixed cost element. Mixed costs change in total but not proportionately with changes in activity level.Mixed costs change in total but not proportionately with changes in activity level. Examples: Utility costs such as electricity, computer, and telephone charges where there is a flat service fee plus a usage charge.Examples: Utility costs such as electricity, computer, and telephone charges where there is a flat service fee plus a usage charge.

$ Cost 0 Total Cost Line Variable Cost Element Fixed Cost Element ILLUSTRATION 20-5 COST- BEHAVIOUR ANALYSIS Mixed Costs ILLUSTRATION 20-5 COST- BEHAVIOUR ANALYSIS Mixed Costs Kilometres The rental of a U-Haul truck is a good example of a mixed cost. To illustrate, assume it costs $40 per day plus $.40 per kilometre to rent a truck. The daily charge is a fixed cost with respect to the kilometres driven, whereas the mileage charge is a variable cost.

COST- BEHAVIOUR ANALYSIS Mixed Costs COST- BEHAVIOUR ANALYSIS Mixed Costs For cost-volume-profit (CVP) analysis, mixed costs must be classified into their fixed and variable elements. One method used to make this determination is the high-low method. For cost-volume-profit (CVP) analysis, mixed costs must be classified into their fixed and variable elements. One method used to make this determination is the high-low method. High-low method uses the total costs at the high and low levels of activity.High-low method uses the total costs at the high and low levels of activity. The difference in total cost between the high and low levels represents variable costs as only the variable cost element can change as activity levels change.The difference in total cost between the high and low levels represents variable costs as only the variable cost element can change as activity levels change.

Change in Total Cost Change in Activity Level Variable Cost per Unit /= $37,50050,000 km$.75/= COST- BEHAVIOUR ANALYSIS Mixed Costs COST- BEHAVIOUR ANALYSIS Mixed Costs The first step for the high-low method is to determine the variable cost per unit. To illustrate, assume City Transit’s highest and lowest activity months for its buses have the following mileage data and maintenance costs: Highest activity85,000 kilometres$73,750 Lowest activity 35,000 kilometres$36,250 Change of $37,500

COST- BEHAVIOUR ANALYSIS Mixed Costs COST- BEHAVIOUR ANALYSIS Mixed Costs The second step for the high-low method is to determine the fixed cost by subtracting the total variable cost from the total cost at either the high or low activity level.To illustrate: The second step for the high-low method is to determine the fixed cost by subtracting the total variable cost from the total cost at either the high or low activity level. To illustrate: Highest activity month $73,750 total cost Less Variable Costs: (85,000 kilometres x $.75) $63,750 Total Fixed Cost$10,000 Maintenance costs are therefore $10,000 per month plus $.75 per kilometre.

COST-VOLUME-PROFIT (CVP) ANALYSIS ANALYSIS COST-VOLUME-PROFIT (CVP) ANALYSIS ANALYSIS CVP analysis is the study of the effects of changes in cost and volume on a company’s profits. It considers the interrelationships among the following components: Volume or level of activityVolume or level of activity Unit selling pricesUnit selling prices Variable cost per unitVariable cost per unit Total fixed costsTotal fixed costs Sales mixSales mix

COST-VOLUME-PROFIT ANALYSIS CVP Income Statement COST-VOLUME-PROFIT ANALYSIS CVP Income Statement Given the importance of CVP for decision making, management often wants this information reported in a CVP income statement format. To illustrate the CVP income statement and CVP analysis, we will use the following example: Vargo Video Limited produced DVDs players during the month of June, 2005 with following relevant data: Unit selling price of DVD player $500 Unit variable costs $300 Total monthly fixed costs $200,000 Units sold 1,600

COST-VOLUME-PROFIT ANALYSIS CVP Income Statement COST-VOLUME-PROFIT ANALYSIS CVP Income Statement TotalPer Unit Sales (1,600 x $500)$800,000$500 Variable Costs (1,600 x $300) 480, Contribution Margin 320,000$200 Fixed Costs 200,000 Net Income$120,000 VARGO VIDEO LIMITED CVP Income Statement Month ended June 30, 2005 The CVP income statement classifies costs as variable and fixed and calculates contribution margin which is the amount of revenue after deducting variable costs. A traditional income statement would have the same net income but it does not classify costs as variable and fixed. “Cost” means all expenses incurred in the production and sale of the product (manufacturing and selling and administrative expenses).

COST-VOLUME-PROFIT ANALYSIS Contribution Margin COST-VOLUME-PROFIT ANALYSIS Contribution Margin The formula for contribution margin per unit is: It indicates that for every DVD player sold, Vargo will have $200 to cover fixed costs and contribute to net income. Selling Price per Unit Variable Cost per Unit Contribution Margin per Unit -= $500$300$200 -=

Contribution margin can also be expressed as a ratio: COST-VOLUME-PROFIT ANALYSIS Contribution Margin COST-VOLUME-PROFIT ANALYSIS Contribution Margin It indicates that 40 cents of each sales dollar ($1 x 40%) can be used to pay for fixed costs and to contribute to income. The ratio helps management determine the effect of changes in sales on income. For instance, a $100,000 increase in sales will result in a $40,000 increase in net income. Contribution Margin per Unit Selling Price per Unit Contribution Margin Ratio = $200$50040% = ÷ ÷

COST-VOLUME-PROFIT ANALYSIS Break-Even Analysis COST-VOLUME-PROFIT ANALYSIS Break-Even Analysis The break-even point is the level of activity where total revenue equals total costs, both fixed and variable. Net income = zero.The break-even point is the level of activity where total revenue equals total costs, both fixed and variable. Net income = zero. Break-even analysis is useful to management in deciding whether to:Break-even analysis is useful to management in deciding whether to: introduce new product lines,introduce new product lines, change sales prices, orchange sales prices, or enter new market areas.enter new market areas.

ILLUSTRATION COST-VOLUME- PROFIT ANALYSIS: Break-Even Analysis Break-even occurs where total sales equal variable costs plus fixed costs. For Vargo Video, it would be: Break-Even Sales Variable Costs Fixed Costs = + $500,000(1,000 x $300)$200,000 Using the formula and knowing the unit sales price, unit variable cost, and total fixed costs, the break- even number of units can be calculated = 1,000 units. = +

ILLUSTRATION and COST-VOLUME-PROFIT ANALYSIS Break-Even Analysis ILLUSTRATION and COST-VOLUME-PROFIT ANALYSIS Break-Even Analysis Since contribution margin = revenue – variable costs, break-even occurs when contribution margin = fixed costs. For Vargo Video, this relationship can be used to calculate break-even as follows: Fixed Costs Contribution Margin per Unit Break-Even Point in Units ÷ = $200,000$2001,000 units Fixed Costs Contribution Margin Ratio Break-Even Point in Dollars ÷ = $200,00040%$500,000 ÷ ÷ = =

Dollars (000) Units of Sales $ Break-even Point Profit Area Total Revenue Line Total Cost Line Fixed Cost Line Loss Area ILLUSTRATION COST-VOLUME-PROFIT ANALYSIS Break-Even Analysis ILLUSTRATION COST-VOLUME-PROFIT ANALYSIS Break-Even Analysis Another way to find the break- even point is to prepare a cost- volume-profit (CVP) graph. Sales volume is recorded on the horizontal axis while both revenue and total costs are recorded on the vertical axis.

COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis As sales increase beyond break-even, managers use CVP information to analyse options and strategies including considerations about: the company’s margin of safety andthe company’s margin of safety and target net income.target net income.

COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis Margin of safety is the difference between actual or expected sales, and sales at the break-even point.Margin of safety is the difference between actual or expected sales, and sales at the break-even point. It is the “cushion” management has above break-even sales, which may be expressed in dollars or as a ratio.It is the “cushion” management has above break-even sales, which may be expressed in dollars or as a ratio. The higher the dollars or ratio, the greater the margin of safety, and the lower risk of not breaking even.The higher the dollars or ratio, the greater the margin of safety, and the lower risk of not breaking even.

ILLUSTRATION and COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis ILLUSTRATION and COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis Margin of Safety in Dollars Actual (Expected) Sales Break-Even Sales =- $250,000$750,000$500,000=- If the actual (expected) sales of Vargo Video are $750,000, the margin of safety would be: Margin of Safety Ratio ÷= 33% ÷= Margin of Safety in Dollars $250,000 Actual (Expected) Sales $750,000

ILLUSTRATION COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis ILLUSTRATION COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis Management usually sets a target net income which indicates the necessary sales needed to achieve the desired income level.Management usually sets a target net income which indicates the necessary sales needed to achieve the desired income level. Assuming that the target net income for Vargo Video is $120,000, then the calculation of required sales is as follows:Assuming that the target net income for Vargo Video is $120,000, then the calculation of required sales is as follows: Variable Costs Fixed Costs Target Net Income ++ $480,000$200,000$120,000++ Required Sales $800,000 = =

ILLUSTRATION and COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis ILLUSTRATION and COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis The sales required to obtain a target net income can also be calculated using the contribution margin. Using contribution margin, the required sales level for Vargo Video can be calculated as follows: Fixed Costs + Target Net Income Contribution Margin per Unit Required Sales in Units ÷ = ($200,000 + $120,000)$2001,600 units Contribution Margin Ratio Required Sales in Dollars ÷ = 40%$800,000 Fixed Costs + Target Net Income ($200,000 + $120,000) ÷ ÷ = =

COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis COST-VOLUME-PROFIT ANALYSIS Applying Cost-Volume-Profit Analysis CVP analysis can help management respond to changes in business conditions. Fixed Costs Contribution Margin per Unit Break-Even Point in Units ÷ = $200,000 ($500 price - $300 variable cost) $200 ($500 price - $300 variable cost) 1,000 units Fixed Costs Contribution Margin per Unit Break-Even Point in Units ÷ = $200,000$150 ($450 price - $300 variable cost) 1,333 units To illustrate, assume a competitor of Vargo Video is offering a 10% discount on the selling price of its DVD players. If management is considering a similar discount, what effect will it have on the break-even point? As previously calculated With 10% price discount

CVP INCOME STATEMENT REVISITED A conventional income statement and detailed CVP income statement both show net income. The major difference is the format for expenses.

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