The Total Costs Curve TOTAL COSTS FIXED COSTS Revenue $$$ SALES VOLUME BREAKEVEN VOLUME VARIABLE COSTS

The Cost-Price-Volume (CPV) Curve REVENUES TOTAL COSTS FIXED COSTS $$$ SALES VOLUME BREAKEVEN VOLUME BREAKEVEN REVENUES VARIABLE COSTS

The CPV Curve for Profit Planning To make a profit sales Revenues must exceed the sum of Fixed and Variable Expenses. Revenues > Fixed Expenses + Variable Expenses REVENUES TOTAL COSTS FIXED COSTS $$$ SALES VOLUME BREAKEVEN VOLUME VARIABLE COSTS PRICE INCREASE NEW BREAKEVEN

The CPV Curve for Profit Planning To make a profit sales Revenues must exceed the sum of Fixed and Variable Expenses. REVENUES TOTAL COSTS FIXED COSTS $$$ SALES VOLUME ORIGINAL BREAKEVEN NEW VARIABLE COST CURVE NEW BREAKEVEN

The Contribution Margin The Gross Margin format –Separates costs by function The Contribution Margin format –Separates Costs into Variable Expenses and Fixed Expenses. –The Contribution Margin shows how much revenue is left to contribute to Fixed Expenses. –This is a useful analytical tool for managerial accounting.

The Contribution Margin Ratio Shows the percentage of sales revenues required to cover variable costs. Calculate the Breakeven Point Revenues = Fixed Expenses / CM Ratio

Operating Leverage BREAKEVEN VOLUME TC REVENUES $ V BREAKEVEN VOLUME TC REVENUES $ V HIGH LEVERAGE (HIGH FIXED COSTS) LOW LEVERAGE (LOW FIXED COSTS)

Business Decisions and Costing Analysis Costing information is used to make a wide range of business decisions. –Make-or-Buy –Production decisions –Capital Investment Alternatives –Equipment Replacement –Product Design (new and redesigns) –Inventory levels

Common Pitfalls When performing decision analysis it is important to avoid a few common pitfalls. –Cash flows are the only elements to be considered; –Consider the timing and amount of cash flows; –Consider only relevant costs and analyze only those financial elements that are affected by the choices; –Sunk costs are not included.

Common Pitfalls –Non-cash flows, such as depreciation, are after-tax savings: Depreciation reduces Net Income on the Income Statement and therefore has a net savings of Income Taxes; Depreciation is a multi-year savings so the amount and timing of the after-tax savings must be considered; The Income Tax savings must usually be provided by the Accounting department; –Consider all reasonable alternatives.

Additional Cost Definitions Differential (a.k.a. Marginal or Incremental) Costs –The difference in costs between two alternatives. Opportunity Costs –The value of lost benefits when a course of action is chosen; expected benefits foregone when one alternative is chosen. –Only used in Managerial Accounting. Sunk Costs –Costs that have already been incurred and cannot be recovered. They will have no bearing when choosing between alternative courses of action.