23-1 Copyright  Houghton Mifflin Company. All rights reserved. Chapter 23 Cost-Volume-Profit Analysis and Variable Costing Belverd E. Needles, Jr. Marian Powers Sherry K. Mills Henry R. Anderson Multimedia Slides by: Dr. Paul J. Robertson New Mexico State University Steve Leask Steve Leask New Mexico State University

23-2 Copyright  Houghton Mifflin Company. All rights reserved. 1.Define cost behaviour and explain how managers make use of this concept in the management cycle. 2.Identify specific types of variable and fixed cost behaviour, and define and discuss the relationships of operating capacity and relevant range to cost behaviour. 3.Define mixed cost, and use the high-low method to separate the variable and fixed components of a mixed cost. LEARNING OBJECTIVES

23-3 Copyright  Houghton Mifflin Company. All rights reserved. 4.Define cost-volume-profit analysis and discuss how managers use this analysis. 5.Compute a breakeven point in units of output and in sales dollars, and prepare a breakeven graph. 6.Define contribution margin and use the concept to determine a company’s breakeven point for a single product and for multiple products. LEARNING OBJECTIVES

23-4 Copyright  Houghton Mifflin Company. All rights reserved. 7.Apply cost-volume-profit analysis to estimated levels of future sales and to changes in costs and selling prices. 8.Apply cost-volume-profit analysis to a service business. LEARNING OBJECTIVES

23-5 Copyright  Houghton Mifflin Company. All rights reserved. Cost Behaviour Patterns OBJECTIVE 1 Define cost behaviour and explain how managers make use of this concept in the management cycle.

23-6 Copyright  Houghton Mifflin Company. All rights reserved. The Use of Cost Behaviour in the Management Cycle Determine how many units need to be sold to obtain the desired net income. Determine how changes in planned operating, investing, or financial activities will affect income. Determine how decisions about current operating, investing, or financing activities affect income. Report the budgeted net income. Determine the best alternative.

23-7 Copyright  Houghton Mifflin Company. All rights reserved. Cost Behaviour »Cost behaviour refers to how costs change in relation to volume or activity.  Some costs vary with volume or operating activity.  Others remain fixed as volume changes.  Some costs exhibit characteristics between these two extremes.

23-8 Copyright  Houghton Mifflin Company. All rights reserved. The Management Cycle  Managers use their knowledge of cost behaviour to estimate future costs and impact of operational changes on future profitability.  Managers use assumptions about cost behaviour in almost every decision they make.  Managers must understand cost behaviour patterns to anticipate cost ramifications of alternatives in order to decide correctly.

23-9 Copyright  Houghton Mifflin Company. All rights reserved. A.1.Some costs vary with volume or operating activity. 2.Others remain fixed as volume changes. Discussion Q.What are the two extremes concerning cost behaviour discussed in this chapter?

23-10 Copyright  Houghton Mifflin Company. All rights reserved. The Behaviour of Variable Costs OBJECTIVE 2 Identify specific types of variable and fixed cost behaviour, and define and discuss the relationships of operating capacity and relevant range to cost behaviour.

23-11 Copyright  Houghton Mifflin Company. All rights reserved. Variable Costs »Total costs that change in direct proportion to changes in productive output are called variable costs.  On a per unit basis, however, variable costs remain constant as volume changes.

23-12 Copyright  Houghton Mifflin Company. All rights reserved. Variable Costs  Examples of variable costs:  Direct materials.  Direct and indirect labour (hourly).  Operating supplies.  Sales commissions.

23-13 Copyright  Houghton Mifflin Company. All rights reserved. Examples of Variable, Fixed, and Mixed Costs

23-14 Copyright  Houghton Mifflin Company. All rights reserved. Examples of Variable, Fixed, and Mixed Costs

23-15 Copyright  Houghton Mifflin Company. All rights reserved. Examples of Variable, Fixed, and Mixed Costs

23-16 Copyright  Houghton Mifflin Company. All rights reserved. Capacity »Capacity can be expressed in several ways, including:  Total labour hours.  Total machine hours.  Total units of output.

23-17 Copyright  Houghton Mifflin Company. All rights reserved. Capacity »Operating Capacity: Maximum productive output and related costs, given existing resources. »Theoretical Capacity: Maximum productive output possible over a given period of time. »Practical Capacity: Theoretical capacity reduced by normal, expected work stoppages.

23-18 Copyright  Houghton Mifflin Company. All rights reserved. Capacity »Excess Capacity: Extra machinery and equipment available when regular facilities are being repaired or when expected volume is greater. »Normal Capacity: Average annual operating capacity needed to satisfy expected sales demand.

23-19 Copyright  Houghton Mifflin Company. All rights reserved. Measures of Capacity »Each variable cost should be related to an appropriate measure of capacity, but often more than one measure of capacity applies.

23-20 Copyright  Houghton Mifflin Company. All rights reserved. Measures of Capacity  Management accountants must aggregate variable costs that have the same activity base to facilitate estimation of future costs.  The traditional definition of variable costs assumes a linear relationship exists between costs and the measure of capacity chosen.

23-21 Copyright  Houghton Mifflin Company. All rights reserved. A Common Variable-Cost Behaviour Pattern: Linear Relationship Labour Cost Units $2.50 per unit $5 0 $10 $15 $

23-22 Copyright  Houghton Mifflin Company. All rights reserved. Nonlinear Variable Costs »Many costs vary with operating activity in a nonlinear fashion.  Costs of computer usage.  Costs of power consumption. »Cost behaviour of nonlinear costs can be approximated within the relevant range using a linear approximation technique.

23-23 Copyright  Houghton Mifflin Company. All rights reserved. Relevant Range »The relevant range is the volume range within which actual operations are likely to occur.

23-24 Copyright  Houghton Mifflin Company. All rights reserved. The Relevant Range and Linear Approximation The Relevant Range and Linear Approximation Total Cost Volume $ Linear Approximation True Behaviour Pattern RelevantRange 0

23-25 Copyright  Houghton Mifflin Company. All rights reserved. Fixed Costs »Fixed costs are costs that remain constant within a relevant range of volume or activity. Examples of fixed costs are:  Depreciation.  Rent.  Supervisory salaries.  Property taxes. »Unit fixed costs vary inversely with changes in volume.

23-26 Copyright  Houghton Mifflin Company. All rights reserved. A Common Fixed-Cost Behaviour Pattern Units of Output $2,000 0 $4,000 $6,000 $8, ,000400,000600,000800,000 Original Relevant Range New Relevant Range Fixed Overhead Cost Fixed Cost Pattern

23-27 Copyright  Houghton Mifflin Company. All rights reserved. A.1. Direct materials. 2. Direct and indirect labour (hourly). 3. Operating supplies. 4. Sales commissions. Discussion Q.What are examples of variable costs?

23-28 Copyright  Houghton Mifflin Company. All rights reserved. Mixed Costs OBJECTIVE 3 Define mixed cost, and use the high-low method to separate the variable and fixed components of a mixed cost.

23-29 Copyright  Houghton Mifflin Company. All rights reserved. Mixed Costs »Mixed costs have both variable and fixed cost components. »Part of the cost changes with volume or usage, and part of the cost is fixed over time.

23-30 Copyright  Houghton Mifflin Company. All rights reserved. Total Telephone Cost Long Distance Calls $ Behaviour Patterns of Mixed Costs: Telephone Costs

23-31 Copyright  Houghton Mifflin Company. All rights reserved. Total Maintenance Cost Maintenance Hours $ Behaviour Patterns of Mixed Costs: Maintenance Costs

23-32 Copyright  Houghton Mifflin Company. All rights reserved. High-Low Method »A scatter diagram is a chart of plotted points that helps determine if there is a linear relationship between a cost item and its related activity measure.

23-33 Copyright  Houghton Mifflin Company. All rights reserved. A.1.Part of the cost changes with volume or usage. 2.Part of the cost is fixed over the period. Discussion Q.What are the characteristics of a mixed cost?

23-34 Copyright  Houghton Mifflin Company. All rights reserved. Cost-Volume-Profit Analysis OBJECTIVE 4 Define cost-volume-profit analysis and discuss how managers use this analysis.

23-35 Copyright  Houghton Mifflin Company. All rights reserved. Cost-Volume-Profit Analysis »Cost-volume-profit analysis is used primarily as a planning and control tool.  Projecting net income at different activity levels.  Measuring the performance of a department within a company.  Assisting in the analysis of decision alternatives.

23-36 Copyright  Houghton Mifflin Company. All rights reserved. Cost-Volume-Profit Analysis The C-V-P Formula Sales Revenue Fixed Costs Total Variable Costs S VC FC S = VC + FC + Net Income

23-37 Copyright  Houghton Mifflin Company. All rights reserved. A.1.Projecting net income. 2.Measuring departmental performance. 3.Analysis of decision alternatives. Discussion Q.What are the management uses of cost-volume-profit analysis?

23-38 Copyright  Houghton Mifflin Company. All rights reserved. Breakeven Analysis OBJECTIVE 5 Compute a breakeven point in units of output and in sales dollars, and prepare a breakeven graph.

23-39 Copyright  Houghton Mifflin Company. All rights reserved. The Breakeven Point »The breakeven point is the point of zero profit.  Breakeven units equal fixed costs divided by contribution margin per unit.  Breakeven dollars equal breakeven units times the selling price per unit.

23-40 Copyright  Houghton Mifflin Company. All rights reserved. The Breakeven Graph »A standard breakeven graph has five components.  The horizontal axis (volume).  The vertical axis (dollars).  The fixed cost line.  The total cost line.  The total revenue line.

23-41 Copyright  Houghton Mifflin Company. All rights reserved. The Breakeven Graph »Normally, a loss area, profit area, and breakeven point will result. »At zero volume, net loss equals fixed costs.

23-42 Copyright  Houghton Mifflin Company. All rights reserved. Graphic Breakeven Analysis: Dakota Products, Inc. $60 $10 $20 $50 $40 $ Dollars (in thousands) Units of Output Fixed Costs Unit Breakeven Sales Breakeven Total Revenue Line Total Cost Line Loss Area Net Income Area Variable Costs

23-43 Copyright  Houghton Mifflin Company. All rights reserved. A.1.Breakeven units equal fixed costs divided by contribution margin per unit. 2.Breakeven dollars equal breakeven units times the selling price per unit. Discussion Q.What are the formulas for breakeven units and breakeven dollars?

23-44 Copyright  Houghton Mifflin Company. All rights reserved. Contribution Margin OBJECTIVE 6 Define contribution margin and use the concept to determine a company’s breakeven point for a single product and for multiple products.

23-45 Copyright  Houghton Mifflin Company. All rights reserved. Contribution Margin »Contribution margin equals sales minus total variable costs. CM = S - VC »Contribution margin per unit equals selling price minus variable cost per unit.

23-46 Copyright  Houghton Mifflin Company. All rights reserved. Contribution Margin »The breakeven point (in units) equals fixed costs divided by the contribution margin per unit. BE units = FC / CM per unit »A sales mix is used to calculate the breakeven point for each product when an organization sells more than one product.

23-47 Copyright  Houghton Mifflin Company. All rights reserved. A.Sales - Variable costs = Contribution margin - Fixed costs = Net income (loss) Discussion Q.What is the calculation of net income when using the contribution format?

23-48 Copyright  Houghton Mifflin Company. All rights reserved. Planning Future Sales OBJECTIVE 7 Apply cost-volume-profit analysis to estimated levels of future sales and to changes in costs and selling prices.

23-49 Copyright  Houghton Mifflin Company. All rights reserved. Cost-Volume-Profit »The contribution approach is extremely useful for profit planning. »Target sales in units = (FC + NI) / (CM per unit). »Projected net income can be calculated, assuming changes in volume, selling price, and/or costs.

23-50 Copyright  Houghton Mifflin Company. All rights reserved. Assumptions Underlying C-V-P Analysis 1.The behaviour of variable and fixed costs can be measured accurately. 2.Costs and revenues have a close linear approximation. 3.Efficiency and productivity hold steady within the relevant range of activity.

23-51 Copyright  Houghton Mifflin Company. All rights reserved. Assumptions Underlying C-V-P Analysis 4.Cost and price variables hold steady during the period being planned. 5.The product sales mix does not change during the period being planned. 6.Production and sales volume are roughly equal.

23-52 Copyright  Houghton Mifflin Company. All rights reserved. A.Target Sales Units = (FC + NI) / CM per unit Discussion Q.The contribution margin approach can be used for profit planning. What is the calculation to determine target sales units?

23-53 Copyright  Houghton Mifflin Company. All rights reserved. Applying C-V-P Analysis to a Service Business OBJECTIVE 8 Apply cost-volume-profit analysis to a service business.

23-54 Copyright  Houghton Mifflin Company. All rights reserved. Cost-Volume-Profit »A service concern does not manufacture a physical product. »The cost per service rendered includes the following:  Professional (direct) labour costs.  Service overhead costs (may be fixed or variable).

23-55 Copyright  Houghton Mifflin Company. All rights reserved. Cost-Volume-Profit »A service business can separate mixed costs into their variable and fixed portions in order to: 1.Calculate a breakeven point. 2.Plan net income when changes in cost, volume, or price occur.

23-56 Copyright  Houghton Mifflin Company. All rights reserved. A.1.Separate mixed costs into their variable and fixed portions. 2.Calculate a breakeven point. 3.Plan net income when changes in cost, volume, or price occur. Discussion Q.How can a service business use cost-volume-profit analysis?

23-57 Copyright  Houghton Mifflin Company. All rights reserved. 1.Define cost behaviour and explain how managers make use of this concept in the management cycle. 2.Identify specific types of variable and fixed cost behaviour, and define and discuss the relationships of operating capacity and relevant range to cost behaviour. 3.Define mixed cost, and use the high-low method to separate the variable and fixed components of a mixed cost. OK, LET’S REVIEW...

23-58 Copyright  Houghton Mifflin Company. All rights reserved. 4.Define cost-volume-profit analysis and discuss how managers use this analysis. 5.Compute a breakeven point in units of output and in sales dollars, and prepare a breakeven graph. 6.Define contribution margin and use the concept to determine a company’s breakeven point for a single product and for multiple products. CONTINUING OUR REVIEW...

23-59 Copyright  Houghton Mifflin Company. All rights reserved. 7.Apply cost-volume-profit analysis to estimated levels of future sales and to changes in costs and selling prices. 8.Apply cost-volume-profit analysis to a service business. AND FINALLY...