Cost Accounting Traditions and Innovations Barfield, Raiborn, Kinney Chapter 11 Absorption/Variable Costing and Cost-Volume-Profit Analysis

Learning Objectives (1 of 2) Explain the different approaches to cost accumulation and cost presentation Contrast absorption and variable costing Describe how changes in sales and/or production levels affect net income under absorption and variable costing Explain how companies use cost-volume- profit analysis

Learning Objectives (2 of 2) Explain cost-volume-profit analysis for single-product and multiproduct firms Describe how businesses use margin of safety and operating leverage concepts List the underlying assumptions of cost- volume-profit analysis (Appendix) Construct break-even charts and profit-volume graphs

Absorption Vs. Variable Costing Absorption or Full GAAP Classify by Function –Cost of goods sold –Selling expense –Administrative expense Variable or Direct Not GAAP Classify by Behavior –Variable –Fixed

Absorption Vs. Variable Costing Absorption or Full Product costs –Direct material –Direct labor –Variable mfg. overhead –Fixed mfg. overhead Period costs –Selling –General –Administrative Variable or Direct Product costs –Direct material –Direct labor –Variable mfg. overhead Period Costs –Fixed mfg. overhead –Selling –General –Administrative

Income Statement Absorption Costing Sales Less: Cost of Goods Sold Gross Profit Less: Operating Expenses Net Income Product Costs Direct Material Direct Labor Fixed and Variable Mfg. Overhead Period Costs Selling, General, Administrative

Income Statement Variable Costing Sales Less:Variable Cost of Goods Sold Product Contribution Margin Less: Variable Operating Expenses Contribution Margin Less:Fixed Mfg. Overhead Less:Fixed Operating Expenses Net Income Direct Material Direct Labor Variable Mfg. Overhead Selling, General, Administration Selling General Administrative

Difference in Income Absorption Vs. Variable No change in inventory level –Absorption Income = Variable Income Increase in inventory level –Absorption Income > Variable Income –Phantom Profits Decrease in inventory level –Absorption Income < Variable Income

Cost-Volume-Profit Analysis Relationship of –Revenue –Costs –Volume changes –Taxes –Profits Applies to –Manufacturers –Wholesalers –Retailers –Service Industries

Cost-Volume-Profit Analysis Compute the break-even point Calculate the level of sales necessary to achieve a target profit Set sales price Answer “what-if” questions

Cost-Volume-Profit Assumptions Company is operating within the relevant range Revenue per unit remains constant Variable costs per unit remain constant Total fixed costs remain constant Mixed costs are separated into variable and fixed elements

Equations Break-even point Total Revenues = Total Costs Total Revenues - Total Costs = Zero Profit Contribution Margin (CM) Sales Price - Variable Cost = CM per unit Revenue - Total Variable Costs = CM in total

Break-Even Formula - Units Total Fixed Costs Sales Price (per unit) - Variable Cost (per unit) $100, = 12,500 units If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is 12,500 units Contribution Margin

Break-Even Formula - Dollars Total Fixed Costs Sales Price (per unit) - Variable Cost (per unit) Sales Price (per unit) If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is $150,000 $100, = $150, Contribution Margin Ratio

Income Statement Proof Sales LessTotal variable costs Contribution Margin LessTotal fixed costs Profit before taxes $ 150,000 (12,500 * 12) (50,000) (12,500 * 4) $ 100,000 (100,000) -0- If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is 12,500 units

Using Cost-Volume-Profit Analysis Setting a target profit –Enter before-tax profit in numerator $100,000 + $30, = $195, If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired before-tax profit is $30,000, the required sales are $195,000

Using Cost-Volume-Profit Analysis Setting a target profit –Convert after-tax profit to before-tax profit Before-tax profit = After-tax profit 1 - tax rate $36,000 = % $60,000 At a 40% tax rate, an after-tax profit of $36,000 equals a before-tax profit of $60,000

Setting a target profit –Convert after-tax profit to before-tax profit –Enter before-tax profit in numerator If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $36,000, the required sales are $240,000 $100,000 + $60, = $240, Using Cost-Volume-Profit Analysis

Income Statement Proof Sales LessTotal variable costs Contribution Margin LessTotal fixed costs Profit before taxes Income taxes Profit after taxes $ 240,000 (20,000 * 12) (80,000) (20,000 * 4) $ 160,000 (100,000) $ 60,000 (24,000) (60,000 * 40%) $ 36,000 If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $36,000, the required sales are $240,000

Using Cost-Volume-Profit Analysis Variable profit related to number of units sold X = FC / (CM u - P u BT) Sales Volume Total Fixed Cost Contribution Margin Ratio Variable Amount of Profit Before Tax per Unit

Incremental Analysis Changes in revenues, costs, and/or volume Break-even point increases when –fixed costs increase –sales price decreases –variable costs increases

Multiproduct Cost-Volume-Profit Analysis Assumes a constant product sales mix Contribution margin is weighted on the quantities of each product included in the “bag” of products Contribution margin of the product making up the largest proportion of the bag has the greatest impact on the average contribution margin of the product mix

Multiproduct Cost-Volume-Profit Analysis 3 2 Sales mix Contribution margin per unit $2 $1 FC = $8,000 “The Bag” Three units of spray for every two units of liquid

Multiproduct Cost-Volume-Profit Analysis 3 2 Sales mix Contribution margin per unit $2 $1 $8000 3($2) + 2($1) = 1,000 “bags” Breakeven

Multiproduct Cost-Volume-Profit Analysis 3 2 Sales mix x 1,000 3,000 x 1,000 2,000 Breakeven “bag” Breakeven units To break even sell 3,000 sprays and 2,000 liquids

Margin of Safety Budgeted (or actual) sales after the break-even point Indication of risk

Margin of Safety Units Actual units - break-even units Dollars Actual sales dollars - break-even sales dollars Percentage Margin of Safety in units or dollars Break-even units or sales in dollars

Operating Leverage Relationship of variable and fixed costs Effect on profits when volume changes Cost structure strongly influences the impact changes in volume have on profits

Operating Leverage High Operating Leverage Low variable costs High fixed costs High contribution margin High break-even point Sales after break-even have greater impact on profits Low Operating Leverage High variable costs Low fixed costs Low contribution margin Low break-even point Sales after break-even have lesser impact on profits

Degree of Operating Leverage Measures how a percentage change in sales will affect profits Degree of Operating Leverage Contribution Margin Profit Before Taxes When margin of safety is small, the degree of operating leverage is large

Cost-Volume-Profit Assumptions Company is operating within the relevant range Revenue and variable cost per unit are constant Total contribution margin increases proportionally with increases in unit sales Total fixed costs remain constant Mixed costs are separated into variable and fixed elements

Cost-Volume-Profit Assumptions No change in inventory (production equals sales) No change in capacity Sales mix remains constant Anticipated price level changes included in formulas Labor productivity, production technology, and market conditions remain constant

Additional Considerations Are they fixed costs or long-term variable costs? Quality improvements may violate assumptions –increase costs during implementation –increase productivity –decrease costs –adjust sales price

Traditional CVP Graph Total $ Activity Level Fixed Costs

Traditional CVP Graph Total $ Activity Level Fixed Costs Total Costs

Traditional CVP Graph Total $ Activity Level Total Costs Variable Costs

Traditional CVP Graph Total $ Activity Level Total Costs Total Revenues

Traditional CVP Graph Total $ Activity Level Total Costs Total Revenues BEP Loss Profit

Contemporary CVP Graph Total $ Activity Level Variable Costs

Contemporary CVP Graph Total $ Activity Level Total Revenues Variable Costs Contribution Margin

Contemporary CVP Graph Total $ Activity Level Total Revenues Total Costs Total Variable Costs

Contemporary CVP Graph Total $ Activity Level Total Revenues Total Costs Total Variable Costs BEP

Profit-Volume Graph $ Activity Level

Profit-Volume Graph $ Activity Level Fixed Costs

Profit-Volume Graph $ Activity Level Fixed Costs BEP

Profit-Volume Graph $ Activity Level Fixed Costs BEP

Questions What is the difference between absorption and variable costing? How do companies use cost-volume-profit analysis? What are the underlying assumptions of cost-volume-profit analysis?