1. 22 - 1©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Chapter 22 Cost-Volume-Profit Analysis

2. 22 - 2©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Identify different cost behavior patterns. Objective 1

3. 22 - 3©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Variable Fixed Mixed Types of Costs

4. 22 - 4©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Variable Costs Example n Consider Grand Canyon Railway. n Assume that breakfast costs Grand Canyon Railway $3 per person. n If the railroad carries 2,000 passengers, it will spend $6,000 for breakfast services.

5. 22 - 5©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Variable Costs Example 012345012345 $24 – $18 – $12 – $6 – – Volume (Thousands of passengers) Total Variable Costs (thousands)

6. 22 - 6©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Fixed Costs Example 012345012345 $400 – $300 – $200 – $100 – – Volume (Thousands of passengers) Total Fixed Costs (thousands)

7. 22 - 7©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Mixed Costs Example n A mixed cost is part variable and part fixed. n Assume a department of a company has fixed costs of $50 per month ($600 per year). n There are also variable costs of $3 per hour.

8. 22 - 8©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Mixed Costs Example 0 125 250 375 500 625 $2,850 – $2,100 – $1,350 – $600 – – Volume (hours) Total Costs Variable Cost Fixed Cost

9. 22 - 9©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Relevant Range... – is a band of volume in which a specific relationship exists between cost and volume. n Outside the relevant range, the cost either increases or decreases. n A fixed cost is fixed only within a given relevant range and a given time span.

10. 22 - 10©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Relevant Range Fixed Costs Volume in Units $160,000 – $120,000 – $80,000 – $40,000 0 5,000 10,000 15,000 20,000 25,000 –––––– Relevant Range

11. 22 - 11©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Use a contribution margin income statement to make business decisions. Objective 2

12. 22 - 12©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Conventional income statement Contribution margin income statement Two Approaches to Compute Profits

13. 22 - 13©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Conventional Income Statement Sales – Cost of Goods Sold = Gross Margin – Operating Expenses = Net Income Gross Margin

14. 22 - 14©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Contribution Margin Income Statement Sales – Variable Expenses = Contribution Margin – Fixed Expenses = Net Income Contribution Margin

15. 22 - 15©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Contribution Margin Example n Luis and Tom manufacture a device that allows users to take a closer look at icebergs from a ship. n The usual price for the device is $100. n Variable costs are $70. n They receive a proposal from a company in Newfoundland to sell 20,000 units at a price of $85.

16. 22 - 16©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Contribution Margin Example n There is sufficient capacity to produce the order. n How do we analyze this situation? n $85 – $70 = $15 contribution margin. n $15 × 20,000 units = $300,000 (total increase in contribution margin)

17. 22 - 17©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Objective 3 Compute breakeven sales and perform sensitivity analyses.

18. 22 - 18©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Cost-Volume-Profit Analysis — Sales — Fixed — Fixed + Variable

19. 22 - 19©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sx – Vx – F = 0 Cost-Volume-Profit Analysis n Accountants use two methods to perform CVP analysis. n Both methods use an equation or formula derived from the contribution margin income statement.

20. 22 - 20©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Equation Approach With the equation approach, breakeven sales in units is calculated as follows: Unit sales price × Units sold Variable unit cost × Units sold Fixed expenses Operating income = – –

21. 22 - 21©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Breakeven Point Example n Assume that fixed expenses amount to $90,000. n How many devices must be sold at the regular price of $100 to break even? n ($100 × Units sold) – ($70 × Units sold) – $90,000 = 0 n Units sold = $90,000 ÷ $30 = 3,000

22. 22 - 22©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Per Unit Percent Ratio Sales price$1001001.00 Variable expenses 70 70.70 Contribution margin$ 30 30.30 Contribution Margin

23. 22 - 23©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber (Fixed expenses + Operating income) ÷ Contribution margin per unit = Units ($90,000 + 0) ÷ $30 = 3,000 Units Contribution Margin Formula

24. 22 - 24©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber (Fixed expenses + Operating income) ÷ Contribution margin ratio = $ Sales ($90,000 + 0) ÷.30 = $300,000 Contribution Margin Ratio Formula

25. 22 - 25©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Change in Sales Price Example n Suppose that the sales price per device is $106 rather than $100. n What is the revised breakeven sales in units? n New contribution margin: $106 – $70 = $36 n $90,000 ÷ $36 = 2,500 units

26. 22 - 26©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Change in Variable Costs Example n Suppose that variable expenses per device are $75 instead of $70. n Other factors remain unchanged. n $90,000 ÷ $25 = 3,600 n $90,000 ÷ 0.25 = $360,000

27. 22 - 27©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Change in Fixed Costs Example n Suppose that rental costs increased by $30,000. n What are the new fixed costs? n $90,000 + $30,000 = $120,000 n What is the new breakeven point? n $120,000 ÷ $30 = 4,000 units n $120,000 ÷ 0.30 = $400,000

28. 22 - 28©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Compute the sales level needed to earn a target operating income. Objective 4

29. 22 - 29©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Target Operating Income Example n Suppose that a business would be content with operating income of $45,000. n Assuming $100 per unit selling price, variable expenses of $70 per unit, and fixed expenses of $90,000, how many units must be sold? n ($90,000 + $45,000) ÷ $30 = 4,500

30. 22 - 30©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Graph a set of cost-volume-profit relationships. Objective 5

31. 22 - 31©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Various Sales Levels Example n Assume selling price is $35 per unit. n Variable expense is $21 per unit. n Fixed cost is $7,000. n What is the breakeven point? n 500 units or $17,500

32. 22 - 32©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Cost-Volume-Profit Graph Breakeven sales point 500 units or $17,500 Sales revenue line Total expense line Fixed expense line

33. 22 - 33©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Various Sales Levels Example n What operating income is expected when sales are 300 units? n $14 × 300 = $4,200 $4,200 – $7,000 = ($2,800)

34. 22 - 34©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Various Sales Levels Example n What operating income is expected when sales are 1,000 units? n $14 × 1,000 = $14,000 $14,000 – $7,000 = $7,000

35. 22 - 35©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Compute a margin of safety. Objective 6

36. 22 - 36©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Margin of Safety Example n Margin of safety is the excess of expected sales over breakeven sales. n Assume Luis and Tom’s breakeven point is 3,000 devices. n Suppose they expect to sell 4,000 during the period. n What is the margin of safety?

37. 22 - 37©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 4,000 – 3,000 = 1,000 units 1,000 × $100 = $100,000 Margin of Safety Example 1,000 × 4,000 = 25% $100,000 × $400,000 = 25%

38. 22 - 38©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Assumptions of CVP Analysis 1 Expenses can be classified as either variable or fixed. 2 CVP relationships are linear over a wide range of production and sales. 3 Sales prices, unit variable cost, and total fixed expenses will not vary within the relevant range.

39. 22 - 39©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Assumptions of CVP Analysis 4 Volume is the only cost driver. 5 The relevant range of volume is specified. 6 Inventory levels will be unchanged. 7 The sales mix remains unchanged during the period.

40. 22 - 40©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Use the sales mix in CVP analysis. Objective 7

41. 22 - 41©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sales Mix Example n Suppose that Luis and Tom plan to sell two types of devices instead of one. n They estimate that sales will be 3,000 regular devices and 1,000 large devices. n This is a 3:1 sales mix. n They expect 3/4 of the devices sold to be regular devices and 1/4 to be large devices.

42. 22 - 42©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Regular Large Sales price $100 $154 Variable expenses 70 100 Contribution margin 30 54 Sales mix (units) 3 1 $ 90 $ 54 The total is $144. Sales Mix Example

43. 22 - 43©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sales Mix Example Weighted-average contribution margin $144 ÷ (3 + 1) = $36 Breakeven sales $90,000 ÷ $36 = 2,500 2,500 × 3/4 = 1,875 regular devices 2,500 × 1/4 = 625 large devices

44. 22 - 44©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sales Mix Example 1,875 regular× $100 =$187,500 625 large× $154 = 96,250 Breakeven$283,750 $90,000 ÷ $144 = 625 packages in the mix

45. 22 - 45©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Compute income using variable costing and absorption costing. Objective 8

46. 22 - 46©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Absorption costing assigns all manufacturing costs to products. Financial statements prepared under GAAP use absorption costing. Absorption costing assigns all manufacturing costs to products. Financial statements prepared under GAAP use absorption costing. Variable costing assigns only variable manufacturing costs to products. Variable costing is for internal use only. Variable costing assigns only variable manufacturing costs to products. Variable costing is for internal use only. Product Costing

47. 22 - 47©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Assume the following costs: Direct material unit cost$6.00 Direct labor unit cost$3.00 Variable manufacturing overhead$2.00 Variable marketing$2.50 Fixed manufacturing overhead per unit$5.00 What is the product cost/unit? Product Costing Example

48. 22 - 48©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Absorption Costing Direct materials $ 6.00 Direct labor 3.00 Variable manufacturing overhead 2.00 Fixed manufacturing overhead 5.00 Total $16.00 Product Costing Example

49. 22 - 49©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Variable Costing Direct materials $ 6.00 Direct labor 3.00 Variable manufacturing overhead 2.00 Fixed manufacturing overhead -0- Total $11.00 Product Costing Example

50. 22 - 50©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber End of Chapter 22