1. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost Behavior and Cost-Volume-Profit Analysis Chapter 19

2. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objectives 1.Classify costs as variable costs, fixed costs, or mixed costs. 2.Compute the contribution margin, the contribution margin ratio, and the unit contribution margin. 3.Determine the break-even point and sales necessary to achieve a target profit. 4.Using a cost-volume-profit chart and a profit-volume chart, determine the break-even point and sales necessary to achieve a target profit. 5. Compute the break-even point for a company selling more than one product, the operating leverage, and the margin of safety.

3. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost Behavior Cost behavior is the manner in which a cost changes as a related activity changes. Understanding the behavior of a cost depends on: Activity bases (activity drivers) Relevant range (range of activity) Types of Costs: Variable Fixed Mixed

4. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Variable Costs Variable costs are costs that vary in proportion to changes in the level of activity. Cost per unit remains the same regardless of changes in the activity base. Total cost changes in proportion to changes in the activity base. LO 1

5. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fixed Costs Fixed costs are costs that remain the same in total dollar amount as the activity base changes. Cost per unit changes inversely to changes in the activity base. Total cost remains the same regardless of changes in the activity base. LO 1

6. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Mixed Costs Mixed costs have characteristics of both a variable and a fixed cost. Mixed costs are sometimes called semi variable or semi fixed costs. Over one range of activity, the total mixed cost may remain the same. Over another range of activity, the mixed cost may change in proportion to changes in the level of activity. LO 1

7. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Small Group Activity Group 1: Joe B/Carly/Chelsea Group 2: CJ/Emily/Alex Group 3: Mia/Julianna/Hannah/Corrie Group 4: Michelle/JoeR/Andrew 1. List examples of fixed, variable and mixed costs incurred by a McDonald’s restaurant. 2. List as many as you can. 3. Identify the activity base (driver) for each variable cost.

8. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ProductionTotal (Units) Cost June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 Separating Costs Using HIGH LOW METHOD – Variable Costs First, select the highest and lowest levels of activity. Next, fill in the formula for difference in total cost. Then, fill in the formula for difference in production. Variable cost per unit is $15 Variable Cost per Unit = Difference in Total cost Difference in Production $20,250 1,350

9. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Subtract the total variable costs from the total costs for the units produced. Fixed Cost using High Low Method Highest and Lowest Level June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 Fixed Cost = Total Costs – (Variable Cost per Unit x Units Produced) Fixed Cost = $61,500 – ($15 x 2,100 units) Fixed Cost = $61,500 – $31,500 Fixed Cost = $ 30,00030,000 Estimated total cost would be calculated as follows: Total Cost = ($15 x Units Produced) + $30,000 Total Cost = ($15 x 2,000) + $30,000 Total Cost = $30,000 + $30,000 Total Cost = $60,000

10. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EE 19-1

11. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary of Cost Behavior Concepts LO 1 Some examples of variable, fixed, and mixed costs for the activity base units produced are as follows: One method of reporting variable and fixed costs is called variable costing or direct costing. Under variable costing, only the variable manufacturing costs are included in the product cost. The fixed factory overhead is treated as an expense of the period in which it is incurred.

12. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Volume-Profit Relationships Cost-volume-profit analysis is the examination of the relationships among selling prices, sales and production volume, costs, expenses, and profits. LO 2 Some of the ways cost-volume-profit analysis may be used include: 1.Analyzing the effects of changes in selling prices on profits 2.Analyzing the effects of changes in costs on profits 3.Analyzing the effects of changes in volume on profits 4.Setting selling prices 5.Selecting the mix of products to sell 6.Choosing among marketing strategies

13. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Contribution Margin Contribution margin is the excess of sales over variable costs, as shown in the formula below. LO 2 Contribution Margin = Sales – Variable Costs

14. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The contribution margin ratio, sometimes called the profit-volume ratio, indicates the percentage of each sales dollar available to cover fixed costs and to provide income from operations. It is computed as follows: Contribution Margin Ratio LO 2 Contribution Margin Ratio = Contribution Margin Sales Contribution Margin Ratio = $400,000 $1,000,000 Contribution Margin Ratio = 40%

15. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Contribution Margin Ratio If Lambert Inc. adds $80,000 in sales from the sale of an additional 4,000 units, its income will increase by $32,000, as computed below. Change in Income from Operations Change in Sales Dollars x Contribution Margin Ratio = Change in Income from Operations $80,000 x 40% = $32,000 =

16. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Unit Contribution Margin The unit contribution margin is useful for analyzing the profit potential of proposed decisions. The unit contribution margin is computed as follows: Unit Contribution Margin = Sales Price per Unit Variable Cost per Unit – LO 2 The unit contribution margin is most useful when the increase or decrease in sales volume is measured in sales units (quantities). The change in income from operations can be determined using the following formula: Change in Income from Operations Change in Sales Units = x Unit Contribution Margin

17. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. LO 2 Unit Contribution Margin Lambert Inc.’s sales could be increased by 15,000 units, from 50,000 to 65,000 units. Lambert’s income from operations would increase by $120,000 (15,000 x $8), as shown below. Change in Income from Operations Change in Sales Units = x Unit Contribution Margin Change in Income from Operations = 15,000 units x $8 = $120,000

18. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Review LO 2 1. Total contribution margin in dollars. 2. Contribution margin ratio (percentage). The contribution margin can be expressed in three ways: 3. Unit contribution margin (dollars per unit). 100% 60% 40% 30% 10% $20 12 $ 8 Sales (50,000 units)$1,000,000 Variable costs 600,000 Contribution margin$ 400,000 Fixed costs 300,000 Income from operations$ 100,000

19. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Break-Even Point The break-even point is the level of operations at which a company’s revenues and expenses are equal. LO 3

20. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The break-even point (in sales units) is calculated using the following equation: Break-Even Sales (units) = Fixed Costs Unit Contribution Margin Break-Even Sales (units) = $90,000 $10 Break-Even Sales (units) = 9,000 units Break-Even Point LO 3 Assume the following data for Baker Corporation: Fixed costs$90,000 Unit selling price$25 Unit variable cost 15 Unit contribution margin$10

21. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Break-Even Point LO 3 Income from operations is zero when 9,000 units are sold— hence, the break-even point is 9,000 units.

22. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Break-Even Point LO 3 The break-even point (in sales dollars) is calculated using the following equation: Break-Even Sales (dollars) = Fixed Costs Contribution Margin Ratio Break-Even Sales (dollars) = $225,000 $90,000.40 Break-Even Sales (dollars) = $10 $25

23. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Effect of Changes in Fixed Costs Bishop Co. is evaluating a proposal to budget an additional $100,000 for advertising. The data for Bishop Co. are as follows: LO 3 Break-Even Sales (units) = Fixed Costs Unit Contribution Margin Without additional advertising: Break-Even Sales (units) = $600,000 $20 = 30,000 units With additional advertising: Break-Even Sales (units) = $700,000 $20 = 35,000 units

24. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Effect of Changes in Unit Variable Costs LO 3 Park Co. is evaluating a proposal to pay an additional 2% commission on sales to its salespeople (a variable cost) as an incentive to increase sales. Fixed costs are estimated at $840,000. The other data for Park Co. are as follows: Break-Even Sales (units) = Fixed Costs Unit Contribution Margin Without additional 2% commission: Break-Even Sales (units) = $840,000 $105 = 8,000 units With additional 2% commission: Break-Even Sales (units) = $840,000 $100 = 8,400 units $250 – [$145 + ($250 x 2%)] = $100

25. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Effect of Changes in Unit Selling Price LO 3 Graham Co. is evaluating a proposal to increase the unit selling price of a product from $50 to $60. The estimated fixed costs are $600,000. The following additional data have been gathered: Without price increase: Break-Even Sales (units) = $600,000 $20 = 30,000 units With price increase: Break-Even Sales (units) = $600,000 $30 = 20,000 units Break-Even Sales (units) = Fixed Costs Unit Contribution Margin

26. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary of Effects of Changes on B/E Point LO 3

27. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Target Profit The sales volume required to earn a target profit is determined by modifying the break-even equation. LO 3 Sales (units) = Fixed Costs + Target Profit Unit Contribution Margin Sales (units) = $200,000 + $100,000 $30 Sales (units) = 10,000 units

28. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EE 19-4

29. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Volume-Profit (Break-Even) Chart A cost-volume-profit chart, sometimes called a break-even chart, graphically shows sales, costs, and the related profit or loss for various levels of units sold. LO 4

30. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Volume-Profit (Break-Even) Chart LO 4 Sales and Costs (in thousands) 0 Units of Sales (in thousands) $500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 Dollar amounts are indicated along the vertical axis. 12345678910 Volume is shown along the horizontal axis.

31. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Volume-Profit (Break-Even) Chart LO 4 1 2 3 4 5 6 7 8 9 10 Sales and Costs (in thousands) 0 Units of Sales (in thousands) Cost-Volume-Profit (Break-Even) Chart LO 4 Break-even is sales of 5,000 units or $250,000. Break-even Point

32. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Volume-Profit (Break-Even) Chart LO 4 Cost-Volume-Profit (Break-Even) Chart LO 4

33. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Volume-Profit (Break-Even) Chart LO 4 Cost-Volume-Profit (Break-Even) Chart LO 4

34. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Assumptions of Cost-Volume-Profit Analysis The primary assumptions are: 1.Total sales and total costs can be represented by straight lines. 2.Within the relevant range of operating activity, the efficiency of operations does not change. 3.Costs can be divided into fixed and variable components. 4.The sales mix is constant. 5.There is no change in the inventory quantities during the period. LO 4

35. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Margin of Safety The margin of safety indicates the possible decrease in sales that may occur before an operating loss results. The margin of safety may be expressed in the following ways: Dollars of sales Units of sales Percent of current sales LO 5 If sales are $250,000, the unit selling price is $25, and the sales at the break- even point are $200,000, the margin of safety is 20%, computed as follows: Margin of Safety = Sales – Sales at Break-Even Point Sales Margin of Safety = $250,000 – $200,000 $250,000 Margin of Safety = 20%

36. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. EE 19-7