Chapter 22-1

Chapter 22-2

CHAPTER CHAPTER 2222

COST - VOLUME - COST - VOLUME - PROFITPROFIT

Accounting Principles, Eighth Edition

Chapter 22-3

Cost Behavior AnalysisCost Behavior AnalysisCost Behavior AnalysisCost Behavior Analysis

Cost Behavior Analysis is Cost Behavior Analysis is

the study of how specific costs the study of how specific costs respond to respond to changes in the level of changes in the level of business activity.business activity.

Some costs change; others remain the sameSome costs change; others remain the same

Helps management plan operations and decide Helps management plan operations and decide between alternative courses of actionbetween alternative courses of action

Applies to all types of businesses and entitiesApplies to all types of businesses and entities

LO 1: Distinguish between variable and fixed costs.LO 1: Distinguish between variable and fixed costs.

Chapter 22-4

Cost Behavior Analysis - continuedCost Behavior Analysis - continuedCost Behavior Analysis - continuedCost Behavior Analysis - continued

Starting point is Starting point is measuring key business activitiesmeasuring key business activities

Activity levels may be expressed in terms of:Activity levels may be expressed in terms of:Sales dollars (in a retail company)Sales dollars (in a retail company)Miles driven (in a trucking company)Miles driven (in a trucking company)Room occupancy (in a hotel)Room occupancy (in a hotel)Dance classes taught (by a dance studio)Dance classes taught (by a dance studio)

Many companies use more Many companies use more than one measurement basethan one measurement base

LO 1: Distinguish between variable and fixed costs.LO 1: Distinguish between variable and fixed costs.

Chapter 22-5

Cost Behavior Analysis - continuedCost Behavior Analysis - continuedCost Behavior Analysis - continuedCost Behavior Analysis - continued

For an activity level to be useful: For an activity level to be useful:

Changes in the level or volume of Changes in the level or volume of activity activity should be correlated with should be correlated with changes in costschanges in costs

The activity level selected is called theThe activity level selected is called theactivity or volume indexactivity or volume index

The activity index:The activity index:Identifies the activity that causes changes in Identifies the activity that causes changes in the behavior of coststhe behavior of costsAllows costs to be classified according to their Allows costs to be classified according to their response to changes in activity as either:response to changes in activity as either:

Variable Costs Fixed Costs Mixed CostsVariable Costs Fixed Costs Mixed Costs

LO 1: Distinguish between variable and fixed costs.LO 1: Distinguish between variable and fixed costs.

Chapter 22-6

Variable CostsVariable CostsVariable CostsVariable Costs

Costs that Costs that vary vary in totalin total directly and directly and proportionately with changes in the activity proportionately with changes in the activity levellevel

Example: If the activity level Example: If the activity level increasesincreases 10 10 percent, total variable costs percent, total variable costs increaseincrease 10 percent 10 percent

Example: If the activity level Example: If the activity level decreasesdecreases by 25 by 25 percent, total variable costs percent, total variable costs decreasedecrease by 25 by 25 percentpercent

Variable costs Variable costs remain constant per unit at remain constant per unit at every level of activity.every level of activity.

LO 1: Distinguish between variable and fixed costs.LO 1: Distinguish between variable and fixed costs.

Chapter 22-7

Variable Costs – ExampleVariable Costs – ExampleVariable Costs – ExampleVariable Costs – Example

Damon Company manufactures radios that Damon Company manufactures radios that contain a $10 clockcontain a $10 clock

Activity index is the number of radios Activity index is the number of radios producedproduced

For each radio produced, the total cost of the For each radio produced, the total cost of the clocks increases by $10:clocks increases by $10:

If 2,000 radios are made, the total cost of the If 2,000 radios are made, the total cost of the clocks is $20,000 (2,000 X $10)clocks is $20,000 (2,000 X $10)

If 10,000 radios are made, the total cost of the If 10,000 radios are made, the total cost of the clocks is $100,000 (10,000 X $10)clocks is $100,000 (10,000 X $10)

LO 1: Distinguish between variable and fixed costs.LO 1: Distinguish between variable and fixed costs.

Chapter 22-8

Variable Costs – GraphsVariable Costs – GraphsVariable Costs – GraphsVariable Costs – Graphs

LO 1: Distinguish between variable and fixed costs.LO 1: Distinguish between variable and fixed costs.

Chapter 22-9

Fixed CostsFixed CostsFixed CostsFixed Costs

Costs that Costs that remain the same in total regardless of changes in the activity level.regardless of changes in the activity level.

Per unit costPer unit cost variesvaries inversely with activity:with activity:As volume increases,

unit cost declines, and vice versa

Examples include:Examples include:Property taxesProperty taxesInsuranceInsuranceRentRentDepreciation on buildings and equipmentDepreciation on buildings and equipment

LO 1: Distinguish between variable and fixed costs.LO 1: Distinguish between variable and fixed costs.

Chapter 22-10

Fixed Costs - ExampleFixed Costs - ExampleFixed Costs - ExampleFixed Costs - Example

Damon Company leases its productive facilities Damon Company leases its productive facilities for $10,000 per monthfor $10,000 per month

Total fixed costs of the facilities remain constant Total fixed costs of the facilities remain constant at all levels of activity - $10,000 per monthat all levels of activity - $10,000 per month

On a On a per unitper unit basis, the cost of rent decreases basis, the cost of rent decreases as as activity increases and vice versaactivity increases and vice versa

At 2,000 radios, the unit cost is At 2,000 radios, the unit cost is $5$5 ($10,000 ($10,000 ÷ 2,000 units)÷ 2,000 units)

At 10,000 radios, the unit cost is At 10,000 radios, the unit cost is $1$1 ($10,000 ($10,000 ÷ 10,000 ÷ 10,000

units)units)LO 1: Distinguish between variable and fixed costs.LO 1: Distinguish between variable and fixed costs.

Chapter 22-11

Fixed Costs - GraphsFixed Costs - GraphsFixed Costs - GraphsFixed Costs - Graphs

LO 1: Distinguish between variable and fixed costs.LO 1: Distinguish between variable and fixed costs.

Chapter 22-12

Variable costs are costs that:Variable costs are costs that:

a.a. Vary in total directly and proportionately with Vary in total directly and proportionately with changes in the activity levelchanges in the activity level.

b. Remain the same per unit at every activity level.

c. Neither of the above.

d. Both (a) and (b) above.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 1: LO 1: Distinguish between variable and fixed costsDistinguish between variable and fixed costs..

Chapter 22-13

Relevant RangeRelevant RangeRelevant RangeRelevant Range

Throughout the range of possible levels of Throughout the range of possible levels of activity, a activity, a straight-line relationship usually does not exist for either variable costs or fixed for either variable costs or fixed costs costs

The relationship between variable costs and The relationship between variable costs and changes in activity level is often changes in activity level is often curvilinear

For fixed costs, the relationship is also For fixed costs, the relationship is also nonlinear – some fixed costs will not change over the entire – some fixed costs will not change over the entire range of activities while other fixed costs may range of activities while other fixed costs may change.change.

LO 2: Explain the significance of the relevant range.LO 2: Explain the significance of the relevant range.

Chapter 22-14

Relevant Range - GraphsRelevant Range - GraphsRelevant Range - GraphsRelevant Range - Graphs

LO 2: Explain the significance of the relevant range.LO 2: Explain the significance of the relevant range.

Chapter 22-15

Relevant Range Relevant Range Relevant Range Relevant Range

Defined as the range of activity over which a Defined as the range of activity over which a companycompany expects to operate during a year

Within this range, a straight-line relationshipWithin this range, a straight-line relationship usually exists for both variable and fixed costsusually exists for both variable and fixed costs

LO 2: Explain the significance of the relevant range.LO 2: Explain the significance of the relevant range.

Chapter 22-16

The relevant range is:The relevant range is:

a.a. The range of activity in which variable costs The range of activity in which variable costs will be curvilinearwill be curvilinear.

b. The range of activity in which fixed costs will be curvilinear.

c. The range over which the company expects to operate during a year.

d. Usually from zero to 100% of operating capacity.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 2: Explain the significance of the relevant range.LO 2: Explain the significance of the relevant range.

Chapter 22-17

Mixed CostsMixed CostsMixed CostsMixed Costs

Costs that have Costs that have both a variable a variable cost element cost element and a fixed a fixedcost elementcost element

Sometimes Sometimes calledcalledsemivariable cost

Change Change in total but not proportionately with changes inwith changes inactivity levelactivity level

LO 3: Explain the concept of mixed costs.LO 3: Explain the concept of mixed costs.

Chapter 22-18

Mixed Costs: High–Low MethodMixed Costs: High–Low MethodMixed Costs: High–Low MethodMixed Costs: High–Low Method

Mixed costs must be classified into their Mixed costs must be classified into their fixed and and variable elements elements

One approach to separate the costs is called the One approach to separate the costs is called the high-low method

Uses the total costs incurred at both the high and Uses the total costs incurred at both the high and the low levels of activity to classify mixed coststhe low levels of activity to classify mixed costs

The difference in costs between the high and low The difference in costs between the high and low levels levels represents variable costs, since only variable costs change as activity levels changechange

LO 3: Explain the concept of mixed costs.LO 3: Explain the concept of mixed costs.

Chapter 22-19

Mixed Costs: Mixed Costs: Steps in High–Low-Method Steps in High–Low-Method

Mixed Costs: Mixed Costs: Steps in High–Low-Method Steps in High–Low-Method

STEP 1: Determine variable cost per unit using the following formula:

STEP 2: Determine the fixed cost by subtracting the total variable cost at either the high or the low activity level from the total cost at that level

LO 3: Explain the concept of mixed costs.LO 3: Explain the concept of mixed costs.

Chapter 22-20

Mixed Costs: Mixed Costs: High–Low-Method ExampleHigh–Low-Method Example

Mixed Costs: Mixed Costs: High–Low-Method ExampleHigh–Low-Method Example

High Level of Activity:High Level of Activity: April $63,000 50,000 milesApril $63,000 50,000 milesLow Level of Activity: Low Level of Activity: January January 30,000 30,000 20,000 miles20,000 miles

Difference $33,000 30,000 Difference $33,000 30,000 milesmiles

Step 1:Step 1: Using the formula, variable costs per unit are Using the formula, variable costs per unit are $33,000 $33,000 30,000 = 30,000 = $1.10 variable cost $1.10 variable cost per mileper mile

Data for Metro Transit Company for 4 month period:

LO 3: Explain the concept of mixed costs.LO 3: Explain the concept of mixed costs.

Chapter 22-21

Mixed Costs: Mixed Costs: High–Low-Method ExampleHigh–Low-Method Example

Mixed Costs: Mixed Costs: High–Low-Method ExampleHigh–Low-Method Example

Step 2:Step 2: Determine the fixed costs by subtracting total Determine the fixed costs by subtracting total variable costs at variable costs at either the high or low the high or low

activity activity level from the total cost at that level from the total cost at that same levelsame level

LO 3: Explain the concept of mixed costs.LO 3: Explain the concept of mixed costs.

Chapter 22-22

Mixed Costs:Mixed Costs:High–Low-Method ExampleHigh–Low-Method Example

Mixed Costs:Mixed Costs:High–Low-Method ExampleHigh–Low-Method Example

Maintenance costs:Maintenance costs: $8,000 per month plus $1.10 per mile$8,000 per month plus $1.10 per mile

To determine maintenance costs at a particular To determine maintenance costs at a particular activity level:activity level:

1. multiply the activity level times the variable cost per unit

2. then add that total to the fixed cost

EXAMPLE: If the activity level is 45,000 miles, the If the activity level is 45,000 miles, the estimated maintenance costs would be $8,000 estimated maintenance costs would be $8,000 fixed and $49,500 variable ($1.10 X 45,000 fixed and $49,500 variable ($1.10 X 45,000 miles) for a total of $57,500.miles) for a total of $57,500.

LO 3: Explain the concept of mixed costs.LO 3: Explain the concept of mixed costs.

Chapter 22-23

Mixed costs consist of a:Mixed costs consist of a:

a.a. Variable cost element and a fixed cost Variable cost element and a fixed cost elementelement.

b. Fixed cost element and a controllable cost element.

c. Relevant cost element and a controllable cost element.

d. Variable cost element and a relevant cost element.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 3: Explain the concept of mixed costs.LO 3: Explain the concept of mixed costs.

Chapter 22-24

Cost-Volume-Profit AnalysisCost-Volume-Profit AnalysisCost-Volume-Profit AnalysisCost-Volume-Profit Analysis

Study of the Study of the effects of changes of costs and volume on a company’s profits on a company’s profits

A critical factor in management decisionsA critical factor in management decisions

Important in profit planningImportant in profit planning

LO 4: List the five components of cost-volume-profit analysis.LO 4: List the five components of cost-volume-profit analysis.

Chapter 22-25

Cost-Volume-Profit AnalysisCost-Volume-Profit AnalysisCost-Volume-Profit AnalysisCost-Volume-Profit Analysis

CVP analysis considers the interrelationships CVP analysis considers the interrelationships among five basic componentsamong five basic components

LO 4: List the five components of cost-volume-profit analysis.LO 4: List the five components of cost-volume-profit analysis.

Chapter 22-26

Assumptions Underlying CVP AnalysisAssumptions Underlying CVP AnalysisAssumptions Underlying CVP AnalysisAssumptions Underlying CVP Analysis

Behavior of both costs and revenues is Behavior of both costs and revenues is linear throughout the throughout the relevant range of the activity index of the activity index

All costs can be classified as either All costs can be classified as either variable or fixed with reasonable accuracywith reasonable accuracy

Changes in Changes in activity are the only factors that affect are the only factors that affect costscosts

All units All units produced are sold

When more than one type of product is sold, the When more than one type of product is sold, the sales mix will remain constant

LO 4: List the five components of cost-volume-profit analysis.LO 4: List the five components of cost-volume-profit analysis.

Chapter 22-27

Which of the following is Which of the following is NOTNOT involved in CVP analysis? involved in CVP analysis?

a.a. Sales mixSales mix.

b. Unit selling prices.

c. Fixed costs per unit.

d. Volume or level of activity.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 4: List the five components of cost-volume-profit LO 4: List the five components of cost-volume-profit analysis.analysis.

Chapter 22-28

CVP Income StatementCVP Income StatementCVP Income StatementCVP Income Statement

A statement for internal useClassifies costs and expenses as fixed or variable Reports contribution margin in the body of the statement.

Contribution margin –amount of revenue

remaining afterdeducting variable costs

Reports the same netincome as a traditionalincome statementincome statement

LO 5: Indicate what contribution margin is and how it can be expressed.LO 5: Indicate what contribution margin is and how it can be expressed.

Chapter 22-29

CVP Income Statement - ExampleCVP Income Statement - ExampleCVP Income Statement - ExampleCVP Income Statement - Example

Vargo Video Company produces DVD Vargo Video Company produces DVD players. players.

Relevant data for June 2008: Relevant data for June 2008: Unit selling price of DVD playerUnit selling price of DVD player $500 $500Unit variable costsUnit variable costs $300 $300Total monthly fixed costsTotal monthly fixed costs $200,000$200,000Units soldUnits sold 1,600 1,600

LO 5: Indicate what contribution margin is and how it can be expressed.LO 5: Indicate what contribution margin is and how it can be expressed.

Chapter 22-30

Contribution Margin Per UnitContribution Margin Per UnitContribution Margin Per UnitContribution Margin Per Unit

Contribution margin is availableContribution margin is available to cover fixed costs and to contribute to income

The formula for The formula for contribution margin per unit and the computation for Vargo Video are:and the computation for Vargo Video are:

LO 5: Indicate what contribution margin is and how it can be expressed.LO 5: Indicate what contribution margin is and how it can be expressed.

Chapter 22-31

Contribution Margin RatioContribution Margin RatioContribution Margin RatioContribution Margin Ratio

Shows the percentage of each sales dollar Shows the percentage of each sales dollar available to apply toward fixed costs and profitsavailable to apply toward fixed costs and profits

The formula for The formula for contribution margin ratio and the computation for Vargo Video are:and the computation for Vargo Video are:

LO 5: Indicate what contribution margin is and how it can be expressed.LO 5: Indicate what contribution margin is and how it can be expressed.

Chapter 22-32

Contribution margin:Contribution margin:

a.a. Is revenue remaining after deducting variable Is revenue remaining after deducting variable costscosts.

b. May be expressed as contribution margin per unit.

c. Is selling price less cost of goods sold.

d. Both (a) and (b) above.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 5: Indicate what contribution margin is and how it can be LO 5: Indicate what contribution margin is and how it can be expressed.expressed.

Chapter 22-33

Break-Even AnalysisBreak-Even AnalysisBreak-Even AnalysisBreak-Even Analysis

Process of finding the Process of finding the break-even point

level of activity at which level of activity at which total revenues equal total costs (both fixed and (both fixed and variable)variable)

Can be computed or derivedCan be computed or derivedfrom a mathematical equation,by using contribution margin, orfrom a cost-volume profit (CVP) graph

Expressed either in sales units or in sales dollars

LO 6: Identify the three ways to determine the break-even point.LO 6: Identify the three ways to determine the break-even point.

Chapter 22-34

Break-Even Analysis: Mathematical Break-Even Analysis: Mathematical EquationEquation

Break-Even Analysis: Mathematical Break-Even Analysis: Mathematical EquationEquationBreak-even occurs where total sales equal

variable costs plus fixed costs; i.e., net income is zero.

The formula for the The formula for the break-even point and the and the computation for Vargo Video are:computation for Vargo Video are:

To find To find sales dollarssales dollars required to break-even: required to break-even:1000 units X $500 = $500,000 (break-even dollars)1000 units X $500 = $500,000 (break-even dollars)

LO 6: Identify the three ways to determine the break-even point.LO 6: Identify the three ways to determine the break-even point.

Chapter 22-35

Break-Even Analysis:Break-Even Analysis:Contribution Margin TechniqueContribution Margin Technique

Break-Even Analysis:Break-Even Analysis:Contribution Margin TechniqueContribution Margin Technique

At the break-even point, contribution margin must equal total fixed costs

(CM = total revenues – variable costs)

The break-even point can be computed using either contribution margin per unit or contribution margin ratio.

LO 6: Identify the three ways to determine the break-even point.LO 6: Identify the three ways to determine the break-even point.

Chapter 22-36

Contribution Margin TechniqueContribution Margin TechniqueContribution Margin TechniqueContribution Margin Technique

When the BEP in units is desired, contribution margin per unit is used in the following formula which shows the computation for Vargo Video:

When the BEP in dollars is desired, contribution margin ratio is used in the following formula which shows the computation for Vargo Video:

LO 6: Identify the three ways to determine the break-even point.LO 6: Identify the three ways to determine the break-even point.

Chapter 22-37

Break-Even Analysis: Graphic Break-Even Analysis: Graphic PresentationPresentation

Break-Even Analysis: Graphic Break-Even Analysis: Graphic PresentationPresentation

A cost-volume profit (CVP) graph shows costs, volume and profits.Used to visually find the break-even point

To construct a CVP graph:To construct a CVP graph:Plot the total sales line starting at the zero activity levelPlot the total fixed cost using a horizontal linePlot the total cost line (starts at the fixed-cost line at zero activityDetermine the break-even point from the intersection of the total cost line and the total sales line

LO 6: Identify the three ways to determine the break-even point.LO 6: Identify the three ways to determine the break-even point.

Chapter 22-38

Break-Even Analysis: Graphic Break-Even Analysis: Graphic PresentationPresentation

Break-Even Analysis: Graphic Break-Even Analysis: Graphic PresentationPresentation

LO 6: Identify the three ways to determine the break-even point.LO 6: Identify the three ways to determine the break-even point.

Chapter 22-39

Gossen Company is planning to sell 200,000 pliers Gossen Company is planning to sell 200,000 pliers for $4 per unit. The contribution margin ratio is for $4 per unit. The contribution margin ratio is 25%. If Gossen will break even at this level of 25%. If Gossen will break even at this level of sales, what are the fixed costs?sales, what are the fixed costs?

a.a. $100,000$100,000.

b. $160,000.

c. $200,000.

d. $300,000.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 6: Identify the three ways to determine the break-even point.LO 6: Identify the three ways to determine the break-even point.

Chapter 22-40

Break-Even Analysis: Target Net Break-Even Analysis: Target Net IncomeIncome

Break-Even Analysis: Target Net Break-Even Analysis: Target Net IncomeIncome

Level of sales necessary to achieve a specified income

Can be determined from each of the approaches Can be determined from each of the approaches used to determine break-even sales/units:used to determine break-even sales/units:

from a mathematical equation,by using contribution margin, orfrom a cost-volume profit (CVP) graph

Expressed either in sales units or in sales dollars

LO 7: Give the formulas for determining sales LO 7: Give the formulas for determining sales required to earn target net income.required to earn target net income.

Chapter 22-41

Break-Even Analysis: Target Net IncomeBreak-Even Analysis: Target Net IncomeBreak-Even Analysis: Target Net IncomeBreak-Even Analysis: Target Net Income

Mathematical EquationMathematical Equation

Using the formula for the Using the formula for the break-even point, simply include the desired net income as a factor. The computation for Vargo Video is as The computation for Vargo Video is as follows:follows:

LO 7: Give the formulas for determining sales LO 7: Give the formulas for determining sales required to earn target net income.required to earn target net income.

Chapter 22-42

Break-Even Analysis: Target Net IncomeBreak-Even Analysis: Target Net IncomeBreak-Even Analysis: Target Net IncomeBreak-Even Analysis: Target Net Income

Contribution Margin TechniqueContribution Margin Technique

To determine the required sales in units for Vargo Video:

To determine the required sales in dollars for Vargo Video:

LO 7: Give the formulas for determining sales LO 7: Give the formulas for determining sales required to earn target net income.required to earn target net income.

Chapter 22-43

The mathematical equation for computing The mathematical equation for computing required sales to obtain target net income is:required sales to obtain target net income is:

Required sales =Required sales =

a.a. Variable costs + Target net incomeVariable costs + Target net income.

b. Variable costs + Fixed costs + Target net income.

c. Fixed costs + Target net income.

d. No correct answer is given.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 7: Give the formulas for determining sales required LO 7: Give the formulas for determining sales required to earn target net income.to earn target net income.

Chapter 22-44

Break-Even Analysis: Margin of SafetyBreak-Even Analysis: Margin of SafetyBreak-Even Analysis: Margin of SafetyBreak-Even Analysis: Margin of Safety

Difference between actual or expected sales and sales at the break-even point

Measures the “cushion” that management has if expected sales fail to materialize

May be expressed in dollars or as a ratio

To determine the margin of safety in dollars for Vargo Video assuming that actual/expected sales are $750,000:

LO 8: Define margin of safety, and give the formulas for LO 8: Define margin of safety, and give the formulas for computing it.computing it.

Chapter 22-45

Break-Even Analysis: Margin of SafetyBreak-Even Analysis: Margin of SafetyBreak-Even Analysis: Margin of SafetyBreak-Even Analysis: Margin of Safety

Margin of Safety RatioMargin of Safety Ratio

Computed by dividing the margin of safety in dollars by the actual or expected sales

To determine the margin of safety ratio for Vargo Video assuming that actual/expected sales are $750,000:

The higher the dollars or the percentage, The higher the dollars or the percentage, the greater the margin of safetythe greater the margin of safety

LO 8: Define margin of safety, and give the formulas for LO 8: Define margin of safety, and give the formulas for computing it.computing it.

Chapter 22-46

Marshall Company had actual sales of $600,000 Marshall Company had actual sales of $600,000 when break-even sales were $420,000. What is when break-even sales were $420,000. What is the margin of safety ratio?the margin of safety ratio?

a.a. 25%25%.

b. 30%.

c. 33 1/3%.

d. 45%.

Let’s ReviewLet’s ReviewLet’s ReviewLet’s Review

LO 8: Define margin of safety, and give the formulas LO 8: Define margin of safety, and give the formulas for computing it.for computing it.