Managerial accounting

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1 Managerial accounting

2 Concept of Cost COST definition and classifications In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to a given thing. However, the term cost cannot be exactly defined. Its interpretation depends upon the following factors: The nature of business or industry The context in which it is used In a business where selling and distribution expenses are quite nominal the cost of an article may be calculated without considering the selling and distribution overheads. At the same time, in a business where the nature of a product requires heavy selling and distribution expenses, the calculation of cost without taking into account the selling and distribution expenses may prove very costly to a business. The cost may be factory cost, office cost, cost of sales and even an item of expense. For example, prime cost includes expenditure on direct materials, direct labour and direct expenses. Money spent on materials is termed as cost of materials just like money spent on labour is called cost of labour and so on. Thus, the use of term cost without understanding the circumstances can be misleading. Different costs are found for different purposes. The work-in-progress is valued at factory cost while stock of finished goods is valued at office cost. Numerous other examples can be given to show that the term cost does not mean the same thing under all circumstances and for all purposes. Many items of cost of production are handled in an optional manner which may give different costs for the same product or job without going against the accepted principles of cost accounting. Depreciation is one of such items. Its amount varies in accordance with the method of depreciation being used. However, endeavour should be, as far as possible, to obtain an accurate cost of a product or service. Elements of Cost Following are the three broad elements of cost: 1. Material The substance from which a product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect. 2. Labour For conversion of materials into finished goods, human effort is needed and such human effort is called labour. Labour can be direct as well as indirect. 3. Expenses 501

3 Classification of Cost Cost may be classified into different categories depending upon the purpose of classification. Consider some ways of classifying costs: A. Based on business function (R&D, Design, Production, Marketing, Distribution, Customer service) B. Based on financial statement presentation (capitalized, noncapitalized, inventoriable, non-inventoriable: product vs. period) C. Based on assignment to cost object (direct vs. indirect) D. Based on behavior in relation to cost driver (variable vs. fixed) E. Based on aggregation (total vs. unit) Some of the important categories in which the costs are classified are as follows: First. Direct and Indirect Costs The expenses incurred on material and labor which are economically and easily traceable for a product, service or job is considered as direct costs. In the process of manufacturing of production of articles, materials are purchased, laborers are employed and the wages are paid to them. Certain other expenses are also incurred directly. All of these take an active and direct part in the manufacture of a particular commodity and hence are called direct costs. The expenses incurred on those items which are not directly chargeable to production are known as indirect costs. For example, salaries of timekeepers, storekeepers and foremen. Also certain expenses incurred for running the administration are the indirect costs. All of these cannot be conveniently allocated to production and hence are called indirect costs. Second. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or department) with which they are directly related is discontinued. Unavoidable costs are those which will not be eliminated with the segment. Such costs are merely reallocated if the segment is discontinued. For example, in case a product is discontinued, the salary of a factory manager or factory rent cannot be eliminated. It will simply mean that certain other products will have to absorb a large amount of such overheads. However, the salary of people attached to a product or the bad debts traceable to a product would be eliminated. Certain costs are partly avoidable and partly unavoidable. For example, closing of one department of a store might result in decrease in delivery expenses but not in their altogether elimination. It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate a segment of a business. 501

4 Third. Differentials, Incremental or Decrement Cost The difference in total cost between two alternatives is termed as differential cost. In case the choice of an alternative results in an increase in total cost, such increased costs are known as incremental costs. While assessing the profitability of a proposed change, the incremental costs are matched with incremental revenue. This is explained with the following example: Example A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows: Selling price per unit $. 10 Variable cost per unit $. 5 Fixed costs $. 4,000 The management is considering the following two alternatives: a. To accept an export order for another 200 units at $. 8 per unit. The expenditure of the export order will increase the fixed costs by $ b. To reduce the production from present 1,000 units to 600 units and buy another 400 units from the market at $. 6 per unit. This will result in reducing the present fixed costs from $. 4,000 to $. 3,000. Which alternative the management should accept? Solution Statement showing profitability under different alternatives is as follows: Particulars Sales. Less: Variable purchase costs Fixed costs Profit Present situation $. $. 5,000 4,000 10,000 9,000 1,000 6,000 4,500 Proposed situations 11,600 10,500 1,100 5,400 3,000 10,000 8,400 1,600 Observations i. In the present situation, the company is making a profit of $. 1,000. ii. In the proposed situation (a), the company will make a profit of $. 1,100. The incremental costs will be $. 1,500 (i.e. $. 10,500 - $. 9,000) and the incremental revenue (sales) will be 501

5 Total variable cost [COST-VOLUME-PROFIT ANALYSIS] 1433 iii. $. 1,600. Hence, there is a net gain of $. 100 under the proposed situation as compared to the existing situation. In the proposed situation (b), the detrimental costs are $. 600 (i.e. $. 9,000 to $. 8,400) as there is no decrease in sales revenue as compared to the present situation. Hence, there is a net gain of $. 600 as compared to the present situation. Thus, under proposal (b), the company makes the maximum profit and therefore it should adopt alternative (b). The technique of differential costing which is based on differential cost is useful in planning and decision-making and helps in selecting the best alternative. In case the choice results in decrease in total costs, this decreased costs will be known as detrimental costs. cost behavior The most important building block of both microeconomic analysis and cost accounting is the characterization of how costs change as output volume changes. Output volume can refer to production, sales, or any other principle activity that is appropriate for the organization under consideration (e.g.: for a school, number of students enrolled; for a health clinic, number of patient visits; for an airline, number of passenger miles). The following discussion examines the volume of production in a factory, but the same principles apply regardless of the type of organization and the appropriate measure of activity. Costs can be variable, fixed, or mixed. 1st. Variable Costs: Variable costs vary in a linear fashion with the production level. However, when stated on a per unit basis, variable costs remain constant across all production levels within the relevant range. The following two charts depict this relationship between variable costs and output volume Production level (units produced) 508

6 Total fixed cost variable cost per unit [COST-VOLUME-PROFIT ANALYSIS] Production Level (units produced) A good example of a variable cost is materials. If one pair of pants requires $10 of fabric, then every pair of pants requires $10 of fabric, no matter how many pairs are made. The fabric cost is $10 per unit at every level of production. If one pair is made, the total fabric cost is $10; if two pairs are made, the total fabric cost is $20; and if 1,000 pairs are made, the total fabric cost is $10,000. Hence, the total cost is increasing and linear in the production level. 2nd. Fixed Costs: Fixed costs do not vary with the production level. Total fixed costs remain the same, within the relevant range. However, the fixed cost per unit decreases as production increases, because the same fixed costs are spread over more units. The following two charts depict this relationship between fixed costs and output volume Production level (units produced) 501

7 Fixed cost per unit [COST-VOLUME-PROFIT ANALYSIS] Production level (units produced) In this example, fixed costs are $50,000. The first chart shows that fixed costs remain $50,000 at all production levels from 100 units to 1,000 units. The second chart shows that the fixed cost per unit decreases as production increases. Hence, when 100 units are manufactured, the fixed cost per unit is $500 ($50, ). When 500 units are manufactured, the fixed cost per unit is $100 ($50, ). Relevant Range: The relevant range is the range of activity (e.g., production or sales) over which these relationships are valid. For example, if the factory is operating at capacity, increasing production requires additional investment in fixed costs to expand the facility or to lease or build another factory. Alternatively, production might be reduced below a threshold at which point one of the company s factories is no longer needed, and the fixed costs associated with that factory can be avoided. With respect to variable costs, the company might qualify for a volume discount on fabric purchases above some production level. The relevant range for characterizing fabric as a variable cost ends at that production level, because the fabric cost per unit of output is different when the factory produces above that threshold than when the factory produces below that threshold. 3rd. Mixed Costs: If, within a relevant range, a cost is neither fixed nor variable, it is called semi-variable or mixed. Following are two common examples of mixed costs. 550

8 Total cost Total cost [COST-VOLUME-PROFIT ANALYSIS] Production level (units produced) In this example, although the total cost line increases in production, it does not pass through the origin because there is a fixed cost component. An example of a cost that fits this description is electricity. A fixed amount of electricity is required to run the factory air conditioning, computers and lights. There is also a variable cost component related to running the machines on the factory floor. The fixed component in this example is $3,000 per month. The variable cost component is $10 per unit of output. Hence, at a production level of 500 units, the total electric cost is $8,000 [$3,000 + ($10 x 500)] Production level (units produced) The mixed cost illustrated in the above chart is called a step function. An example of such cost behavior would be the total salary expense for shift supervisors. If the factory runs one shift, only one shift supervisor is required. In order for the factory to produce above the 555

9 maximum capacity of a single shift, the factory must add a second shift and hire a second shift supervisor, so that total shift supervisor salary expense doubles. If the factory runs three shifts, three shift supervisors are required. Methods for separating mixed costs into fixed and variable The common three methods for separating mixed costs into their fixed and variable cost components: Prepare a scattergraph by plotting points onto a graph. High-low method. Regression analysis. It is wise to prepare the scattergraph even if you use the high-low method or regression analysis. The benefit of the scattergraph is that it allows you to see if some of the plotted points are simply out of line. These points are referred to as outliers and will need to be reviewed and possibly adjusted or eliminated. In other words, you don t want incorrect data to distort your calculations under any of the three methods. Let s assume that a company uses only one type of equipment and it wants to know how much of the monthly electricity bill is a constant amount and how much the electricity bill will increase when its equipment runs for an additional hour. The scattergraph s vertical or y-axis will indicate the dollars of total monthly electricity cost. Its horizontal or x-axis will indicate the number of equipment hours. For each monthly electricity bill, a point will be entered on the graph at the intersection of the dollar amount of the total electricity bill and the equipment hours occurring between the meter reading dates shown on the electricity bill. If you plot this information for the most recent 12 months, you may see some type of pattern, such as a line that rises as the number of equipment hours increase. If you draw a line through the plotted points and extend the line through the y-axis, the amount where the line crosses the y-axis is the approximate amount of fixed costs for each month. The slope of the line indicates the variable cost per equipment hour. The slope or variable rate is the increase in the total monthly electricity cost divided by the change in the total number of equipment hours. The high-low calculation is similar but it uses only two of the plotted points: the highest point and the lowest point. Regression analysis uses all of the monthly electricity bill amounts along with their related number of equipment hours in order to calculate the monthly fixed cost of electricity and the variable rate for each equipment hour. Software can be used for regression analysis and it will also provide statistical insights. If a scattergraph of data shows no clear pattern, you should not place much confidence in the calculated amount of the fixed cost and variable rate regardless of the method used. The high-low method The high-low method is a simple technique for computing the variable cost rate and the total amount of fixed costs that are part of mixed costs. Mixed costs are costs that are partially variable and partially fixed. The cost of electricity used in a factory is likely to be a mixed cost since some of the electricity will vary with the number of machine hours, while some of the cost will not vary with machine hours. Perhaps this second part of the electricity cost is associated with circulating and chilling the air in the factory and from the public utility billing its large customers with a significant fixed monthly charge not directly tied to the kilowatt hours of electricity used. The high-low method uses two sets of numbers: 551

10 The total number of the mixed costs occurring at the highest volume of activity, and The total number of the mixed costs occurring at the lowest volume of activity. It is assumed that at both points of activity the total amount of fixed costs is the same. Therefore, the change in the total costs is assumed to be the variable cost rate times the change in the number of units of activity. Prior to using the high-low method, it is important to plot or graph all of the data available to be certain that the two sets of numbers being used are indeed representative. To illustrate the high-low method, let s assume that a company had total costs of electricity of $18,000 in the month when its highest activity was 120,000 machine hours. (Be sure to match the dates of the machine hours to the electric meter reading dates.) During the month of its lowest activity there were 100,000 machine hours and the total cost of electricity was $16,000. This means that the total monthly cost of electricity changed by $2,000 when the number of machine hours changed by 20,000. This indicates that the variable cost rate was $0.10 per machine hour. Continuing with this example, if the total electricity cost was $18,000 when there were 120,000 machine hours, the variable portion is assumed to have been $12,000 (120,000 machine hours times $0.10). Since the total electricity cost was $18,000 and the variable cost was calculated to be $12,000, the fixed cost of electricity for the month must have been the $6,000. If we use the lowest level of activity, the total cost of $16,000 would include $10,000 of variable cost (100,000 machine hours times $0.10) with the remainder of $6,000 being the fixed cost for the month. Example Suppose that the maintenance cost and volume of production for some months are: Production volume 5o 11o Costs Required: separating maintenance costs into their fixed and variable cost components Solution Determine the highest volume of activity (volume of production) and its costs and the lowest volume of activity (volume of production) and its costs as the following. volume of activity (production) costs highest lowest Calculate the variable cost rate Costs at the highest level highest volume of activity - Costs at the lowest level - lowest volume of activity = 4 SR/unit (that is mean that variable cost for each production unit is 4 SR). 551

11 At any level of production (suppose that level of 110 units): Variable cost = variable cost rate number of units = 4 11o units = 440 SR Fixed cost = total cost at this level variable cost = = 2000 SR Summary Cost Concepts & Definitions CONCEPT DEFINITION Direct costs Costs directly related to cost object. Indirect costs Costs not directly related to a cost object. Cost Concepts Used in Decision Making Variable costs Cost that vary with the volume of activity. Fixed costs Costs that do not vary with volume of activity over a specified time span. Differential Costs that change in response to a particular course of action. Costs Sunk Costs Costs that result from an expenditure made in the past and that cannot be changed by present or future decisions. Opportunity cost: The return that one could realize from the best foregone alternative use of a resource. 551

12 Questions Variable costs are those costs that: A) vary inversely with changes in activity. B) vary directly with changes in activity. C) remain constant as activity changes. D) decrease on a per-unit basis as activity increases. E) increase on a per-unit basis as activity increases. As activity decreases, unit variable cost: A) increases proportionately with activity. B) decreases proportionately with activity. C) remains constant. D) increases by a fixed amount. E) decreases by a fixed amount. Fixed costs are those costs that: A) vary directly with changes in activity. B) vary inversely with changes in activity. C) remain constant on a per-unit basis. D) increase on a per-unit basis as activity increases. E) remain constant as activity changes. The fixed costs per unit are $10 when a company produces 10,000 units of product. What are the fixed costs per unit when 12,500 units are produced? A) $4. B) $6. C) $8. D) $10. E) $12. Total costs are $80,000 when 8,000 units are produced; of this amount, variable costs are $48,000. What are the total costs when 10,000 units are produced? A) $80,000. B) $92,000. C) $98,000. D) $100,000. E) $108,000. Costs that can be easily traced to a specific department are called: A) direct costs. B) indirect costs. C) product costs. D) manufacturing costs. E) processing costs. Midwest Motors manufactures automobiles Which of the following would not be classified as direct materials by the company? A) Sheet metal used in the automobile's body. B) Tires. C) Interior leather. D) CD player. E) Wheel lubricant. Selling and administrative expenses would likely appear on the balance sheet of: A) American Airlines. 551

13 B) Wal-Mart Corporation. C) Dell Computer. D) all of the above firms. E) none of the above firms. The relationship between cost and activity is termed: A) cost estimation. B) cost prediction. C) cost behavior. D) cost analysis. E) cost approximation. Which of the following costs changes in direct proportion to a change in the activity level? A) Variable cost. B) Fixed cost. C) Semi variable cost. D) Step-variable cost. E) Step-fixed cost. Costs that remain the same over a wide range of activity, but jump to a different amount outside that range, are termed: A) step-fixed costs. B) step-variable costs. C) semi variable costs. D) curvilinear costs. E) mixed costs. A cost that has both a fixed and variable component is termed a: A) step-fixed cost. B) step-variable cost. C) semi variable cost. D) curvilinear cost. E) discretionary cost. The relevant range is that range of activity: A) where a company achieves its maximum efficiency. B) where units produced equal units sold. C) where management expects the firm to operate. D) where the firm will earn a profit. E) where expected results are abnormally high. A variable cost that has a definitive physical relationship to the activity measure is called a(n): A) discretionary cost. B) engineered cost. C) managed cost. D) programmed cost. E) committed cost. Controllable costs, as used in a responsibility accounting system, consist of: A) only fixed costs. B) only direct materials and direct labor. C) those costs that a manager can influence in the time period under review. D) those costs about which a manager has some knowledge. E) those costs that are influenced by parties external to the organization. A common cost is: A) not easily related to a segment's activities B) easily related to a segment's activities. 551

14 C) avoidable. D) unavoidable. E) applicable only to manufacturing organizations. Which of the following statements is true? A) The word "cost" has the same meaning in all situations in which it is used. B) Cost data, once classified and recorded for a specific application, can then be used in any application. C) Different cost concepts and classifications are used for different purposes. D) All organizations incur the same types of costs. E) Costs incurred in one year are always meaningful in the following year. Which of the following is not an example of a variable cost? A) Straight-line depreciation on a machine expected to last five years. B) Piece-rate wages paid to manufacturing workers. C) Tires used to produce tractors. D) Lumber used to make patio furniture. E) Commissions paid to sales personnel. The tuition that is paid this semester by a college student who pursues a degree is a(n): A) sunk cost. B) out-of-pocket cost. C) opportunity cost. D) average cost. E) marginal cost. The variable costs per unit are $4 when a company produces 10,000 units of product. What are the variable costs per unit when 8,000 units are produced? A) $4.00. B) $4.50. C) $5.00. D) $5.50. E) $6.00. Costs that can be easily traced to a specific department are called: A) direct costs. B) indirect costs. C) product costs. D) manufacturing costs. E) processing costs. Which of the following employees of a commercial printer/publisher would be classified as direct labor? A) Book binder. B) Plant security guard. C) Sales representative. D) Plant supervisor. E) Payroll supervisor. Indirect costs: A) can be traced to a cost object. B) cannot be traced to a particular cost object. 551

15 C) are not important. D) are always variable costs. E) may be indirect with respect to Disney World but direct with respect to one its major components, Epcot Center. Quality Appliance produces washers and dryers in an assembly-line process. Labor costs incurred during a recent period were: corporate executives, $100,000; assembly-line workers, $60,000; security guards, $11,000; and plant supervisor, $18,000. The total of Quality's direct labor cost was: A) $60,000. B) $71,000. C) $78,000. D) $89,000. E) $189,000. Conversion costs are: A) direct material, direct labor, and manufacturing overhead. B) direct material and direct labor. C) direct labor and manufacturing overhead. D) prime costs. E) period costs. The salary of the president of a manufacturing company would be classified as which of the following? A) Manufacturing overhead. B) Direct labor. C) Direct material. D) Period cost. E) Sunk cost. The relationship between cost and activity is termed: A) cost estimation. B) cost prediction. C) cost behavior. D) cost analysis. E) cost approximation. Atlanta, Inc., which uses the high-low method to analyze cost behavior, has determined that machine hours best explain the company's utilities cost. The company's relevant range of activity varies from a low of 600 machine hours to a high of 1,100 machine hours, with the following data being available for the first six months of the year: Month Utilities Machine Hours January $8, February 8, March 8, April 9, May 9, June 9, st. The variable utilities cost per machine hour is: A) $

16 B) $4.50. C) $5.00. D) $5.50. E) none of these. 2nd. The fixed utilities cost per month is: A) $3,764. B) $4,400. C) $4,760. D) $5,100. E) none of these. 3rd. Using the high-low method, the utilities cost associated with 980 machine hours would be: A) $9,510. B) $9,660. C) $9,700. D) $9,790. E) none of these. 551

17 COST-VOLUME-PROFIT analysis Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following five elements: 1. Prices of products 2. Volume or level of activity 3. Per unit variable cost 4. Total fixed cost 5. Mix of product sold Because cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and profit it is a vital tool in many business decisions. These decisions include, for example, what products to manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of productive facilities to acquire. The Basic Profit Equation Cost-Volume-Profit analysis (CVP) relates the firm s cost structure to sales volume and profitability. A formula that facilitates CVP analysis can be easily derived as follows: Profit = Sales Costs Profit = Sales (Variable Costs + Fixed Costs) Profit + Fixed Costs = Sales Variable Costs Profit + Fixed Costs = Units Sold x (Unit Sales Price Unit Variable Cost) This formula is henceforth called the Basic Profit Equation and is abbreviated P + FC = Q x (SP VC) Typically, the Basic Profit Equation is used to solve one equation in one unknown, where the unknown can be any of the elements of the equation. For example, given an understanding of the firm s cost structure and an estimate of sales volume for the coming period, the equation predicts profits for the period. As another example, given the firm s cost structure, the equation indicates the required sales volume Q to achieve a targeted level of profits P. If targeted profits are zero, the equation simplifies to Q = FC Unit Contribution Margin In this case, Q indicates the required sales volume to break even, and the exercise is called breakeven analysis. Assumptions in CVP Analysis The Basic Profit Equation relies on a number of simplifying assumptions. 1. Only one product is sold. However, multiple products can be accommodated by using an average sales mix and restating Q, SP and VC in terms of a representative bundle of products. For example, a hot dog vendor might calculate that the average customer buys two hot dogs, one bag of chips, and two-thirds of a beverage. Q is the number of customers, and SP and VC refer to the sales price and variable cost for this average customer order. 510

18 2. If the equation is applied to a manufacturer, beginning inventory is assumed equal to zero, and production is assumed equal to sales. Relaxing these assumptions requires additional structure on the equation, including specifying an inventory flow assumption (e.g., FIFO or LIFO) and the extent to which the matching principle is honored for manufacturing costs. 3. The analysis is confined to the relevant range. In other words, fixed costs remain unchanged in total, and variable costs remain unchanged per unit, over the range of Q under consideration. Contribution Margin and Basics of Cost Volume Profit (CVP) Analysis Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period. Contribution margin is first used to cover the fixed expenses and then whatever remains go towards profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period. This concept is explained in the following equations: Sales revenue Variable cost* = Contribution Margin *Both Manufacturing and Non Manufacturing Contribution margin Fixed cost* = Net operating Income or Loss *Both Manufacturing and Non Manufacturing Example: Assume that Omar s company has been able to sell only one unit of product during the period. If company does not sell any more units during the period, the company's contribution margin income statement will appear as follows: Total Per Unit Sales (1 Unit only) $250 $250 Less Variable expenses Contribution margin Less fixed expenses 35,000 ====== Net operating loss $(34,900) For each additional unit that the company is able to sell during the period, $100 more in contribution margin will become available to help cover the fixed expenses. If a second unit 515

19 is sold, for example, then the total contribution margin will increase by $100 (to a total of $200) and the company's loss will decrease by $100, to $ If enough units can be sold to generate $35,000 in contribution margin, then all of the fixed costs will be covered and the company will have managed to at least break even for the month-that is to show neither profit nor loss but just cover all of its costs. To reach the break even point, the company will have to sell 350 units in a period, since each unit sold contribute $100 in the contribution margin. This is shown as follows by the contribution margin format income statement. Total Per Unit Sales (350 Units) $87,500 $250 Less variable expenses 52, Contribution margin 35,000 $100 Less fixed expenses 35,000 ====== Net operating profit $0 Once the break even point has been reached, net income will increase by unit contribution margin by each additional unit sold. For example, if 351 units are sold during the period then we can expect that the net income for the month will be $100, since the company will have sold 1 unit more than the number needed to break even. This is explained by the following contribution margin income statement. Total Per Unit Sales (351 Units) $87,750 $250 Less Variable expenses 52, Contribution margin 35, Less fixed expenses 35,000 ====== Net operating loss $100 If 352 units are sold then we can expect that net operating income for the period will be $200 and so forth. To know what the profit will be at various levels of activity, therefore, 511

20 manager do not need to prepare a whole series of income statements. To estimate the profit at any point above the break even point, the manager can simply take the number of units to be sold above the breakeven and multiply that number by the unit contribution margin. The result represents the anticipated profit for the period. Or to estimate the effect of a planned increase in sale on profits, the manager can simply multiply the increase in units sold by the unit contribution margin. The result will be expressed as increase in profits. To illustrate it suppose company is currently selling 400 units and plans to sell 425 units in near future, the anticipated impact on profits can be calculated as follows: Increased number of units to be sold 25 Contribution margin per unit 100 Increase in the net operating income 2,500 ====== To summarize these examples, if there were no sales, the company's loss would equal to its fixed expenses. Each unit that is sold reduces the loss by the amount of the unit contribution margin. Once the break even point has been reached, each additional unit sold increases the company's profit by the amount of the unit contribution margin. Difference between Gross Margin and Contribution Margin Gross Margin is the Gross Profit as a percentage of Net Sales. The calculation of the Gross Profit is: Sales minus Cost of Goods Sold. The Cost of Goods Sold consists of the fixed and variable product costs, but it excludes all of the selling and administrative expenses. Contribution Margin is Net Sales minus the variable product costs and the variable period expenses. The Contribution Margin Ratio is the Contribution Margin as a percentage of Net Sales. Example Let s illustrate the difference between gross margin and contribution margin with the following information: company had Net Sales of $600,000 during the past year. Its inventory of goods was the same quantity at the beginning and at the end of year. Its Cost of Goods Sold consisted of $120,000 of variable costs and $200,000 of fixed costs. Its selling and administrative expenses were $40,000 of variable and $150,000 of fixed expenses. The company s Gross Margin is: Net Sales of $600,000 minus its Cost of Goods Sold of $320,000 ($120,000 + $200,000) for a Gross Profit of $280,000 ($600,000 - $320,000). The Gross Margin or Gross Profit Percentage is the Gross Profit of $280,000 divided by $600,000, 511

21 or 46.7%. The company s Contribution Margin is: Net Sales of $600,000 minus the variable product costs of $120,000 and the variable expenses of $40,000 for a Contribution Margin of $440,000. The Contribution Margin Ratio is 73.3% ($440,000 divided by $600,000). Cost Volume Profit (CVP) Relationship in Graphic Form The relationships among revenue, cost, profit and volume can be expressed graphically by preparing a cost-volume-profit (CVP) graph or break even chart. A CVP graph highlights CVP relationships over wide ranges of activity and can give managers a perspective that can be obtained in no other way. Preparing a CVP Graph or Break-Even Chart In a CVP graph sometimes called a break even chart unit volume is commonly represented on the horizontal (X) axis and dollars on the vertical (Y) axis. Preparing a CVP graph involves three steps. The graph below shows total revenue (SP x Q) as a function of sales volume (Q), when the unit sales price (SP) is $

22 Total cost Total Revenue [COST-VOLUME-PROFIT ANALYSIS] Units produced and sold The following graph shows the total cost function when fixed costs (FC) are $4,000 and the variable cost per unit (VC) is $ Units produced and sold The following graph combines the revenue and cost functions depicted in the previous two graphs into a single graph. 511

23 Total dollars [COST-VOLUME-PROFIT ANALYSIS] Revenue Total cost Units produced and sold The intersection of the revenue line and the total cost line indicates the breakeven volume, which in this example, occurs between 571 and 572 units. To the left of this point, the company incurs a loss. To the right of this point, the company generates profits. The amount of profit or loss can be measured as the vertical distance between the revenue line and the total cost line. Contribution Margin Ratio (CM Ratio) The contribution margin as a percentage of total sales is referred to as contribution margin ratio (CM Ratio). Formula of CM Ratio: [CM Ratio = Contribution Margin / Sales] This ratio is extensively used in cost-volume profit calculations. Example Consider the following contribution margin income statement of Omar s company in which sales revenues, variable expenses, and contribution margin are expressed as percentage of sales. 511

24 Total Per Unit Percent of Sales Sales (400 units) $100,000 $ % Less variable expenses 60, % Contribution margin $40,000 $100 40% ====== ====== Less fixed expenses 35, Net operating income $5,000 ====== According to above data of Omar s company the computations are: Contribution Margin Ratio = (Contribution Margin / Sales) 100 = ($40,000 / $100,000) 100 = 40% In a company that has only one product such as Omar s company CM ratio can also be calculated as follows: Contribution Margin Ratio = (Unit contribution margin / Unit selling price) 100 = ($100 / $250) 100 = 40% Importance of Contribution Margin Ratio The CM ratio is extremely useful since it shows how the contribution margin will be affected by a change in total sales. To illustrate notice that Omar s company has a CM ratio of 40%. This means that for each dollar increase in sales, total contribution margin will increase by 40 cents ($1 sales CM ratio of 40%). Net operating income will also increase by 40 cents, assuming that fixed cost do not change. The impact on net operating income of any given dollar change in total sales can be computed in seconds by simply applying the contribution margin ratio to the dollar change. For example if the A Omar s company plans a $30,000 increase in sales during the coming 511

25 month, the contribution margin should increase by $12,000 ($30,000 increased sales CM ratio of 40%). As we noted above, Net operating income will also increase by $12,000 if fixed cost do not change. This is verified by the following table: Sales Volume Percent Expected Increase Percent of Sales Sales $100,000 $130,000 $30,000 10% Less variable expenses 60,000 78,000 18,000 60% Contribution margin 40,000 52,000 12,000 40% Less fixed expenses 35,000 35,000 0 ====== Net operating income 5,000 17,000* 12,000 ====== ====== ====== *Expected net operating income of $17,000 can also be calculated directly by using the following formula: [P*= (Sales CM ratio) Fixed Cost] P* = Profit Review Problems Problem 1 Sales = $5,000,000 CM = 0.40 Fixed cost = $1,600,000 Calculate Profit. Solution P = (Sales CM ratio) Fixed Cost P = ($5,000, ) $1,600,000 P = $2,000,000 $1,600,000 = $400,

26 Problem 2 A company has budgeted sales of $200,000, a profit of $60,000 and fixed expenses of $40,000. Calculate contribution margin ratio. Solution: P = (Sales CM ratio) Fixed Cost $60,000 = ($200,000 CM ratio) $40,000 $60,000 + $40,000 = ($200,000 CM ratio) CM ratio = $100,000 / $200,000 = 0.5 Some managers prefer to work with the contribution margin ratio rather than the unit contribution margin. The CM ratio is particularly valuable in situations where trade-offs must be made between more dollar sales of one product versus more dollar sales of another. Generally speaking, when trying to increase sales, products that yield the greatest amount of contribution margin per dollar of sales should be emphasized. Target Costing A relatively recent innovation in product planning and design is called target costing. In the context of the Basic Profit Equation, target costing sets a goal for profits, and solves for the unit variable cost required to achieve those profits. The design and manufacturing engineers are then assigned the task of building the product for a unit cost not to exceed the target. This approach differs from a more traditional product design approach, in which design engineers (possibly with input from merchandisers) design innovative products, manufacturing engineers then determine how to make the products, cost accountants then determine the manufacturing costs, and finally, merchandisers and sales personnel set sales prices. Hence, setting the sales price comes last in the traditional approach, but it comes first in target costing. Target costing is appropriate when SP and Q are predictable, but are not choice variables, such as might occur in well-established competitive markets. In such a setting, merchandisers might know the price that they want to charge for the product, and can probably estimate the sales volume that will be achieved at that price. Target costing has been used successfully by a number of companies including Toyota, which redesigned the Camry around the turn of the century as part of a target costing strategy. Examples Breakeven: Omar owns a service station in Walnut Creek. Steve is considering leasing a machine that will allow him to offer customers the mandatory California emissions test. Every car in the state must be tested every two years. The machine costs $6,000 per month to lease. The variable cost per test (i.e., per car inspected) is $10. The amount that Steve can charge each customer is set by state law, and is currently $

27 How many inspections would Steve have to perform monthly to break even from this part of his business? Q = FC Unit Contribution Margin Q = $6,000 ($40 $10) = 200 inspections Targeted profits, solving for volume: Refer to the information in the previous question. How many inspections would Steve have to perform monthly to generate a profit of $3,000 from this part of his business? P + FC = Q x (SP VC) $3,000 + $6,000 = Q x ($40 $10) Q = 300 inspections Targeted profits, solving for sales price: Alice Waters (age 9) runs a lemonade stand in the summer in Palo Alto, California. Her daily fixed costs are $20. Her variable costs are $2 per glass of ice-cold, refreshing, lemonade. Alice sells an average of 100 glasses per day. What price would Alice have to charge per glass, in order to generate profits of $200 per day? P + FC = Q x (SP VC) $200 + $20 = 100 x (SP - $2) SP = $4.20 per glass Contribution margin: Refer to the previous question. What price would Alice have to charge per glass, in order to generate a total contribution margin of $200 per day? Total CM = Q x (SP VC) $200 = 100 x (SP - $2.00) SP = $4.00 per glass Target costing: Refer to the information about Alice, but now assume that Alice wants to charge $3 per glass of lemonade, and at this price, Alice can sell 110 glasses of lemonade daily. Applying target costing, what would the variable cost per glass have to be, in order to generate profits of $200 per day? P + FC = Q x (SP VC) $200 + $20 = 110 x ($3 VC) VC = $1 510

28 Questions The unit contribution margin is calculated as the difference between: A) selling price and fixed cost per unit. B) selling price and variable cost per unit. C) selling price and product cost per unit. D) fixed cost per unit and variable cost per unit. E) fixed cost per unit and product cost per unit. The break-even point is that level of activity where: A) total revenue equals total cost. B) variable cost equals fixed cost. C) total contribution margin equals the sum of variable cost plus fixed cost. D) sales revenue equals total variable cost. E) profit is greater than zero. The contribution margin ratio is: A) the difference between the selling price and the variable cost per unit. B) fixed cost per unit divided by variable cost per unit. C) variable cost per unit divided by the selling price. D) unit contribution margin divided by the selling price. E) unit contribution margin divided by fixed cost per unit. Cost-volume-profit analysis is based on certain general assumptions. Which of the following is not one of these assumptions? A) Product prices will remain constant as volume varies within the relevant range. B) Expenses can be categorized as fixed, variable, or semi variable. C) The efficiency and productivity of the production process and workers will change to reflect manufacturing advances. D) Total fixed expenses remain constant as activity changes. E) Unit variable expense remains constant as activity changes. The contribution income statement differs from the traditional income statement in which of the following ways? A) The traditional income statement separates costs into fixed and variable components. B) The traditional income statement subtracts all variable expenses from sales to obtain the contribution margin. C) Cost-volume-profit relationships can be analyzed from the contribution income statement. D) The effect of sales volume changes on profit is readily apparent on the traditional income statement. E) The contribution income statement separates costs into product and period categories. A company that desires to lower its break-even point should strive to: A) decrease selling prices. B) reduce variable costs. C) increase fixed costs. D) sell more units. E) pursue more than one of the above actions. 515

29 The extent to which an organization uses fixed costs in its cost structure is measured by: A) financial leverage. B) operating leverage. C) fixed cost leverage. D) contribution leverage. E) efficiency leverage. A company, subject to a 40% tax rate, desires to earn $300,000 of after-tax income. How much should the firm add to fixed expenses when figuring the sales revenues necessary to produce this income level? A) $120,000. B) $180,000. C) $300,000. D) $500,000. E) $750,000. Which of the following would take place if a company were able to reduce its variable cost per unit? Contribution Margin Breakeven Point A) Increase Increase B) Increase Decrease C) Decrease Increase D) Decrease Decrease E) Increase No effect 511

30 Break Even Point Analysis Definition of Break Even point Break even point is the level of sales at which profit is zero. According to this definition, at break even point sales are equal to fixed cost plus variable cost. This concept is further explained by the following equation: [Break even sales = fixed cost + variable cost] The break even point can be calculated using either the equation method or contribution margin method. These two methods are equivalent. Equation Method: The equation method centers on the contribution approach to the income statement. The format of this statement can be expressed in equation form as follows: Profit = (Sales Variable expenses) Fixed expenses Rearranging this equation slightly yields the following equation, which is widely used in cost volume profit (CVP) analysis: Sales = Variable expenses + Fixed expenses + Profit According to the definition of break even point, break even point is the level of sales where profits are zero. Therefore the break even point can be computed by finding that point where sales just equal the total of the variable expenses plus fixed expenses and profit is zero. For example we can use the following data to calculate break even point. Sales price per unit = SR250 variable cost per unit = SR150 Total fixed expenses = SR35,000 Calculate break even point Sales = Variable expenses + Fixed expenses + Profit SR 250Q* = SR 150Q* + SR 35,000 + SR 0** SR100Q = SR35000 Q = SR35,000 /SR100 Q = 350 Units Q* = Number (Quantity) of units sold. 511

31 **The break even point can be computed by finding that point where profit is zero The break even point in sales dollars can be computed by multiplying the break even level of unit sales by the selling price per unit. 350 Units SR250 Per unit = SR87,500 Contribution Margin Method: The contribution margin method is actually just a short cut conversion of the equation method already described. The approach centers on the idea discussed earlier that each unit sold provides a certain amount of contribution margin that goes toward covering fixed cost. To find out how many units must be sold to break even, divide the total fixed cost by the unit contribution margin. Break even point in units = Fixed expenses / Unit contribution margin SR35,000 / SR100* per unit 350 Units *S250 (Sales) SR150 (Variable exp.) A variation of this method uses the Contribution Margin ratio (CM ratio) instead of the unit contribution margin. The result is the break even in total sales dollars rather than in total units sold. Break even point in total sales value= Fixed expenses / CM ratio SR35,000 / 0.40 = SR87,500 This approach is particularly suitable in situations where a company has multiple products lines and wishes to compute a single break even point for the company as a whole. The following formula is also used to calculate break even point Break Even Sales in Dollars = [Fixed Cost / 1 (Variable Cost / Sales)] This formula can produce the same answer: Break Even Point = [SR35,000 / 1 (150 / 250)] = SR35,000 / = SR35,000 /

32 = SR87,500 Benefits / Advantages of Break Even Analysis The main advantage of break even point analysis is that it explains the relationship between cost, production, volume and returns. It can be extended to show how changes in fixed cost, variable cost, commodity prices, revenues will effect profit levels and break even points. Break even analysis is most useful when used with partial budgeting, capital budgeting techniques. The major benefits to use break even analysis is that it indicates the lowest amount of business activity necessary to prevent losses. Assumption of Break Even Point The Break-even Analysis depends on three key assumptions: 1. Average per-unit sales price (per-unit revenue): This is the price that you receive per unit of sales. Take into account sales discounts and special offers. Get this number from your Sales Forecast. For non-unit based businesses, make the per-unit revenue SR1 and enter your costs as a percent of a dollar. The most common questions about this input relate to averaging many different products into a single estimate. The analysis requires a single number, and if you build your Sales Forecast first, then you will have this number. You are not alone in this, the vast majority of businesses sell more than one item, and have to average for their Break-even Analysis. 2. Average per-unit cost: This is the incremental cost, or variable cost, of each unit of sales. If you buy goods for resale, this is what you paid, on average, for the goods you sell. If you sell a service, this is what it costs you, per dollar of revenue or unit of service delivered, to deliver that service. If you are using a Units-Based Sales Forecast table (for manufacturing and mixed business types), you can project unit costs from the Sales Forecast table. If you are using the basic Sales Forecast table for retail, service and distribution businesses, use a percentage estimate, e.g., a retail store running a 50% margin would have a per-unit cost of.5, and a per-unit revenue of Monthly fixed costs: Technically, a break-even analysis defines fixed costs as costs that would continue even if you went broke. Instead, we recommend that you use your regular running fixed costs, including payroll and normal expenses (total monthly Operating Expenses). This will give you a better insight on financial realities. If averaging and estimating is difficult, use your Profit and Loss table to calculate a working fixed cost estimate it will be a rough estimate, but it will provide a useful input for a conservative Break-even Analysis. Limitations of Break Even Analysis It is best suited to the analysis of one product at a time. It may be difficult to classify a cost as all variable or all fixed; and there may be a tendency to continue to use a break even analysis after the cost and income functions have changed. 511

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