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CHAPTER 22

CHAPTER 22. COST - VOLUME - PROFIT. Accounting Principles, Eighth Edition. Study Objectives. Distinguish between variable and fixed costs. Explain the significance of the relevant range. Explain the concept of mixed costs. List the five components of cost-volume-profit analysis.

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CHAPTER 22

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  1. CHAPTER 22 COST - VOLUME - PROFIT Accounting Principles, Eighth Edition

  2. Study Objectives • Distinguish between variable and fixed costs. • Explain the significance of the relevant range. • Explain the concept of mixed costs. • List the five components of cost-volume-profit analysis. • Indicate what contribution margin is and how it can be expressed • Identify the three ways to determine the break-even point.

  3. Study Objectives • Give the formulas for determining sales required to earn target net income • Define margin of safety, and give the formulas for computing it. • Describe the essential features of a cost-volume-profit income statement.

  4. Cost-Volume-Profit Cost Behavior Analysis Cost-Volume-Profit Analysis Variable costs Fixed costs Relevant range Mixed costs Identifying variable and fixed costs Basic components CVP income statement Break-even analysis Target net income Margin of safety Changes in business environment CVP income statement revisited

  5. Cost Behavior Analysis • Cost Behavior Analysis is the study of how specific costs respond to changes in the level of business activity. • Some costs change; others remain the same • Helps management plan operations and decide between alternative courses of action • Applies to all types of businesses and entities LO 1: Distinguish between variable and fixed costs.

  6. Cost Behavior Analysis - continued • Starting point is measuring key business activities • Activity levels may be expressed in terms of: Sales dollars (in a retail company) Miles driven (in a trucking company) Room occupancy (in a hotel) • Many companies use more than one measurement base LO 1: Distinguish between variable and fixed costs.

  7. Cost Behavior Analysis - continued • For an activity level to be useful: Changes in the level or volume of activity should be correlated with changes in costs • The activity level selected is called the activity or volume index • The activity index: Identifies the activity that causes changes in the behavior of costs Allows costs to be classified according to their response to changes in activity as either: Variable Costs Fixed Costs Mixed Costs LO 1: Distinguish between variable and fixed costs.

  8. Variable Costs • Costs that vary in total directly and proportionately with changes in the activity level • Example: If the activity level increases 10 percent, total variable costs increase 10 percent • Example: If the activity level decreases by 25 percent, total variable costs decrease by 25 percent • Variable costs remain constant per unit at every level of activity. LO 1: Distinguish between variable and fixed costs.

  9. Variable Costs – Example • Damon Company manufactures radios that contain a $10 clock • Activity index is the number of radios produced • For each radio produced, the total cost of the clocks increases by $10: If 2,000 radios are made, the total cost of the clocks is $20,000 (2,000 X $10) If 10,000 radios are made, the total cost of the clocks is $100,000 (10,000 X $10) LO 1: Distinguish between variable and fixed costs.

  10. Variable Costs – Graphs LO 1: Distinguish between variable and fixed costs.

  11. Fixed Costs • Costs that remain the same in totalregardless of changes in the activity level. • Per unit costvariesinverselywith activity: As volume increases, unit cost declines, and vice versa • Examples include: Property taxes Insurance Rent Depreciation on buildings and equipment LO 1: Distinguish between variable and fixed costs.

  12. Fixed Costs - Example • Damon Company leases its productive facilities for $10,000 per month • Total fixed costs of the facilities remain constant at all levels of activity - $10,000 per month • On a per unit basis, the cost of rent decreases as activity increases and vice versa At 2,000 radios, the unit cost is $5 ($10,000 ÷ 2,000 units) At 10,000 radios, the unit cost is $1 ($10,000 ÷ 10,000 units) LO 1: Distinguish between variable and fixed costs.

  13. Fixed Costs - Graphs LO 1: Distinguish between variable and fixed costs.

  14. Relevant Range • Throughout the range of possible levels of activity, a straight-line relationship usually does not exist for either variable costs or fixed costs • The relationship between variable costs and changes in activity level is often curvilinear • For fixed costs, the relationship is also nonlinear – some fixed costs will not change over the entire range of activities while other fixed costs may change LO 2: Explain the significance of the relevant range.

  15. Relevant Range - Graphs LO 2: Explain the significance of the relevant range.

  16. Relevant Range • Defined as the range of activity over which a companyexpects to operate during a year • Within this range, a straight-line relationshipusually exists for both variable and fixed costs LO 2: Explain the significance of the relevant range.

  17. Mixed Costs • Costs that have both a variable cost element and a fixed cost element • Sometimes called semivariable cost • Change in total but not proportionately with changes in activity level LO 3: Explain the concept of mixed costs.

  18. Mixed Costs: High–Low Method • Mixed costs must be classified into their fixed and variable elements • One approach to separate the costs is called the high-low method • Uses the total costs incurred at both the high and the low levels of activity to classify mixed costs • The difference in costs between the high and low levels represents variable costs, since only variable costs change as activity levels change LO 3: Explain the concept of mixed costs.

  19. Mixed Costs: 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 ateither the high or the low activity level from the total cost at that level LO 3: Explain the concept of mixed costs.

  20. Mixed Costs: High–Low-Method Example High Level of Activity:April $63,000 50,000 miles Low Level of Activity: January 30,000 20,000 miles Difference $33,000 30,000 miles Step 1: Using the formula, variable costs per unit are $33,000  30,000 = $1.10 variable cost per mile Data for Metro Transit Company for 4 month period: LO 3: Explain the concept of mixed costs.

  21. Mixed Costs: High–Low-Method Example Step 2: Determine the fixed costs by subtracting total variable costs at eitherthe high or low activity level from the total cost at that same level LO 3: Explain the concept of mixed costs.

  22. Mixed Costs:High–Low-Method Example • Maintenance costs: $8,000 per month plus $1.10 per mile • To determine maintenance costs at a particular 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 estimated maintenance costs would be $8,000 fixed and $49,500 variable ($1.10 X 45,000 miles) for a total of $57,500. LO 3: Explain the concept of mixed costs.

  23. Cost-Volume-Profit Analysis • Study of the effects of changes of costs and volume on a company’s profits • A critical factor in management decisions • Important in profit planning LO 4: List the five components of cost-volume-profit analysis.

  24. Cost-Volume-Profit Analysis • CVP analysis considers the interrelationships among five basic components LO 4: List the five components of cost-volume-profit analysis.

  25. Assumptions Underlying CVP Analysis • Behavior of both costs and revenues is linearthroughout the relevant range of the activity index • All costs can be classified as either variable or fixedwith reasonable accuracy • Changes in activity are the only factors that affect costs • All units produced are sold • 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.

  26. CVP Income Statement • A statement for internal use • Classifies costs and expenses as fixed or variable • Reports contribution margin in the body of the statement. Contribution margin– amount of revenue remaining after deducting variable costs • Reports the same net income as a traditional income statement LO 5: Indicate what contribution margin is and how it can be expressed.

  27. CVP Income Statement - Example • Vargo Video Company produces DVD players. • Relevant data for June 2008: Unit selling price of DVD player $500 Unit variable costs $300 Total monthly fixed costs $200,000 Units sold 1,600 LO 5: Indicate what contribution margin is and how it can be expressed.

  28. Contribution Margin Per Unit • Contribution margin is availableto cover fixed costs and to contribute to income • The formula for contribution margin per unitand the computation for Vargo Video are: LO 5: Indicate what contribution margin is and how it can be expressed.

  29. CVP Income Statement-CM effect LO 5: Indicate what contribution margin is and how it can be expressed.

  30. Contribution Margin Ratio • Shows the percentage of each sales dollar available to apply toward fixed costs and profits • The formula for contribution margin ratioand the computation for Vargo Video are: LO 5: Indicate what contribution margin is and how it can be expressed.

  31. Contribution Margin Ratio • Ratio helps to determine the effect of changes in sales on net income LO 5: Indicate what contribution margin is and how it can be expressed.

  32. Break-Even Analysis • Process of finding the break-even point level of activity at which total revenues equaltotal costs(both fixed and variable) • Can be computed or derived from a mathematical equation, by using contribution margin, or from 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.

  33. Break-Even Analysis: Mathematical Equation • Break-even occurs where total sales equal variable costs plus fixed costs; i.e., net income is zero. • The formula for the break-even pointand the computation for Vargo Video are: • To find sales dollars required to break-even: 1000 units X $500 = $500,000 (break-even dollars) LO 6: Identify the three ways to determine the break-even point.

  34. Break-Even Analysis:Contribution 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.

  35. Contribution 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.

  36. Break-Even Analysis: Graphic Presentation • A cost-volume profit (CVP) graph shows costs, volume and profits. • Used to visually find the break-even point • To construct a CVP graph: Plot the total sales line starting at the zero activity level Plot the total fixed cost using a horizontal line Plot the total cost line (starts at the fixed-cost line at zero activity Determine 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.

  37. Break-Even Analysis: Graphic Presentation LO 6: Identify the three ways to determine the break-even point.

  38. Break-Even Analysis: Target Net Income • Level of sales necessary to achieve a specified income • Can be determined from each of the approaches used to determine break-even sales/units: from a mathematical equation, by using contribution margin, or from a cost-volume profit (CVP) graph • Expressed either in sales units or in sales dollars LO 7: Give the formulas for determining sales required to earn target net income.

  39. Break-Even Analysis: Target Net Income Mathematical Equation • Using the formula for the break-even point, simply include the desired net incomeas a factor.The computation for Vargo Video is as follows: LO 7: Give the formulas for determining sales required to earn target net income.

  40. Break-Even Analysis: Target Net Income Contribution 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 required to earn target net income.

  41. Break-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 computing it.

  42. Break-Even Analysis: Margin of Safety Margin 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 greater the margin of safety LO 8: Define margin of safety, and give the formulas for computing it.

  43. CVP Income Statement Revisited LO 9: Describe the essential features of a cost-volume-profit income statement.

  44. Chapter Review - Brief Exercise 22-4 Deines Company accumulates the following data concerning a mixed cost, using miles as the activity level. Miles Total Miles Total DrivenCostDrivenCost January 8,000 $14,150 March 8,500 $15,000 February 7,500 $13,600 April 8,200 $14,490 Compute the variable and fixed cost elements using the high-low method.

  45. Chapter Review - Brief Exercise 22-4 High Level of Activity:March $15,000 8,500 miles Low Level of Activity: February 13,600 7,500 miles Difference $ 1,400 1,000 miles Step 1: Variable Cost per Unit = $1,400 ÷ 1,000 miles = $1.40 variable cost per mile Step 2: High Low Total Cost: $15,000 $13,600 Variable Cost: 8,500 X $1.4011,900 7,500 X $1.40 10,500 Total Fixed Costs $ 3,100 $ 3,100

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