Chapter
22-1
CHAPTER 22
COST - VOLUME PROFIT
Accounting Principles, Eighth Edition
Chapter
22-2
Study Objectives
1.
Distinguish between variable and fixed costs.
2. Explain the significance of the relevant range.
3. Explain the concept of mixed costs.
4. List the five components of cost-volume-profit
analysis.
5. Indicate what contribution margin is and how it
can be expressed
6. Identify the three ways to determine the
break-even point.
Chapter
22-3
Study Objectives
7. Give the formulas for
determining sales required
to earn target net income
8. Define margin of safety,
and give the formulas for
computing it.
9. Describe the essential
features of a cost-volumeprofit income statement.
Chapter
22-4
Preview of Chapter
To manage any business, you must understand:
How costs respond to changes in sales volume
and
The effect of costs and revenues on profit
To understand cost-volume-profit (CVP), you must
know how costs behave
Chapter
22-5
Cost-Volume-Profit
Cost Behavior
Analysis
Cost-VolumeProfit Analysis
Variable costs
Basic components
Fixed costs
CVP income statement
Relevant range
Break-even analysis
Mixed costs
Target net income
Identifying
variable and fixed
costs
Margin of safety
Changes in business
environment
CVP income statement
revisited
Chapter
22-6
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
Chapter
22-7
LO 1: Distinguish between variable and fixed costs.
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)
Dance classes taught (by a dance studio)
Many companies use more
than one measurement base
Chapter
22-8
LO 1: Distinguish between variable and fixed costs.
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
Chapter
22-9
Fixed Costs
Mixed Costs
LO 1: Distinguish between variable and fixed costs.
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.
Chapter
22-10
LO 1: Distinguish between variable and fixed costs.
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)
Chapter
22-11
LO 1: Distinguish between variable and fixed costs.
Variable Costs – Graphs
Chapter
22-12
LO 1: Distinguish between variable and fixed costs.
Fixed Costs
Costs that remain the same in total regardless of
changes in the activity level.
Per unit cost varies inversely with activity:
As volume increases,
unit cost declines, and vice versa
Examples include:
Property taxes
Insurance
Rent
Depreciation on buildings and equipment
Chapter
22-13
LO 1: Distinguish between variable and fixed costs.
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)
Chapter
22-14
LO 1: Distinguish between variable and fixed costs.
Fixed Costs - Graphs
Chapter
22-15
LO 1: Distinguish between variable and fixed costs.
Let’s Review
Variable costs are costs that:
a.
Vary in total directly and proportionately with
changes 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.
Chapter
22-16
LO 1: Distinguish between variable and fixed costs.
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
Chapter
22-17
LO 2: Explain the significance of the relevant range.
Relevant Range - Graphs
Chapter
22-18
LO 2: Explain the significance of the relevant range.
Relevant Range
Defined as the range of activity over which a
company expects to operate during a year
Within this range, a straight-line relationship
usually exists for both variable and fixed costs
Chapter
22-19
LO 2: Explain the significance of the relevant range.
Let’s Review
The relevant range is:
a.
The range of activity in which variable costs will
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.
Chapter
22-20
LO 2: Explain the significance of the relevant range.
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
Chapter
22-21
LO 3: Explain the concept of mixed costs.
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
Chapter
22-22
LO 3: Explain the concept of mixed costs.
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 at either the high
or the low activity level from the total cost
at that level
Chapter
22-23
LO 3: Explain the concept of mixed costs.
Mixed Costs:
High–Low-Method Example
Data for Metro Transit Company for 4 month period:
High Level of Activity:
Low Level of Activity:
April
January
Difference
$63,000
30,000
$33,000
50,000 miles
20,000 miles
30,000 miles
Step 1: Using the formula, variable costs per unit are
$33,000  30,000 = $1.10 variable cost per mile
Chapter
22-24
LO 3: Explain the concept of mixed costs.
Mixed Costs:
High–Low-Method Example
Step 2: Determine the fixed costs by subtracting total
variable costs at either the high or low activity
level from the total cost at that same level
Chapter
22-25
LO 3: Explain the concept of mixed costs.
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.
Chapter
22-26
LO 3: Explain the concept of mixed costs.
Let’s Review
Mixed costs consist of a:
a.
Variable cost element and a fixed cost element.
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.
Chapter
22-27
LO 3: Explain the concept of mixed costs.
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
Chapter
22-28
LO 4: List the five components of cost-volume-profit analysis.
Cost-Volume-Profit Analysis
CVP analysis considers the interrelationships
among five basic components
Chapter
22-29
LO 4: List the five components of cost-volume-profit analysis.
Assumptions Underlying CVP Analysis
Behavior of both costs and revenues is linear
throughout the relevant range of the activity index
All costs can be classified as either variable or fixed
with 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
Chapter
22-30
LO 4: List the five components of cost-volume-profit analysis.
Let’s Review
Which of the following is NOT involved in CVP analysis?
a.
Sales mix.
b. Unit selling prices.
c.
Fixed costs per unit.
d. Volume or level of activity.
Chapter
22-31
LO 4: List the five components of cost-volume-profit analysis.
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
Chapter
22-32
LO 5: Indicate what contribution margin is and how it can be expressed.
CVP Income Statement - Example
Vargo Video Company produces DVD players.
Relevant data for June 2008:
Unit selling price of DVD player
Unit variable costs
Total monthly fixed costs
Units sold
Chapter
22-33
$500
$300
$200,000
1,600
LO 5: Indicate what contribution margin is and how it can be expressed.
Contribution Margin Per Unit
Contribution margin is available to cover fixed
costs and to contribute to income
The formula for contribution margin per unit and
the computation for Vargo Video are:
Chapter
22-34
LO 5: Indicate what contribution margin is and how it can be expressed.
CVP Income Statement-CM effect
Chapter
22-35
LO 5: Indicate what contribution margin is and how it can be expressed.
Contribution Margin Ratio
Shows the percentage of each sales dollar
available to apply toward fixed costs and profits
The formula for contribution margin ratio and the
computation for Vargo Video are:
Chapter
22-36
LO 5: Indicate what contribution margin is and how it can be expressed.
Contribution Margin Ratio
Ratio helps to determine the effect of changes in
sales on net income
Chapter
22-37
LO 5: Indicate what contribution margin is and how it can be expressed.
Let’s Review
Contribution margin:
a.
Is revenue remaining after deducting variable
costs.
b. May be expressed as contribution margin per
unit.
c.
Is selling price less cost of goods sold.
d. Both (a) and (b) above.
Chapter
22-38
LO 5: Indicate what contribution margin is and how it can be expressed.
Break-Even Analysis
Process of finding the break-even point
level of activity at which total revenues equal
total 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
Chapter
22-39
LO 6: Identify the three ways to determine the break-even point.
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 point and the
computation for Vargo Video are:
To find sales dollars required to break-even:
1000 units X $500 = $500,000 (break-even dollars)
Chapter
22-40
LO 6: Identify the three ways to determine the break-even point.
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.
Chapter
22-41
LO 6: Identify the three ways to determine the break-even point.
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:
Chapter
22-42
LO 6: Identify the three ways to determine the break-even point.
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
Chapter
22-43
LO 6: Identify the three ways to determine the break-even point.
Break-Even Analysis: Graphic Presentation
Chapter
22-44
LO 6: Identify the three ways to determine the break-even point.
Let’s Review
Gossen Company is planning to sell 200,000 pliers for
$4 per unit. The contribution margin ratio is 25%. If
Gossen will break even at this level of sales, what are
the fixed costs?
a.
$100,000.
b. $160,000.
c.
$200,000.
d. $300,000.
Chapter
22-45
LO 6: Identify the three ways to determine the break-even point.
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
Chapter
22-46
LO 7: Give the formulas for determining sales required
to earn target net income.
Break-Even Analysis: Target Net Income
Mathematical Equation
Using the formula for the break-even point, simply
include the desired net income as a factor. The
computation for Vargo Video is as follows:
Chapter
22-47
LO 7: Give the formulas for determining sales required to
earn target net income.
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:
Chapter
22-48
LO 7: Give the formulas for determining sales required to
earn target net income.
Let’s Review
The mathematical equation for computing required
sales to obtain target net income is:
Required sales =
a.
Variable costs + Target net income.
b. Variable costs + Fixed costs + Target net income.
c.
Fixed costs + Target net income.
d. No correct answer is given.
Chapter
22-49
LO 7: Give the formulas for determining sales required to
earn target net income.
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:
Chapter
22-50
LO 8: Define margin of safety, and give the formulas for computing it.
Break-Even Analysis: Margin of Safety
Margin of Safety Ratio



Chapter
22-51
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.
CVP Income Statement Revisited
Chapter
22-52
LO 9: Describe the essential features of a cost-volumeprofit income statement.
Let’s Review
Marshall Company had actual sales of $600,000 when
break-even sales were $420,000. What is the margin
of safety ratio?
a.
25%.
b. 30%.
c.
33 1/3%.
d. 45%.
Chapter
22-53
LO 8: Define margin of safety, and give the formulas for
computing it.
Chapter Review - Brief Exercise 22-4
Deines Company accumulates the following data concerning a
mixed cost, using miles as the activity level.
Miles
Driven
January 8,000
February 7,500
Total
Cost
$14,150
$13,600
March
April
Miles
Driven
8,500
8,200
Total
Cost
$15,000
$14,490
Compute the variable and fixed cost elements using the highlow method.
Chapter
22-54
Chapter Review - Brief Exercise 22-4
High Level of Activity:
Low Level of Activity:
March
February
Difference
$15,000
13,600
$ 1,400
8,500 miles
7,500 miles
1,000 miles
Step 1:
Variable Cost per Unit = $1,400 ÷ 1,000 miles
= $1.40 variable cost per mile
Step 2:
Total Cost:
Variable Cost:
8,500 X $1.40
7,500 X $1.40
Total Fixed Costs
Chapter
22-55
High
$15,000
11,900
$ 3,100
Low
$13,600
10,500
$ 3,100
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Chapter
22-56