04 03 2011 CHAPTER 6 Describe Key Characteristics and Graphs of Various Cost Behaviors Cost Behavior how costs change as volume change Three Common Cost Behaviors Variable costs o Total variable costs change in direct proportion to changes in o Variable cost per unit remains constant o Variable cost per unit of activity v x volume of activity x slope o Total fixed costs stay constant over relevant range normal operating range of activity o Fixed costs per unit of activity vary inversely with changes in volume Fixed costs volume Mixed costs o Total costs increase as volume increases o Total mixed costs can be expressed as a combination of the variable and fixed cost equations o Total mixed cost Y total variable cost vx total fixed cost f Use cost equations to express and predict costs Cost equation a mathematical equation for a straight line predict total cost Y vx f Cost Graphs Vertical y axis always shows total costs Horizontal x axis shows volume of activity Costs and Decisions Committed fixed costs Discretionary fixed costs Relevant Range Other cost behaviors Step costs Curvilinear costs Band of volume where total fixed costs remain constant at a certain level Variable costs per unit remain constant at a certain level Use account analysis and scatter plots to analyze cost behavior Use the high low method to analyze cost behavior Use regression analysis to analyze cost behavior Three methods to analyze cost behavior Scatter plots o Use historical data to determine a cost s behavior o Historical cost data on y axis volume data on x axis o Helps managers visually determine how strong the relationship is between cost and volume of chosen activity base High low Method 1 find variable cost per unit slope of cost line 2 find the fixed costs vertical intercept 3 create the cost equation easy to use only uses 2 data points Regression Analysis o Statistical procedure to find the line that best fits data cost equation o Uses all data points o R square intercept X variable 1 R Square value goodness of fit how well does the line fit the data points ranges from 0 to 1 o Predicting costs and data concerns Data concerns Only valid within relevant range seasonal variations inflation outliers Account analysis use of judgment to classify each general ledger account as variable fixed or mixed subjective Prepare contribution margin income statements for service firms and merchandising firms Traditional Income Statement Sales Cost of goods sold Gross Margin Selling general administrative costs Operating income Contribution Margin Income Statement Sales Variable costs Contribution Margin Fixed costs Operating Income Use variable costing to prepare contribution margin income statements for manufacturers Variable costing assigns only variable manufacturing costs to products DM DL Var MOH Fixed manufacturing overhead period cost For internal management decisions Absorption Costing Required by GAAP for external reporting Assign all manufacturing costs to products DM DL Var MOH Fixed MOH Traditional income statement Absorption costing and Manager Incentives When inventories increase absorption costing income is higher than variable costing income When inventories decrease absorption costing income is lower than variable costing income Therefore Managers may increase production to build up inventory to maximize income and therefore their own bonus CHAPTER 7 Cost Volume Profit Analysis Calculate the unit contribution margin and the contribution margin ratio Cost Volume Profit CVP Analysis A powerful tool that helps managers make important business decisions Relationship among costs volume and profit or loss Determines how much the company must sell each month to cover costs or break even Helps managers decide how sales volume would need to change to achieve the same profit level Components of CVP analysis Relies on the interdependency of five components or pieces of information o Sales price per unit o Volume sold o Variable costs per unit o Fixed costs o Operating income If you know or can estimate four of these five you can compute the remaining unknown amount CVP Assumptions Change in volume is only factor that affects costs Managers can classify each cost as either variable or fixed these costs are linear throughout relevant range Revenues are linear throughout relevant range Inventory levels will not change The sales mix of products will not change Unit Contribution Margin Sales price per unit variable costs per unit contribution margin per unit Contribution margin fixed cost operating income Contribution Margin Ratio Percentage of each sales dollar that is available for covering fixed expenses and generating a profit Contribution margin ratio unit contribution margin sales price per unit contribution margin sales revenue Use CVP analysis to find breakeven points and target profit volumes Breakeven point sales level at which operating income is zero o If sales are above breakeven then profit o If sales are below breakeven then loss Fixed expenses total contribution margin Total sales total expenses Calculating Breakeven Point Three Approaches Income Statement approach 1 2 Shortcut approach using unit contribution margin 3 Shortcut approach using contribution margin ratio Income Statement Approach Contribution Margin Income Statement Breakeven point sales revenue variable exp fixed exp oper income Shortcut Approach to Calculating Breakeven Using Unit Contribution Margin Units sold Fixed Exp Oper Income Contribution Margin per Unit Shortcut Approach using the Unit Contribution Margin Ratio Sales in Fixed Exp Oper Income Contribution Margin Ratio Finding the Volume Needed for a Target Profit CVP analysis helps managers determine what they need to sell to earn a target amount of profit Using Unit CM Using Ratio o Units sold F Exp Operating Income CM per Unit o Units sold F Exp Target Oper Income CM Ratio Graphing the CVP Relationships 1 Choose a sales volume units x price o Plot point for total sales revenue o Draw sales revenue line from origin through plotted point 2 Draw the fixed cost line 3 Draw the total cost line fixed plus variable 4 5 Mark operating income and operating loss areas on graph Identify the breakeven point and the areas of operating income and loss Perform sensitivity analysis in response to changing business conditions Sensitivity Analysis Managers need to be prepared for increasing costs pricing pressure from competitors and other changing business conditions Conducts what if
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