Absorption Costing Rule When inventories increase more units are produced than sold absorption costing income is higher than variable costing income When inventories decreace decline when fewer units are produced than sold absorption costing income is lower than variable costing income More produced more Absorption Costing Required by GAAP for external reporting Assign all manufacturing costs to products DM DL Variable MOH and Fixed MOH fixed variable manufacturing costs treated as inventoriable product costs Account Analysis managers use of judgment to classify each general ledger account as variable fixed or mixed cost subjective Breakeven Point Sales level at which operating income is zero If sales above breakeven then profit If sales below breakeven then loss the point is where sales revenue line intersects with the total expense line Committed Fixed Costs means a business is locked in to these costs because of previous management decisions Ex long term lease landlord Contribution Margin indicator of how much sales contribute to coverage of Fixed Costs can be used to predict how changes in volume will affect operating income internal management decisions excess of sales revenue over variable expenses tells managers how much revenue is left Contribution Margin Income Statement organizes costs by behavior rather than by function not GAAP separates costs by behavior rather than function Contribution Margin Ratio of each sales dollar that is available for covering fixed expenses generating a profit Contribution Margin Per Unit is the excess of the selling price per unit over the variable cost of obtaining and selling each unit Cost behavior how costs change as volume changes to make good decisions and accurate projections Cost Equation mathematical equation for a straight line to predict total cost Cost Plus Pricing opposite of target pricing approach starts with company s full costs adds the desired profit to determine a cost plus price Cost Volume Profit CVP Analysis determines how much the company must sell each month sales volume just to cover costs or to breakeven relationship among costs volume profit or loss Curvilinear Costs not linear do not fit in a neat pattern can be approximated as mixed cost Decisions Approach relevant info approach or incremental analysis research Discretionary Fixed Costs costs such as advertising expenses charitable contributions that are a result of annual management decisions Ex charitable contributions but if business falters they back out Fixed costs costs that do not change in total despite wide changes in volume fixed costs per unit of activity changes inversely w changes in volume Ex Depreciation for a hotel Property taxes for a retail store Salary of the president or chancellor for a college High Low Method Advantage Easy to use Disadvantage Only uses 2 data points High Operating Leverage higher fixed costs lower variable costs higher contribution margin ratios higher risk higher potential for reward Horizontal axis x axis shows volume of activity Irrelevant costs that do not differ b w alternatives they are the fixed costs sunk costs Low Operating Leverage higher variable costs lower fixed costs lower contribution margin ratios changes in sales volume do not have significant effect on operating income lower risk lower potential for reward Ex merch companies Margin of Safety Excess of expected sales over breakeven sales cushion or drop in sales the company can absorb before incurring a loss used to evaluate risk of current operations as well as the risk of new plans Mixed Costs Total Costs costs that change in total but not in direct proportion to changes in volume contain variable fixed cost components Operating Leverage Relative amount of fixed and variable cost that make up a company s total costs Outsourcing To buy a product or service or produce it in house Price Setter Product more unique less competition pricing approach emphasizes cost plus pricing more control on pricing Always take the high low volume points when using the high low method Price Taker Product lacks uniqueness heavy competition pricing approach emphasizes target costing no control over prices Regression analysis statistical procedure for determining the line and cost equation that best fits the data by using all of the data points info needed intercept coefficient Fixed cost the X variable 1 coefficient variable cost per activity R Square value Goodness of fit Relevant expected future cost and revenue data differs among alternative actions Relevant Range band of volume where the total fixed costs variable cost per unit remains constant at a certain level Sales mix combination of products that make up total sales Scatter Plots use historical data to determine a cost s behavior help managers determine visually how strong the relationship between cost and volume of the chosen activity base is Sensitivity Analysis what if technique that asks what results will be if the actual process or costs change if the sales price changes or if an underlying assumption such as sales mix changes Step Costs resemble stair steps ex kids per day care worker Special Order when a customer requests a one time order at a reduced sales price Sunk Cost cost that has already been incurred and cannot be recovered Ex Price you paid for your old car Sustainability Reducing variable costs making it easier to reach target profit helping environment Target Costing Market price minus desired profit target cost Includes Development cost Marketing cost Design cost Delivery cost Production cost Service cost 2 potential outcomes Actual cost less than target total cost Actual cost greater than target total cost characteristics of Price Taker Variable costing assigns only variable manufacturing costs to products DM DL and variable MOH for internal management decisions Variable Costs costs that are incurred for every unit of volume Ex Bed linens for a hospital with respect to of patients Vertical axis y axis always shows total costs Cost Behavior Methods Account analysis Scatter plots High low method Regression analysis Cost Equation Data concerns Data Concerns Only valid within relevant range Seasonal variations Inflation Outliers abnormal data points Difference b w absorption and variable costing is that fixed manufacturing overhead is a product cost under absorption costing but a period cost under variable costing As sales grow total variable costs increase As sales decrease total variable costs