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1. 4 Click to edit Master title style • Click to edit Master text styles • Second level • Third level • Fourth level • Fifth level Cost Behavior and Cost-Volume-Profit Analysis 10/26/2014 1

2. Classify costs as variable costs, fixed costs, or mixed costs. 1 Compute the contribution margin, the contribution margin ratio, and the unit contribution margin. Determine the break-even point and sales necessary to achieve a target profit. 2 3 Learning Objective 1 Learning Objective 1 Cost Behavior and Cost-Volume-Profit Analysis 3-1 3-1 After studying this chapter, you should be able to: Insert Chapter Objectives Describe the nature of the adjusting process. Describe the nature of the adjusting process. 4-2

3. Using a cost-volume-profit chart and a profit-volume chart, determine the break-even point and sales necessary to achieve a target profit. Compute the break-even point for a company selling more than one product, the operating leverage, and the margin of safety. 4 5 Cost Behavior and Cost-Volume-Profit Analysis (continued) 4-3

4. 1 Classify costs as variable costs, fixed costs, or mixed costs. 4-4

5. 1 Cost Behavior Cost behavior is the manner in which a cost changes as a related activity changes. Understanding the behavior of a cost depends on the following: • Identifying the activities that cause the cost to change, called activity base (or activity driver). • Specifying the range of activity over which the changes in the cost are of interest. This range of activity is called the relevant range.

6. 1 Variable Costs Variable costs are costs that vary in proportion to changes in the level of activity.

7. 1 Jason Sound Inc. Jason Sound Inc. produces stereo systems. The parts for the stereo system are purchased from suppliers for $10 per unit (a variable cost) and assembled by Jason Sound Inc.

8. 1 For Model JS-12, the direct materials for the relevant range of 5,000 to 30,000 units of production are shown below.

9. Exhibit 1 1 Variable Cost Graphs

10. 1 Unit Cost Compared to Total Cost $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $20 $15 $10 $5 Cost per Unit Total Costs 0 10 20 30 Units Produced (000) 0 10 20 30 Units Produced (000) Number of Units of Model JS-12 Produced Direct Materials Cost per Unit Total Direct Materials Cost 5,000 units $10 $ 50,000 10,000 10 l00,000 15,000 10 150,000 20,000 10 200,000 25,000 10 250,000 30,000 10 300,000

11. 1 Fixed Costs Fixed costs are costs that remain the same in total dollar amount as the activity base changes.

12. 1 Minton Inc. Minton Inc. manufactures, bottles, and distributes perfume. The production supervisor is Jane Sovissi. She is paid $75,000 per year. The plant produces from 50,000 to 300,000 bottles of La Fleur Perfume.

13. 1 Fixed Versus Variable Cost of Jane Sovissi’s Salary per Bottle of Perfume Salary per Bottle of Perfume Produced Number of Bottles of Perfume Produced Total Salary for Jane Sovissi 50,000 bottles $75,000 $1.500 100,000 75,000 0.750 150,000 75,000 0.500 200,000 75,000 0.375 250,000 75,000 0.300 300,000 75,000 0.250

14. Exhibit 2 1 Fixed Cost Graphs

15. 1 $1.50 $1.25 $1.00 $.75 $.50 $.25 $150,000 $125,000 $100,000 $75,000 $50,000 $25,000 Total Costs Unit Cost 100 200 300 0 0 100 200 300 Bottles Produced (000) Units Produced (000) Salary per Bottle of Perfume Produced Total Salary for Jane Sovissi Number of Bottles of Perfume Produced 50,000 bottles $75,000 $1.500 100,000 75,000 0.750 150,000 75,000 0.500 200,000 75,000 0.375

16. 1 Mixed Costs Mixed costs (sometimes called semivariable or semifixed costs) have characteristics of both a variable and a fixed cost. Over one range of activity, the total mixed cost may remain the same. Over another range of activity, the mixed cost may change in proportion to changes in level of activity.

17. 1 Simpson Inc. Simpson Inc. manufactures sails, using rented equipment. The rental charges are $15,000 per year, plus $1 for each machine hour used over 10,000 hours.

18. Exhibit 3 1 Mixed Costs

19. 1 High-Low Method The high-low method is a cost estimation method that may be used for separating mixed costs into their fixed and variable components.

20. 1 Estimating Variable Cost Using High-Low Production Total (Units) Cost Actual costs incurred June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 First, select the highest and lowest levels of activity. Difference in Total Cost Variable Cost per Unit = Difference in Production

21. $20,250 1 Estimating Variable Cost Using High-Low Production Total (Units) Cost Fill in the formula for difference in cost. June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 $61,500 41,250 Difference in Total cost $20,250 Variable Cost per Unit = Difference in Production

22. 1 Estimating Variable Cost Using High-Low Production Total (Units) Cost Then, fill in the formula for difference in production. June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 2,100 750 1,350 Difference in total cost $20,250 Variable Cost per Unit = Difference in Production 1,350

23. 1 Estimating Variable Cost Using High-Low Production Total (Units) Cost June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 Variable cost per unit is $15 $20,250 = $15 Variable Cost per Unit = 1,350

24. 1 Estimating Fixed Cost Using High-Low The first step in determining fixed cost is to insert the variable cost of $15 into the following formula: Total Cost = (Variable Cost per Unit × Units of Production) + Fixed Cost Total Cost = ($15 × Units of Production) + Fixed Cost

25. 1 Production Total (Units) Cost Using the highest level of production, we insert the total cost and units produced in the formula. June 1,000 $45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 Total Cost = (Variable Cost per Unit × Units of Production) + Fixed Cost $61,500 Total cost = ($15 × Units of Production) + Fixed Cost 2,100 units)

26. 1 $61,500 = ($15 × 2,100 units) + Fixed cost $61,500 = $31,500 + Fixed cost $61,500 – $31,500 = Fixed cost $30,000 = Fixed cost If the lowest level had been chosen, the results of the formula would provide the same fixed cost of $30,000.

27. 1 With fixed costs and variable costs estimated at $30,000 and $15 per unit, a formula is in place to estimate production at any level. If the company is expected to produce 950 units in November, the estimated total overhead would be calculated as follows: Total Cost = (Variable Cost per Unit × Units of Production) + Fixed cost Total Cost = $15 (950) + $30,000 Total Cost = $44,250

28. 1 Example Exercise 4-1 High-Low Method The manufacturing costs of Alex Industries for the first three months of the year are provided below: Total Cost Production January $80,000 1,000 units February $125,000 2,500 March $100,000 1,800 Using the high-low method, determine the (a) variable cost per unit, and (b) the total fixed cost. 4-28

29. Follow My Example 4-1 For Practice: PE 4-1A, PE 4-1B 1 Example Exercise 4-1 (continued) $125,000 – $80,000 (2,500 – 1,000) • $30 per unit = b. $50,000 = $125,000 – ($30 × 2,500) or $80,000 – ($30 × 1,000) 4-29

30. Unit costs remain the same per unit regardless of activity. Total costs increase and decrease proportionately with activity level. 1 Summary of Cost Behavior Concepts Total Variable Costs Total Costs Total Units Produced Unit Variable Costs Per Unit Cost Total Units Produced

31. Total cost per unit decreases as activity increases. Unit costs remain the same regardless of activity. 1 Summary of Cost Behavior Concepts Total Fixed Costs Total Costs Total Units Produced Unit Fixed Costs Per Unit Cost Total Units Produced

32. 2 Compute the contribution margin, the contribution margin ratio, and the unit contribution margin. 4-32

33. 2 Cost-Volume-Profit Relationships Cost-volume-profit analysis is the examination of the relationships among selling prices, sales and production volume, costs, expenses, and profits.

34. 2 Some of the ways cost-volume-profit analysis may be used include the following: • Analyzing the effects of changes in selling prices on profits • Analyzing the effects of changes in costs on profits • Analyzing the effects of changes in volume on profits • Setting selling price (continued)

35. 2 • Selecting the mix of products to sell • Choosing among marketing strategies

36. 2 Contribution Margin Thecontribution margin is the excess of sales revenues over variable costs. It is especially useful because it provides insight into the profit potential of a company.

37. Exhibit 4 2 Contribution Margin Income Statement

38. 2 Contribution Margin Ratio The contribution margin ratio, sometimes called the profit-volume ratio, indicates the percentage of each sales dollar available to cover fixed costs and to provide income from operations. The contribution margin ratio is computed as follows: Contribution Margin Sales Contribution Margin Ratio =

39. 2 Contribution Margin Ratio (in dollars) The contribution margin ratio is most useful when the increase or decrease in sales volume is measured in sales dollars. In this case, the following formula is used to determine change in income from operations. Change in Sales Dollars × Contribution Margin Ratio Change in Income from Operations =

40. 30% 10% Contribution Margin Ratio = Sales – Variable Costs Sales $1,000,000 – $600,000 $1,000,000 Contribution Margin Ratio = 40% Contribution Margin Ratio = 2 Contribution Margin Ratio 100% 60% 40%

41. 2 Unit Contribution Margin The unit contribution margin is also useful for analyzing the profit potential of proposed projects. The unit contribution margin is the sales price per unit lessthe variable cost per unit.

42. Change in Income from Operations Changes in Sales Units × Unit Contribution Margin = Change in Income from Operations 15,000 × $8 = Change in Income from Operations $120,000 = 2 Using Contribution Margin per Unit as a Shortcut Lambert Inc.’s sales could be increased by 15,000 units from 50,000 to 65,000 units. Lambert’s income from operations would increase by $120,000 (15,000 × $8) as shown below.

43. 65,000 units $120,000 2 Proof of Shortcut 50,000 units $1,300,000 780,000 $ 520,000 300,000 Sales ($20) $1,000,000 Variable costs ($12) 600,000 Contribution margin ($8) $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 $ 220,000

44. 2 Review Sales (50,000 units) $1,000,000 Variable costs 600,000 Contribution margin $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 100% 60% 40% 30% 10% $20 12 $ 8 Unit contribution margin analyses can provide useful information for managers.

45. Sales (50,000 units) $1,000,000 Variable costs 600,000 Contribution margin $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 100% 60% 40% 30% 10% $20 12 $ 8 2 Review The contribution margin can be expressed three ways: 1. Total contribution margin in dollars. 2. Contribution margin ratio (percentage). 3. Unit contribution margin (dollars per unit).

46. 2 Example Exercise 4-2 Contribution Margin Molly Company sells 20,000 units at $12 per unit. Variable costs are $9 per unit, and fixed costs are $25,000. Determine the (a) contribution margin ratio, (b) unit contribution margin, and (c) income from operations. 4-46

47. a. 25% = ($12 – $9)/$12 or ($240,000 – $180,000)/$240,000 • Sales $240,000 (20,000 × $12) • Variable costs 180,000 (20,000 × $9) • Contribution margin $ 60,000 [20,000 ×($12 – $9)] • Fixed costs 25,000 • Income from operations $ 35,000 Follow My Example 4-2 For Practice: PE 4-2A, PE 4-2B 2 Example Exercise 4-2 (continued) • $3 per unit = $12 – $9 4-47

48. 3 Determine the break-even point and sales necessary to achieve a target profit. 4-48

49. 3 Break-Even Point The break-even point is the level of operations at which a company’s revenues and expenses are equal.

50. Unit selling price $25 Unit variable cost 15 Unit contribution margin $10 3 Baker Corporation’s fixed costs are estimated to be $90,000. The unit contribution margin is calculated as follows: