learning objectives - john wiley · • explain the difference between absorption costing and...

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AccountingBuilding Business Skills

Paul D. Kimmel

Chapter Fourteen:Cost-volume-profit Relationships

PowerPoint presentation by Kate Wynn-WilliamsUniversity of Otago, Dunedin

©2003 John Wiley & Sons Australia, Ltd

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Learning Objectives:

• Distinguish between variable, fixedand mixed cost behaviour.

• Explain the difference betweenabsorption costing and variablecosting.

• Explain the five basic assumptionsof cost-volume-profit (CVP)analysis.

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• Indicate the meaning of contributionmargin and identify break-evenpoint and the use of break-evenanalysis.

• Give formulas for determining targetnet profit.

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• Explain how CVP analysis is usedwith multiple products.

• Describe the essential features ofa CVP statement of financialperformance.

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Cost Behaviour Analysis

• How costs behave when levels ofbusiness activity change:

– some costs change– some costs stay the same

• Helps in planning and choosingbetween alternatives

• Starts with identification of keyactivities and their relationshipswith various costs

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• Variable costs – change withincreases and decreases in activitylevel

– e.g. direct materials, direct labour,COGS, freight costs, fuel

– cost is identified on a per-unit basis– cost stays the same per unit as

activity level changes– total costs change in proportion to

change in activity level

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• Fixed costs – do not change withincreases and decreases in activitylevel

– e.g. rates, rent, insurance,supervisors’ salaries

– cost per unit = total cost divided byunits of activity level

– total costs stay the same– cost per unit changes as activity level

changes

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• Relevant range – activity levelsover which the business expects tooperate during the period

– linear relationships assumed to existbetween costs and activity levelswithin relevant range

– variable costs per unit may changeoutside range (very high or low)

– fixed costs may also change beyondrelevant range

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• Mixed costs – also calledsemi-variable costs

– includes a fixed cost component plusvariable cost according to activitylevel

– e.g. electricity (fixed line charge pluscharge per unit consumed)

– often separated into fixed andvariable components at end of period

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• Identification of costs as fixed orvariable is important for businessdecisions:

– effect on profitability of reduction insales price

– effect on activity level when expensesincrease per unit to keep currentprofitability

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– minimum level of sales to cover costs– costs of maintaining level of

production for different manufacturingmethods

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• Two methods of costing products:– Absorption costing – all material,

labour and overhead costs = productcosts

– Variable costing – direct material,direct labour and variable overheadcosts = product costs, and fixedoverheads = period costs

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– Note: both systems show selling,administration and finance expensesas period costs

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Cost Behaviour Analysis• Financial performance – if units

produced exceed units sold:– absorption costing yields higher profit

because cost of units sold includeper-unit allocations of fixed overheadcosts

– remaining unsold inventory still carriessome current period fixed overhead

– variable costing yields lower profitbecause entire fixed overhead= period cost

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• if production = sales:– both systems show same profits

• if production is less than sales:– absorption costing yields lower profit

because units sold in excess ofproduction carry some fixed overheadfrom beginning inventory (previousperiod costs)

– variable costing yields higher profitbecause fixed overhead remainsthe same

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• Variable costing used for internaldecisions:– managers focus on cost behaviours of

each cost item– not allowed for external reports

• Absorption costing required forexternal financial reports:– fixed overhead costs seen as product

costs in same manner as directmaterials and direct labour

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Cost-Volume-Profit Analysis

• CVP Analysis – how changes incosts and volume affect profits

• Underlying assumptions:– costs and revenues are linear within

relevant range– all costs identifiable as variable or fixed– costs affected only by changes in

activity level– all units produced are sold– constant sales mix if more than one

product

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• Contribution margin = revenue lessvariable costs– calculate per unit: how much of each

sales dollar is left to contribute towardsfixed costs and profits

– or as ratio: what per cent of each salesdollar is left to contribute towards fixedcosts and profits

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• Break-even analysis – determineslevel of activity where total revenuesequal total costs– at break-even point, zero profit/loss– expressed in sales dollars or sales units– determined by mathematical equation,– by contribution margin, or– by cost-volume-profit graph

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• Mathematical equation – basicformula is:

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• Break-even sales can be defined as:– required level of sales dollars, or– required units of sales volume

• in equation, variable costs can beexpressed as a dollar amount or asproportion of sales revenue

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• Contribution margin technique –basic formula is:

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• Break-even point can also bedefined in terms of sales dollars,by using contribution marginratio:

fixed costscontribution margin ratio

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• Graphic presentation – break-evenpoint determined visually atintersection of:– total sales revenue line, and

– total costs line (fixed plus variable)

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– level of activity (units) recorded onhorizontal axis, and

– dollars (revenues and costs) recordedon vertical axis

– net profit and loss at all levels ofactivity is also visually portrayed

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• Margin of safety = differencebetween expected sales and break-even sales– can be expressed in dollars or as ratio

• adequacy of margin of safetydepends on the business– e.g. competitive position, general

economic conditions

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• Target Net Profit – profit objective forthe product line– expand break-even analysis by adding

target net profit to total costs

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• CVP for profit planning –management can quickly predicteffects of such events as:– changes in sales revenues and costs– matching competitor’s discount on

sales price per unit– investing in equipment (fixed costs) in

order to reduce labour (variable costs)– changes in profitability with changes

in variable or fixed costs

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• CVP and multiple products –management can use break-evenpoint with 2+ products to analysesales mix for highest profitability– based on assumption of constant

sales mix– sales mix = relative combination

of the different products sold

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– need to calculate weighted averageunit contribution margin (CM) over allproducts

– weighted average unit CM =

total CM for sales mixnumber of units in the sales mix

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Cost-Volume-Profit Analysis• Limited resources – best use of

resources to maximise net profits:– if limitations on some part of business– e.g. floorspace, labour, machine hours– use CM per unit of limited resource:

CM per unit amount of resource needed for each unit

– total CM = units of limited resource X CM per unit of limited resource

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• CVP Statement of FinancialPerformance – for internaldecision-making only– expenses classified as variable or fixed– financial reports for external use

classify expenses by function(e.g. COGS, selling expenses) anddo not show contribution margin (CM)

learning objectives - john wiley · • explain the difference between absorption costing and...

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