cost accounting traditions and innovations barfield, raiborn, kinney chapter 11 absorption/variable...
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Cost AccountingTraditions and Innovations
Barfield, Raiborn, Kinney
Chapter 11
Absorption/Variable Costing and
Cost-Volume-Profit Analysis
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Learning Objectives (1 of 2)
• Explain the different approaches to cost accumulation and cost presentation
• Contrast absorption and variable costing
• Describe how changes in sales and/or production levels affect net income under absorption and variable costing
• Explain how companies use cost-volume-profit analysis
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Learning Objectives (2 of 2)
• Explain cost-volume-profit analysis for single-product and multiproduct firms
• Describe how businesses use margin of safety and operating leverage concepts
• List the underlying assumptions of cost-volume-profit analysis
• (Appendix) Construct break-even charts and profit-volume graphs
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Absorption Vs. Variable CostingAbsorption or Full• GAAP• Classify by Function
– Cost of goods sold– Selling expense– Administrative
expense
Variable or Direct• Not GAAP• Classify by Behavior
– Variable– Fixed
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Absorption Vs. Variable CostingAbsorption or Full• Product costs
– Direct material– Direct labor– Variable mfg. overhead– Fixed mfg. overhead
• Period costs – Selling– General– Administrative
Variable or Direct• Product costs
– Direct material– Direct labor– Variable mfg. overhead
• Period Costs– Fixed mfg. overhead– Selling– General– Administrative
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Income Statement Absorption Costing
Sales
Less: Cost of Goods Sold
Gross Profit
Less: Operating Expenses
Net Income
Product CostsDirect MaterialDirect Labor
Fixed and Variable Mfg. Overhead
Period CostsSelling, General,
Administrative
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Income StatementVariable Costing
Sales
Less: Variable Cost of Goods Sold
Product Contribution Margin
Less: Variable Operating Expenses
Contribution Margin
Less: Fixed Mfg. Overhead
Less: Fixed Operating Expenses
Net Income
Direct MaterialDirect Labor
Variable Mfg. Overhead
Selling, General,
Administration
Selling General
Administrative
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Difference in Income Absorption Vs. Variable
• No change in inventory level– Absorption Income = Variable Income
• Increase in inventory level– Absorption Income > Variable Income– Phantom Profits
• Decrease in inventory level– Absorption Income < Variable Income
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Cost-Volume-Profit Analysis
• Relationship of– Revenue– Costs– Volume changes– Taxes– Profits
• Applies to– Manufacturers– Wholesalers– Retailers– Service Industries
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Cost-Volume-Profit Analysis
• Compute the break-even point
• Calculate the level of sales necessary to achieve a target profit
• Set sales price
• Answer “what-if” questions
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Cost-Volume-Profit Assumptions
• Company is operating within the relevant range
• Revenue per unit remains constant
• Variable costs per unit remain constant
• Total fixed costs remain constant
• Mixed costs are separated into variable and fixed elements
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Equations
• Break-even point
Total Revenues = Total CostsTotal Revenues - Total Costs = Zero Profit
• Contribution Margin (CM)Sales Price - Variable Cost = CM per unit
Revenue - Total Variable Costs = CM in total
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Break-Even Formula - Units
Total Fixed Costs
Sales Price (per unit) - Variable Cost (per unit)
$100,000 12 - 4 = 12,500 units
If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is 12,500 units
ContributionMargin
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Break-Even Formula - DollarsTotal Fixed Costs
Sales Price (per unit) - Variable Cost (per unit)
Sales Price (per unit)
If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is $150,000
$100,000 12 - 4 = $150,000 12
ContributionMargin Ratio
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Income Statement Proof
Sales
Less Total variable costs
Contribution Margin
Less Total fixed costs
Profit before taxes
$ 150,000 (12,500 * 12)
(50,000) (12,500 * 4)
$ 100,000
(100,000)
-0-
If fixed costs are $100,000, unit sales price is $12, and unit variable cost is $4, the break-even point is 12,500 units
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Using Cost-Volume-Profit Analysis
• Setting a target profit– Enter before-tax profit in numerator
$100,000 + $30,000 12 - 4 = $195,000 12
If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired before-tax profit is $30,000, the required sales are $195,000
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Using Cost-Volume-Profit Analysis• Setting a target profit
– Convert after-tax profit to before-tax profit
Before-tax profit = After-tax profit
1 - tax rate
$36,000 = 1 - 40%$60,000
At a 40% tax rate, an after-tax profit of $36,000 equals a before-tax profit of $60,000
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• Setting a target profit– Convert after-tax profit to before-tax profit – Enter before-tax profit in numerator
If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $36,000, the required sales are $240,000
$100,000 + $60,000 12 - 4 = $240,000 12
Using Cost-Volume-Profit Analysis
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Income Statement ProofSales
Less Total variable costs
Contribution Margin
Less Total fixed costs
Profit before taxes
Income taxes
Profit after taxes
$ 240,000 (20,000 * 12)
(80,000) (20,000 * 4)
$ 160,000
(100,000)
$ 60,000
(24,000) (60,000 * 40%)
$ 36,000
If fixed costs are $100,000, unit sales price is $12, unit variable cost is $4, and the desired after-tax profit is $36,000, the required sales are $240,000
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Using Cost-Volume-Profit Analysis• Variable profit related to number of units sold
• X = FC / (CMu - PuBT)
Sales Volume
TotalFixedCost
ContributionMarginRatio
Variable Amountof Profit Before
Tax per Unit
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Incremental Analysis
• Changes in revenues, costs, and/or volume
• Break-even point increases when– fixed costs increase– sales price decreases– variable costs increases
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Multiproduct Cost-Volume-Profit Analysis
• Assumes a constant product sales mix
• Contribution margin is weighted on the quantities of each product included in the “bag” of products
• Contribution margin of the product making up the largest proportion of the bag has the greatest impact on the average contribution margin of the product mix
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Multiproduct Cost-Volume-Profit Analysis
Multiproduct Cost-Volume-Profit Analysis
3 2Sales mix
Contribution
margin per unit$2 $1
FC = $8,000
“The Bag”Three units of spray for every two units of liquid
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Multiproduct Cost-Volume-Profit Analysis
Multiproduct Cost-Volume-Profit Analysis
3 2Sales mix
Contribution
margin per unit$2 $1
$80003($2) + 2($1) = 1,000 “bags”
Breakeven
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Multiproduct Cost-Volume-Profit Analysis
Multiproduct Cost-Volume-Profit Analysis
3 2Sales mix
x 1,000 3,000
x 1,000 2,000
Breakeven “bag”Breakeven units
To break evensell 3,000 sprays and 2,000 liquids
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Margin of Safety
• Budgeted (or actual) sales after the break-even point
• Indication of risk
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Margin of Safety
• Units
Actual units - break-even units• Dollars
Actual sales dollars - break-even sales dollars• Percentage
Margin of Safety in units or dollarsBreak-even units or sales in dollars
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Operating Leverage
• Relationship of variable and fixed costs
• Effect on profits when volume changes
• Cost structure strongly influences the impact changes in volume have on profits
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Operating Leverage
High Operating Leverage• Low variable costs• High fixed costs• High contribution margin • High break-even point• Sales after break-even
have greater impact on profits
Low Operating Leverage• High variable costs• Low fixed costs• Low contribution margin• Low break-even point• Sales after break-even
have lesser impact on profits
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Degree of Operating Leverage
• Measures how a percentage change in sales will affect profits
• Degree of Operating Leverage
Contribution Margin
Profit Before Taxes
• When margin of safety is small, the degree of operating leverage is large
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Cost-Volume-Profit Assumptions• Company is operating within the relevant range
• Revenue and variable cost per unit are constant
• Total contribution margin increases proportionally with increases in unit sales
• Total fixed costs remain constant
• Mixed costs are separated into variable and fixed elements
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Cost-Volume-Profit Assumptions
• No change in inventory (production equals sales)
• No change in capacity
• Sales mix remains constant
• Anticipated price level changes included in formulas
• Labor productivity, production technology, and market conditions remain constant
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Additional Considerations
• Are they fixed costs or long-term variable costs?
• Quality improvements may violate assumptions– increase costs during implementation– increase productivity– decrease costs– adjust sales price
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Traditional CVP Graph
Total$
Activity Level
Fixed Costs
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Traditional CVP Graph
Total$
Activity Level
Fixed Costs
Total Costs
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Traditional CVP Graph
Total$
Activity Level
Total Costs
Variable Costs
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Traditional CVP Graph
Total$
Activity Level
Total Costs
Total Revenues
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Traditional CVP Graph
Total$
Activity Level
Total Costs
Total Revenues
BEP
Loss
Profit
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Contemporary CVP Graph
Total$
Activity Level
Variable Costs
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Contemporary CVP Graph
Total
$
Activity Level
Total Revenues
Variable Costs
Contribution Margin
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Contemporary CVP Graph
Total$
Activity Level
Total Revenues
Total Costs
Total Variable Costs
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Contemporary CVP Graph
Total$
Activity Level
Total Revenues
Total Costs
Total Variable CostsBEP
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Profit-Volume Graph
$
Activity Level
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Profit-Volume Graph
$
Activity Level
Fixed Costs
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Profit-Volume Graph
$
Activity Level
Fixed Costs
BEP
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Profit-Volume Graph
$
Activity Level
Fixed Costs
BEP
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Questions
• What is the difference between absorption and variable costing?
• How do companies use cost-volume-profit analysis?
• What are the underlying assumptions of cost-volume-profit analysis?