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Chapter 7

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Rotman Commerce
Michael Khan

CHAPTER 7: Cost-Volume-Profit Relationships CVP focuses on how profits are affected by: 1. Prices of products 2. Volume/activity level 3. Per unit variable costs 4. Total fixed costs 5. Mix of products sold Contribution Income Statement – emphasizes the behaviour of costs, which reports sales, variable expenses, and Contribution Margin on both a total and per-unit basis. Contribution Margin – the amount remaining from sales revenue after variable expenses have been deducted. It’s the amount available to cover fixed expenses and provide profits. Breakeven Point – the level of sales at which profit is zero. Point where total sales = total expenses, or when total CM = total FC. Once this point has been reached, income will increase by the CM for each additional unit sold. CVP Graph/Breakeven Chart 1. Draw a horizontal line at the level of fixed expenses 2. Choose some volume of sales with total expenses, plot that point, and connect it back to the y-axis to where the fixed expense line was 3. Choose some volume of sales and total sales dollars, drawing it back to the origin Contribution Margin Ratio CM Ratio = CM/Sales Can be calculated using total CM/total Sales or on a per-unit basis. It measures how much the contribution margin will increase for each dollar increase in sales. Operating income will also increase by the contribution margin if fixed costs do not change. It’s helpful to determine which products sales’ should be increased, as well as when working with a group of products where units can’t be sensibly added. Incremental Analysis/Marginal Analysis – focus only on revenue, cost, and volume that will CHANGE as a result of a decision. BreakEven Point can be calculated using two methods: 1) Equation Method a. Sales = VC + FC + Profits b. 250Q = 150Q + 35,000 + 0 c. Or, expressed in sales dollars; x = 0.6x +35,000 + 0 2) Contribution Margin Method a. Fixed Expenses / Unit Contribution Margin b. In sales dollars, it’s fixed expenses/CM Ratio (multiple products) Margin of Safety The excess of budgeted (or actual) sales over the breakeven volume of sales. It’s the amount by which sales can drop before losses begin to be incurred. The higher the margin of safety, the lower risk of not breaking even. = Total budgeted (or actual) sales – Break-even sales MofS Percentage = Margin of Safety/Total Budgeted Sales For example, companies with high fixed costs and low variable costs (higher CM) will be more volatile to sales changes. Although they can gain more with more sales, they stand to lose more in bad times. Companies with lower fixed costs and higher variable costs are more stable and protected through bad years, and has a higher margin of safety then. Operating Leverage A measure of how sensitive operating income is to percentage changes in sales. Degree of Operating Leverage = Contribution Margin/Income. If it is high, a small percentage increase in sales can produce a larger percentage increase in income. The company that has the higher proportion of fixed costs in its cost structure will have higher operating leverage. The degree of operating leverage will decrease the further the company moves from its breakeven point. Change in operating income = change in sales x degree of operating leverage Indifference Analysis Indifferent about using a labour intensive or capital intensive production system: 1. Determine the unit CM times the number of units (Q) – FC of each alternative 2. Set up equation with each alternative on opposite sides of the equal sign a. 10Q-35000 = 14Q-60,000, Solve for Q 3. Or, use Change in fixed cost/Change in Contribution Margin to get Q Assumptions in CVP analysis: 1. Selling price is constant 2. Costs are linear, and can be divdied nto variable and fixed elements 3. In multiproduct companies, the sales mix is constant 4. In manufacturing companies, inventories don’t change – the number of units produced equals the number of units sold. CHAPTER 8 – Variable Costing VC focuses on cost behaviour and distinguishes between variable and fixed costs. Fixed Manufacturing overhead is a period cost, not product cost. Under Variable Costing, only variable costs are product costs. This would generally include direct materials, direct labour, and the variable portion of manufacturing overhead. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and, like selling and administrative expenses, it is expensed in its entirety against revenue each period. E.g. Under absorption costing, since there’s still 1000 units in ending inventory that are unsold, the fixed overhead manufacturing cost of $5/unit, or $5000 in total is not allocated in this period. Instead, it is carried over to the next period. This is called a cost deferral in inventory. Under variable costing, only the variable costs $7/unit are assigned to inventory. VC is compatible with CVP and contribution approaches for management decisions. Advocates of variable costing say that fixed manufacturing costs should be expensed immediately in total, whereas advocates of absorption costing say that fixed manufacturing costs should be charged against revenues bit by bit as units of product are sold. Any units of product not sold under absorption costing result in fixed costs being inventoried and carried forward as assets to the next period Note that when inventories increase in year 2 (not everything is sold, inventory DEFERRAL), absorption costing operating income exceeds variable costing operating income. When inventories decrease in year 3, the opposite occurs—variable costing operating income exceeds absorption costing operating income *Operating income is not affected by changes in production under variable costing. Operating income IS affected by changes in production under absorption costing. CHOOSING A COSTING SYSTEM Under absorption costing, the profits may be erratic and confusing for managers, because fluctuations can be a result of the fixed MOH of inventories. Revenue and production drive income. There is a problem with CVP analysis, though. If the breakeven point is TFC/CM per unit, even at the breakeven point the company may have a ‘profit’ because extra money is not allocated to the Fixed Costs portion of goods. It can lead to unethical decisions for managers to build up inventory in order to get a high profit on paper. However, it follows the matching principle, can be used for external reports, and is the traditional way of costing. Also, it allows for better management of fixed cost, unlike the strong emphasis on variable cost. Income and contribution margin are constant under variable costing. Revenue drives operating income. Other advantages of Variable Costing: 1. Data required for CVP analysis can be taken directly from a contribution margin-format income statement. These data are not available on a conventional absorption costing statement. 2. Under variable costing, the profit for a period is not affected by changes in inventories. Other things remaining equal (i.e., selling prices, costs, sales mix, etc.), profits move in the same direction as sales when variable costing is used. 3. Managers often assume that unit product costs are variable costs. This is a problem under absorption costing because unit product costs are a combination of both fixed and variable costs. Under variable costing, unit product costs do not contain fixed costs. 4. The impact of fixed costs on profits is emphasized under the variable costing and contribution approach. The total amount of fixed costs appears explicitly on the income statement, highlighting that the whole amount of fixed costs must be covered for the company to be truly profitable. Under absorption costing, the fixed costs are mingled together with the variable costs and are buried in cost of goods sold and in ending inventories. 5. Variable costing data make it easier to estimate the profitability of products, customers, and other segments of the business. With absorption costing, profitability is obscured by arbitrary allocations of fixed costs. These issues will be discussed in later chapters. 6. Variable costing ties in with cost control methods such as standard costs and flexible budgets, which will be covered in later chapters. 7. Variable costing operating income is closer to net cash flow than absorption costing operating income. This is particularly important for companies with potential cash flow problems. If a lean production system is put in place, the differences between absorption and variable costing will disappear. CHAPTER 9 – Budgeting Budgets are important tools to communicate financial objectives for the comi
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