CHAPTER 22 SStu

tuddyy OObbjejecctitivveess

1. Distinguish between variable and fixed costs.

2. Explain the significance of the relevant
range.
COST - VOLUME - 3. Explain the concept of mixed costs.
4. List the five components of cost-
cost-volume-
volume-
PROFIT profit analysis.
5. Indicate what contribution margin is and how
it can be expressed
6. Identify the three ways to determine the
break-
break-even point.
Accounting Principles, Eighth Edition

1 2

Study
Study Objectives
Objectives Preview
Preview of
of Chapter
Chapter
7. Give the formulas for determining To manage any business, you must understand:
sales required to earn target net
How costs respond to changes in sales volume
income and
8. Define margin of safety, and give The effect of costs and revenues on profit
the formulas for computing it. To understand cost-
cost-volume-
volume-profit (CVP), you must
know how costs behave
9. Describe the essential features of a
cost-
cost-volume-
volume-profit income
statement.

3 4
 Cost-
Cost-Volume-
Volume-Profit
Cost-Volume-Profit Cost
Cost Behavior
Behavior Analysis
Analysis
Cost Behavior Analysis is
the study of how specific costs respond to
C o s t B eh av io r C o s t-V
t -V o l u m e - changes in the level of business activity.
A n alys is P r o fi t A n a l y s i s

Some costs change; others remain the same

Variable costs Basic components
Fixed costs CVP income statement
Helps management plan operations and decide
Relevant range Break-
Break-even analysis
Mixed costs Target net income
between alternative courses of action
Identifying Margin of safety
variable and fixed
Applies to all types of businesses and entities
Changes in business
costs environment
CVP income statement
revisited
5
LO 1: Distinguish between variable and fixed costs.
6

Cost
Cost Behavior
Behavior Analysis
Analysis -- Cost
Cost Behavior
Behavior Analysis
Analysis -- continued
continued
continued For an activity level to be useful:
continued Changes in the level or volume of activity
Starting point is measuring key business
activities should be correlated with changes in costs

Activity levels may be expressed in terms of: The activity level selected is called the
Sales dollars (in a retail company) activity or volume index
Miles driven (in a trucking company)
The activity index:
Room occupancy (in a hotel) Identifies the activity that causes changes in
Dance classes taught (by a dance studio) the behavior of costs
Allows costs to be classified according to
Many companies use more their response to changes in activity as
than one measurement base either:
Variable Costs Fixed Costs Mixed Costs
7 8
LO 1: Distinguish between variable and fixed costs.
LO 1: Distinguish between variable and fixed costs.
 Variable
Variable Costs
Costs Variable
Variable Costs
Costs –– Example
Example
Damon Company manufactures radios that
Costs that vary in total directly and
proportionately with changes in the activity level contain a $10 clock

Activity index is the number of radios produced

Example: If the activity level increases 10
percent, total variable costs increase 10
percent
Example: If the activity level decreases by 25
percent, total variable costs decrease by 25
percent
Variable costs remain constant per unit at every
level of activity.
For each radio produced, the total cost of the
clocks increases by $10:
If 2,000 radios are made, the total cost of the
clocks is $20,000 (2,000 X $10)
If 10,000 radios are made, the total cost of the
clocks is $100,000 (10,000 X $10)

LO 1: Distinguish between variable and fixed costs.

9
LO 1: Distinguish between variable and fixed costs.
10

Variable
Variable Costs
Costs –– Graphs
Graphs Fixed
Fixed Costs
Costs
Costs that remain the same in total regardless of
changes in the activity level.
Per unit cost varies inversely with activity:
As volume increases,
unit cost declines, and vice versa

Examples include:
Property taxes
Insurance
Rent
Depreciation on buildings and equipment

LO 1: Distinguish between variable and fixed costs.

11
LO 1: Distinguish between variable and fixed costs.
12
 Fixed
Fixed Costs
Costs -- Example
Example Fixed
Fixed Costs
Costs -- Graphs
Graphs
Damon Company leases its productive facilities
for $10,000 per month

Total fixed costs of the facilities remain

constant at all levels of activity - $10,000
per month

On a per unit basis, the cost of rent decreases

as activity increases and vice versa
At 2,000 radios, the unit cost is $5
($10,000 ÷ 2,000 units)
At 10,000 radios, the unit cost is $1
($10,000 ÷ 10,000 units)
LO 1: Distinguish between variable and fixed costs.
13
LO 1: Distinguish between variable and fixed costs.
14

Let’s Review
Let’s Review Relevant
Relevant Range
Range
Variable costs are costs that: Throughout the range of possible levels of
activity, a straight-line relationship usually does
a. Vary in total directly and proportionately with not exist for either variable costs or fixed
changes in the activity level.
level costs
b. Remain the same per unit at every activity level.
The relationship between variable costs and
c. Neither of the above.
changes in activity level is often curvilinear
d. Both (a) and (b) above.
For fixed costs, the relationship is also
nonlinear – some fixed costs will not change
over the entire range of activities while
other fixed costs may change

LO 1: Distinguish between variable and fixed costs.

15 LO 2: Explain the significance of the relevant range.
16
 Relevant
Relevant Range
Range -- Graphs
Graphs Relevant
Relevant Range
Range
Defined as the range of activity over which a
company expects to operate during a year

Within this range, a straight-

straight-line relationship
usually exists for both variable and fixed costs

LO 2: Explain the significance of the relevant range.

17 18
LO 2: Explain the significance of the relevant range.

Let’s Review Mixed

Mixed Costs
Costs
Let’s Review
Costs that have
The relevant range is: both a variable
cost element
a. The range of activity in which variable costs will and a fixed
be curvilinear.
curvilinear cost element
b. The range of activity in which fixed costs will be Sometimes called
curvilinear. semivariable cost
c. The range over which the company expects to Change in total
operate during a year. but not
proportionately
d. Usually from zero to 100% of operating capacity. with changes in
activity level

LO 2: Explain the significance of the relevant range.

19
LO 3: Explain the concept of mixed costs.
20
 Mixed
Mixed Costs:
Costs: Steps
Steps in
in High–
High–Low-
Low-Method
High–Low-Method
Mixed
Mixed Costs:
Costs: High –Low Method
High–Low Method
Mixed costs must be classified into their fixed STEP 1: Determine variable cost per unit using the
and variable elements following formula:

One approach to separate the costs is called

the high-low method

Uses the total costs incurred at both the high

and the low levels of activity to classify mixed STEP 2: Determine the fixed cost by subtracting
costs the total variable cost at either the
The difference in costs between the high and high or the low activity level from the
low levels represents variable costs, since only total cost at that level
variable costs change as activity levels change
LO 3: Explain the concept of mixed costs.
21
LO 3: Explain the concept of mixed costs.
22

Mixed
Mixed Costs:
Costs: High–
High–Low-
Low-Method Example
Mixed
Mixed Costs:
Costs: High–Low-Method Example

High –Low-Method Example

High–Low-Method Example
Data for Metro Transit Company for 4 month period: Step 2: Determine the fixed costs by subtracting total
variable costs at either the high or low
activity level from the total cost at that
same level

High Level of Activity: April $63,000

50,000 miles
Low Level of Activity: January 30,000
20,000 miles
Difference $33,000
30,000 miles

Step 1: Using the formula, variable

LO 3: Explain costs
the concept of mixedper
costs.
23 24
LO 3: Explain the concept of mixed costs.
unit are
Mixed
Mixed Costs:High–
Costs:High–Low-
Low-Method Example
Costs:High–Low-Method Example
Let’s Review
Let’s Review
Maintenance costs:
Mixed costs consist of a:
$8,000 per month plus $1.10 per mile
a. Variable cost element and a fixed cost element.
element
To determine maintenance costs at a particular
activity level: b. Fixed cost element and a controllable cost
element.
1. multiply the activity level times the
variable cost per unit c. Relevant cost element and a controllable cost
2. then add that total to the fixed cost element.
d. Variable cost element and a relevant cost
EXAMPLE: If the activity level is 45,000 miles, element.
the estimated maintenance costs would be
$8,000 fixed and $49,500 variable ($1.10 X
45,000 miles) for a total of $57,500.
LO 3: Explain the concept of mixed costs.
25
LO 3: Explain the concept of mixed costs.
26

Cost -Volume-Profit Analysis

Cost-Volume-Profit Analysis Cost -Volume-Profit Analysis
Cost-Volume-Profit Analysis
CVP analysis considers the
Study of the effects of changes of interrelationships among five basic
costs and volume on a company’
company’s profits components

A critical factor in management

decisions

Important in profit planning

LO 4: List the five components of cost-

cost-volume-
volume-profit analysis.
27 LO 4: List the five components of cost-
cost-volume-
volume-profit analysis.
28
 Assumptions
Assumptions Underlying
Underlying CVP
CVP Let’s Review
Let’s Review
Analysis
Analysis
Which of the following is NOT involved in
• Behavior of both costs and revenues is linear CVP analysis?
throughout the relevant range of the activity index a. Sales mix.
mix
• All costs can be classified as either variable or fixed b. Unit selling prices.
with reasonable accuracy
• Changes in activity are the only factors that affect c. Fixed costs per unit.
costs
• All units produced are sold d. Volume or level of activity.
• When more than one type of product is sold, the
sales mix will remain constant

LO 4: List the five components of cost-

cost-volume-
volume-profit analysis.
29
LO 4: List the five components of cost-
cost-volume-
volume-profit analysis.
30

CVP
CVP Income
Income Statement
Statement CVP
CVP Income
Income Statement
Statement -- Example
Example
A statement for internal use
Vargo Video Company produces DVD
Classifies costs and expenses as fixed or variable players.
Reports contribution margin in the body of the statement. Relevant data for June 2008:
Contribution margin – Unit selling price of DVD player $500
amount of revenue Unit variable costs $300
remaining after Total monthly fixed costs $200,000
deducting variable costs Units sold 1,600

Reports the same net

income as a traditional
income statement

LO 5: Indicate what contribution margin is and how it can be expressed.

expressed.
31 32
LO 5: Indicate what contribution margin is and how it can be expressed.
expressed.
 CVP
CVP Income
Income Statement -CM effect
Statement-CM effect
Contribution
Contribution Margin
Margin Per
Per Unit
Unit
Contribution margin is available to cover
fixed costs and to contribute to income
The formula for contribution margin per
unit and the computation for Vargo
Video are:

LO 5: Indicate what contribution margin is and how it can be expressed.

expressed.
33 34
LO 5: Indicate what contribution margin is and how it can be expressed
expressed.

Contribution
Contribution Margin
Margin Ratio
Ratio Contribution
Contribution Margin
Margin Ratio
Ratio
Shows the percentage of each sales dollar Ratio helps to determine the effect of
available to apply toward fixed costs and
changes in sales on net income
profits
The formula for contribution margin ratio and
the computation for Vargo Video are:

LO 5: Indicate what contribution margin is and how it can be expressed.

expressed.
35
LO 5: Indicate what contribution margin is and how it can be expressed.
expressed.
36
 Let’s Review
Let’s Review Break -Even Analysis
Break-Even Analysis
Contribution margin: Process of finding the break-even point
level of activity at which total revenues equal
a. Is revenue remaining after deducting variable total costs (both fixed and variable)
costs.
costs
b. May be expressed as contribution margin per Can be computed or derived
unit. from a mathematical equation,
by using contribution margin, or
c. Is selling price less cost of goods sold.
from a cost-volume profit (CVP) graph
d. Both (a) and (b) above.
Expressed either in sales units or in sales dollars

LO 5: Indicate what contribution margin is and how it can be expressed.

expressed.
37
LO 6: Identify the three ways to determine the break-
break-even point.
38

Break-
Break-Even Analysis:
Break-Even Analysis: Mathematical
Mathematical Equation
Equation
Break-even occurs where total sales equal variable Break -Even Analysis:
Break-Even Analysis:
costs plus fixed costs; i.e., net income is zero.
Contribution
Contribution Margin
Margin Technique
Technique
The formula for the break-even point and the
computation for Vargo Video are:
At the break-even point, contribution
margin must equal total fixed costs
(CM = total revenues – variable
costs)

The break-even point can be computed

using either contribution margin per unit
To find sales dollars required to break-
break-even:
or contribution margin ratio.
1000 units X $500 = $500,000 (break-
(break-even dollars)
39
LO 6: Identify the three ways to determine the break-
break-even point.
40
LO 6: Identify the three ways to determine the break-
break-even point.
Contribution
Contribution Margin
Margin Technique
Technique Break -Even Analysis:
Break-Even Analysis: Graphic
Graphic
A cost-volume Presentation
Presentation
profit (CVP) graph shows costs,
When the BEP in units is desired, contribution volume and profits.
margin per unit is used in the following formula
which shows the computation for Vargo Video: Used to visually find the break-even point
To construct a CVP graph:
Plot the total sales line starting at the zero
activity level
Plot the total fixed cost using a horizontal line
When the BEP in dollars is desired, contribution Plot the total cost line (starts at the fixed-cost
margin ratio is used in the following formula line at zero activity
which shows the computation for Vargo Video: Determine the break-even point from the
intersection of the total cost line and the
total sales line

LO 6: Identify the three ways to determine the break-

break-even point.
41
LO 6: Identify the three ways to determine the break-
break-even point.
42

Break -Even Analysis:

Break-Even Analysis: Graphic
Graphic Let’s Review
Let’s Review
Presentation
Presentation Gossen Company is planning to sell 200,000
pliers for $4 per unit. The contribution
margin ratio is 25%. If Gossen will break
even at this level of sales, what are the
fixed costs?
a. $100,000.
$100,000
b. $160,000.
c. $200,000.
d. $300,000.

43
LO 6: Identify the three ways to determine the break-
break-even point.
44
LO 6: Identify the three ways to determine the break-
break-even point.
 Break-
Break-Even Analysis:
Break-Even Analysis: Target
Target Net
Net Income
Income Break -Even Analysis:
Break-Even Analysis: Target
Target Net
Net
Mathematical Equation Income
Income
Level of sales necessary to achieve a specified income
Using the formula for the break-even point, simply
include the desired net income as a factor. The
Can be determined from each of the approaches computation for Vargo Video is as follows:
used to determine break-
break-even sales/units:
from a mathematical equation,
by using contribution margin, or
from a cost-volume profit (CVP) graph

Expressed either in sales units or in sales dollars

LO 7: Give the formulas for determining sales required

45 LO 7: Give the formulas for determining sales required46to
to earn target net income. earn target net income.

Break-
Break-Even Analysis:
Break-Even Analysis: Target
Target Net
Net Income
Income Let’s Review
Let’s Review
Contribution Margin Technique
To determine the required sales in units for The mathematical equation for computing
Vargo Video: required sales to obtain target net income
is:
a. Variable costs + Target net income.
income
Required sales =
b. Variable costs + Fixed costs + Target net income.
c. Fixed costs + Target net income.
To determine the required sales in dollars for
Vargo Video: d. No correct answer is given.

LO 7: Give the formulas for determining sales required to

LO 7: Give the formulas for determining sales required47to 48
earn target net income.
earn target net income.
 Operating Leverage Break -Even Analysis:
Break-Even Analysis: Margin
Margin of
of
Safety
Safety
• Operating Leverage is a measure of how Difference between actual or expected sales and
sensitive net operating income is to sales at the break-even point
percentages in sales. Operating leverage Measures the “cushion” that management has if
acts as a multiplier. If operating leverage expected sales fail to materialize
is high, a small percentage increase in May be expressed in dollars or as a ratio
sales can produce a much larger
To determine the margin of safety in dollars for
percentage increase in net operating Vargo Video assuming that actual/expected sales
income. are $750,000:

Degree of Operating Leverage = Contribution Margin/NOI

49
LO 8: Define margin of safety, and give the formulas for computing
computing it.
50

Break -Even Analysis:

Break-Even Analysis: Margin
Margin of
of CVP
CVP Income
Income Statement
Statement Revisited
Revisited
Safety
Safety
Margin of Safety Ratio
¾ Computed by dividing the margin of safety in
dollars by the actual or expected sales
¾ To determine the margin of safety ratio for Vargo
Video assuming that actual/expected sales are
$750,000:

¾ The higher the dollars or the percentage, the

greater the margin of safety
LO 8: Define margin of safety, and give the formulas for computing
computing51it. LO 9: Describe the essential features of a cost-
cost-volume-
52 -
volume
profit income statement.
 Let’s Review Chapter
Chapter Review
Review -- Brief
Brief Exercise
Exercise 22 -4
22-4
Let’s Review
Deines Company accumulates the following data concerning
Marshall Company had actual sales of a mixed cost, using miles as the activity level.
$600,000 when break-
break-even sales were Miles Total Miles
Total
$420,000. What is the margin of safety Driven Cost Driven Cost
ratio? January 8,000
$15,000
$14,150 March 8,500

a. 25%.
25% February 7,500 $13,600 April 8,200
$14,490
b. 30%.
Compute the variable and fixed cost elements using the high-
c. 33 1/3%. low method.

d. 45%.

LO 8: Define margin of safety, and give the formulas for

53 54
computing it.

Chapter
Chapter Review
Review -- Brief
Brief Exercise
Exercise 22 -4
22-4
High Level of Activity: March $15,000 8,500 miles
Low Level of Activity: February 13,600
13,600 7,500 miles
Difference $ 1,400 1,000 miles

Step 1:
1:
Variable Cost per Unit = $1,400 ÷1,000 miles
= $1.40 variable cost per mile

Step 2: High Low

Total Cost: $15,000 $13,600
Variable Cost:
8,500 X $1.40 11,900
7,500 X $1.40 10,500

Total Fixed Costs $ 3,100 $ 3,100

55