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Copyright
2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Chapter 7-8
Cost-Volume-Profit Analysis &
Inventory Costing
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8-2
Cost-Volume-Profit Analysis
CVP includes all fixed costs to computebreakeven.
Variable costing and CVP are consistent as bothtreat fixed costs as a lump sum.
Absorption costing defers fixed costs intoinventory.
Absorption costing is inconsistent with CVPbecause absorption costing treats fixed costs ona per unit basis.
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7-3
The Break-Even Point
The break-even point is the point in thevolume of activity where the organizations
revenues and expenses are equal.
Sales 250,000$
Less: variable expenses 150,000
Contribution margin 100,000Less: fixed expenses 100,000
Net income -$
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7-4
Equation Approach
Sales revenueVariable expensesFixed expenses = Profit
Unitsalesprice
Salesvolumein units
Unit
variableexpense
Salesvolumein units
($500 X) ($300 X) $80,000 = $0
($200X) $80,000 = $0
X = 400 surf boards
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7-5
Contribution-Margin Approach
For each additional surf board sold,Curl generates $200 in contributionmargin.
Total Per Unit Percent
Sales (500 surf boards) 250,000$ 500$ 100%
Less: variable expenses 150,000 300 60%
Contribution margin 100,000$ 200$ 40%Less: fixed expenses 80,000
Net income 20,000$
Consider the following informationdeveloped by the accountant at Curl, Inc.:
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7-6
Contribution-Margin Approach
Fixed expensesUnit contribution margin
=Break-even point
(in units)
Total Per Unit Percent
Sales (500 surf boards) 250,000$ 500$ 100%
Less: variable expenses 150,000 300 60%
Contribution margin 100,000$ 200$ 40%
Less: fixed expenses 80,000
Net income 20,000$
$80,000
$200
= 400 surf boards
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7-7
Contribution-Margin Approach
Here is the proof!
Total Per Unit Percent
Sales (400surf boards) 200,000$ 500$ 100%
Less: variable expenses 120,000 300 60%
Contribution margin 80,000$ 200$ 40%
Less: fixed expenses 80,000Net income -$
400 $500 = $200,000400 $300 = $120,000
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7-8
Contribution Margin Ratio
Calculate the break-even point in sales dollarsrather than units by using the contribution margin
ratio.
Contribution marginSales
= CM
RatioFixed expense
CM RatioBreak-even point(in sales dollars)
=
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Total Per Unit Percent
Sales (400surf boards) 200,000$ 500$ 100%Less: variable expenses 120,000 300 60%
Contribution margin 80,000$ 200$ 40%
Less: fixed expenses 80,000
Net income -$
Contribution Margin Ratio
$80,000
40%
$200,000 sales=
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Graphing Cost-Volume-ProfitRelationships
Viewing CVP relationships in a graph givesmanagers a perspective that can be obtained inno other way.
Consider the following information for Curl, Inc.:
300units 400units 500units
Sales 150,000$ 200,000$ 250,000$
Less: variable expenses 90,000 120,000 150,000Contribution margin 60,000$ 80,000$ 100,000$
Less: fixed expenses 80,000 80,000 80,000
Net income (loss) (20,000)$ -$ 20,000$
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Cost-Volume-Profit Graph
Dollars
600 700 800
Units
200 300 400 500
450,000
100
200,000
150,000
100,000
50,000
400,000
350,000
300,000
250,000
Fixed expenses
Break-even
point
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Profit-Volume GraphSome managers like the profit-volume
graph because it focuses on profits and volume.
100 200 300 400 500 600 700
Units
Profit
0
100,000
(20,000)
(40,000)
(60,000)
80,000
60,000
40,000
20,000
Break-evenpoint
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Target Net Profit
We can determine the number of surfboardsthat Curl must sell to earn a profit of $100,000
using the contribution margin approach.
Fixed expenses + Target profitUnit contribution margin
=Units sold to earnthe target profit
$80,000 + $100,000$200
= 900 surf boards
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Effect of Income Taxes
Target after-tax net income1 - t = Before-taxnet income
Income taxes affect a companys
CVP relationships. To earn aparticular after-tax net income, a
greater before-tax income will berequired.
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Equation Approach
Sales revenueVariable expensesFixed expenses = Profit
($500 X) ($300 X) $80,000 = $100,000
($200X) = $180,000
X = 900 surf boards
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Applying CVP Analysis
Safety Margin The difference between budgeted sales
revenue and break-even sales revenue.
The amount by which sales can drop beforelosses begin to be incurred.
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Safety Margin
Curl, Inc. has a break-even point of $200,000.If actual sales are $250,000, the safety margin is$50,000or 100 surf boards.
Break-even
sales
400 units
Actual sales
500 units
Sales 200,000$ 250,000$
Less: variable expenses 120,000 150,000Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net income -$ 20,000$
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Changes in Fixed Costs
Curl is currently selling 500 surfboards peryear.
The owner believes that an increase of$10,000 in the annual advertising budget,would increase sales to 540 units.
Should the company increase the advertisingbudget?
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Current
Sales
(500 Boards)
Proposed
Sales
(540 Boards)
Sales 250,000$ 270,000$Less: variable expenses 150,000 162,000
Contribution margin 100,000$ 108,000$
Less: fixed expenses 80,000 90,000
Net income 20,000$ 18,000$
Changes in Fixed Costs
$80,000 + $10,000 advertising = $90,000
540 units $500 per unit = $270,000
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Current
Sales
(500 Boards)
Proposed
Sales
(540 Boards)
Sales 250,000$ 270,000$
Less: variable expenses 150,000 162,000Contribution margin 100,000$ 108,000$
Less: fixed expenses 80,000 90,000
Net income 20,000$ 18,000$
Changes in Fixed Costs
Sales will increase by$20,000, but net income
decreasedby $2,000.
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Changes in UnitContribution Margin
Because of increases in cost of raw materials,Curls variable cost per unit has increased
from $300 to $310 per surfboard. With nochange in selling price per unit, what will be
the new break-even point?
($500 X) ($310 X) $80,000 = $0
X = 422 units (rounded)
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Changes in UnitContribution Margin
Suppose Curl, Inc. increases the price of
each surfboard to $550. With no changein variable cost per unit, what will be the
new break-even point?
($550 X) ($300 X) $80,000 = $0
X = 320 units
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Predicting Profit Given ExpectedVolume
Fixed expensesUnit contribution margin
Target net profit
Find: {reqd sales volume}Given:
Fixed expensesUnit contribution marginExpected sales volume
Find: {expected profit}Given:
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Predicting Profit GivenExpected Volume
In the coming year, Curls owner expects to sell
525 surfboards. The unit contribution margin isexpected to be $190, and fixed costs are
expected to increase to $90,000.
($190 525) $90,000 = X
X = $9,750 profit
X = $99,750 $90,000
Total contribution - Fixed cost = Profit
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CVP Analysis with MultipleProducts
For a company with more than one product,sales mixis the relative combination in which a
companys products are sold.
Different products have different selling prices,cost structures, and contribution margins.
Lets assume Curl sells surfboards and sailboards and see how we deal with break-
even analysis.
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CVP Analysis with MultipleProducts
Curl provides us with the followinginformation:
Description
Selling
Price
Unit
Variable
Cost
Unit
Contribution
Margin
Number
of
BoardsSurfboards 500$ 300$ 200$ 500
Sailboards 1,000 450 550 300
Total sold 800
DescriptionNumberof Boards
% ofTotal
Surfboards 500 62.5% (500 800)
Sailboards 300 37.5% (300 800)
Total sold 800 100.0%
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CVP Analysis with MultipleProducts
Weighted-average unit contribution margin
Description
Contribution
Margin % of Total
Weighted
ContributionSurfboards 200$ 62.5% 125.00$
Sailboards 550 37.5% 206.25
Weighted-average contribution margin 331.25$
$200 62.5%
$550 37.5%
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CVP Analysis with MultipleProducts
Break-even point
Break-even
point
=Fixed expenses
Weighted-average unit contribution margin
Break-evenpoint
=$170,000$331.25
Break-evenpoint
= 514 combined unit sales
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7-29
CVP Analysis with MultipleProducts
Break-even pointBreak-even
point= 514 combined unit sales
Description
Breakeven
Sales
% of
Total
Individual
Sales
Surfboards 514 62.5% 321
Sailboards 514 37.5% 193Total units 514
A i U d l i
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Assumptions UnderlyingCVP Analysis
1. Selling price is constant throughoutthe entire relevant range.
2. Costs are linear over the relevant
range.3. In multi-product companies, the
sales mix is constant.
4. In manufacturing firms, inventoriesdo not change (units produced =units sold).
C t St t d O ti
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Cost Structure and OperatingLeverage
The cost structure of an organization is therelative proportion of its fixed and variablecosts.
Operating leverage is . . . the extent to which an organization uses fixed
costs in its cost structure.
greatest in companies that have a highproportion of fixed costs in relation tovariable costs.
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Measuring Operating Leverage
Contribution marginNet income
Operating leveragefactor
=
Actual sales
500 BoardSales 250,000$
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000Net income 20,000$
$100,000
$20,000
= 5
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Measuring Operating Leverage
A measure of how a percentage change insales will affect profits. If Curl increases itssales by 10%, what will be the percentage
increase in net income?
Percent increase in sales 10%
Operating leverage factor 5
Percent increase in profits 50%
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Measuring Operating Leverage
A firm with proportionately high fixed costs hasrelatively high operating leverage On the otherhand, a firm with high operating leverage has a
relatively high break-even point.
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Absorption Costing
A system of accounting for costs in whichboth fixed and variable production costs
are considered product costs.
FixedCosts
VariableCosts
Product
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Variable Costing
A system of cost accounting that onlyassigns the variable cost of production to
products.
FixedCosts
VariableCosts
Product
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Absorption and Variable Costing
Absorption
Costing
Variable
Costing
Direct materials
Direct labor Product costsProduct costs Variable mfg. overhead
Fixed mfg. overhead
Period costs
Period costs Selling & Admin. exp.
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Absorption and Variable Costing
Absorption
Costing
Variable
Costing
Direct materials
Direct labor Product costsProduct costs Variable mfg. overhead
Fixed mfg. overhead
Period costs
Period costs Selling & Admin. exp.
The difference between absorption and variablecosting is the treatment of fixed manufacturing overhead.
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Lets put some numbers to an example andsee what we can learn about the differencebetween absorption and variable costing.
Absorption and Variable Costing
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Mellon Co. produces a single product withthe following information available:
Number of units produced annually 25,000
Variable costs per unit:Direct materials, direct labor
and variable mfg. overhead 10$
Selling & administrative
expenses 3$
Fixed costs per year:Mfg. overhead 150,000$
Selling & administrative
expenses 100,000$
Absorption and Variable Costing
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Unit product cost is determined as follows:
Absorption
Costing
Variable
CostingDirect materials, direct labor, and
variable mfg. overhead 10$ 10$
Fixed mfg. overhead
($150,000 25,000 units) 6 -
Unit product cost 16$ 10$
Absorption and Variable Costing
Selling and administrative expenses are always treated as periodexpenses and deducted from revenue.
Ab ti C ti
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Absorption Costing
Sales (20,000 $30) 600,000$Less cost of goods sold:
Beginning inventory -$
Add COGM (25,000 $16) 400,000
Goods available for sale 400,000$
Ending inventory (5,000 $16) 80,000 320,000
Gross margin 280,000$Less selling & admin. exp.
Variable (20,000 $3) 60,000$
Fixed 100,000 160,000
Net income 120,000$
Mellon Co. had no beginning inventory, produced25,000 units and sold 20,000 units this year at $30
each.
Absorption CostingIncome Statements
V i bl C ti
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Variable CostingSales (20,000 $30) 600,000$
Less variable expenses:
Beginning inventory -$Add COGM (25,000 $10) 250,000
Goods available for sale 250,000$
Ending inventory (5,000 $10) 50,000
Variable cost of goods sold 200,000$
Variable selling & administrative
expenses (20,000 $3) 60,000 260,000Contribution margin 340,000$
Less fixed expenses:
Manufacturing overhead 150,000$
Selling & administrative expenses 100,000 250,000
Net income 90,000$
Variable CostingIncome Statements
Now lets look at variable costing by MellonCo.
C i Ab ti d
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Cost of
Goods
Sold
Ending
Inventory
Period
Expense Total
Absorption costing
Variable mfg. costs 200,000$ 50,000$ -$ 250,000$
Fixed mfg. costs 120,000 30,000 - 150,000
320,000$ 80,000$ -$ 400,000$
Variable costing
Variable mfg. costs 200,000$ 50,000$ -$ 250,000$Fixed mfg. costs - - 150,000 150,000
200,000$ 50,000$ 150,000$ 400,000$
Comparing Absorption andVariable Costing
Lets compare the methods.
Reconciling Income Under
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Reconciling Income UnderAbsorption and Variable Costing
We can reconcile the difference betweenabsorption and variable net income as
follows:Variable costing net income 90,000$Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units $6 per unit) 30,000
Absorption costing net income 120,000$
Fixed mfg. overhead $150,000Units produced 25,000
= $6.00 per unit=
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Extending the Example
Lets look at
the secondyear ofoperationsfor MellonCompany.
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Mellon Co. Year 2
In its second year of operations, Mellon Co. started withan inventory of 5,000 units, produced 25,000 units and
sold 30,000 units at $30 each.
Number of units produced annually 25,000
Variable costs per unit:Direct materials, direct labor
and variable mfg. overhead 10$
Selling & administrative
expenses 3$
Fixed costs per year:
Mfg. overhead 150,000$
Selling & administrative
expenses 100,000$
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Mellon Co. Year 2
Unit product cost is determined asfollows:
Absorption
Costing
Variable
CostingDirect materials, direct labor,
and variable mfg. overhead 10$ 10$
Fixed mfg. overhead
($150,000 25,000 units) 6 -
Unit product cost 16$ 10$
There has been nochange in Mellonscost structure.
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Absorption CostingSales (30,000 $30) 900,000$
Less cost of goods sold:
Beg. inventory (5,000 x $16) 80,000$
Add COGM (25,000 $16) 400,000Goods available for sale 480,000$
Ending inventory - 480,000
Gross margin 420,000$
Less selling & admin. exp.
Variable (30,000 $3) 90,000$Fixed 100,000 190,000
Net income 230,000$
Mellon Co. Year 2
25,000 units produced in the current period.
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Variable CostingSales (30,000 $30) 900,000$Less variable expenses:
Beg. inventory (5,000 $10) 50,000$
Add COGM (25,000 $10) 250,000
Goods available for sale 300,000$
Ending inventory -Variable cost of goods sold 300,000$
Variable selling & administrative
expenses (30,000 $3) 90,000 390,000
Contribution margin 510,000$
Less fixed expenses: Manufacturing overhead 150,000$
Selling & administrative expenses 100,000 250,000
Net income 260,000$
Mellon Co. Year 2
Excludes fixed manufacturing overhead.
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Summary
In the first period, production (25,000 units)was greater than sales (20,000).
Income Comparison
Costing Method 1st Period 2nd Period Total
Absorption 120,000$ 230,000$ 350,000$
Variable 90,000 260,000 350,000
In the second period, production (25,000 units)was less than sales (30,000).
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Summary
Lets see if we can get an overviewof what we have done.
Summary Comparison of Absorption
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Production versusSales
Total
InventoryEffect Period Expense Effect Profit Effect
Fixed mfg. Fixed mfg.
Produced > Sold Increase costs expensed < costs expensed AC > VC
AC VC
Fixed mfg. Fixed mfg.
Produced < Sold Decrease costs expensed > costs expensed AC < VC
AC VC
Fixed mfg. Fixed mfg.
Produced = Sold No change costs expensed = costs expensed AC = VCAC VC
Summary Comparison of Absorption(AC) and Variable Costing (VC)
For the two-year period, units producedequals units sold, so total absorption incomeequals total variable income.
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Advantages
Management finds iteasy to understand.
Consistent withCVP analysis.
Emphasizes contribution inshort-run pricing decisions.
Profit for period notaffected by changesin fixed mfg. overhead.
Impact of fixedcosts on profitsemphasized.
Evaluation of Variable Costing
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AdvantagesConsistent with long-runpricing decisions that mustcover full cost.
External reportingand income tax lawrequire absorption costing.
Evaluation of Absorption Costing
Fixed manufacturing overhead istreated the same as the other productcosts, direct material and direct labor.
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Throughput Costing
Example
In an automated process direct material may bethe only unit-level cost and so is the only product cost.
All other manufacturing costs are expensed as period costs.
Incentive to
overproduceis reduced
Average unit cost does
not vary with changesin production levels.
Advantages
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Throughput Income Statement
Sales Revenue $600,000Throughput cost of goods sold (dir. mat.) 150,000
Gross Margin $450,000
Less: Operating costs
Direct labor 100,000Variable mfg overhead 60,000
Fixed mfg overhead 150,000
Variable sales & admin costs 50,000
Fixed sales & admin costs 125,000
Total operating costs 375,000
Net Income $ 75,000
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End of Chapter 8
The nd