Chapter 6 Cost Behavior and Decision Making: Cost, Volume, Profit Analysis

Chapter 6

Cost Behavior and Decision Making: Cost, Volume, Profit

Analysis

Topics

Introduction

The Contribution Margin Income Statement

The Contribution Margin and Its Uses

Introduction

Cost-Volume-Profit Analysis (CVP) Focuses on the following factors:

The prices of products or services

The volume of products or services produced and sold

The per-unit variable costs

The total fixed costs

The mix of products or services produced


The Contribution Margin Income Statement is structured by behavior rather than by function.

Sales - All Variable Costs = Contribution Margin

Contribution Margin - All Fixed Costs = Net Income

Income Statements

TRADITIONAL CONTRIBUTION MARGIN

Sales Less: Cost of Goods Sold

Variable CostsFixed Costs

Total Costs of Goods SoldGross ProfitLess: S&A Costs


Total S&A CostsNet Income

SalesLess: Variable Costs

Manuf. CostsS&A Costs

Total Variable CostsContribution MarginLess: Fixed Costs


Total Fixed CostsNet Income

$1,000

350150

$ 500$ 500

$ 50250

$ 300$ 200

$1,000

$35050

$400$600

$150250

$400$200


Key Concept

The contribution margin income statement is structured to emphasize cost behavior as opposed to cost function.

Contribution Margin Per Unit

Sales (100,000 units) Less: Variable Costs Contribution MarginLess: Fixed CostsNet Income

Total

$200,00080,000

$120,00040,000

$80,000

Per Unit

$2.00.80

$1.20



Total

$200,002.0080,000.80

$120,001.2040,000.00

$80,001.20

Per Unit

$2.00.80

$1.20

What if HD Inc. sold one more unit?


Key Concept

For every unit change in sales, contribution margin will increase or decrease by the contribution margin per unit multiplied by the increase or decrease in sales volume.

Contribution Margin Ratio


=

Contribution Margin (in $)

Sales (in $)



Total

$200,00080,000

$120,00040,000

$80,000

Percent

100%40 60%


Key Concept

The contribution margin per unit and the contribution margin ratio will remain constant as long as sales vary in direct proportion with volume.


Key Concept

For every dollar change in sales, contribution margin will increase or decrease by the contribution margin ratio multiplied by the increase or decrease in sales dollars.


Using either contribution margin per unit or contribution margin ratio, calculate HD Inc.’s net income (loss) when sales are 25,000 units or $50,000.

Answer:

25,000 units x $1.20 cm = $30,000 or $50,000 x 60% = $30,000

The Contribution Margin and Its Uses

What would happen if sales increase?

Use the CM to determine the increase of net income. Then consider what must happen before sales increase. Lower sales price? Increase incentives for sales staff? Improve quality of product? Increase advertising budget?

What-If Decisions Using CVP

Step 1: Define the Problem

Contribution margin is not sufficient to cover fixed costs.


Step 2: Identify Objectives

1. Increase net income

2. Maintain a high-quality product


1. Reduce variable costs of manufacturing the product

2.Increase sales through a change in the sales incentive structure or commissions (a variable cost)

3. Increase sales through increasing advertising (a fixed cost)

Step 3:Identify and analyze available options

What-If Options Using CVP

Option 1

When variable costs are reduced, contribution margin will increase.

Find less expensive supplier of raw material

Reduce the amount of labor used

Use lower-wage employees

What would be the consequences of each?


SalesLess: Variable Costs Contribution MarginLess: Fixed CostsNet Income (Loss)

Total

$100,00072,000

$28,00035,000

$(7,000)

Option 1

$100,00064,800

$35,20035,000

$200


Option 2

Raise sales commissions on all sales above the present level by 10 percent. Sales will increase by $30,000 or 2,400 games. Additional sales commission will be $3,000.


Impact of increasing Sales Incentives, Sales = $130,000


Total

$100,00072,000

$28,00035,000

$(7,000)

Option 1

$130,00096,600

$33,40035,000

$(1,600)


Option 2A

Increase net income by $5,400 by increasing the sales commission by 10 percent on all sales of more than $100,000.

The new variable costs = 72% of sales up to $100,000 and 82% on all sales over $100,000.


Option 3

Spending an additional $10,000 on advertising will increase sales by $40,000 or 3,200 games.


Impact of increasing Sales Incentives, Sales = $140,000


Total

$100,00072,000

$28,00035,000

$(7,000)

Option 3

$140,000100,800$39,20045,000

$(5800)


Step 4: Select the best option

Option 1, NI = $200

Option 2, NI = $(1,600)

Option 2a, NI = $200

Option 3, NI = $(5,800)

Assess risk inherent in each option

Assess sensitivity of a decision to changes in key assumptions

Changes in Price and Volume

If the manager changes the sales price resulting in a change in sales volume, what will be the impact on net income?

Raising the sales price may decrease sales volume but the impact on total sales revenue may be offset by the increase in sales price.

Decreasing the sales price may increase the sales volume without increasing total sales revenue.

Changes in Price and Volume

These business strategies decisions involve individuals in many areas of an organization, such as marketing, sales, production management, and even human resources personnel for hiring decisions. The implications of a bad decision in this area can affect the firm’s bottom line.

Changes in Cost, Price and Volume

Changes can be made to cost, price and volume at the same time.

Changes in one almost always impact one or both of the other variables.

Break-Even Analysis

Break-Even Point: the level of sales where contribution margin just covers fixed costs and consequently net income is equal to zero.

Break-Even Analysis

Fixed CostsContribution Margin Per Unit

Break-Even (Sales $)

Break-Even (units)

=

Fixed CostsContribution Margin%

=

Break-Even Graph

Volume

$

Revenue

Total Cost

Break-Even Point

Break-Even Point in VolumeBreak-EvenPointin $

Loss

Income

Break-Even Calculations with Multiple Products

The calculation of “average” contribution margin is really a weighted average.

Break-Even Point =

Fixed Costs

Weighted Average Contribution Margin Ratio


Pause and Reflect

Imagine how difficult it is for large retail stores such as Wal-Mart or JCPenney to compute a break-even point for the entire store or company.


When using ABC, costs are classified as unit, batch, product, or facility level instead of variable or fixed.

Break-Even (units) =

Fixed Costs + Batch-level costs + Product-level costs


Target Profit Analysis(Before and After Tax)

To determine the sales units required to achieve a Target Profit before taxes:

Sales (units) =

Fixed Costs + Target Profit (before taxes)



Multiple Product formula to reach a Target Profit:

Sales (units) =

Fixed Costs + Target Profit

Weighted Average Contribution Margin Per Unit


ABC Formula to reach a Target Income:

Sales (units) =

Fixed Costs + Batch-level Costs + Product-level Costs + Target Profit


The Impact of Taxes

If

After-Tax Profit = Before-Tax Profit (1-tax rate)

then

Before-Tax Profit = After-Tax Profit / (1-tax rate)

Therefore, to determine after-tax Target Income

Sales in units =Fixed costs + After-Tax Profit / (1-tax rate)

Contribution Margin per unit

The Impact of Taxes

Key Concept

The payment of income tax is an important variable in target profit and other CVP decisions.

The Impact of Taxes

Pause and reflect

What impact do income taxes have on the calculation of the break-even point?

Assumptions of CVP Analysis

Selling price is constant throughout the relevant range.

Costs are linear throughout the relevant range.

The sales mix used to calculate the weighted average contribution margin is constant.

The amount of inventory is constant.

Cost Structure and Operating Leverage

Operating Leverage: The measure of the proportion of fixed costs in a company’s cost structure. It is used as an indicator of how sensitive profit is to changes in sales volume.


Operating Leverage =Contribution Margin

Net Income

Multiply OL x % increase in Sales = % increase in Net Income


Company A B C

Sales

Cont. Margin

Net Income

$100,000

$ 60,000

$ 20,000

$200,000

$120,000

$ 80,000

$400,000

$240,000

$200,000

Operating Leverage

60,000 20,000

120,000 80,000

240,000 200,000

= 3.0 1.5 1.2

10% Inc Sales 30% 15% 12%


Pause and Reflect

Unlike measures of contribution margin, operating leverage changes as sales change.


Key Concept

A company operating near the break-even point will have a high level of operating leverage and income will be very sensitive to changes in sales volume.

Variable Costing for Decision Making

The only difference between absorption and variable costing is the treatment of fixed overhead.

Absorption Costing: FO is treated as a product cost, and expensed when the product is sold.

Variable Costing: FO is treated as a period cost and expensed as incurred.


Absorption Costing Variable Costing

Sales Less: Cost of Goods Sold


Total Costs of Goods SoldGross ProfitLess: S&A Costs


Total S&A CostsNet Income

SalesLess: Variable Costs


Total Variable CostsContribution MarginLess: Fixed Costs


Total Fixed CostsNet Income

$1,000

350150

$ 500$ 500

$ 50250

$ 300$ 200

$1,000

$35050

$400$600

$150250

$400$200



Product Cost

Direct MaterialDirect LaborVariable OverheadFixed Overhead

Period Cost

Sell. & Adm.

Product Cost


Period Cost

Fixed OHSell. & Adm.




Total per unit

$.30.35.10.30

$1.05

$.30.35.10

$.75

Direct MaterialDirect LaborVariable Overhead

Total per unit

Product Costs

.30

Differences Between Absorption and Variable Costing

When units sold equal units produced, net income is the same under both costing methods.

When units produced exceed units sold, absorption costing will report higher net income than variable costing.

When units sold exceeds units produced, variable costing will report higher net income than absorption costing.


Key Concept

Variable costing is consistent with CVP’s focus on differentiating fixed from variable costs, and provides useful information for decision making that is often not apparent when using absorption costing.


I’m ready! Bring on the

costs!

Documents

Chapter 6 Cost Behavior and Decision Making: Cost, Volume, Profit Analysis