COST MANAGEMENT Accounting Control HansenMowenGuan Chapter 17 CostVolumeProfit

COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan • Chapter 17 • Cost-Volume-Profit Analysis 1

Study Objectives 1. Determine the number of units that must be sold to break even or to earn a targeted profit. 2. Calculate the amount of revenue required to break even or to earn a targeted profit. 3. Apply cost-volume-profit analysis in a multiple-product setting. 4. Prepare a profit-volume graph and a cost-volume-profit graph, and explain the meaning of each. 5. Explain the impact of risk, uncertainty, and changing variables on cost-volume-profit analysis. 6. Discuss the impact of activity-based costing on costvolume-profit analysis. 2

The Break-Even Point in Units The controller of More-Power Company has prepared the following projected income statement: Sales (72, 500 units @ $40) Less: Variable expenses Contribution margin Less: Fixed expenses Operating income $2, 900, 000 1, 740, 000 $1, 160, 000 800, 000 $ 360, 000 3

The Break-Even Point in Units Operating Income Approach 0 = ($40 x Units) – ($24 x Units) – $800, 000 0 = ($16 x Units) – $800, 000 $1, 740, 000 ÷ 72, 500 ($16 x Units) = $800, 000 Units = 50, 000 Proof Sales (50, 000 units @ $40) Less: Variable expenses Contribution margin Less: Fixed expenses Operating income $2, 000 1, 200, 000 $ 800, 000 $ 0 4

The Break-Even Point in Units Contribution Margin Approach Number of units = $800, 000 ÷ ($40 - $24) = $800, 000 ÷ $16 contribution margin per unit = 50, 000 5

The Break-Even Point in Units Target Income as a Dollar Amount $424, 000 = ($40 x Units) – ($24 x Units) – $800, 000 $1, 224, 000 = $16 x Units = $1, 224, 000 ÷ $16 = 76, 500 Proof Sales (76, 500 units @ $40) Less: Variable expenses Contribution margin Less: Fixed expenses Operating income $3, 060, 000 1, 836, 000 $1, 224, 000 800, 000 $ 424, 000 6

The Break-Even Point in Units Target Income as a Percentage of Sales Revenue More-Power Company wants to know the number of sanders that must be sold in order to earn a profit equal to 15 percent of sales revenue. 0. 15($40)(Units) = ($40 x Units) – ($24 x Units) – $800, 000 $6 x Units = ($16 x Units) – $800, 000 $10 x Units = $800, 000 Units = 80, 000 7

The Break-Even Point in Units After-Tax Profit Targets Net income = Operating income – Income taxes = Operating income – (Tax rate × Operating income) = Operating income × (1 – Tax rate) Or 8

The Break-Even Point in Units After-Tax Profit Targets More-Power Company wants to achieve net income of $487, 500 and its income tax rate is 35 percent. $487, 500 = Operating income – 0. 35(Operating income) $487, 500 = 0. 65(Operating income) $750, 000 = Operating income Units = ($800, 000 + $750, 000) ÷ $16 = $1, 550, 000 ÷ $16 = $96, 875 9

Break-Even Point in Sales Dollars 10

Break-Even Point in Sales Dollars The following More-Power Company contribution margin income statement is shown for sales of 72, 500 sanders. Sales Less: Variable expenses Contribution margin Less: Fixed expenses Operating income $2, 900, 000 1, 740, 000 $1, 160, 000 800, 000 $ 360, 000 11

Break-Even Point in Sales Dollars To determine the break-even in sales dollars, the contribution margin ratio must be determined ($1, 160, 000 ÷ $2, 900, 000) Sales Less: Variable expenses Contribution margin Less: Fixed expenses Operating income $2, 900, 000 1, 740, 000 $1, 160, 000 800, 000 $ 360, 000 100% 60% 40% 12

Break-Even Point in Sales Dollars Operating income = Sales – Variable costs – Fixed Costs 0 = Sales – (Variable cost ratio × Sales) – Fixed costs 0 = Sales × (1 – Variable cost ratio) – Fixed costs 0 = Sales × (1 –. 60) – $800, 000 Sales × 0. 40 = $800, 000 Sales = $2, 000 13

Break-Even Point in Sales Dollars 14

Break-Even Point in Sales Dollars 15

Break-Even Point in Sales Dollars 16

Break-Even Point in Sales Dollars Profit Targets How much sales revenue must More-Power generate to earn a before-tax profit of $424, 000? Sales = ($800, 000 + $424, 000) ÷ 0. 40 = $1, 224, 000 ÷ 0. 40 = $3, 060, 000 17

Multiple-Product Analysis More-Power plans on selling 75, 000 regular sanders and 30, 000 mini-sanders. The sales mix is 5: 2 Sales Less: Variable expenses Contribution margin Less: Direct fixed expenses Product margin Less: Common fixed exp. Operating income Regular Mini. Sander Total $3, 000 $1, 800, 000 $4, 800, 000 1, 800, 000 900, 000 2, 700, 000 $1, 200, 000 $ 900, 000 $2, 100, 000 250, 000 450, 000 700, 000 $ 950, 000 $ 450, 000 $1, 400, 000 600, 000 $ 800, 000 18

Multiple-Product Analysis Break-Even Point in Units Regular sander break-even units = Fixed costs ÷ (Price – Unit variable) = $250, 000 ÷ $16 = 15, 625 units Mini-sander break-even units = Fixed costs ÷ (Price – Unit variable) = $450, 000 ÷ $30 = 15, 000 units 19

Multiple-Product Analysis Sales Mix and CVP Analysis Package break-even units = Fixed costs ÷ Package contribution margin = $1, 300, 000 ÷ $140 = 9, 285. 71 units Sales volume for break-even Regular sander: 46, 429 units Mini sander: 18, 571 units 20

Multiple-Product Analysis 21

Multiple-Product Analysis Sales Dollar Approach Projected Income: Sales Less: Variable expenses Contribution margin Less: Fixed expenses Operating income $4, 800, 000 2, 700, 000 $2, 100, 000 1, 300, 000 $ 800, 000 0. 4375 Break-even sales = Fixed costs ÷ contribution margin ratio = 1, 300, 000 ÷ 0. 4375 = $2, 971, 429 22

Graphical Representation of CVP Relationships 23

Graphical Representation of CVP Relationships 24

Graphical Representation of CVP Relationships Assumptions of C-V-P Analysis 1. 2. 3. 4. 5. The analysis assumes a linear revenue function and a linear cost function. The analysis assumes that price, total fixed costs, and unit variable costs can be accurately identified and remain constant over the relevant range. The analysis assumes that what is produced is sold. For multiple-product analysis, the sales mix is assumed to be known. The selling price and costs are assumed to be known with certainty. 25

Changes in the CVP Variables Alternative 1: If advertising expenditures increase by $48, 000, sales will increase from 72, 500 units to 75, 000 units. 26

Changes in the CVP Variables Alternative 2: A price decrease from $40 per sander to $38 would increase sales from 72, 500 units to 80, 000 units. 27

Changes in the CVP Variables Alternative 3: Decreasing price to $38 and increasing advertising expenditures by $48, 000 will increase sales from 72, 500 units to 90, 000 units. 28

Changes in the CVP Variables Margin of safety – The excess of units sold over break-even units – The excess of revenue earned over breakeven sales Current sales Break-even volume Margin of safety (in units) 500 200 300 Current revenue $350, 000 Break-even volume 200, 000 Margin of safety (in dollars) $150, 000 29

Changes in the CVP Variables Operating Leverage Automated System Manual System Sales (10, 000 units) Less: Variable expenses Contribution margin Less: Fixed expenses Operating income $1, 000 500, 000 $ 500, 000 375, 000 $ 125, 000 $1, 000 800, 000 $ 200, 000 100, 000 $ 100, 000 Unit selling price Unit variable cost Unit contribution margin $100 50 50 $100 80 20 DOL of 4 $500, 000 ÷ $125, 000 DOL of 2 $200, 000 ÷ $100, 000 30

Changes in the CVP Variables Operating Leverage Assume a 40% increase in sales Increase in sales Degree of operating leverage Increase in operating income Sales (14, 000 units) Less: Variable expenses Contribution margin Less: Fixed expenses Operating income Automated System 40% × 4 160% $1, 400, 000 700, 000 $ 700, 000 375, 000 $ 325, 000 Manual System 40% × 2 80% $1, 400, 000 1, 120, 000 $ 280, 000 100, 000 $ 180, 000 31

CVP Analysis and Activity-Based Costing The ABC Cost Equation: + + + = Fixed costs Unit variable cost × number of units Setup cost × number of setups Engineering cost × number of engineering hours Total cost Operating Income: Total revenue – Total Cost = Operating income Break-Even in Units: 32

CVP Analysis and Activity-Based Costing • Differences between ABC break-even and conventional break-even – Fixed costs differ • Costs by vary with non-unit cost drivers – The numerator of the ABC break-even equation has two nonunit-variable cost terms • Batch-related activities • Product-sustaining activities 33

CVP Analysis and Activity-Based Costing Example Comparing Conventional and ABC Analysis Cost Driver Unit Variable Cost Units sold $ 10 Setups 1, 000 Engineering hours 30 Other data: Total fixed costs (conventional) Total fixed costs (ABC) Unit selling price Level of Cost Driver -20 1, 000 $100, 000 50, 000 20 34

CVP Analysis and Activity-Based Costing Example Comparing Conventional and ABC Analysis Units to be sold to earn a before-tax profit of $20, 000: Units = = (Targeted income + Fixed costs) ÷ (Price – Unit variable cost) ($20, 000 + $100, 000) ÷ ($20 – $10) $120, 000 ÷ $10 12, 000 Same data using the ABC Units = ($20, 000 + $50, 000 + $20, 000 + $30, 000) ÷ ($20 – $10) = $120, 000 ÷ $10 = 12, 000 35

CVP Analysis and Activity-Based Costing Example Comparing Conventional and ABC Analysis Suppose that marketing indicates that only 10, 000 units can be sold. A new design reduces direct labor by $2 (thus, the new variable cost is $8). The new break-even is : Units = Fixed costs ÷ (Price – Unit variable cost) = $100, 000 ÷ ($20 – $8) = 8, 333 36

CVP Analysis and Activity-Based Costing Example Comparing Conventional and ABC Analysis Projected income if 10, 000 units are sold: Sales ($20 × 10, 000) Less: Variable expenses ($8 × 10, 000) Contribution margin Less: Fixed expenses Operating income $200, 000 80, 000 $120, 000 100, 000 $ 20, 000 37

CVP Analysis and Activity-Based Costing Example Comparing Conventional and ABC Analysis Suppose that the new design requires a more complex setup, increasing the cost per setup from $1, 000 to $1, 600. Also, suppose that the new design requires a 40 percent increase in engineering support. New cost equation: $50, 000 (fixed costs) + ($8 × units) + ($1, 600 × setups) + ($30 × engineering hours) 38

CVP Analysis and Activity-Based Costing Example Comparing Conventional and ABC Analysis Break-even point using the ABC equation: This exceeds the firm’s sales capacity! 39

COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan • End Chapter 17 40