In this chapter, we have demonstrated a number of ratios and mathematical relationships that are useful in cost-volume-profit analysis. For your convenience, these relationships are sum- marized in Exhibit 20–16 .
Calculating semivariable administrative costs Monthly fixed administrative cost . . . $23,000
Variable costs ($2.40 930 units) . . . 2,232 Total estimated administrative cost. . . $25,232
Exhibit 20–16
COST-VOLUME-PROFIT MATHEMATICAL RELATIONSHIPS Measurement Method of Computation
Contribution Margin Sales Revenue Total Variable Costs
Unit Contribution Margin Unit Sales Price Variable Costs per Unit Contribution Margin Ratio Unit Sales Price Variable Costs per Unit
Unit Sales Price or
Sales Total Variable Costs Sales
Sales Volume (in units) Fixed Costs Target Operating Income
Unit Contribution Margin
Sales Volume (in dollars) Fixed Costs Target Operating Income
Contribution Margin Ratio
Margin of Safety Actual Sales Volume Break-Even Sales Volume
Operating Income Margin of Safety Contribution Margin Ratio
Change in Operating Income Change in Sales Volume Contribution
Margin Ratio
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Ethics, Fraud & Corporate Governance
As discussed in this chapter, some industries are characterized by high fixed costs. Examples of industries characterized by high fixed costs include airlines, automobile manufacturers, and telecommunications companies. Companies in these industries purchase or self-construct different types of fixed assets—for example, airplanes, production equipment, fiber optic cable, and so on. A company’s heavy reliance on fixed assets may result in: (1) an airline contracting with Boeing or Airbus to purchase or lease new planes, (2) an automobile manufacturer’s decision to close a production facility and lay off workers covered by its pension plan, or (3) a telecommunications company investing in a technology that later becomes obsolete or unproductive and thereby makes the investment impaired. All of these events are potentially of interest to investors and creditors. And although these events (or the effects thereof ) would be reflected in quarterly and annual financial statements filed with the Securities and Exchange Commission (SEC), the Sarbanes-Oxley Act (SOX) requires a more rapid disclosure of these events to the capital markets.
Section 409 of SOX requires public companies to disclose, by filing a Form 8-K, certain material events within four business days after they occur. Such events include entering
into, or terminating, material agreements. For example, if an airline enters into an agreement to purchase or lease additional planes, the airline must disclose the date of the agreement, the parties to the agreement, any relationship between the company and the parties, and the terms and conditions of the agreement.
Companies must also file a Form 8-K if management is committed to disposing of long-lived assets or terminating employees covered under a pension plan. These disclosures must include all relevant dates and costs associated with these actions. Finally, a Form 8-K must be filed if a fixed asset or intangible asset has become materially impaired.
Section 409 of SOX identifies other events that require disclosure on a Form 8-K on a rapid and current basis.
Examples of these events include: (1) company bankruptcy or receivership, (2) buying another business or disposing of the company’s own assets, (3) delisting from a stock exchange, (4) a change in the company’s audit firm, (5) the departure/
election/appointment of board members or principal officers, and (6) amendments to the company’s code of ethics or waivers of provisions of the code of ethics. The goal of requiring disclosure of certain material events on a rapid and current basis is to provide more timely information to market participants of material information.
Ethics, Fraud & Corporate Governance
Concluding Remarks
An understanding of cost behavior—the manner in which costs normally respond to changes in the level of activity—is required in each remaining chapter of this textbook. In these chap- ters, we will explore the use of accounting information in evaluating the performance of managers and departments, in planning future business operations, and in making numerous types of management decisions. The concepts and terminology introduced in Chapter 20 will be used extensively in these discussions.
Concluding Remarks
A d t di f t b h i th i hi h t ll d t h
Confirming Pages
END-OF-CHAPTER REVIEW
S U M M A R Y O F L E A R N I N G O B J E C T I V E S
Explain how fixed, variable, and semivariable costs respond to changes in the volume of business activity. Fixed costs (fixed expenses) remain unchanged despite changes in sales volume, while variable costs (or expenses) change in direct proportion to changes in sales volume. With a semivariable cost, part of the cost is fixed and part is variable.
Semivariable costs change in response to a change in the level of activity, but they change by less than a proportionate amount.
Explain how economies of scale can reduce unit costs. Economies of scale are reductions in unit cost that can be achieved through a higher volume of activity.
One economy of scale is fixed costs that are spread over a larger number of units, thus reducing unit cost.
Prepare a cost-volume-profit graph. The vertical axis on a break-even graph is dollars of revenue or costs, and the horizontal axis is unit sales. Lines are plotted on the graph showing revenue and total costs at different sales volumes. The vertical distance between these lines represents the amount of operating income (or loss). The lines intersect at the break-even point.
Compute contribution margin and explain its usefulness. Contribution margin is the excess of revenue over variable costs. Thus, it represents the amount of revenue available to cover fixed costs and to provide an operating profit. Contribution margin is useful in estimating the sales volume needed to achieve earnings targets, or the income likely to result from a given sales volume.
Determine the sales volume required to earn a desired level of operating income. The sales volume (in units) required to earn a target profit is equal to the
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sum of the fixed costs plus the target profit, divided by the unit contribution margin. To determine the sales volume in dollars, the sum of the fixed costs plus the target profit is divided by the contribution margin ratio.
Use the contribution margin ratio to estimate the change in operating income caused by a change in sales volume. Multiplying the expected dollar change in sales volume by the contribution margin ratio indicates the expected change in operating income.
Use CVP relationships to evaluate a new marketing strategy. An understanding of CVP relationships assists managers in estimating the changes in revenue and costs which are likely to accompany a change in sales volume. Thus, they are able to estimate the likely effects of marketing strategies on overall profitability.
Use CVP when a company sells multiple products.
For companies that sell multiple products, CVP analysis is performed using a weighted-average contribution margin. The weighted-average contribution margin is based on each product’s individual contribution margin and the percentage it comprises of the company’s overall sales mix.
Determine semivariable cost elements. Semivariable costs have both a fixed component and a variable component. Separating semivariable costs into their fixed and variable components is a constant challenge faced by managers. The high-low method is a simple approach used by managers to better understand the structure of semivariable costs.
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Key Terms Introduced or Emphasized In Chapter 20
break-even point (p. 886) The level of sales at which a com- pany neither earns an operating profit nor incurs a loss. Revenue exactly covers costs and expenses.
contribution margin (p. 888) Sales minus variable costs. The portion of sales revenue that is not consumed by variable costs and, therefore, is available to cover fixed costs and contribute to operating income.
contribution margin per unit (p. 888) The excess of unit sales price over variable cost per unit; the dollar amount con- tributed by the sale of each unit toward covering fixed costs and generating operating income.
contribution margin ratio (p. 889) The contribution margin expressed as a percentage of sales price. Represents the percentage
of each revenue dollar that is available to cover fixed costs or to provide an operating profit.
cost formula (p. 895) A mathematical statement expressing the expected amount of a cost in terms of the fixed element of the cost and/or the portion of the cost that varies in response to changes in some activity base. For example, the cost formula for a semivari- able cost might be $2,500 per month, plus 5 percent of net sales.
economies of scale (p. 884) A reduction in unit cost achieved through a higher volume of output.
fixed costs (p. 880) Costs and expenses that remain unchanged despite changes in the level of the activity base.
high-low method (p. 894) A method of dividing a semivari- able (or mixed) cost into its fixed and variable elements by relating the change in the cost to the change in the activity base between the highest and lowest levels of observed activity.
margin of safety (p. 890) Amount by which actual sales exceed the break-even point.
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semivariable costs (p. 881) Costs and expenses that respond to changes in the level of the activity base by less than a propor- tionate amount.
variable costs (p. 881) Costs and expenses that vary directly and proportionately with changes in the level of the activity base.
relevant range (p. 885) The span or range of output over which output is likely to vary and assumptions about cost behav- ior are generally valid. Excludes extreme volume variations.
sales mix (p. 893) The relative percentages of total sales gen- erated by each type of product that a business sells.
Demonstration Problem
The management of Fresno Processing Company has engaged you to assist in the development of information to be used for management decisions.
The company has the capacity to process 20,000 tons of cottonseed per year. This processing results in several salable products, including oil, meal, hulls, and lint.
A marketing study indicates that the company can sell its output for the coming year at $200 per ton processed.
You have determined the company’s cost structure to be as follows:
Demonstration Problem
Cost of cottonseed . . . $80 per ton Processing costs:
Variable. . . $26 per ton Fixed . . . $340,000 per year Marketing costs . . . All variable, $44 per ton Administrative costs . . . All fixed, $300,000 per year
Instructions
a. Compute ( 1 ) the contribution margin and ( 2 ) the contribution margin ratio per ton of cotton- seed processed.
b. Compute the break-even sales volume in ( 1 ) dollars and ( 2 ) tons of cottonseed.
c. Assume that the company’s budget calls for an operating income of $240,000. Compute the sales volume required to reach this profit objective, stated ( 1 ) in dollars and ( 2 ) in tons of cottonseed.
d. Compute the maximum amount that the company can afford to pay per ton of raw cottonseed and still break even by processing and selling 16,000 tons during the current year.
Solution to the Demonstration Problem
a. (1) Total revenue per ton of cottonseed . . . $200 Less: Variable costs:
Cottonseed . . . $80 Processing . . . 26 Marketing . . . 44 150 Unit contribution margin ($200 $150) . . . $ 50 (2) Contribution margin ratio ($50 $200) . . . 25%
b. (1) Break-even dollar sales volume:
Fixed costs ($340,000 $300,000) . . . $ 640,000 Contribution margin ratio (part a ) . . . 25%
Break-even dollar sales volume ($640,000 0.25) . . . $2,560,000 (2) Break-even unit sales volume (in tons):
Fixed costs (per previous) . . . $ 640,000 Unit contribution margin (part a ) . . . $ 50 Break-even unit sales volume, stated in tons of
cottonseed products ($640,000 $50) . . . 12,800 (Alternative computation: Break-even dollar sales volume,
$2,560,000, divided by unit sales price, $200, equals 12,800 tons.)
Confirming Pages Rev. Confirming Pages
Self-Test Questions 899
c. (1) Required dollar sales volume:
Fixed expenses . . . $ 640,000 Add: Target operating income . . . 240,000 Required contribution margin . . . $ 880,000 Contribution margin ratio (part a ) . . . 25%
Required dollar sales volume ($880,000 0.25) . . . $3,520,000 (2) Required unit sales volume:
Required dollar sales volume [from (1) ] . . . $3,520,000 Unit sales price . . . $ 200 Required unit sales volume, in tons
($3,520,000 $200) . . . 17,600 (Alternative computation: Required contribution margin to
cover fixed expenses and target operating income, $880,000, [part c (1)], divided by unit contribution margin, $50 per ton, equals 17,600 tons.)
d. Total revenue (16,000 tons $200) . . . $3,200,000 Less: Costs other than cottonseed:
Processing (16,000 tons $26) . . . $416,000 Marketing (16,000 tons $44) . . . 704,000
Fixed costs . . . 640,000 1,760,000 Maximum amount that can be paid for 16,000 tons of
cottonseed, while allowing company to break even . . . $1,440,000 Maximum amount that can be paid per ton of cottonseed,
while allowing company to break even
($1,440,000 16,000 tons) . . . $90
Self-Test Questions Self-T est Questions
The answers to these questions appear on page 915.
1. During the current year, the net sales of Ridgeway, Inc., were 10 percent below last year’s level. You should expect Ridge- way’s semivariable costs to:
a. Decrease in total, but increase as a percentage of net sales.
b. Increase in total and increase as a percentage of net sales.
c. Decrease in total and decrease as a percentage of net sales.
d. Increase in total, but decrease as a percentage of net sales.
2. Marston Company sells a single product at a sales price of
$50 per unit. Fixed costs total $15,000 per month, and vari- able costs amount to $20 per unit. If management reduces the sales price of this product by $5 per unit, the sales vol- ume needed for the company to break even will:
a. Increase by $5,000. c. Increase by $2,000.
b. Increase by $4,500. d. Remain unchanged.
3. Olsen Auto Supply typically earns a contribution margin ratio of 40 percent. The store manager estimates that by spending an additional $5,000 per month for radio advertis- ing the store will be able to increase its operating income by $3,000 per month. The manager is expecting the radio advertising to increase monthly dollar sales volume by:
a. $12,500. c. $7,500.
b. $8,000. d. Some other amount.
4. Shown below are the monthly high and low levels of direct labor hours and total manufacturing overhead for Apex Mfg. Co.
In a month in which 5,000 direct labor hours are used, the fixed element of total manufacturing overhead costs should be approximately:
a. $15,500. c. $7,500.
b. $8,000. d. $8,000 plus $1.50 per unit.
5. Driver Company manufactures two products. Data concern- ing these products are shown below:
Direct Total
Labor Manufacturing Hours Overhead Highest observed level . . . 6,000 $17,000
Lowest observed level . . . 4,000 14,000
Product A Product B Total monthly demand (in units). . 1,000 200 Sales price per unit . . . $400 $500 Contribution margin ratio . . . 30% 40%
Relative sales mix . . . 80% 20%
If fixed costs are equal to $320,000, what amount of total sales revenue is needed to break even?
a. $914,286. c. $320,000.
b. $457,143. d. $1,000,000.
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1. Why is it important for management to understand cost- volume-profit relationships?
2. What is an activity base and why is it important in analyzing cost behavior?
3. What is the effect of an increase in activity on the following items?
a. Total variable costs.
b. Variable costs per unit of activity.
c. Total fixed costs.
d. Fixed costs per unit of activity.
4. The simplifying assumption that costs and volume vary in straight-line relationships makes the analysis of cost behav- ior much easier. What factors make this a reasonable and useful assumption in many cases?
5. Define the relevant range of activity.
6. Explain how the high-low method determines:
a. The variable portion of a semivariable cost.
b. The fixed portion of a semivariable cost.
7. Define ( a ) contribution margin, ( b ) contribution margin ratio, and ( c ) average contribution margin ratio .
8. What important relationships are shown on a cost-volume- profit (break-even) graph?
9. Explain how the unit contribution margin can be used to determine the unit sales required to break even.
10. Define margin of safety.
11. An executive of a large American steel company put the blame for lower net income for a recent fiscal period on the
“shift in product mix to a higher proportion of export sales.”
Sales for the period increased slightly while net income declined by 28 percent. Explain how a change in product (sales) mix to a higher proportion in export sales could result in a lower level of net income.
12. Explain why businesses normally can reduce unit costs by utilizing their facilities more intensively.
13. Why does cost-volume-profit analysis focus upon operating income instead of net income?
14. A regional airline and a furniture manufacturer each gener- ate annual revenue of $120 million and earn net income of
$10 million. Which company probably has the higher break- even point? Explain.
15. List the assumptions that underlie cost-volume-profit analysis.
Brief Exercises
Explain the effects of an increase in the volume of activity on the following costs. (Assume volume remains within the relevant range.)
a. Total variable costs d. Fixed cost per unit b. Variable cost per unit e. Total semivariable costs c. Total fixed cost f. Semivariable cost per unit
Explain whether you regard each of the following costs or categories of costs as fixed, variable, or semivariable with respect to net sales. Briefly explain your reasoning. If you do not believe that a cost fits into any of these classifications, explain.
a. The cost of goods sold.
b. Salaries to salespeople (these salaries include a monthly minimum amount, plus a commission on all sales).
c. Income taxes expense.
d. Property taxes expense.
e. Depreciation expense on a sales showroom, based on the straight-line method of depreciation.
f. Depreciation expense on a sales showroom, based on the double-declining-balance method of depreciation.
City Ambulance Service estimates the monthly cost of responding to emergency calls to be
$19,500, plus $110 per call.
a. In a month in which the company responds to 125 emergency calls, determine the estimated:
1. Total cost of responding to emergency calls.
2. Average cost of responding to emergency calls.
b. Assume that in a given month, the number of emergency calls was unusually low. Would you expect the average cost of responding to emergency calls during this month to be higher or lower than in other months? Explain.
accounting
BRIEF
EXERCISE 20.1 Patterns of Cost Behavior
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EXERCISE 20.2 Classification of Various Costs B
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EXERCISE 20.3 Using a Cost Formula B
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Brief Exercises accounting Discussion Questions
Discussion Questions
ASSIGNMENT MATERIAL
Confirming Pages
Brief Exercises 901
Through using the high-low method, Regency Hotels estimates the total costs of providing room service meals to amount to $5,950 per month, plus 30 percent of room service revenue.
a. What is the contribution margin ratio of providing room service meals?
b. What is the break-even point for room service operations in terms of total room service revenue?
c. What would you expect to be the total cost of providing room service in a month in which room service revenue amounts to $15,000?
Porter Corporation has fixed costs of $660,000, variable costs of $24 per unit, and a contribution margin ratio of 40 percent.
Compute the following:
a. Unit sales price and unit contribution margin for the above product.
b. The sales volume in units required for Porter Corporation to earn an operating income of
$300,000.
c. The dollar sales volume required for Porter Corporation to earn an operating income of
$300,000.
Jackson Company recently calculated its break-even sales revenue to be $15,000. For each dollar of sales revenue, $0.70 goes to cover variable costs.
Compute the following:
a. The contribution margin ratio.
b. Total fixed costs.
c. The sales revenue that would have to be generated to earn an operating income of $9,000.
Firebird Mfg. Co. has a contribution margin ratio of 45 percent and must sell 25,000 units at a price of $80 each in order to break even.
a. Compute total fixed costs.
b. Compute variable cost per unit.
c. Develop the company’s cost formula.
Chaps & Saddles, a retailer of tack and Western apparel, earns an average contribution margin of 45 percent on its sales volume. Recently, the advertising manager of a local “country” radio station offered to run numerous radio advertisements for Chaps & Saddles at a monthly cost of $1,800.
Compute the amount by which the proposed radio advertising campaign must increase Chaps &
Saddles’s monthly sales volume to:
a. Pay for itself.
b. Increase operating income by $1,000 per month. (Round computations to the nearest dollar.)
You have been hired as a consultant to assist the following companies with cost-volume-profit analysis:
Freeman’s Retail Floral Shop Susquehanna Trails Bus Service Wilson Pump Manufacturers
McCauley & Pratt, Attorneys-at-Law
Suggest an appropriate activity base for each of these clients.
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EXERCISE 20.4 Using a Cost Formula B
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EXERCISE 20.5 Computing Sales Volume
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EXERCISE 20.6 Computing Sales Volume
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EXERCISE 20.7 Relating Contribution Margin Ratio to Sales Price
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EXERCISE 20.8 Evaluating a Marketing Strategy
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EXERCISE 20.9 Selecting an Activity Base
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