Lecture 3

Topic 3: Absorption costing vs Variable Costing & CostVolume-Profit Relationships Ref: LS Appendix to Chapter 7 and Chapter 18

Overview of Absorption and Variable Costing

As we saw in the last lecture, manufacturing costs consist of:
Direct materials Direct labour Manufacturing overhead (MOH can be variable or fixed)

Under absorption costing, only the fixed MOH which has been attached to the units sold during the period is expensed on the income statement. Under variable costing, the total amount of fixed MOH for the period is expensed.

Overview of Absorption and Variable Costing

Absorption Costing

Variable Costing

Direct Materials
Product Costs

Direct Labor Variable Manufacturing Overhead Fixed Manufacturing Overhead

Product Costs

Period Costs

Variable Selling and Administrative Expenses Fixed Selling and Administrative Expenses

Period Costs

Note: Manufacturing Cost Flows

Costs Balance Sheet Inventories Income Statement Expenses

Material Purchases Direct Labour Variable Manufacturing Overhead Fixed Manufacturing Overhead Selling and Administrative

Raw Materials
Work in Process Cost of Goods Sold

Finished Goods

Period Costs

Selling and Administrative

Quick Check
Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. . .

Quick Check
Which method will produce the highest values for work in process and finished goods inventories? a. Absorption costing. b. Variable costing. c. They produce the same values for these inventories. d. It depends. . .

Overview of Absorption and Variable Costing

Lets put some numbers to the issue and see if it will sharpen our understanding.

Unit Cost Calculations

Harvey Co. produces a single product which sells for $30 per unit.
Number of units produced annually: 25,000 Variable costs per unit: Direct materials, direct labour, and variable manufact. overhead $10 Selling and administrative expenses $3 Fixed costs per year: Manufacturing overhead $150,000 Selling & administrative expenses $100,000

Unit Cost Computations

Unit product cost is determined as follows:

Selling and administrative expenses are always treated as period expenses and deducted from revenue.

Income Comparison of 10 Absorption and Variable Costing

Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.
Absorption Costing
Sales (20,000 $30) 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 Gross profit Less selling & admin. exp. Variable Fixed Net operating income $ 600,000

320,000 280,000

Income Comparison of 11 Absorption and Variable Costing

Harvey Co. had no beginning inventory, produced 25,000 units and sold 20,000 units this year.
Absorption Costing
Sales (20,000 $30) 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 Gross profit Less selling & admin. exp. Variable (20,000 $3) $ 60,000 Fixed 100,000 Net operating income $ 600,000

320,000 280,000

160,000 $ 120,000

Income Comparison of 12 Absorption and Variable Costing

Now lets look at variable costing by Harvey Co.
Sales (20,000 $30) Less variable expenses: Beginning inventory $ Add COGM (25,000 $10) 250,000 Goods available for sale 250,000 Less ending inventory (5,000 $10) 50,000 Variable cost of goods sold 200,000 Variable selling & administrative expenses (20,000 $3) 60,000 Contribution margin Less fixed expenses: Manufacturing overhead $ 150,000 Selling & administrative expenses 100,000 Net operating income

Variable costs only.

Variable Costing
$ 600,000

All fixed manufacturing overhead is expensed.

260,000 340,000

250,000 $ 90,000

Quick Check
The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 cost under absorption costing?

13

a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasnt a real cost, so nothing is really missing.

Quick Check
The net operating income under absorption costing was $120,000 and under variable costing it was $90,000 because of higher expenses. Where is the missing $30,000 cost under absorption costing?

14

a. It has disappeared into an accounting black hole. b. It is in ending inventories. c. It represents taxes that have been saved. d. The $30,000 wasnt a real cost, so nothing is really missing.

Income Comparison of 15 Absorption and Variable Costing

Lets compare the methods.

Reconciliation

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We can reconcile the difference between absorption and variable income as follows:
Variable costing net operating income Add: Fixed mfg. overhead costs deferred in the inventory of FG (5,000 units $6 per unit) Absorption costing net operating income
Fixed mfg. overhead Units produced $150,000 25,000 units

90,000

30,000 $ 120,000

= $6.00 per unit

Summary

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COST VOLUME PROFIT (CVP) ANALYSIS

18

Shows how alternate actions can affect profit. Focuses on the relationships between cost, volume and profit. It enables us to: (1) determine the break-even level of production, and (2) predict how changes in the level of production, selling price or costs will affect profit

The Basics of Cost-VolumeProfit Analysis

WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (500 bikes) $ 250,000 $ 500 Less: variable expenses 150,000 300 Contribution margin 100,000 $ 200 Less: fixed expenses 80,000 Profit BT $ 20,000

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Contribution Margin (CM) is the amount remaining from sales revenue after all variable expenses have been deducted.

The Basics of Cost-VolumeProfit Analysis

WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (500 bikes) $ 250,000 $ 500 Less: variable expenses 150,000 300 Contribution margin 100,000 $ 200 Less: fixed expenses 80,000 Profit BT $ 20,000

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CM goes to cover fixed expenses.

The Basics of Cost-VolumeProfit Analysis

WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (500 bikes) $ 250,000 $ 500 Less: variable expenses 150,000 300 Contribution margin 100,000 $ 200 Less: fixed expenses 80,000 Profit BT $ 20,000

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After covering fixed costs, any remaining CM contributes to profit.

The Contribution Approach

For each additional unit Wind sells, $200 more in contribution margin will help to cover fixed expenses and profit.
Total Sales (500 bikes) $ 250,000 Less: variable expenses 150,000 Contribution margin $ 100,000 Less: fixed expenses 80,000 Profit BT $ 20,000 Per Unit $ 500 300 $ 200

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Perce 10 6 4

The Contribution Approach

Each month Wind must generate at least $80,000 in total CM to break even.
Total Sales (500 bikes) $ 250,000 Less: variable expenses 150,000 Contribution margin $ 100,000 Less: fixed expenses 80,000 Profit BT $ 20,000 Per Unit $ 500 300 $ 200

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Percen 100 60 40

The Contribution Approach

If Wind sells 400 units in a month, it will be operating at the break-even point.
WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (400 bikes) $ 200,000 $ 500 Less: variable expenses 120,000 300 Contribution margin 80,000 $ 200 Less: fixed expenses 80,000 Profit BT $ 0

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The Contribution Approach

25

If Wind sells one more bike (401 bikes), net operating income will increase by $200.
WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (401 bikes) $ 200,500 $ 500 Less: variable expenses 120,300 300 Contribution margin 80,200 $ 200 Less: fixed expenses 80,000 Profit BT $ 200

CVP Relationships in Graphic Form

26

Viewing CVP relationships in a graph is often helpful. Consider the following information for Wind Co.:
Income 300 units Sales $ 150,000 Less: variable expenses 90,000 Contribution margin $ 60,000 Less: fixed expenses 80,000 Profit BT $ (20,000) Income 400 units $ 200,000 120,000 $ 80,000 80,000 $ Income 500 units $ 250,000 150,000 $ 100,000 80,000 $ 20,000

CVP Graph
450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 100 200 300 400 500 600 700 800

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Total Revenue

Total Cost
Total Fixed Cost

Units

CVP Graph
450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 100 200 300 400 500 600 700 800

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Break-even point

Units

Contribution Margin Ratio

The contribution margin ratio is:
CM Ratio =
Total CM Total sales revenue

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For Wind Bicycle Co. the ratio (using numbers at the B.E. point) is:
$ 80,000 $200,000 = 40%

Contribution Margin Ratio

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Or, in terms of units, the contribution margin ratio is:

Unit CM CM Ratio = Unit selling price

For Wind Bicycle Co. the ratio is:

$200 = 40% $500

Contribution Margin Ratio

At Wind, each $1.00 increase in sales revenue results in a total contribution margin increase of 40.

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If sales increase by $50,000, what will be the increase in total contribution margin?

Contribution Margin Ratio

400 Bikes Sales $ 200,000 Less: variable expenses 120,000 Contribution margin 80,000 Less: fixed expenses 80,000 Profit BT $ -

32

500 Bikes $ 250,000 150,000 100,000 80,000 $ 20,000

A $50,000 increase in sales revenue

Contribution Margin Ratio

400 Bikes Sales $ 200,000 Less: variable expenses 120,000 Contribution margin 80,000 Less: fixed expenses 80,000 Profit BT $ -

33

500 Bikes $ 250,000 150,000 100,000 80,000 $ 20,000

A $50,000 increase in sales revenue results in a $20,000 increase in CM. ($50,000 40% = $20,000)

Quick Check

34

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the CM Ratio for Coffee Klatch? a. 1.319 b. 0.758 c. 0.242 d. 4.139

Quick Check

35

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is Unit contribution margin the CM Ratio for Coffee CM Ratio =Klatch? Unit selling price a. 1.319 ($1.49-$0.36) = b. 0.758 $1.49 c. 0.242 $1.13 = = 0.758 $1.49 d. 4.139

Changes in Fixed Costs and Sales Volume

36

Wind is currently selling 500 bikes per month. The companys sales manager believes that an increase of $10,000 in the monthly advertising budget would increase bike sales to 540 units.
Should we authorize the requested increase in the advertising budget?

Changes in Fixed Costs and Sales Volume

$80,000 + $10,000 advertising = $90,000
Current Sales (500 bikes) Sales $ 250,000 Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Profit BT $ 20,000

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Projected Sales (540 bikes) $ 270,000 162,000 108,000 90,000 $ 18,000

Sales increased by $20,000, but profit before tax decreased by $2,000.

Changes in Fixed Costs and Sales Volume

The Shortcut Solution
Increase in CM (40 units X $200) Increase in advertising expenses Decrease in profit before tax $ $

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8,000 10,000 (2,000)

Break-Even Analysis
Break-even analysis can be approached in three ways:
1. Graphical analysis. 2. Equation method. 3. Contribution margin method.

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Equation Method
OR

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Profit = Sales (Variable expenses + Fixed expenses)

Sales = Variable expenses + Fixed expenses + Profit

At the break-even point profit equals zero.

Break-Even Analysis

41

Here is the information from Wind Bicycle Co.

Total Sales (500 bikes) $ 250,000 Less: variable expenses 150,000 Contribution margin $ 100,000 Less: fixed expenses 80,000 Profit BT $ 20,000 Per Unit $ 500 300 $ 200 Percent 100% 60% 40%

Equation Method

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We calculate the break-even point as follows:

Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0

Where: Q = Number of bikes sold $500 = Unit selling price $300 = Unit variable expense $80,000 = Total fixed expense

Equation Method

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We calculate the break-even point as follows:

Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = $80,000 $200 per bike Q = 400 bikes
This is the break-even point in terms of units sold.

Equation Method

44

We can also use the following equation to compute the break-even point in sales dollars.
Sales $ = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0
Where: X = Total sales dollars 0.60 = Variable expenses as a % of sales* $80,000 = Total fixed expenses

*variable cost ratio (0.60)

Equation Method

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We can also use the following equation to compute the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $80,000 0.40 X = $200,000

Contribution Margin Method

The contribution margin method is a variation of the equation method.
Break-even point = in units sold Break-even point in total sales dollars = Fixed expenses Unit contribution margin

46

Fixed expenses CM ratio

Quick Check

47

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in units? a. 872 cups b. 3,611 cups c. 1,200 cups d. 1,150 cups

Quick Check

48

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average Fixed expenses Break-even = variable expense per cup is $0.36. Themargin average Unit contribution fixed expense per month is $1,300. 2,100 cups $1,300 are sold each month = on average. What is $1.49 per cup - $0.36 per cup the break-even sales in units? $1,300 = a. 872 cups $1.13 per cup b. 3,611 cups = 1,150 cups c. 1,200 cups d. 1,150 cups

Quick Check

49

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in dollars? a. $1,300 b. $1,715 c. $1,788 d. $3,129

Quick Check

50

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the break-even sales in dollars? Fixed expenses a. $1,300 Break-even sales = CM Ratio $1,300 b. $1,715 = 0.758 c. $1,788 = $1,715 d. $3,129

Target Profit Analysis

51

Suppose Wind Co. wants to know how many bikes must be sold to earn a profit of $100,000 before tax.

We can use our CVP formula to determine the sales volume needed to achieve a target profit figure.

The CVP Equation

52

Sales $ = Variable expenses + Fixed expenses + Profit BT $500Q = $300Q + $80,000 + $100,000 $200Q = $180,000 Q = 900 bikes

The Contribution Margin Approach

53

We can determine the number of bikes that must be sold to earn a profit of $100,000 using the contribution margin approach.
Unit sales to attain = the target profit Fixed expenses + Target profit BT Unit contribution margin

$80,000 + $100,000 $200 per bike

= 900 bikes

Quick Check

54

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. How many cups of coffee would have to be sold to attain a target profit of $2,500 per month? a. 3,363 cups b. 2,212 cups c. 1,150 cups d. 4,200 cups

Quick Check

55

Fixed expenses + Target profit Unit sales to = Unit contribution margin attain target profit Coffee Klatch is an espresso stand in a $1,300 + average $2,500 selling downtown office building. The = $1.49 - $0.36

price of a cup of coffee is $1.49 and the average $3,800 variable expense per = cup is $0.36. The average $1.13 fixed expense per month is $1,300. How many cups of coffee=would have to be sold to 3,363 cups attain target profits of $2,500 per month? a. 3,363 cups b. 2,212 cups c. 1,150 cups d. 4,200 cups

Effect of income tax

Tax is paid on profit The CVP formulae use profit before tax Need to convert a target dollar profit after tax into the before tax amount by dividing it by 1 the tax rate

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Effect of income tax

Sales volume required to earn a target after - tax profit target net profit after tax Fixed expenses + (1- t) = Unit contributi on margin

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Effect of income tax

We can determine the number of bikes that must be sold to earn an after tax profit of $90,000 when the tax rate is 40%.
Units sold to attain = the target profit $80,000 + $200 $90,000 (1- 0.40)

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$80,000 + $150,000 $200

= 1150 bikes

Changes in CVP variables

59

Changes in fixed costs When fixed costs change, the break-even point will change. A given percentage change in TFC will lead to the same percentage change in the break-even point (in units or dollars).

If TFC falls by $150 and the CM ratio is 0.4:

profit will increase by the same amount as the change in TFC i.e. by $150. however break-even sales revenue will fall by 150 / 0.4 i.e. by $375

Changes in CVP variables

60

Different fixed costs may apply to different levels of sales volume can have more than one break-even point. TR
TC

Changes in CVP variables

61

Changes in the unit contribution margin A change in VC/unit will change the CM/unit and produce a new break-even point. An increase in the VC/unit will reduce the CM/unit and produce a higher break-even point. An increase in the selling price per unit will increase the CM/unit and lower the breakeven point.

Operating Leverage

62

- a measure of how sensitive profit is to percentage changes in sales. With high leverage, a small percentage increase in sales can produce a much larger percentage increase in profit before tax LS uses term operating leverage factor
Degree of operating leverage =
Total Contribution margin Profit before tax

Operating Leverage
Actual sales 500 Bikes Sales $ 250,000 Less: variable expenses 150,000 Contribution margin 100,000 Less: fixed expenses 80,000 Profit BT $ 20,000

63

DOL =

$100,000 $ 20,000

= 5

Operating Leverage
Actual sales (500) Sales $ 250,000 Less variable expenses 150,000 Contribution margin 100,000 Less fixed expenses 80,000 Profit BT $ 20,000

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Increased sales (550) $ 275,000 165,000 110,000 80,000 $ 30,000

10% increase in sales from $250,000 to $275,000 . . . . . . results in a 50% increase in profit - from $20,000 to $30,000.

Quick Check

66

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the operating leverage? a. 2.21 b. 0.45 c. 0.34 d. 2.92

Quick Check

67

Actual Coffee Klatch is an espresso stand in a sales 2,100 cups downtown office building. The average selling Sales $ average 3,129 price of a cup of coffee is $1.49 and the Less: Variable expenses 756 variable expense per cup is $0.36. The average Contribution margin 2,373 fixed expense per month is $1,300. 2,100 cups Less: Fixed expenses 1,300 are sold each month on average. What is Profit BT $ 1,073 the operating leverage? a. 2.21 Operating Contribution margin = leverage Profit BT b. 0.45 $2,373 c. 0.34 = $1,073 = 2.21 d. 2.92

Quick Check

68

At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, and the average fixed expense per month is $1,300. 2,100 cups are sold each month on average. If sales increase by 20%, by how much should profit before tax increase? a. 30.0% b. 20.0% c. 22.1% d. 44.2%

Quick Check

69

At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, and the average fixed expense per month is $1,300. 2,100 cups are sold each month on average. If sales increase by 20%, by how much should net operating income increase? Percent increase in sales 20.0% a. 30.0% Degree of operating leverage 2.21 b. 20.0% Percent increase in profit 44.20% c. 22.1% d. 44.2%

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To verify the increase in profit:

Actual sales 2,100 cups Sales $ 3,129 Less: Variable expenses 756 Contribution margin 2,373 Less: Fixed expenses 1,300 Profit BT $ 1,073 % change in sales % change in profit before tax Increased sales 2,520 cups $ 3,755 907 2,848 1,300 $ 1,548 20.0% 44.2%

The Safety Margin

71

This is the excess of budgeted (or actual) sales over the break-even volume of sales i.e the amount by which sales can drop before losses begin to be incurred.
Safety margin = Total sales - Break-even sales
Lets calculate the safety margin for Wind Bicycles.

The Safety Margin

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Wind has a break-even point of $200,000. If actual sales are $250,000, the safety margin is $50,000 or 100 bikes.
Break-even sales 400 units Sales $ 200,000 Less: variable expenses 120,000 Contribution margin 80,000 Less: fixed expenses 80,000 Profit BT $ Actual sales 500 units $ 250,000 150,000 100,000 80,000 $ 20,000

The Safety Margin

The safety margin can be expressed as 20% of actual sales. ($50,000 $250,000)
Break-even sales 400 units Sales $ 200,000 Less: variable expenses 120,000 Contribution margin 80,000 Less: fixed expenses 80,000 Profit BT $ -

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Actual sales 500 units $ 250,000 150,000 100,000 80,000 $ 20,000

Quick Check

74

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the margin of safety? a. 3,250 cups b. 950 cups c. 1,150 cups d. 2,100 cups

Quick Check

75

Coffee of Klatch is espresso stand in a sales Margin safety =an Total sales Break-even downtown office building. The average selling = 2,100 cups 1,150 cups = 950is cups price of a cup of coffee $1.49 and the average variable expense per cup or is $0.36. The average fixed expense per month is $1,300. 2,100 cups 950 cups of safety are Margin sold each month on average. What is = 2,100 = 45% cups percentage the margin of safety? a. 3,250 cups b. 950 cups c. 1,150 cups d. 2,100 cups

The Concept of Sales Mix

76

Sales mix is the relative proportions in which a companys products are sold. Different products will have different selling prices, cost structures, and contribution margins. Lets assume Wind sells bikes and carts and see how we deal with break-even analysis (assume carts sell for $491)

Multi-product break-even analysis

Wind Bicycle Co. provides the following information:
Bikes (500) Carts (611) Total Sales $ 250,000 100% $ 300,000 100% $ 550,000 Var. exp. 150,000 60% 135,000 45% 285,000 Contrib. margin $ 100,000 40% $ 165,000 55% 265,000 Fixed exp. 170,000 Profit BT $ 95,000 Sales mix $ 250,000 45% $ 300,000 55% $ 550,000

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100.0% 51.8% 48.2%

100.0%

Weighted average CMR

$265,000 = 48.2% $550,000 (rounded)

Multi-product break-even analysis

B/E sales revenue =
Fixed expenses WACM Ratio $170,000 = 0.482 = $352,697
Bikes Carts Sales $ 158,714 100% $ 193,983 Var. exp. 95,228 60% 87,292 Contrib. margin $ 63,486 40% $ 106,691 Fixed exp. Profit BT Rounding error Sales mix $ 158,714 45% $ 193,983 100% 45% 55% Total $ 352,697 182,520 170,177 170,000 $ 177 $ 352,697

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100.0% 48.2%

55%

100.0%

Assumptions underlying CVP analysis

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The behaviour of total revenue is linear The behaviour of total costs is linear over a relevant range
costs can be categorised as fixed, variable or semivariable labour productivity, production technology and market conditions do not change there are no capacity changes during the period under consideration

Assumptions underlying CVP analysis

For both variable and fixed costs, sales volume is the only cost driver The sales mix remains constant over the relevant range In manufacturing firms, levels of inventory at the beginning and end of the period are the same i.e. sales in units = production in units

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Treating CVP analysis with caution

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CVP analysis is merely a simplified model The usefulness of CVP analysis may be greater in less complex smaller firms For larger firms, CVP analysis can be valuable as a decision tool for the planning stages of new projects and ventures

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END OF LECTURE 3