Chapter 5

Front 1

Define Chapter 5 Concepts

Back 1

Cost behavior analysis -
variable costs -
fixed costs -
Relevant range -
mixed costs -
identifying variable and fixed costs -

COST-VOLUME-PROFIT ANALYSIS -
basic components -
CVP income statement -
Break - even analysis -
target net income -
margin of safety -

Front 2

Cost behavior analysis

Back 2

The study of how specific costs respond to changes in the level of business activity.
- some cost change others remain the same
- helps management plan operations and decide between alternative courses of action.
- applies to all types of businesses and entities.
- starting point is measuring key business activities.
- many companies use more than one measurement base.
- activity levels may be expressed in terms of
sales dollars in a retail company
miles driven in a trucking company
room occupancy in a hotel
dance classes taught by a dance studio
- changes in the level or volume of activity should be correlated with changes in cost
activity level selected is called activity or volume index
activity index - identifies the activity that causes changes in the behavior of costs
- allows costs to be classified as variable fixed or mixed.

Front 3

Variable costs

Back 3

Cost that vary in total directly and proportionately to changes in the activity level
ex - activity level +10% = total variable cost + 10 %
Variable costs remain the same per unit at every level of activity.

Front 4

Fixed costs

Back 4

Cost that remain the same in total regardless of changes in the activity level.
per unit cost varies inversely with activity ; as volume increases unit cost declines and vice versa
Ex
- property taxes, insurance, rent, depreciation on building and equipment.

Front 5

Relevant range

Back 5

Range of activity over which a company expects to operate during a year
Although the linear straight line relationship may not be completely realistic the linear assumption produces useful data for CVP analysis as long as the level activity remains within the relevant range.
In most business situations a straight-line relationship does not exist for variable or fixed costs throughout the entire range of possible activity abnormally low levels activity it may be impossible to be cost efficient as a result in the real world the relationship between the behavior of a variable cost and changes in the activity level is often curvilinear . in curved sections of the line a change in the activity index will not result in a direct proportional change in the variable cost.

Front 6

Mixed costs

Back 6

Cost to have both a variable cost element and a fixed cost element
change in total but not proportionately with changes in activity level
For purposes of CVP analysis mixed costs must be classified into their fixed and variable elements
one method of doing so is called the high - low method
other methods include the scatter diagram method and least-squares regression analysis

Front 7

High-low method

Back 7

Step 1 Change in total costs / high - low activity level = variable cost per unit
Step 2 fixed cost = total cost @ high/low activity level - Total variable cost
Cost to produce units(x) = (variable cost per unit x units(y)) + fixed costs

Mixed costs must be classified into their fixed and variable elements
uses the total costs incurred at both the high and low levels of activity to classify mixed costs
the difference in cost between the high and low levels represents variable costs since only variable cost change as activity level changes

Front 8

Cost-volume-profit analysis

Back 8

The study of the effects of changes of costs and volume on a company's profits
- important in profit planning
- critical factor in management decisions as
setting selling prices, determining product mix, and maximizing use of production facilities.
Basic components include
- activity level
- unit selling prices
- variable cost per unit
- total fixed cost
- sales mix

Front 9

Cost-volume-profit income statement

Back 9

- a statement for internal use.
- classifies costs and expenses as fixed or variable. enter - reports contribution margin in the body of the statement.
- contribution margin - amount of revenue remaining after deducting variable costs, reports the same net income as traditional income statement.

Front 10

Contribution margin per unit

Back 10

Contribution margin per unit = unit selling price - unit variable costs
Contribution margin is available to cover fixed costs and to contribute to income

Front 11

Contribution margin ratio

Back 11

Contribution margin ratio = contribution margin per unit / unit selling price
Shows the percentage of each sales dollar available to apply towards fixed costs and profit.

Front 12

Break - even analysis

Back 12

Process of finding the break-even point level of activity at which total revenues equal total costs

Expressed either in sales units or in sales dollars

- can be computed or derived from a mathematical equation, by contribution margin, or from a cost volume profit graph.

Math method
Sales = variable costs + fixed costs + net income(break even occurs @$0 net income)

contribution margin method
Break even point In units = fixed costs / contribution margin per unit
Break even point in dollars = fixed costs / contribution margin ratio

graphic presentation method
Cost volume profit graph(break even graph) - includes costs, volume, and profits.

Front 13

Target net income

Back 13

Target net income = required sales - variable costs - fixed costs
Contribution margin method
Required sales in units = fixed costs + target net income / contribution margin per unit
Required sales in dollars = fixed cost + target net income / contribution margin ratio

Level of sales necessary to achieve a specified income.
Expressed either in sales units or in sales dollars
Can be determined for each of the approaches used to determine break even sales / units
math equation, contribution margin, CVP graph

Front 14

Margin of safety

Back 14

Margin of safety in dollars = annual (expected) sales - break-even sales
Margin of safety ratio = margin of safety in dollars / annual expected sales
Difference between actual or expected sales and sales at the break-even point.
Measures the cushion that management has if expected sales fail to materialize.
May be expressed in dollars or as a ratio
The higher the dollars or percentage the greater the margin of safety.