Cost Accounting

Traditions and Innovations

Barfield, Raiborn, Kinney

Absorption/Variable Costing and

Cost-Volume-Profit Analysis
 Learning Objectives (1 of 2)
• Explain the different approaches to cost
accumulation and cost presentation
• Contrast absorption and variable costing
• Describe how changes in sales and/or
production levels affect net income under
absorption and variable costing
• Explain how companies use cost-volume-
profit analysis
 Learning Objectives (2 of 2)
• Explain cost-volume-profit analysis for
single-product and multiproduct firms
• Describe how businesses use margin of
safety and operating leverage concepts
• List the underlying assumptions of cost-
volume-profit analysis
• (Appendix) Construct break-even charts and
profit-volume graphs
 Absorption Vs. Variable Costing
Absorption or Full Variable or Direct
• GAAP • Not GAAP
• Classify by Function • Classify by Behavior
– Cost of goods sold – Variable
– Selling expense – Fixed
– Administrative
expense
 Absorption Vs. Variable Costing
Absorption or Full Variable or Direct
• Product costs • Product costs
– Direct material – Direct material
– Direct labor – Direct labor
– Variable mfg. overhead – Variable mfg. overhead
– Fixed mfg. overhead • Period Costs
• Period costs – Fixed mfg. overhead
– Selling – Selling
– General – General
– Administrative – Administrative
 Income Statement
Absorption Costing
Product Costs
Sales Direct Material
Direct Labor
Less: Cost of Goods Sold
Fixed and Variable
Gross Profit Mfg. Overhead
Less: Operating Expenses
Period Costs
Net Income
Selling, General,
Administrative
 Income Statement
Variable Costing
Direct Material
Sales
Direct Labor
Less: Variable Cost of Goods Sold Variable Mfg.
Product Contribution Margin Overhead
Less: Variable Operating Expenses
Contribution Margin Selling,
Selling
General,
General
Less: Fixed Mfg. Overhead
Administration
Administrative
Less: Fixed Operating Expenses
Net Income
 Difference in Income
Absorption Vs. Variable
• No change in inventory level
– Absorption Income = Variable Income
• Increase in inventory level
– Absorption Income > Variable Income
– Phantom Profits
• Decrease in inventory level
– Absorption Income < Variable Income
 Cost-Volume-Profit Analysis
• Relationship of • Applies to
– Revenue – Manufacturers
– Costs – Wholesalers
– Volume changes – Retailers
– Taxes – Service Industries
– Profits
 Cost-Volume-Profit Analysis
• Compute the break-even point
• Calculate the level of sales necessary to
achieve a target profit
• Set sales price
• Answer “what-if” questions
Cost-Volume-Profit Assumptions
• Company is operating within the relevant
range
• Revenue per unit remains constant
• Variable costs per unit remain constant
• Total fixed costs remain constant
• Mixed costs are separated into variable and
fixed elements
 Equations
• Break-even point
Total Revenues = Total Costs
Total Revenues - Total Costs = Zero Profit

• Contribution Margin (CM)

Sales Price - Variable Cost = CM per unit
Revenue - Total Variable Costs = CM in total
 Break-Even Formula - Units

Total Fixed Costs

Sales Price (per unit) - Variable Cost (per unit)
Contribution
$100,000 Margin

12 - 4 = 12,500 units

If fixed costs are $100,000, unit sales price is $12, and

unit variable cost is $4, the break-even point is 12,500 units
 Break-Even Formula - Dollars
Total Fixed Costs
Sales Price (per unit) - Variable Cost (per unit)
Sales Price (per unit)
$100,000 Contribution
Margin
12 - 4 = $150,000 Ratio
12
If fixed costs are $100,000, unit sales price is $12, and
unit variable cost is $4, the break-even point is $150,000
 Income Statement Proof
Sales $ 150,000 (12,500 * 12)
Less Total variable costs (50,000) (12,500 * 4)
Contribution Margin $ 100,000
Less Total fixed costs (100,000)
Profit before taxes -0-

If fixed costs are $100,000, unit sales price is $12, and

unit variable cost is $4, the break-even point is 12,500 units
 Using Cost-Volume-Profit Analysis
• Setting a target profit
– Enter before-tax profit in numerator

$100,000 + $30,000
12 - 4 = $195,000
12
If fixed costs are $100,000, unit sales price is $12,
unit variable cost is $4, and the desired before-tax
profit is $30,000, the required sales are $195,000
Using Cost-Volume-Profit Analysis
• Setting a target profit
– Convert after-tax profit to before-tax profit

Before-tax profit = After-tax profit

1 - tax rate

$36,000
$60,000 = 1 - 40%
At a 40% tax rate, an after-tax profit of $36,000
equals a before-tax profit of $60,000
 Using Cost-Volume-Profit Analysis
• Setting a target profit
– Convert after-tax profit to before-tax profit
– Enter before-tax profit in numerator

$100,000 + $60,000
12 - 4 = $240,000
12
If fixed costs are $100,000, unit sales price is $12,
unit variable cost is $4, and the desired after-tax
profit is $36,000, the required sales are $240,000
 Income Statement Proof
Sales $ 240,000 (20,000 * 12)
Less Total variable costs (80,000) (20,000 * 4)
Contribution Margin $ 160,000
Less Total fixed costs (100,000)
Profit before taxes $ 60,000
Income taxes (24,000) (60,000 * 40%)
Profit after taxes $ 36,000
If fixed costs are $100,000, unit sales price is $12,
unit variable cost is $4, and the desired after-tax
profit is $36,000, the required sales are $240,000
 Using Cost-Volume-Profit Analysis
• Variable profit related to number of units sold
Variable Amount
of Profit Before
• X = FC / (CMu - PuBT)
Tax per Unit

Total Contribution
Sales
Fixed Margin
Volume
Cost Ratio
 Incremental Analysis
• Changes in revenues, costs, and/or volume
• Break-even point increases when
– fixed costs increase
– sales price decreases
– variable costs increases
 Multiproduct
Cost-Volume-Profit Analysis
• Assumes a constant product sales mix
• Contribution margin is weighted on the
quantities of each product included in the
“bag” of products
• Contribution margin of the product making
up the largest proportion of the bag has the
greatest impact on the average contribution
margin of the product mix
 Multiproduct
Cost-Volume-Profit Analysis

Sales mix 3 2
Contribution
$2 $1
margin per unit

FC = $8,000
“The Bag”
Three units of spray for every two units of liquid
 Multiproduct
Cost-Volume-Profit Analysis

Sales mix 3 2

Contribution
$2 $1
margin per unit
Breakeven
$8000
3($2) + 2($1) = 1,000 “bags”
 Multiproduct
Cost-Volume-Profit Analysis

Sales mix 3 2

Breakeven “bag” x 1,000 x 1,000

Breakeven units 3,000 2,000
To break even
sell 3,000 sprays and 2,000 liquids
 Margin of Safety
• Budgeted (or actual) sales after the break-even
point
• Indication of risk
 Margin of Safety
• Units
Actual units - break-even units
• Dollars
Actual sales dollars - break-even sales dollars
• Percentage
Margin of Safety in units or dollars
Break-even units or sales in dollars
 Operating Leverage
• Relationship of variable and fixed costs
• Effect on profits when volume changes
• Cost structure strongly influences the
impact changes in volume have on profits
 Operating Leverage
High Operating Leverage Low Operating Leverage
• Low variable costs • High variable costs
• High fixed costs • Low fixed costs
• High contribution margin • Low contribution margin
• High break-even point • Low break-even point
• Sales after break-even • Sales after break-even
have greater impact on have lesser impact on
profits profits
 Degree of Operating Leverage
• Measures how a percentage change in sales
will affect profits
• Degree of Operating Leverage
Contribution Margin
Profit Before Taxes
• When margin of safety is small, the degree
of operating leverage is large
Cost-Volume-Profit Assumptions
• Company is operating within the relevant
range
• Revenue and variable cost per unit are
constant
• Total contribution margin increases
proportionally with increases in unit sales
• Total fixed costs remain constant
• Mixed costs are separated into variable and
fixed elements
Cost-Volume-Profit Assumptions
• No change in inventory (production equals
sales)
• No change in capacity
• Sales mix remains constant
• Anticipated price level changes included in
formulas
• Labor productivity, production technology,
and market conditions remain constant
 Additional Considerations
• Are they fixed costs or long-term variable
costs?
• Quality improvements may violate
assumptions
– increase costs during implementation
– increase productivity
– decrease costs
– adjust sales price
 Traditional CVP Graph

Total
$ Fixed Costs

Activity Level
 Traditional CVP Graph

Total Costs
Total
$ Fixed Costs

Activity Level
 Traditional CVP Graph

Total Costs
Total
Variable Costs
$

Activity Level
 Traditional CVP Graph
Total Revenues

Total Costs
Total
$

Activity Level
 Traditional CVP Graph
Total Revenues

BEP Total Costs

Total
$
Profit
Loss Activity Level
 Contemporary CVP Graph

Total
$ Variable Costs

Activity Level
 Contemporary CVP Graph
Total Revenues

Contribution Margin
Total
$ Variable Costs

Activity Level
 Contemporary CVP Graph
Total Revenues
Total Costs
Total Variable Costs
Total
$

Activity Level
 Contemporary CVP Graph
Total Revenues
BEP Total Costs
Total Variable Costs
Total
$

Activity Level
Profit-Volume Graph
$

Activity Level
 Profit-Volume Graph
$

Activity Level
Fixed Costs
 Profit-Volume Graph
$

BEP
Activity Level
Fixed Costs
 Profit-Volume Graph
$

BEP
Activity Level
Fixed Costs
 Questions
• What is the difference between absorption
and variable costing?
• How do companies use cost-volume-profit
analysis?
• What are the underlying assumptions of
cost-volume-profit analysis?