Change in Sale, variable cost and Fixed Cost

A change in demand affects your sales and impacts your variable costs. As your sales grow, your
variable costs increase. As your sales fall, your variable costs decrease. If you raise or lower your
sales price, the new selling price must be enough to cover your variable costs and fixed costs in
order to break even.

Break even analysis

It is defined as:

“In sales when total revenue is equal to total expense. No loss or gain in your business”

Or
“It is the level of sales at which profit is zero”

It is also known as:

 Critical point
 Balancing point
 Equilibrium point
For example
Rs.1000 is cost of production and Rs.1000 is cost of sale. Here two questions arise:
1. Is there any profit? No
2. Is there any loss? No
So, this is breakeven point
Formula

The Equation Method

The equation method translates the contribution format income statement illustrated earlier in the
chapter into equation form as follows:

Profits = ( Sales - Variable expenses ) - Fixed expenses

The Contribution Margin Method

The contribution margin method is a shortcut version of the equation method already described.
The approach centers on the idea discussed earlier that each unit sold provides a certain amount
of contribution margin that goes toward covering fixed costs. To find how many units must be
sold to break even, divide the total fixed expenses by the unit contribution margin:

Break - even point in units sold = Fixed expenses / Unit contribution margin
Benefits

1. Helps in finding missing expenses

2. Limiting decisions based on emotions
3. Helps in setting goals
4. Helps in securing funds
5. Helps in pricing appropriately
Variable costing

A costing method that includes only variable manufacturing costs—direct materials, direct labor,
and variable manufacturing overhead—in unit product costs

OR

Variable costing is a methodology that only assigns variable costs to inventory. This
approach means that all overhead costs are charged to expense in the period incurred, while
direct materials and variable overhead costs are assigned to inventory.

Variable costing formula = (Direct Labor Cost + Direct Raw Material Cost + Variable
Manufacturing Overhead) / Number of Units Produced.

 Net operating income is not affected by changes in production under variable costing.

Importance of Variable Costing

 Variable costing is an essential component of management decision-making exercises.

 These costs are more relevant and require direct involvement from management, as fixed
costs have already been incurred and are irreversible.
 It allows for meaningful comparisons of profitability between different units within a
business, as it focuses on variable cost factors and helps overcome problems related to
the allocation of fixed costs, which can be difficult to bifurcate at times.

Features of Variable Costing

 It is easy to compute, as all variable costs are easily identifiable.

 Variable costs can be attributed to units produced, and there is a linear relationship
between the increase in production and variable cost.
 It provides management with information on cost behavior and its impacts on
profitability.
 All costs are bifurcated into fixed and variable, and only variable costs are accounted for.
Margin of safety
The excess of budgeted (or actual) dollar sales over the break-even volume of dollar sales. It is the
amount by which sales can drop before losses are incurred. The higher the margin of safety, the lower the
risk of not breaking even and incurring a loss. The formula for its calculation is:

Margin of safety = Total budgeted ( or actual ) sales - Break even sales

The margin of safety can also be expressed in percentage form by dividing the margin of safety in dollars
by total dollar sales:

Margin of safety percentage = Margin of safety in dollars / Total budgeted (or actual) sales in dollars

How to improve the margin of safety

There are essentially only two ways to improve the margin of safety. The first is to reduce costs,
particularly fixed costs. The second is to increase revenue. Options for decreasing costs include:

 Purchasing infrastructure ‘as a service’ instead of buying it outright.

 Improving productivity to create more units for the same resources.
 Removing the products/services with the lowest profit margins.
 Updating your payment infrastructure.

Options for increasing revenue include:

 Increasing the sales price.

 Implementing a new pricing model.
 Expanding your marketing.
 Updating your payment infrastructure.

Activity-based costing (ABC)

It is a costing method that is designed to provide managers with cost information for strategic
and other decisions that potentially affect capacity and therefore “fixed” as well as variable costs.
Activity-based costing is ordinarily used as a supplement to, rather than as a replacement for, a
company’s usual costing system.

Most organizations that use activity-based costing have two costing systems:

1) the official costing system that is used for preparing external financial reports

2) the activity-based costing system that is used for internal decision making and for managing
activities.
The ABC calculation is as follows:

1. Identify all the activities required to create the product.

2. Divide the activities into cost pools, which includes all the individual costs related to an
activity—such as manufacturing. Calculate the total overhead of each cost pool.
3. Assign each cost pool activity cost drivers, such as hours or units.
4. Calculate the cost driver rate by dividing the total overhead in each cost pool by the total
cost drivers.
5. Divide the total overhead of each cost pool by the total cost drivers to get the cost driver
rate.
6. Multiply the cost driver rate by the number of cost drivers

Activity-based management (ABM)

A management approach that focuses on managing activities as a way of eliminating waste and
reducing delays and defects

Benefits of Activity-Based Costing (ABC)

Activity-based costing (ABC) enhances the costing process in three ways.

1) First, it expands the number of cost pools that can be used to assemble overhead costs.
Instead of accumulating all costs in one company-wide pool, it pools costs by activity.
2) Second, it creates new bases for assigning overhead costs to items such that costs are
allocated based on the activities that generate costs instead of on volume measures, such
as machine hours or direct labor costs.
3) Finally, ABC alters the nature of several indirect costs, making costs previously
considered indirect—such as depreciation, utilities, or salaries—traceable to certain
activities.
Questions
EXERCISE 5-1

Fixed and Variable Cost Behavior [ LO1 ] Koffee Express operates a number of espresso coffee stands in
busy suburban malls. The fixed weekly expense of a coffee stand is $1,100 and the variable cost per cup
of coffee served is $0.26. Required: 1. Fill in the following table with your estimates of total costs and
cost per cup of coffee at the indicated levels of activity for a coffee stand. Round off the cost of a cup of
coffee to the nearest tenth of a cent.

2. Does the cost per cup of coffee served increase, decrease, or remain the same as the number of cups
of coffee served in a week increases? Explain.

EXERCISE 5-6

Cost Behavior; Contribution Format Income Statement [ LO1 , LO4 ] Parker Company manufactures and
sells a single product. A partially completed schedule of the company’s total and per unit costs over a
relevant range of 60,000 to 100,000 units produced and sold each year is given below:
Required: 1. Complete the schedule of the company’s total and unit costs above. 2. Assume that the
company produces and sells 90,000 units during the year at the selling price of $7.50 per unit. Prepare a
contribution format income statement for the year.
EXERCISE 6-4

Changes in Variable Costs, Fixed Costs, Selling Price, and Volume [ LO4 ] Data for Herron Corporation
are shown below:

Fixed expenses are $75,000 per month and the company is selling 3,000 units per month.

Required:

1. The marketing manager argues that an $8,000 increase in the monthly advertising budget would
increase monthly sales by $15,000. Should the advertising budget be increased?

2. Refer to the original data. Management is considering using higher-quality components that would
increase the variable cost by $3 per unit. The marketing manager believes the higher-quality product
would increase sales by 15% per month. Should the higher-quality components be used?
EXERCISE 6-5

Compute the Break-Even Point [ LO5 ] Maxson Products distributes a single product, a woven basket
whose selling price is $8 and whose variable cost is $6 per unit. The company’s monthly fi xed expense is
$5,500.

Required:
1. Solve for the company’s break-even point in unit sales using the equation method.
2. Solve for the company’s break-even point in sales dollars using the equation method and the CM
ratio.
3. Solve for the company’s break-even point in unit sales using the contribution margin method.
4. Solve for the company’s break-even point in sales dollars using the contribution margin method and
the CM ratio
EXERCISE 6-7

Compute the Margin of Safety [ LO7 ] Mohan Corporation is a distributor of a sun umbrella used at
resort hotels. Data concerning the next month’s budget appear below:

Required:

1. Compute the company’s margin of safety.

2. Compute the company’s margin of safety as a percentage of its sale

EXERCISE 6-9

Compute the Break-Even Point for a Multiproduct Company [ LO9 ] Lucky Products markets two
computer games: Predator and Runway. A contribution format income statement for a recent month for
the two games appears below:

Required:

1. Compute the overall contribution margin (CM) ratio for the company.

2. Compute the overall break-even point for the company in sales dollars.

3. Verify the overall break-even point for the company by constructing a contribution format income
statement showing the appropriate levels of sales for the two products
EXERCISE 6-10

Break-Even Analysis; Target Profi t; Margin of Safety; CM Ratio [ LO1 , LO3 , LO5 , LO6 , LO7 ] Pringle
Company distributes a single product. The company’s sales and expenses for a recent month follow
Required:

1. What is the monthly break-even point in units sold and in sales dollars?
2. 2. Without resorting to computations, what is the total contribution margin at the
break-even point?
3. 3. How many units would have to be sold each month to earn a target profi t of
$18,000? Use the contribution margin method. Verify your answer by preparing a
contribution format income statement at the target level of sales.
4. 4. Refer to the original data. Compute the company’s margin of safety in both dollar and
percentage terms.
5. 5. What is the company’s CM ratio? If monthly sales increase by $80,000 and there is no
change in fixed expenses, by how much would you expect monthly net operating
income to increase?
EXERCISE 6-11

Break-Even Analysis and CVP Graphing [ LO2 , LO4 , LO5 ] Chi Omega Sorority is planning its annual
Riverboat Extravaganza. The Extravaganza committee has assembled the following expected costs for
the event:

The committee members would like to charge $30 per person for the evening’s activities.

Required:

1. Compute the break-even point for the Extravaganza (in terms of the number of persons that must
attend).

2. Assume that only 250 persons attended the Extravaganza last year. If the same number attend this
year, what price per ticket must be charged to break even?
3. Refer to the original data ($30 ticket price per person). Prepare a CVP graph for the Extravaganza from
zero tickets up to 600 tickets sold.
EXERCISE 6-14

Break-Even and Target Profi t Analysis [ LO3 , LO4 , LO5 , LO6 ] Super Sales Company is the exclusive
distributor for a revolutionary bookbag. The product sells for $60 per unit and has a CM ratio of 40%.
The company’s fi xed expenses are $360,000 per year.

Required:

1. What are the variable expenses per unit?

2. Using the equation method:

a. What is the break-even point in units and in sales dollars?

b. What sales level in units and in sales dollars is required to earn an annual profi t of $90,000?

c. Assume that through negotiation with the manufacturer the Super Sales Company is able to reduce its
variable expenses by $3 per unit. What is the company’s new break-even point in units and in sales
dollars?

3. Repeat (2) above using the contribution margin method.

EXERCISE 7-4

Evaluating Absorption and Variable Costing as Alternative Costing Methods [ LO4 ] The questions below
pertain to two different scenarios involving a manufacturing company. In each scenario, the cost
structure of the company is constant from year to year. Selling prices, unit variable costs, and total fi xed
costs are the same in every year. However, unit sales and/or unit production levels may vary from year
to year.

Required:

1. Consider the following data for scenario A:

a. Were unit sales constant from year to year? Explain.

b. What was the relation between unit sales and unit production levels in each year? For each year,
indicate whether inventories grew or shrank.
2. Consider the following data for scenario B: Y

a. Were unit sales constant from year to year? Explain.

b. What was the relation between unit sales and unit production levels in each year? For each year,
indicate whether inventories grew or shrank.
3. Given the patterns of net operating income in scenarios A and B above, which costing method,
variable costing or absorption costing, do you believe provides a better refl ection of economic
reality? Explain.
PROBLEM 7-13
 Absorption and Variable Costing; Production Constant, Sales Fluctuate [ LO1 , LO2 , LO3 , LO4 ] Sandi
Scott obtained a patent on a small electronic device and organized Scott Products, Inc., to produce
and sell the device. During the fi rst month of operations, the device was very well received on the
market, so Ms. Scott looked forward to a healthy profi t. For this reason, she was surprised to see a
loss for the month on her income statement. This statement was prepared by her accounting
service, which takes great pride in providing its clients with timely fi nancial data. The statement
follows:

Ms. Scott is discouraged over the loss shown for the month, particularly since she had planned to use
the statement to encourage investors to purchase stock in the new company. A friend, who is a CPA,
insists that the company should be using absorption costing rather than variable costing. He argues that
if absorption costing had been used, the company would probably have reported a profi t for the month.
Selected cost data relating to the product and to the fi rst month of operations follow:

Required:

1. Complete the following:

a. Compute the unit product cost under absorption costing.
b. Redo the company’s income statement for the month using absorption costing.
c. Reconcile the variable and absorption costing net operating income (loss) figures.
2. Was the CPA correct in suggesting that the company really earned a “profit” for the month? Explain.
3. During the second month of operations, the company again produced 50,000 units but sold 60,000
units. (Assume no change in total fixed costs.)
a. Prepare a contribution format income statement for the month using variable costing.
b. Prepare an income statement for the month using absorption costing.
c. Reconcile the variable costing and absorption costing net operating income figures.
EXERCISE 8-7 (Appendix 8B)

Activity-Based Costing Product Costs for External Reports [ LO7 ] Pryad Corporation makes ultra-
lightweight backpacking tents. Data concerning the company’s two product lines appear below:

The company has a traditional costing system in which manufacturing overhead is applied to units based
on direct labor-hours. Data concerning manufacturing overhead and direct labor-hours for the upcoming
year appear below:
Required: 1. Determine the unit product costs of the Deluxe and Standard products under the
company’s traditional costing system. 2. The company is considering replacing its traditional costing
system for determining unit product costs for external reports with an activity-based costing system.
The activity-based costing system would have the following three activity cost pools:

Determine the unit product costs of the Deluxe and Standard products under the activity-based costing
system.
EXERCISE 8-9

Computing ABC Product Costs [ LO3 , LO4 ] Performance Products Corporation makes two products,
titanium Rims and Posts. Data regarding the two products follow

Additional information about the company follows:

a. Rims require $17 in direct materials per unit, and Posts require $10.
b. The direct labor wage rate is $16 per hour.
C. Rims are more complex to manufacture than Posts, and they require special equipment.
D. The ABC system has the following activity cost pools

Required:

1. Compute the activity rate for each activity cost pool.

2. Determine the unit cost of each product according to the ABC system, including direct materials and
direct labor.