Chapter 7-8

Cost-VolumeProfit Analysis &

Inventory Costing

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Cost-Volume-Profit Analysis
CVP includes all fixed costs to compute
breakeven.
Variable costing and CVP are consistent as both
treat fixed costs as a lump sum.

Absorption costing defers fixed costs into

inventory.
Absorption costing is inconsistent with CVP
because absorption costing treats fixed costs on
a per unit basis.
8-2

The Break-Even Point

The break-even point is the point in the
volume of activity where the organizations
revenues and expenses are equal.
Sales
$ 250,000
Less: variable expenses 150,000
Contribution margin
100,000
Less: fixed expenses
100,000
Net income
$
-

7-3

Equation Approach
Sales revenue Variable expenses Fixed expenses = Profit

Unit
Sales
sales volume
price in units

Unit
Sales
variable volume
expense in units

($500 X)

($300 X)

$80,000 = $0

($200X) $80,000 = $0

X = 400 surf boards

7-4

Contribution-Margin Approach
Consider the following information
developed by the accountant at Curl, Inc.:
For each additional surf board sold,
Curl generates $200 in contribution
margin.

Sales (500 surf boards)

Less: variable expenses
Contribution margin
Less: fixed expenses
Net income

Total
$250,000
150,000
$100,000
80,000
$ 20,000

Per Unit
$
500
300
$
200

Percent
100%
60%
40%

7-5

Contribution-Margin Approach
Fixed expenses
Break-even point
=
Unit contribution margin
(in units)
Sales (500 surf boards)
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income

$80,000
$200

Total
$250,000
150,000
$100,000
80,000
$ 20,000

Per Unit
$
500
300
$
200

Percent
100%
60%
40%

= 400 surf boards

7-6

Contribution-Margin Approach
Here is the proof!

Sales (400 surf boards)

Less: variable expenses
Contribution margin
Less: fixed expenses
Net income

400 $500 = $200,000

Total
$200,000
120,000
$ 80,000
80,000
$
-

Per Unit
$
500
300
$
200

Percent
100%
60%
40%

400 $300 = $120,000

7-7

Contribution Margin Ratio

Calculate the break-even point in sales dollars
rather than units by using the contribution margin
ratio.

Contribution margin
Sales
Fixed expense
CM Ratio

= CM
Ratio

Break-even point
=
(in sales dollars)
7-8

Contribution Margin Ratio

Sales (400 surf boards)

Less: variable expenses
Contribution margin
Less: fixed expenses
Net income

$80,000
40%

Total
$200,000
120,000
$ 80,000
80,000
$
-

Per Unit
$
500
300
$
200

Percent
100%
60%
40%

$200,000 sales
7-9

Graphing Cost-Volume-Profit
Relationships
Viewing CVP relationships in a graph gives
managers a perspective that can be obtained in
no other way.
Consider the following information for Curl, Inc.:
300 units
Sales
$ 150,000
Less: variable expenses
90,000
Contribution margin
$ 60,000
Less: fixed expenses
80,000
Net income (loss)
$ (20,000)

400 units
$ 200,000
120,000
$ 80,000
80,000
$
-

500 units
$ 250,000
150,000
$ 100,000
80,000
$ 20,000
7-10

Cost-Volume-Profit Graph
450,000
400,000
350,000

Dollars

300,000

Break-even
point

250,000
200,000
150,000

Fixed expenses

100,000
50,000

100

200

300

400
Units

500

600

700

800

7-11

Profit-Volume Graph
Some managers like the profit-volume
graph because it focuses on profits and volume.
100,000
80,000
60,000

Break-even
point

Profit

40,000
20,000
0
(20,000)

`
100

200

300

400
Units

500

600

700

(40,000)
(60,000)

7-12

Target Net Profit

We can determine the number of surfboards
that Curl must sell to earn a profit of $100,000
using the contribution margin approach.
Fixed expenses + Target profit
Unit contribution margin

$80,000 + $100,000
$200

Units sold to earn

the target profit

= 900 surf boards

7-13

Effect of Income Taxes

Income taxes affect a companys
CVP relationships. To earn a
particular after-tax net income, a
greater before-tax income will be
required.

Before-tax
Target after-tax net income
=
net income
1 - t

7-14

Equation Approach
Sales revenue Variable expenses Fixed expenses = Profit
($500 X)

($300 X) $80,000 = $100,000

($200X) = $180,000
X = 900 surf boards
7-15

Applying CVP Analysis

Safety Margin
The difference between budgeted sales
revenue and break-even sales revenue.
The amount by which sales can drop before
losses begin to be incurred.

7-16

Safety Margin
Curl, Inc. has a break-even point of $200,000.
If actual sales are $250,000, the safety margin is
$50,000 or 100 surf boards.

Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income

Break-even
sales
400 units
$ 200,000
120,000
80,000
80,000
$
-

Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
7-17

Changes in Fixed Costs

Curl is currently selling 500 surfboards per
year.
The owner believes that an increase of
$10,000 in the annual advertising budget,
would increase sales to 540 units.
Should the company increase the advertising
budget?
7-18

Changes in Fixed Costs

Current
Sales
(500 Boards)
Sales
$
250,000
Less: variable expenses
150,000
Contribution margin
$
100,000
Less: fixed expenses
80,000
Net income
$
20,000

Proposed
Sales
(540 Boards)
$
270,000
162,000
$
108,000
90,000
$
18,000

540 units $500 per unit = $270,000

$80,000 + $10,000 advertising = $90,000
7-19

Changes in Fixed Costs

Current
Sales will increase by
Sales
$20,000, but net income
(500 Boards)
decreased by $2,000.
Sales
$
250,000
Less: variable expenses
150,000
Contribution margin
$
100,000
Less: fixed expenses
80,000
Net income
$
20,000

Proposed
Sales
(540 Boards)
$
270,000
162,000
$
108,000
90,000
$
18,000

7-20

Changes in Unit
Contribution Margin
Because of increases in cost of raw materials,
Curls variable cost per unit has increased
from $300 to $310 per surfboard. With no
change in selling price per unit, what will be
the new break-even point?
($500 X)

($310 X) $80,000 = $0
X = 422 units (rounded)
7-21

Changes in Unit
Contribution Margin

Suppose Curl, Inc. increases the price of

each surfboard to $550. With no change
in variable cost per unit, what will be the
new break-even point?
($550 X)

($300 X) $80,000 = $0
X = 320 units
7-22

Predicting Profit Given Expected

Volume

Given:

Given:

Fixed expenses
Unit contribution margin
Target net profit

Fixed expenses
Unit contribution margin
Expected sales volume

Find: {reqd sales volume}

Find: {expected profit}

7-23

Predicting Profit Given

Expected Volume
In the coming year, Curls owner expects to sell
525 surfboards. The unit contribution margin is
expected to be $190, and fixed costs are
expected to increase to $90,000.
Total contribution

Fixed cost = Profit

($190 525) $90,000 = X

X = $99,750 $90,000
X = $9,750 profit
7-24

CVP Analysis with Multiple

Products
For a company with more than one product,
sales mix is the relative combination in which a
companys products are sold.
Different products have different selling prices,
cost structures, and contribution margins.

Lets assume Curl sells surfboards and sail

boards and see how we deal with breakeven analysis.
7-25

CVP Analysis with Multiple

Products
Curl provides us with the following
information:
Unit
Unit
Number
Description
Surfboards
Sailboards
Total sold

Selling Variable Contribution

of
Price
Cost
Margin
Boards
$
500 $ 300 $
200
500
1,000
450
550
300
800

Number
Description of Boards
Surfboards
500
Sailboards
300
Total sold
800

% of
Total
62.5% (500 800)
37.5% (300 800)
100.0%
7-26

CVP Analysis with Multiple

Products
Weighted-average unit contribution margin
Contribution
Weighted
Description
Margin
% of Total Contribution
Surfboards $
200
62.5% $
125.00
Sailboards
550
37.5%
206.25
Weighted-average contribution margin $
331.25

$200 62.5%
$550 37.5%
7-27

CVP Analysis with Multiple

Products
Break-even point
Break-even
Fixed expenses
=
point
Weighted-average unit contribution margin

Break-even
=
point

$170,000
$331.25

Break-even
= 514 combined unit sales
point

7-28

CVP Analysis with Multiple

Products
Break-even point
Break-even
point

Description
Surfboards
Sailboards
Total units

514 combined unit sales

Breakeven
Sales
514
514

% of
Individual
Total
Sales
62.5%
321
37.5%
193
514

7-29

Assumptions Underlying
CVP Analysis
1. Selling price is constant throughout
the entire relevant range.
2. Costs are linear over the relevant
range.
3. In multi-product companies, the
sales mix is constant.
4. In manufacturing firms, inventories
do not change (units produced =
units sold).
7-30

Cost Structure and Operating

Leverage
The cost structure of an organization is the
relative proportion of its fixed and variable
costs.
Operating leverage is . . .
the extent to which an organization uses fixed
costs in its cost structure.

greatest in companies that have a high

proportion of fixed costs in relation to
variable costs.
7-31

Measuring Operating Leverage

Operating leverage
factor

Contribution margin
Net income

Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income

$100,000
$20,000

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

= 5
7-32

Measuring Operating Leverage

A measure of how a percentage change in
sales will affect profits. If Curl increases its
sales by 10%, what will be the percentage
increase in net income?

Percent increase in sales

Operating leverage factor
Percent increase in profits

10%
5
50%
7-33

Measuring Operating Leverage

A firm with proportionately high fixed costs has

relatively high operating leverage On the other
hand, a firm with high operating leverage has a
relatively high break-even point.
7-34

Absorption Costing
A system of accounting for costs in which
both fixed and variable production costs
are considered product costs.
Fixed
Costs
Product
Variable
Costs
8-35

Variable Costing
A system of cost accounting that only
assigns the variable cost of production to
products.
Fixed
Costs
Product
Variable
Costs
8-36

Absorption and Variable Costing

Absorption
Costing

Product costs

Variable
Costing
Direct materials
Direct labor
Variable mfg. overhead

Product costs

Fixed mfg. overhead

Period costs
Period costs

Selling & Admin. exp.

8-37

Absorption and Variable Costing

Absorption
Costing

Product costs

Variable
Costing
Direct materials
Direct labor
Variable mfg. overhead

Product costs

Fixed mfg. overhead

Period costs
Period costs

Selling & Admin. exp.

The difference between absorption and variable

costing is the treatment of fixed manufacturing overhead.
8-38

Absorption and Variable Costing

Lets put some numbers to an example and
see what we can learn about the difference
between absorption and variable costing.

8-39

Absorption and Variable Costing

Mellon Co. produces a single product with
the following information available:
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead
Selling & administrative
expenses
Fixed costs per year:
Mfg. overhead
Selling & administrative
expenses

25,000

10

$ 150,000
$ 100,000
8-40

Absorption and Variable Costing

Unit product cost is determined as follows:

Direct materials, direct labor, and

variable mfg. overhead
Fixed mfg. overhead
($150,000 25,000 units)
Unit product cost

Absorption
Costing

Variable
Costing

10

10

6
16

10

Selling and administrative expenses are always treated as period

expenses and deducted from revenue.

8-41

Absorption Costing
Income Statements
Mellon Co. had no beginning inventory, produced
25,000 units and sold 20,000 units this year at $30
each.
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 margin
Less selling & admin. exp.
Variable (20,000 $3)
$ 60,000
Fixed
100,000
Net income

$ 600,000

320,000
$ 280,000

160,000
$ 120,000
8-42

Variable Costing
Income Statements
Now lets look at variable costing by Mellon
Co.
Variable Costing
Sales (20,000 $30)
Less variable expenses:
Beginning inventory
Add COGM (25,000 $10)
Goods available for sale
Ending inventory (5,000 $10)
Variable cost of goods sold
Variable selling & administrative
expenses (20,000 $3)
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

$ 600,000
$

250,000
$ 250,000
50,000
$ 200,000
60,000

$ 150,000
100,000

260,000
$ 340,000

250,000
$ 90,000
8-43

Comparing Absorption and

Variable Costing
Lets compare the methods.
Cost of
Goods
Sold

Ending
Inventory

Period
Expense

Absorption costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
120,000
$ 320,000

$ 50,000
30,000
$ 80,000

Variable costing
Variable mfg. costs $ 200,000
Fixed mfg. costs
$ 200,000

$ 50,000
$ 50,000

150,000
$ 150,000

Total
$ 250,000
150,000
$ 400,000

$ 250,000
150,000
$ 400,000

8-44

Reconciling Income Under

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

Fixed mfg. overhead

Units produced

$150,000
25,000

90,000

30,000
120,000

$6.00 per unit

8-45

Extending the Example

Lets look at
the second
year of
operations
for Mellon
Company.

8-46

Mellon Co. Year 2

In its second year of operations, Mellon Co. started with
an inventory of 5,000 units, produced 25,000 units and
sold 30,000 units at $30 each.
Number of units produced annually
Variable costs per unit:
Direct materials, direct labor
and variable mfg. overhead
Selling & administrative
expenses
Fixed costs per year:
Mfg. overhead
Selling & administrative
expenses

25,000

10

$ 150,000
$ 100,000
8-47

Mellon Co. Year 2

Unit product cost is determined as
follows:
Direct materials, direct labor,
and variable mfg. overhead
Fixed mfg. overhead
($150,000 25,000 units)
Unit product cost

Absorption
Costing

Variable
Costing

10

10

6
16

10

There has been no

change in Mellons
cost structure.
8-48

Mellon Co. Year 2

Absorption Costing
Sales (30,000 $30)
Less cost of goods sold:
Beg. inventory (5,000 x $16)
Add COGM (25,000 $16)
Goods available for sale
Ending inventory
Gross margin
Less selling & admin. exp.
Variable (30,000 $3)
Fixed
Net income

$ 900,000
$ 80,000
400,000
$ 480,000
-

$ 90,000
100,000

480,000
$ 420,000

190,000
$ 230,000

25,000 units produced in the current period.

8-49

Mellon Co. Year 2

Variable Costing
Sales (30,000 $30)
Less variable expenses:
Beg. inventory (5,000 $10)
Add COGM (25,000 $10)
Goods available for sale
Ending inventory
Variable cost of goods sold
Variable selling & administrative
expenses (30,000 $3)
Contribution margin
Less fixed expenses:
Manufacturing overhead
Selling & administrative expenses
Net income

$ 900,000
$

50,000
250,000
$ 300,000
$ 300,000
90,000

$ 150,000
100,000

390,000
$ 510,000

250,000
$ 260,000

Excludes fixed manufacturing overhead.

8-50

Summary
Income Comparison
Costing Method
Absorption
Variable

1st Period
$ 120,000
90,000

2nd Period
$ 230,000
260,000

Total
$ 350,000
350,000

In the first period, production (25,000 units)

was greater than sales (20,000).

In the second period, production (25,000 units)

was less than sales (30,000).

8-51

Summary
Lets see if we can get an overview
of what we have done.

8-52

Summary Comparison of Absorption

(AC) and Variable Costing (VC)
Production versus
Sales

Produced > Sold

Produced < Sold

Produced = Sold

Total
Inventory
Effect

Period Expense Effect

Profit Effect

Increase

Fixed mfg.
costs expensed
AC

Fixed mfg.
< costs expensed
VC

AC > VC

Decrease

Fixed mfg.
costs expensed
AC

Fixed mfg.
> costs expensed
VC

AC < VC

Fixed mfg.
Fixed mfg.
costs expensed = costs expensed
AC
VC

AC = VC

No change

For the two-year period, units produced

equals units sold, so total absorption income
equals total variable income.
8-53

Evaluation of Variable Costing

Management finds it
easy to understand.

Advantages

Impact of fixed
costs on profits
emphasized.

Consistent with
CVP analysis.

Emphasizes contribution in
short-run pricing decisions.

Profit for period not

affected by changes
in fixed mfg. overhead.
8-54

Evaluation of Absorption Costing

Fixed manufacturing overhead is
treated the same as the other product
costs, direct material and direct labor.

Advantages

Consistent with long-run

pricing decisions that must
cover full cost.

External reporting
and income tax law
require absorption costing.
8-55

Throughput Costing
Example
In an automated process direct material may be
the only unit-level cost and so is the only product cost.

All other manufacturing costs are expensed as period costs.

Incentive to
overproduce
is reduced

Average unit cost does

not vary with changes
in production levels.
Advantages

8-56

Throughput Income Statement

Sales Revenue
Throughput cost of goods sold (dir. mat.)
Gross Margin
Less: Operating costs
Direct labor
100,000
Variable mfg overhead
60,000
Fixed mfg overhead
150,000
Variable sales & admin costs 50,000
Fixed sales & admin costs 125,000
Total operating costs
Net Income

$600,000
150,000
$450,000

375,000
$ 75,000
8-57

End of Chapter 8

The End
8-58