Managerial Accounting

by James Jiambalvo
Chapter 4:
Cost-Volume-Profit Analysis

Slides Prepared by:

Scott Peterson
Northern State University
Chapter 4: Cost-Volume-
Profit-Analysis
Chapter Themes: Learning Objectives:
1.
Its all about how costs
change in total with 2.
respect to changes in
activity.
C-V-P-A is linear. 3.
You must be able to put 4.
all costs into either
variable or fixed cost 5.
categories. 6.
Identify common cost behavior
patterns.
Estimate the relation between cost
and activity using account
analysis, the high-low method, and
scattergraphs.
Perform cost-volume-profit-
analysis for single products.
Perform cost-volume-profit-
analysis for multiple products.
Discuss the effect of operating
leverage.
Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Common Cost Behavior
Patterns
To perform Cost-Volume-
Profit-Analysis (C-V-P-A), you
need to know how costs
behave when business
activity (production volume,
sales volume) changes.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Variable Costs
By definition, Variable Costs
are costs that change (in
total) in response to changes
in volume or activity. It is
assumed, too, that the
relationship between variable
costs and activity is
proportional. That is, if
production volume increases
by 10%, then variable costs
in total will rise by 10%.
Examples include direct
labor, raw materials and sales
commissions.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Fixed Costs
By definition, Fixed Costs are
costs that do not change (in
total) in response to changes
in volume or activity.
Examples include
depreciation, supervisory
salaries and maintenance
expenses.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Mixed Costs
Mixed Costs are costs that
contain both a variable cost
element and a fixed cost
element. These costs are
sometimes referred to as
semi-variable costs. An
example would be a
salespersons salary where
she receives a base salary
plus commissions.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Cost Estimation Methods
Managers need to be able to
predict (plan) costs at various
activity levels. And because
cost information is often not
broken out in terms of fixed
and variable components,
managers use cost estimation
methods to do just that. Four
common methods are:
1. Account analysis
2. Scattergraph
3. High-Low
4. Regression
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between
cost and activity using account
analysis, the high-low method,
and scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Account Analysis
Account Analysis is a common
approach to estimating fixed
and variable costs. This
method requires the manager
to exercise professional
judgment to classify costs into
variable and fixed categories.
Once this is done, total
variable costs are divided by
the activity level to determine
variable costs per unit of
activity. Costs classified as
fixed costs are used to
estimate total fixed cost.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between
cost and activity using account
analysis, the high-low method,
and scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
Use the contribution margin per
6.
unit of the constraint to analyze
situations involving a resource
constraint.
Scattergraph Approach
The Scattergraph Approach
uses cost information from a
number of reporting periods
(monthly for example) to
determine how costs change
with respect to changes in
activity. The periodic cost
data are then plotted on a
graph to get a visual picture
of the correlation between
costs and activity levels. A
sample Scattergraph appears
on the next slide.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between
cost and activity using account
analysis, the high-low method,
and scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Sample Scattergraph
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between
cost and activity using account
analysis, the high-low method,
and scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
High-Low Method
Using the same periodic data
as the scattergraph method,
the High-Low Method may be
used to estimate the fixed
and variable components at
various levels of activity. This
method fits a line to the
data, but uses only the high
and low data points. Here, the
slope of the line (total cost
curve) represents the variable
cost. The Y-intercept
represents the estimate of the
fixed costs.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between
cost and activity using account
analysis, the high-low method,
and scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Regression Analysis
Regression Analysis is a
statistical technique that
uses all available data points
to estimate the slope and
intercept. That is, unlike the
High-Low method which uses
only the high and low data
points, regression uses ALL
of the data points to find the
best fit. It should be noted
that Regression Analysis is a
superior method of cost
estimation.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between
cost and activity using account
analysis, the high-low method,
and scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
The Relevant Range
The Relevant Range is the
activity level within which
cost behavior holds true.
Most models have limits and
this type of linear analysis is
not different. Above or below
this range, forecasts of cost
behavior may not be
accurate.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between
cost and activity using account
analysis, the high-low method,
and scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Cost-Volume-Profit Analysis
Cost-Volume-Profit Analysis
(C-V-P) explores the
relationship between costs
(fixed and variable), activity
levels and profits. That is,
once the variable and fixed
elements have been
determined using the tools
discussed in the preceding
slides, we use the following
profit equation: Profit = SP(x)
- VC(x) TFC=Net Income.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-
analysis for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Break-Even Point
One of the primary purposes of
C-V-P is to calculate the Break-
Even Point. It simply represents
the number of units the firm
must sell to generate exactly
zero net income to earn neither
profit nor loss. Graphically, as
shown in the next slide, Break-
Even is the point where the sales
curve and cost curve cross. It
should be noted here that
managers are seldom interested
in merely breaking even. But the
Break-Even is an important
benchmark!
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-
analysis for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Break-Even Point (Graphic)
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-
analysis for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Margin of Safety
The Margin of Safety is the
difference between the
expected level of sales and
break-even sales. It may be
expressed in units or dollars
of sales.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-
analysis for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Contribution Margin
The Contribution Margin is the
difference between selling
price and variable cost per
unit. It measures the amount
each unit sold contributes to
covering fixed cost (first) and
increasing profit (once fixed
costs are covered).
The relationship is as follows:
SP-VC
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-
analysis for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Contribution Margin Ratio
The Contribution Margin Ratio
expresses the contribution of
every sales dollar to covering
fixed cost (first) and operating
profit (second). It is calculated
as follows: SP VC
SP
In other words, for every
dollar of sales, X% of that will
contribute to covering the
fixed costs, and once fixed
costs are covered X% of every
dollar of sales will be
contribute to net income.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-
analysis for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
What If Analysis
Once the cost structure is
modeled (variable and fixed
costs are estimated)
managers can do sensitivity
analyses or What If
Analyses. This analysis
examines what will happen if
a particular action is taken.
For example, what will happen
if fixed costs rise by X dollars
and variable costs decrease
by Y dollars? Or what will
happen if selling price is
decrease by Z dollars?
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-
analysis for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
Discuss the effect of operating
5.
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Multiproduct Analysis
Up until now we looked at C-V- Related Learning Objectives:
P analysis for a single 1.
product. The next few
slides examine C-V-P as it 2.
applies to multiple product
scenarios. There are two
approaches we will 3.
consider in this section:
Contribution Margin 4.
Approach (for similar
products) 5.
Contribution Margin Ratio 6.
Approach (for substantially
different products).
Identify common cost behavior
patterns.
Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
Perform cost-volume-profit-analysis
for single products.
Perform cost-volume-profit-
analysis for multiple products.
Discuss the effect of operating
leverage.
Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Contribution Margin Approach
As indicated, if the products
under analysis are similar
(e.g., various flavors of ice
cream, various models of
boats), the Weighted Average
Contribution Margin Approach
can be used. For example, if
the contribution margin of
product A is $8 and the
contribution margin of product
B is $5, and if two units of B
are sold for each unit of A, the
Weighted Average
Contribution Margin is $6.00.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-
analysis for multiple products.
5. Discuss the effect of operating
leverage.
Use the contribution margin per
6.
unit of the constraint to analyze
situations involving a resource
constraint.
Contribution Margin Ratio
Approach
If the products under analysis
are substantial different (e.g.,
products in a department
store), the Contribution
Margin Ratio Approach
should be used. It makes little
sense in this case to ask how
many units to break even.
The question should be how
many dollars of sales to
break even.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-
analysis for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Assumptions in C-V-P Analysis
As with most models, there Related Learning Objectives:
are certain assumptions 1.
which are made that 2.
affect the validity of the
analysis.
Costs can be accurately 3.
separated into variable
and fixed components. 4.
Fixed costs remain fixed. 5.
Variable costs per unit do 6.
not change over the
relevant range.
Identify common cost behavior
patterns.
Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
Perform cost-volume-profit-
analysis for single products.
Perform cost-volume-profit-
analysis for multiple products.
Discuss the effect of operating
leverage.
Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Operating Leverage
Operating Leverage relates to
the level of fixed versus
variable costs in a firms cost
structure. The higher the
degree of fixed costs, the
more operating leverage a
firm is considered to have.
Firms with lower variable and
higher fixed costs have
higher contribution margins.
This translates into greater
profit or loss as sales
increase or decrease.
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
Constraints
In the real world there are
constraints on how many
items can be manufactured or
how much service can be
delivered. So the focus shifts
from contribution margin per
unit to contribution margin
per unit of the constraint.
Examples of constraints
include manufacturing space,
labor, parts and materials
etc
Related Learning Objectives:
1. Identify common cost behavior
patterns.
2. Estimate the relation between cost
and activity using account analysis,
the high-low method, and
scattergraphs.
3. Perform cost-volume-profit-analysis
for single products.
4. Perform cost-volume-profit-analysis
for multiple products.
5. Discuss the effect of operating
leverage.
6. Use the contribution margin per
unit of the constraint to analyze
situations involving a resource
constraint.
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2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or
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