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Module 4: Cost behaviour and cost-volume-profit analysis

Required reading

Chapter 6, pages 232-255

Chapter 7, pages 273-296

Appendix 7A, pages 1-3 (located at the textbook Online Learning Centre).

Overview

How costs respond to changes in business activity is known as cost behaviour. Cost behaviour is important for prediction purposes in business, where cost prediction is a factor in planning, decision-making, and control. In this module you study variable, fixed, and mixed cost behaviours, and look at three methods of separating a mixed cost into its variable and fixed elements. You also learn about the contribution approach to the income statement.

Module 4 also covers cost-volume-profit (CVP) analysis, which uses five key elements — product selling price, volume of activity, per unit variable costs, total fixed costs, and mix of products sold — to influence a range of management decisions. Break-even analysis, a major application of CVP analysis, is also covered in this module.

Computer illustrations 4.5-1 and 4.11-1 show how you can use a spreadsheet program to design worksheets for cost-volume-profit analysis and mixed cost analysis using least-squares regression.

Assignment reminder

Assignment 1 (see Module 5) is due at the end of week 5 (see Course Schedule). It is a good idea to take a look at it now in order to become familiar with the requirements and to prepare for any necessary work in advance.

Assignment 2 (see Module 7) is due at the end of week 7. You may wish to take a look at it now in order to become familiar with the requirements as you work through Modules 5-7.

Topic outline and learning objectives

4.1 Variable cost behaviour patterns

4.2 Fixed costs

4.3 Analysis of mixed costs

Identify examples of variable costs, and explain the effect of a change in activity on both total variable costs and per-unit variable costs. (Level 1)

Identify examples of fixed costs, and explain the effect of a change in activity on both total fixed costs and fixed costs expressed on a per-unit basis. (Level 1)

Analyze a mixed cost using the high-low method and the regression method. (Level 1)

Prepare an income statement using the contribution method. (Level 1)

4.4 Contribution margin and contribution format income statement

4.5 Computer illustration 4.5-1: Regression analysis Analyze mixed costs using a spreadsheet program. (Level 2)

4.6

Basics of cost-volume-profit analysis

Explain how changes in activity and changes in variable costs, fixed costs, selling price, and volume affect

contribution margin and net income. (Level 1)

4.7 Break-even analysis

4.8 CVP considerations in choosing a cost structure

4.9 Sales mix

4.10 Assumptions of CVP analysis

4.11 Computer illustration 4.11-1: CVP sensitivity analysis

Module summary

Compute the break-even point by both the equation method and the contribution margin method. (Level 1)

Use cost-volume-profit formulas to determine the

activity level needed to achieve a desired target net profit figure. (Level 1)

Compute the break-even point for a multiple product

company, and explain the effects of shifts in the sales

mix on contribution margin and the break-even point.

(Level 1)

Explain cost–volume–profit with uncertainty. (Level 2)

Design a worksheet to perform a sensitivity analysis on CVP. (Level 2)

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4.1 Variable cost behaviour patterns

Learning objective

LEVEL 1

Variable and fixed costs represent two types of cost behaviour. Sometimes these two types are mixed together (and may also be termed semivariable costs). Note the specific definitions of variable and fixed costs, both in terms of totals and on a per-unit basis.

Variable costs

A cost is variable if the total cost is expected to vary as a function of output. Accountants often assume that

variable costs are linear, as depicted in Exhibit 6-1. This assumption means that variable cost per unit of output

is constant at all levels of output. The relationship can be expressed in the following mathematical form:

V = bx

where:

V |
= Total variable costs |

b |
= Unit variable cost (a constant) |

x |
= Activity base |

V = bx is a linear equation that begins at the origin (0,0). The activity base x is called the independent or

causal variable. For example, the number of copies of a document that you make will be a causal variable of your total printing costs. Exhibit 6-2 illustrates the types of costs normally classified as variable. However, specific facts can change this classification, and actual behaviour of costs in any circumstance must be determined.

Exhibit 6-3 shows a particularly troublesome cost behaviour pattern, the step variable. Step costs remain constant within a range of activity but are different between ranges of activities. Step costs result from input factors that cannot be increased in very small amounts; they can be increased only in large amounts. Since step costs cannot be described by a simple algebraic function, for simplicity, if the steps are narrow, the cost is treated as linear (see Exhibit 4-1).

Exhibit 4.1-1: Step-variable cost shown as a linear function

Where the steps are sufficiently large (Exhibit 5-6), the relevant range concept can be applied to treat the cost as a fixed cost.

Exhibit 6-4 shows a curvilinear representation of variable costs that may be more representative of actual cost behaviour. However, because the functional form of a curvilinear relationship is more complex than V = bx, accountants break the curvilinear function into linear pieces using the concept of relevant range.

Exhibits 6-3 (step variable), 6-4 (curvilinear), and 6-6 (step fixed) suggest that it is difficult to accurately predict costs that are outside the relevant range. It is important that managers take this aspect of cost behaviour into consideration when preparing budgets. Make sure that you understand the concept of relevant range and its impact on cost behaviours.

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4.2 Fixed costs

Learning objective

LEVEL 1

Total fixed costs do not vary with changes in activity. In algebraic form, they can be expressed as:

F = a

where:

F = Total fixed costs

a = Constant amount

The textbook description of the trend toward fixed costs is particularly interesting because it demonstrates how some traditional problems and analyses may not be realistic. For example, recall the explanation in Module 1 of how to treat idle time. Assume a guaranteed employment contract and a short-term decline in production. Labour in total is a fixed cost because of the guarantee, but direct labour could still be variable. How? If idle time is treated as overhead, then hours not worked on a job will be deemed overhead, making direct labour variable. A study of the time worked in an administrative office could even make a salaried employee a variable direct labour cost.

In summary, while a cost incurred may be fixed, the method of accounting may result in the cost appearing to be variable. The direct labour would be represented as:

V = bx

while overhead would be:

z = b (T – x)

Total salary would be:

V + z = bx + bT – bx = bT

where

b |
= |
Hourly rate of pay |

x |
= |
Number of hours worked |

z |
= |
Semivariable overhead cost sloping downward or opposite to that in Exhibit 6-7 |

(T - X) |
= |
Number of idle hours |

T |
= |
Normal hours worked to earn the salary |

If the problem examined is small enough (for example, costing a product), the cost charged may be variable.

However, from the whole-company perspective, the cost incurred is fixed.

The primary difference between committed and discretionary fixed costs relates to the time horizon involved. Committed fixed costs remain intact for a long time, whereas discretionary fixed costs remain intact for a much shorter time — usually one year. In the long term, all costs are discretionary (for example, you can always sell the equipment). Notice how social responsibility and management philosophy interact.

In practice, it is difficult to find a truly variable or truly fixed cost; many costs fall into a semivariable, or mixed, group. The variable element of a mixed cost function may be either linear or curvilinear. If a linear representation is used (Exhibit 6-7), the cost function can be expressed as follows:

Y = a + bX

where:

y |
= |
Total costs |

a |
= |
Constant amount (that is, the fixed element of the cost) |

b |
= |
Slope of total cost line (the constant variable cost per unit of activity) |

X |
= |
Level of activity |

bX |
= |
Total variable costs |

This is a very important cost function because it approximates the company’s true cost function (that is, it involves fixed and variable costs). Estimating the total cost function is often fundamental to business planning.

Activity 4.2-1 Cost behaviour

Work through this activity to reinforce your understanding of the behaviour of fixed and variable costs.

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4.3 Analysis of mixed costs

Learning objective

Analyze a mixed cost using the high-low method and the regression method. (Level 1)

LEVEL 1

Analysis of mixed costs (estimation of fixed and variable costs) can be done in a number of ways. The high– low method attempts to segregate total costs by examining two observations — those representing the highest and the lowest level of activity within the relevant range. Recall that the cost function is:

Y = a + bX

With two observations, (X _{0} , Y _{0} ) and

(the fixed costs) of the cost function can be estimated as

(X _{1} , Y _{1} ), the slope (the variable cost per unit of activity)

b = (Y _{1} – Y _{0} ) / (X _{1} – X _{0} )

a = Y _{0} – bX _{0}

and the intercept

As described in the textbook, the choice of the high Y _{1} and the low Y _{0} is always based on the level of activity, that is, on the independent variable X.

While the high-low method is relatively easy to apply, its major problem lies in the fact that only the two extreme values are used to estimate the total cost line. These two extreme values may not be typical of the relationship between cost and activity.

The visual inspection (scattergraph) method entails plotting the relevant observations on a scattergraph and then fitting a line to the data visually. While this method uses all the data, its major drawback is that it is very subjective. A scattergraph is useful not so much as a method of estimating cost but as a way of seeing a behaviour pattern. This is useful when selecting the appropriate approach for determining the cost function.

The least squares (linear regression) method is a well-developed statistical technique for the analysis of mixed costs. It permits the cost line, Y = a + bX, to be developed using all observations in the scatter diagrams. It fits a line to the observed relationships between costs and volume, which is known as the best fitted line (minimize the sum of the squares of the vertical distances from the regression line to the plots of the actual observations). It also tells the user how the regression line fits the observed data.

Note the formulas for the least squares method on page 254. The solution formulas to calculate the vertical intercept and the slope are as follows:

These formulas eliminate the need to solve two equations in two unknowns. The formulas are useful in computer spreadsheets, where there is no facility to perform regression analysis. Regression analysis using a spreadsheet program is demonstrated in Computer illustration 4.5-1.

Note: Linear regression and multiple regression concepts and techniques are explained in greater detail in Business Quantitative Analysis [QU1] in the CGA program of professional studies.

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4.4 Contribution margin and contribution format income

statement

Learning objective

Prepare an income statement using the contribution method. (Level 1)

LEVEL 1

After management has analyzed fixed and variable costs, the traditional income statement can be reformatted. The new presentation is called the contribution format. This presentation separates income statement costs by their behaviour, not by classifications suggested by generally accepted accounting principles. Exhibit 6-14 compares income statements prepared under both the traditional and contribution approaches. Net income is identical under the two formats.

The contribution margin is the difference between sales and total variable costs. By calculating the contribution margin, management knows whether the company will have a net income, a net loss, or break even. In other words:

If contribution margin > fixed costs, there is a net income.

If contribution margin < fixed costs, there is a net loss.

If contribution margin = fixed costs, net income is zero.

In the short run, variable costs may be controllable. For example, if net income is falling, management may decide to use less expensive raw materials. However, management may not be able to change fixed costs in the short run. For example, the company may own or have a non-cancellable lease on its building. Presenting the income statement in a contribution margin format helps management assess operating flexibility.

Chapter summary

This topic marks the end of the textbook coverage of cost behaviour. To ensure you understand this material and the corresponding terminology, read the summary on page 253, work through the review problem on page

256-257.

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4.5 Computer illustration 4.5-1: Regression analysis

Learning objective

Analyze mixed costs using a spreadsheet program. (Level 2)

LEVEL 2

Material provided

Four worksheets:

M4P1A — Contains the data for the least squares method of cost analysis

M4P1B — Contains a partially completed budgeted income statement

M4P1AS — Solution to Requirement 1

M4P1BS — Solution to Requirement 2

Description

This illustration is based on Problem 6-20 (page 266).

Required

Answer Requirements 1 and 2 using the following procedure.

Procedure

Requirement 1

1. Open the file MA1M4P1 and click the M4P1A sheet tab.

2. Study the layout of the worksheet. Rows 4 to 13 form the data table, and the rest of the worksheet is blank.

3. Perform a least squares regression analysis to derive a cost formula for shipping expense.

4. Choose Tools > Data Analysis in Excel 2003/XP (or choose Data Ribbon in Excel 2007 and select Data Analysis). If this option is not displayed, follow these instructions for installing the Solver Add-In and Analysis ToolPak.

5. Choose Regression and click OK. Type D5:D13 in the Input Y Range text box. This range corresponds to the dependent or "explained" variable (Shipping expense).

6. Click the Input X Range text box and select the range C5:C13, which corresponds to the independent or explanatory variable (Units sold).

The column labels are included in the range so that they appear in the regression output when the Labels option is selected — see the next step.

7.

Select Labels and Output Range. Type the output range A15 in the text box and click OK to place the regression output starting in cell A15.

You should obtain the following results:

Intercept (B31) 40,000 Units sold (cell B32)* 7.50

R Squared (B19) 0.993506494

* The value displayed in cell B32 corresponds to the regression coefficient for the explanatory or independent variable. Note also that the value in B32 needs to be divided by 1,000. See the text explanation on page 266- 267, under Requirement 1.

The results indicate that the cost formula for shipping expense is

$40,000 + 7.50 X

where X is the number of units sold.

The high R Squared value indicates that the data fit very closely to the regression line. However, this conclusion can be misleading given the small number of observations.

Proceed to Requirement 2.

Requirement 2

1. Click the sheet tab M4P1B. Using the relevant information derived from the least squares regression calculations, complete the data table by entering the appropriate cell references in cells C10 and C13 from the worksheet M4P1A.

2. Complete the budgeted income statement in rows 15 to 31.

3. You should obtain a net income figure of $80,000. If you do not obtain this result, print a copy of the formulas of your worksheet M4P1B, and compare your results with the solution worksheet

M4P1BS.

4. Click the tab for the solution worksheet M4P1BS and print the formulas.

5. Compare the results obtained in steps 3 and 4 and correct any errors.

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4.6 Basics of cost-volume-profit analysis

Learning objective

Explain how changes in activity and changes in variable costs, fixed costs, selling price, and volume affect contribution margin and net income. (Level 1)

LEVEL 1

Cost-volume-profit (CVP) analysis explores the interrelationship of the five elements listed at the beginning of Chapter 7. As a direct result of CVP analysis, the income statement can be formatted to facilitate profitability analysis. The basic assumption of cost-volume-profit analysis requires that a firm's total costs be separated into fixed and variable components.

The definition of contribution margin is important because it is a concept that will be used extensively in this course. Contribution margin is the amount remaining when all the variable costs are deducted from revenue. Once "break-even" is achieved, net income will increase by the contribution margin per unit for each additional unit sold.

The contribution margin ratio (CM ratio) is the contribution margin divided by sales. In simple situations, the CM ratio (really a percentage) multiplied by the change in sales gives the profit change before taxes. The applications of CVP (pages 280-284) show how analysis of various plans can be done quickly.

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4.7 Break-even analysis

Learning objective

LEVEL 1

A major application of CVP is break-even analysis. Profit is defined as being equal to total revenues less total costs, or in algebraic form:

P = SPx – (FC + VCx)

where:

P = Profit

SP = Unit selling price FC = Fixed costs VC = Unit variable cost

x = Level of activity (sales volume in units)

At break-even sales volume (x), P = 0, so set

SPx = FC + VCx

and solve for x as follows:

SPx – VCx = FC

x |
(SP – VC) = FC |

x |
= FC ÷ (SP – VC) |

x |
= Break-even sales volume, and (SP – VC) is the contribution margin per unit |

In some situations, VC is not given per unit, in which case the contribution margin ratio can be used to calculate the break even in sales dollars, instead of units:

Break-even in sales $ = FC ÷ (1 – (VC ÷ SP))

where 1 – (VC ÷ SP) is the contribution margin ratio.

A useful concept of margin of safety is defined on pages 287-288.

Margin of safety = Total sales – Break-even sales.

Or as a percentage, Margin of safety % = Margin of safety in dollars ÷ Total sales.

Activity 4.7–1

Work through this activity to reinforce your understanding of CVP relationships.

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4.8 CVP considerations in choosing a cost structure

Learning objective

Use cost-volume-profit formulas to determine the activity level needed to achieve a desired target net profit figure. (Level 1)

LEVEL 1

Managers use CVP analysis to determine the most favourable combination of variable and fixed costs. The answer usually depends on predictions of future sales and management's attitude toward risk.

Operating leverage deals with the risk associated with the fluctuations of sales and cost structures. When a company has a high proportion of fixed costs and a low proportion of variable costs, it is highly leveraged. A small increase in sales volume will significantly increase profits because the contribution margin per unit is substantial (due to low variable costs) and fixed costs do not change. However, if sales are low, the company could suffer losses due to the high level of fixed costs. Therefore, a highly leveraged company has a high risk of losing money when volume is low, but has an opportunity to increase profits substantially if it operates above the break-even level.

The increased use of automation has significantly altered the risks and profitability ratios of highly automated organizations by changing the degree of operating leverage. Highly automated organizations have a higher proportion of fixed costs and thus higher operating leverage.

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4.9 Sales mix

Learning objective

Compute the break-even point for a multiple product company, and explain the effects of shifts in the sales mix on contribution margin and the break-even point. (Level 1)

LEVEL 1

Up to this point, the description of CVP has dealt with one product only. If more than one product exists, the CVP analysis is more complex, as shown by the following formula:

P = SP _{1} x _{1} + SP _{2} x _{2} – VC _{1} x _{1} – VC _{2} x _{2} – FC

where:

SP _{i}

x _{i}

VC _{i}

=

=

=

Selling price of product _{i}

Volume of product _{i}

Variable cost of product _{i}

An infinite number of break-even points are possible in this equation because there are two x values.

One way to solve this problem is to use a weighted-average (use total sales and variable expenses for an assumed sales mix) and compute an average contribution margin ratio. The textbook calls this the “overall CM ratio.” However, if the mix changes, so will the break-even point.

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4.10 Assumptions of CVP analysis

Learning objective

Explain cost–volume–profit with uncertainty. (Level 2)

LEVEL 2

CVP analysis is a static technique that ignores present values, even though its form of presentation might lead one to believe that it is a dynamic (multiple-period) model. The extension of CVP analysis to multiple periods with present values included is beyond the scope of this course. However, you should study and understand the limiting assumptions that must be made when using data for this technique.

Extending the CVP relationship to a more realistic setting introduces uncertainty. The Online learning Centre Appendix 7A offers a more detailed explanation of the topic, as well as a decision tree that quantifies and displays the variables. Study Exhibits 7A-1 and 7A-2.

Chapter summary

This topic marks the end of the textbook coverage of CVP analysis. To ensure you understand this material and the corresponding terminology, read the summary on page 296 and work through the review problem on pages

296-299.

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4.11 Computer illustration 4.11-1: CVP sensitivity analysis

Learning objective

Design a worksheet to perform a sensitivity analysis on CVP. (Level 2)

LEVEL 2

Material provided

A prebuilt worksheet MA1M4P2, which you will complete.

Three completed solution worksheets, M4P2S, M4P2AS, M4P2BS, to which you can compare your work.

Description

Alpine Ltd. has been experiencing losses for some time, as shown by its most recent income statement:

All variable expenses in the company vary in terms of units sold, except for sales omissions, which are based on sales dollars. Variable manufacturing overhead is $0.50 per unit. There were no beginning or ending inventories. The company’s plant has a capacity of 70,000 units.

Management is particularly disappointed with the year’s operating results. Several possible courses of action are being studied to determine what should be done to make the next year profitable.

Required

1. Redo Alpine’s income statement in the contribution format. Show both a Total column and a Per- unit column on your statement. Leave enough space to the right of your numbers to enter the solution to both parts of Requirement 2).

2. In an effort to make next year profitable, the president is considering two proposals prepared by members of her staff:

a. The sales manager would like to decrease the unit selling price by 25%. He is certain that this would fill the plant to capacity.

b. The executive vice-president would like to increase the unit selling price by 25%, increase the sales commission to 12% of sales, and increase advertising by $90,000. Based on experience in another company, he is confident this would trigger a 50% increase in unit sales.

Prepare two contribution income statements, one showing what profits would be under the sales manager’s proposal and one showing what profits would be under the vice-president’s proposal. On each statement, include both Total and Per-unit columns (do not show per-unit data for the fixed costs).

Source: Adapted from Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Managerial _{A}_{c}_{c}_{o}_{u}_{n}_{t}_{i}_{n}_{g}_{,} Sixth Canadian Edition, Case 6-29, pages 273-274. Copyright © 2004, by McGraw-Hill Ryerson Limited. Adapted with permission.

Procedure

1. Open the file MA1M4P2.

2. Click the sheet tab M4P2 and study the layout of the worksheet. The data table in the range A6 to G28 contains the per unit variable costs and the fixed costs for Alpine Inc.

Rows 22 to 27 contain the base data required to complete an income statement in the contribution format.

3. Move to row 29. Rows 29 to 52 contain a partially completed income statement.

Requirement 1

1. Enter the necessary formulas to complete the 20X1 contribution income statement on a total basis (column F) and on a per unit basis (column G) using the data from the data table.

The formulas in rows 43, 44, 50, and 51 have been pre-entered to save you time.

2. Save your worksheet.

3.

Observe in cell F51 the net loss for 20X1. You should obtain a net loss of $46,200. If you do not obtain this result, follow the next steps. If you have obtained the correct answer, proceed to Requirement 2.

4. Print a copy of your formulas in the range F33 to G51.

5. Click the sheet tab M4P2S and compare the solution formulas with your printout from step 4.

6. Correct any errors.

Requirement 2a

1. With your completed worksheet from Requirement 1 or the solution worksheet M4P2S on-screen, modify the data table to reflect the sales manager's proposal as described in the case in Requirement 2a.

2. Save your worksheet.

3. Observe the effect of these changes on the bottom line. The net loss is now $75,300.

If you do not obtain this result, print your worksheet. Click the sheet tab M4P2AS and compare the solution with your printout.

Requirement 2b

4. With the base case income statement or the solution worksheet M4P2S on-screen, make the necessary changes to the data table to reflect the vice president's proposal.

5. Save your worksheet.

6. You should obtain a net income of $102,800. If you do not obtain this result, compare your worksheet with the solution worksheet M4P2BS.

Note the ease with which you can make changes to the different cost and revenue elements to show the effects on net income. Sensitivity analyses are relatively easy to perform on computers and therefore allow management to deal with the dynamics of CVP more efficiently.

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Module 4 summary

This module consists of two related parts: cost behaviour and cost-volume-profit (CVP) analysis. In order to make decisions, control operations, and evaluate performance, managers need to predict how costs behave with changes in activity.

Topics 4.1, 4.2, and 4.3 deal respectively with the analyses of variable, fixed, and mixed costs behaviour patterns.

Topic 4.4 introduces the contribution format income statement as a basic tool for decision-making.

Topic 4.5 conducts a regression analysis for a mixed cost, the result of which is incorporated in a contribution format income statement.

The CVP analysis, introduced in Topic 4.6, builds on the knowledge acquired in previous topics. The CVP model allows the identification of courses of actions for profitability improvement programs.

Topic 4.7 offers a direct application of the CVP model with the break-even point analysis.

The CVP model is also used in decisions involving the choice of cost structure for a business. This is dealt with in Topic 4.8.

The structure of sales commissions and the applicability of CVP analysis extend also to multiproduct and multiservice companies. Topic 4.9 addresses the issues such companies must cope with.

The CVP model has been criticized for its simplified assumptions, and the degree of certainty associated with the analysis. Topic 4.10 responds by introducing probability theory in the model to address uncertainty.

Finally, Topic 4.11 shows with a computer illustration how dynamic and powerful the CVP model can be when used for sensitivity analysis.

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