Chapter 21

notes on chapter

-volume is the measure or degree of an activity of a business action that affects costs, therefore the more volume the more cost incurred. -activities affected by change in volume: selling, producing, driving and calling. -volume of activities can be measured in many ways like number of units sold, produced and miles driven by delivery vehicle as well as number of phone calls placed. -costs are classified as fixed of variable relative to some activity. -traditional income statement classifies costs by functions and are classified as either product or period costs. product costs are costs incurred in purchase or production of a product sold. period are selling and administrative expenses. -managers prefer lower breakeven point to a higher one. -higher fixed costs create greater risk for company - decrease in sales also decreases contribution margin to cover the fixed costs and provide operating income.

Sensitivity Analysis

A "what if" technique that estimates profit or loss results if sales price, costs, volume, or underlying assumptions change. -managers can use cvp relationships to conduct this analysis. -allows managers to see how various business strategies will affect how much profit the company will make and thus empowers mangers with better strategy information for decision making. for changes in sales price you use the required sales in units equation. the lower the sales price the more tablets a company must sell to break even. changes variable costs: -higher the cost raise the breakeven point and a decrease has an opposite effect. lower variable cost increase contribution margin and therefore there will be a lower breakeven point. changes in fixed costs: -higher fixed costs increase the total contribution margin required to break even.

Variable Cost

A cost that increases or decreases in total in direct proportion to increases or decreases in the volume of activity. -total variable costs fluctuate with changes in volume but the cost per unit remains constant. -volume increases total costs increases and vise versa.

High-Low Method

A method used to separate mixed costs into their variable and fixed components, using the highest and lowest activity levels. - requires you to identify the highest and lowest levels of activity over a period of time. three steps: -identify the highest and lowest levels of activity and calculate the variable costs per unit Equation =change in total cost(costs associated with highest volume -cost associated with lowest volume)/change in volume of activity(highest volume-lowest volume) -calculate total fixed costs equation= total mixed cost-total variable cost (cost per unit x number of units) -total mixed cost equation= variable cost per unit x number of units +total fixed cost( this is also the total manufacturing maintenance cost ) -this provides a rough estimate of fixed and variable costs that can be used for planning purpose. -this activity level become the relevant range. -quick and easy for managers to use

Cost-volume-profit (CVP) analysis

A planning tool that expresses the relationships among costs, volume, and prices and their effects on profits and losses. -estimates changes in sales price, variable costs, fixed costs and volume will affect the profits. assumptions: -price per unit does not change as volume changes -managers can classify each cost as variable, fixed or mixed. -only factor that affects total costs is change in value which increase or decreases total variable or mixed cost. -total fixed costs do not change -there are no changes in inventory levels. -most businesses do not meet these assumptions to they regard this analysis

margin of safety

Excess of expected sales over the level of break-even sales.the amount of sales can decrease before the company incurs an operating loss -it is cushion between the profit and loss. -expected sales-breakeven sales= margin of safety units -margin of safety in units x sales price per unit=margin of safety in dollars -margin of safety in units/ expected Salesian units=margin of safety ratio. -managers can use this to asses the risk to the company when there is a possibility of a large decrease in sales. -focuses on sales part of equation.

Contribution Margin

The amount that contributes to covering the fixed costs and then to providing operating income. Net sales revenue - Variable costs. unit contribution margin equation is and are used interchangeably. net sales revenue per unit- variable costs per unit -managers use this to predict change in operating income when volume changes. -increase in contribution margin can be created by an increase in sales price per unit, a decrease in variable costs per unit or combo of the two.

Contribution Margin Ratio

The ratio of contribution margin to net sales revenue. Contribution margin / Net sales revenue. -based on sales price and variable costs therefor the ratio can be calculated using total amounts or unit amounts.

Degree of Operating Leverage

The ratio that measures the effects that fixed costs have on changes in operating income when sales volume changes. Contribution margin / Operating income.

Mixed Cost

a cost that has both fixed and variable components. -example is cost to incur to operate your car.

Fixed Cost (FC)

a cost that remains the same, in total, regardless of wide ranges of volume of activity -costs do not change in total over wide range of volume of activity. -common fixed costs-rent,, salaries, property taxes, and straight line depreciation, cost to incur insurance. -total fixed costs remain constant but the fixed cost per unit is inversely related to changes in volume. volume increases-cost decreases and vise versa.

Operating Leverage

effects that fixed costs have on changes in operating income when sales volume changes

sales mix(product mix)

the combination of products that make up total sales - to calculate the break-even point they must compute the weighted average contribution margin. -sales mix provides weights that makes up total product sales. weights equal 100% of total product sales. breakeven point cal: fixed costs+target profit/weighted average contribution margin per unit weighted average contribution margin cal: sales price per unit-variable cost=contribution margin per unit x sales mix in units =contribution margin then divid by amount of units to get the weighted average margin.

Contribution Margin income statement

the income statement that groups cost by behavior - variable or fixed - and highlights the contribution margin. -classifies cost by behavior and are classified as either variable costs or fixed costs. also highlights the contribution margin rather than gross profit. example of statement: net sales revenue- variable costs=contribution margin-fixed costs=operating income

target profit

the operating income that results when sales revenue minus variable and fixed costs equals management's profit goal net sales revenue-total cost(variable -fixed)=target profit -variation of breakeven point calculation. -focuses on how much operation income is left over from sales revenue after covering all variable and fixed costs.

Relevant Range

the range of volume where total fixed costs and variable cost per unit remain constant. -to estimate costs, managers must know the relevant range because total fixed costs can differ from one relevant range to another and the variable cost per unit can differ from one relevant range to another. -the variable cost per unit can change outside the relevant range.

break-even point

the sales level at which operating income is zero. total revenue equals total costs -cvp can be used to estimate the amount of sales needed to achieve the breakeven point. -sales can be expressed as either number of units or total dollar figure. equation approach: net sale revenue- total cost(target profit)(variable cost-fixed cost)=operating income Contribution margin approach: required sales in units= fixed cost+target profit=contribution margin per unit contribution margin ratio approach: equation ratio= contribution margin/net sales revenue