Accounting Exam #2
Short term decision pitfalls to avoid
- Avoid including sunk costs in your analysis -Avoid using unit costs unless they are purely variable
Changing the Sales Price and Volume
- Break even point changes - Unit contribution margin changes
Changing Fixed Costs
- Changes breakeven point - Does not change unit contribution margin
What is a true statement about fixed cost?
Fixed cost per unit decreases when volume increases
Product cost under absorption costing is
higher than variable costing
1st step in the high-low method
Find the slope of the mixed cost line that connects the two data points. the slope is the variable cost per unit of activity. We can determine the slope of a line as "rise over run." The rise is simply the difference in cost between the high and low data points, while the run is the difference in volume between the high and low data points: - Slope = Variable cost per unit of activity (v) = Rise/ Run = Change in cost / Change in volume = y (high) -- y(low) / x(high) -- x(low)
The shortcut approach using contribution margin ratio
Sales in units = Fixed expenses + Operating income / Contribution margin ratio
Target Costing
Starts with the market price (price customers are willing to pay) and subtracts the company's desired profit. Opposite of cost-plus pricing Revenue at market price - Desired profit = Target total cost If the company's actual total costs are higher than the target total cost, managers must find ways to reduce costs so that they can meet profit goals
On a per-unit basis, variable costs
remain constant
When using a variable costing system, the contribution margin is calculated as the excess of
revenues over variable costs
Managers often want to predict operating income at different
sales volumes. - Managers do not need to produce a full income statement to make these predictions. Rather, they can use the unit contribution margin to quickly foreccast operating income at any volume within their relevant range - Contribution margin (unit contribution margin x number of units expected to sell) -- Fixed expenses = Operating income
Contribution margin income statement
separates costs on the income statement by cost behavior rather than by function (product cost vs. period cost)
Variable cost graph
A graph of a variable cost starts at the origin and slopes upwards
The weighted-average contribution margin is computed as the
total contribution margin divided by total sales
What is true about relevant costs and information?
A manager focuses only on relevant costs and benefits, which include costs that differ amongst alternative and impact the future
What are 3 characteristics of a price-setter?
- Product is branded -Pricing approach emphasizes cost-plus pricing -Product is more unique
How might a change in fixed costs affect the contribution margin?
A change in fixed costs does not affect the contribution margin
What is an example of discretionary fixed cost expense?
Advertising
What expresses the relationship amongst costs, volume, and organizational profits?
CVP analysis
What is not a correct statement about changes in variable and fixed costs?
Lower variable costs increase the contribution margin and lower the breakeven point
What refers to the result of operating income or loss for each individual product line
Segment margin income
What refers to a company's amount of relative fixed and variable costs?
The operating leverage
What includes fixed costs that continues to be incurred even if the product line is discontinued
Unavoidable fixed costs
the margin of safety is the
excess of actual or expected sales over breakeven sales
The contribution margin is the
excess of sales revenue over variable expenses
A manager should consider these concepts when implementing a special order except for
existing fixed costs
A segment margin income statement contains
no allocation of common fixed costs on the statement
Cost-plus pricing starts with the
product's total costs and adds a desired profit to determine a cost-plus price
A ______ cost includes costs that have been incurred in the past and cannot be changed
sunk
What is computed as the total contribution margin divided by total sales?
the contribution margin ratio
A manager uses sensitivity analysis to determine what?
the impact of changes to the sales price and volume
A special order should be rejected when
the price of the special order is not more than variable costs of the order
Total fixed costs stays
constant over a wide range of volume
Managers can also use the contribution margin ratio to
quickly forecast operating income within their relevant range Contribution margin (forecasted sales revenue x contribution margin ratio) -- Fixed expenses = Operating income
Price takers
Companies are price taker when they have little or no control over the prices of their product or services. This occurs when their products and services are not unique, not branded, or when competition is heavy.
Contribution margin ratio
Ratio of contribution margin to sales revenue
The income statement approach
Sales Revenue (Sales price per unit x unit sold) -- Variable expenses (variable cost per unit x units sold) -- Fixed Expenses = Operating income
The shortcut approach using unit contribution margin
Sales in units = Fixed expenses + Operating income / Contribution margin per unit
What is the most likely change to total variable costs if a manager decreases the production of a product by 25%
25% decrease
Changing Variable Costs
- Breakeven point changes - Unit contribution margin changes - Higher variable costs have the same effect as lower selling prices -- reduce unit contribution margin
Variable costs
- Costs that are incurred for every unit of volume - Total variable costs change in direct proportion to changes in volume - Graphs always begin at the origin - Slope represents the variable cost per unit of activity
When it comes to special orders, managers must consider
- Do we have excess capacity to fill the order? - Will the reduced sales price be high enough to cover the incremental costs of filling the order? - Will the special order affect regular sales in the long run?
Considerations for discontinuing products, departments, or stores
- Does the product provide a positive contribution margin? - Are there any fixed costs that can be avoided if we discontinue the product? - Will discontinuing the product affect sales of the company's other products? - What could we do with the freed capacity? - Will discontinuing the product line affect sales of the company's other products? -Could managers make a more profitable product or leases out the capacity to another company?
Managers can use these methods to estimate the cost equation that describes the data in the scatterplot
- High-low method -Regression analysis
Considerations for outsourcing
- How do our variable cost per unit compare to the outsourcing cost per unit? - Are any fixed cost avoidable if we outsource? - What could we do with the freed capacity? - What volume do we need?
Sell As Is or Process Further
- How much revenue will we receive if we sell the product as is? - How much revenue will we receive if we sell the product after processing it further? - How much extra will it cost to process the product further?
Benefits of variable costings
- Often leads to better decisions. By assigning only variable manufacturing costs to each unit of product, managers can easily see how much additional manufacturing cost will be incurred every time another unit is produced. In addition, the unit cost of the product will not be affected by the number of units produced during the period, as it is when fixed manufacturing costs are absorbed into the unit cost. -Operating income cannot be manipulated by manufacturing more product than is needed, as absorption costing can. Variable cost can lead to better inventory management
How do managers figure out the portion of the mixed cost that is fixed and the portion that is variable?
- One way of figuring this out is by collecting and analyzing historical data about costs and volume -Once the data has been collected, the manager creates a scatterplot of the data -A scatterplot, which graphs the historical cost data on the y-axis and volume data on the x-axis, helps managers visualize the relationship between the cost and volume of activity -If there is a fairly strong relationship between the cost and volume, the data points will fall in a linear pattern, meaning they will resemble something close to a straight line -However, if there is little or no relationship between the cost and volume, the data points will appear almost random
Variable costs (or direct costing)
- Only variable manufacturing costs are treated as product costs. - May only be used for internal management purposes
2 characteristics of relevant information
- Pertains to the future - Differs among alternatives
Six short-term decisions
- Pricing - Special Orders - Discontinuing products, departments, or stores - Product mix when resources are constrained - Outsourcing (make or buy) - Selling "as is" or processing further
If the total costs are higher than the target total cost, the company needs to find ways to reduce total costs
- Reduce fixed costs - Reduce the variable costs per unit - Try other strategies, such as branding, product differentiation, or adding more products to the company's product mix. -Accept a lower profit
Step Costs
- Resemble stair steps -They are fixed over a small range of activity and then jump up to a new fixed level with moderately small changes in volume. Example: Maid-to-room ratio, server-to-table ratio, teacher-to-student ratio. -Step costs differ from fixed costs only in that they "step up" to a new relevant range with relatively small changes in volume. Fixed costs hold constant over much larger ranges in volume.
High-low method is an easy way to estimate the variable and fixed cost components of a mixed cost
- The high-low method basically fits a mixed cost line through the highest and lowest volume data points -The high-low method produces the cost equation describing the mixed cost line
3 ways to calculate breakeven points
- The income statement approach -The shortcut approach using unit contribution margin -The shortcut approach using contribution margin ratio
Breakeven Points
- The sales level at which operating income is zero - Total revenues = Total expenses -Sales below breakeven point -- loss - Sale above breakeven point -- profit
The relevant range is the band of volume where the following remain constant
- Total fixed costs -Variable cost per unit
Mixed costs:
- Total mixed cost increase as volume increase because of the variable cost component -Mixed cost per unit decrease as volume increases because of the fixed cost component -Total mixed costs graphs slope upward but do not begin at the origin-- they intersect at the y-axis at the level of fixed costs
Most common cost behaviors
- Variable costs - Fixed costs - Mixed costs
the "what-if" technique
- What if sales price changes? - What if costs changes? - What is the sales mix changes? - Use CVP to conduct sensitivity analysis
Regular Price Considerations
- What is our target profit? - How much are customers willing to pay? - Are we a price-taker or a price-setter for this product?
Unit contribution margin
- excess of the selling price per unit over the variable cost per unit - All variable costs (product and period) must be included when calculating the unit contribution margin - The unit contribution margin tells managers how much profit they make on each unity before considering fixed costs. - Sales price per unit -- Variable cost per unit = Contribution margin per unit
Fixed cost:
- is inversely proportional - When volume increases, not only does the fixed cost per unit decrease, but it also decreases in a proportional fashion -When volume decreases, the fixed cost increases in a proportional fashion - Total fixed costs stays constant over a wide range of volume -Total fixed costs graphs are always flat line with no slope that intersect the y-axis at a level equal to total fixed costs
What is the cost equation?
A mathematical equation for a straight line, to express how a cost behaves.
Special Order Decisions
A special order occurs when a customer requests a one-time order at a reduced sales price. Often, these special orders are for large quantities.
Benefits and Drawbacks of Outsourcing
Benefits: - Concentrate on core competencies - Take advantage of other companies' expertise -Reduce risk - Lower cost Drawbacks: - Less control - Employees need to manage oversees relationship - Often results in layoffs
Mixed costs
Contain both variable and fixed cost components. Example: Utilities of a hotel. Similar to a variable costs, the total mixed cost line increases as the volume of activity increase. However, the line does not begin at the origin. Rather, it intersects the y-axis at a level equal to the fixed cost component
Outsourcing
Contracting an outside company to produce a product or perform a service
Contribution margin ratio using any volume of sales:
Contribution margin ratio = Contribution margin / Sales revenue
Contribution margin ratio at unit level
Contribution margin ratio = Contribution margin per unit / Sales price per unit
Fixed costs
Cost that do not change in total despite wide changes in volume. Examples: Property taxes and insurance, straight line depreciation and maintenance, lease payments, salaries of department managers, etc.
Sunk Costs
Costs that have been incurred in the past and cannot be changed regardless of which future action is taken
A change in the number of hotel rooms that Caesars has would cause a/an __________ proportional change in Caesars' total variable costs
Direct
Pitfall to Avoid on Discontinuation
Do not base decision off of a product line income statement that includes the allocation of common fixed expenses. Prepare a segment margin income statement instead.
2nd step in the high-low method
Find the vertical intercept --- the place where the line connecting the two data points intersects the y-axis. This is the fixed cost component of the mixed cost. Insert the slope found in step 1 and the volume and cost data from either the high or low data into a mixed cost equation: - Total mixed cost (y) = Variable cost component (vx) + Fixed cost component (f)
Cost Behavior
How costs change as volume changes
Short term decision making or incremental analysis approach
Instead of looking at the company's entire income statement under each decison alternative, we'll look at how operating income would change or differ under each alternative. Using this approach, we'll leave out irrelevant information -- the costs and revenues that won't differ between alternatives. - Focus on relevant revenues, costs, and profit - Uses a contribution margin approach that separates variable costs from fixed costs
Why is the concept of relevant range important?
Managers can predict costs accurately only if they use cost information for the appropriate relevant range
Committed Fixed Cost vs. Discretionary Fixed Costs:
Most of the costs like (property taxes, insurance, depreciation, etc) are committed fixed costs, meaning that a hotel ( or other business is locked in to these costs because of previous management decisions. Management has little or no control over these committed fixed costs in the short run. However, the hotel also incurs discretionary fixed costs, such as advertising expenses, that are results of annual management decisions. Companies have more control over discretionary fixed costs.
Pitfall to Avoid on Special Order Decisions
Never compare the special-order sales price with the absorption cost per unit. Rather, use the contribution margin approach
Curvilinear Cost:
Not linear and, therefore, do not fit into any neat pattern. Some businesses approximate these types of costs as mixed costs, knowing that they will have an estimation error at particular volumes
Cost-Plus Pricing
Starts with the product's total cost and add a desired profit. Total Cost + Desired Profit = Cost-plus Price This determines if customers are willing to pay that much for a product by using focus groups and test marketing to determine if the cost is too high or too low
Margin of safety
The excess of actual or expected sales over the sales needed to breakeven. Drop in sales that company can absorb without incurring a loss. The higher the margin of safety, the greater the cushion against loss and the less risky the business plan. Managers use the margin of safety to evaluate the risk of current operations as well as the risk of new plans.
Relevant Range
The range of volume in which cost behaves in a certain way. A change in cost behavior means a change to a different relevant range.
Any variable cost line can be mathematically expressed as:
Total Variable Cost (y) = Variable cost per unit of activity (v) * Volume of activity (x) or simply, y=vx
Cost equation for fixed costs:
Total fixed cost (y) = Fixed amount over a period of time (f) or simply, y=f
Cost equation for mixed cost
Total mixed costs (y) = Variable cost component (vx) + Fixed cost component (f) or simply, y=vx+f
Absorption costing
Under absorption costs, all manufacturing-related costs, whether fixed or variable are "absorbed" into the cost of the product. All direct materials, direct labor, and MOH costs are treated a product costs. Supporters of absorption costing argue that all of these costs -- whether variable or fixed -- are necessary for production to occur, so all of these costs should become part of the product costs. GAAP and IRS require absorption cost for external reporting
3rd step in the high-low method
Using the variable cost per unit of activity found in step 1 and the fixed cost component found in step 2, write the equation representing the costs' behavior. This is the equation for the line connecting the 2 data points on our graph. Y = mx+b
____________ are treated as product costs under the variable costing method
Variable production costs
Contribution margin is also known as
Variable profit
A fixed cost expense that management has little or no control over in the short run is a
committed fixed cost
Sensitivity Analysis
a "what-if" technique that asks what results will be if actual prices or costs change or if an underlying assumption such as sales mix changes. Prepare for increasing costs, pricing pressures, and other changing business conditions.
Account analysis is
a method to determine cost behavior that is based on a manager's judgement in classifying each general ledger account as a variable, fixed, or a mixed cost
The total variable costs
are plotted on the vertical axis (y-axis) of a graph
A unit of product under absorption costing includes
direct materials, direct labor, variable overhead, and fixed overhead costs
Contribution margin
excess of sales revenue over variable expenses.
When production exceeds sales, the net operating income reported under absorption costing is
greater than net operating income reported under variable costing
When sales exceed production, the net operating income reported under variable costing is _____
greater than the net operating income reported under absorption costing
To find the number of units a company must sell to earn a target profit, we can use the same 3 approaches as we used earlier to find breakeven. The only difference from our prior analysis is that
instead of determining the sales level needed for zero profit (breakeven), we are now looking to find the number of units a company needs to sell to earn a target profit. When finding the volume needed to earn a target profit, use the target profit as the operating income in the formulas
One major drawback of the high-low method
it uses only 2 data points.
The contribution margin ratio is the
percentage of each sales dollar that is available for covering fixed expenses and generating a profit
a scatterplot can indicate a
positive correlation
The biggest difference between the high-low method and the regression analysis is that
the high-low method uses only two of the historical data points for this estimate, whereas regression analysis uses all the historical data points. Therefore, regression analysis is theoretically the better of the the two methods.
The vertical axis (y-axis) on a graph plots
the total fixed costs
The only difference between absorption costing and variable costing is
the treatment of fixed MOH, and the timing with which is expensed: - Under variable costing, fixed MOH is expensed immediately as a period cost (operating expenses) - Under absorption costing, fixed MOH becomes part of the product cost of each unit, which isn't expensed until the inventory is sold (as Cost of Goods Sold)
Scatterplots are also very useful because
they allow managers to identify outliers, or abnormal data points. Outliers are data points that do not fall in the same general pattern as the other data points.
the contribution margin is stated as a
total amount on the contribution margin income statement
