Below are the required learning resources for this week.

Activity Based Costing

4.1 Activity-Based Costing and Management

ACTIVITY-BASED COSTING AND MANAGEMENT

Suppose you go to a movie theater that has five screens showing five different movies. Jerome Justin works for the movie theater selling tickets for all five movies. Suppose management wants to know the cost of selling tickets per movie and asks you to assign Justin’s wages to each of the five movies. How would you assign his wages?

You could simply divide Justin’s wages by the number of movies and allocate 20% (1/5 = 20%) of his salary to each movie. Or you could figure out how many tickets he sold to each movie, and allocate his wages on the basis of ticket sales. For example, if 50% of the ticket sales were for Avatar, you might allocate 50% of Justin’s wages to Avatar. You probably also could think of additional ways to allocate Justin’s wages. No matter how we allocate Justin’s wages, his wages would not be directly traceable to one of the movies if he sold tickets for all five movies. In short, the allocation of Justin’s wages to a particular movie is at least somewhat arbitrary because alternative methods could allocate different amounts of Justin’s wages to each movie. Justin’s wages would be indirect costs to the different movies because his wages could not be directly assigned to any one of the movies.

By definition, the allocation of indirect costs is at least somewhat arbitrary. Nevertheless, accountants have discovered that they can improve the ways costs are assigned, such as to movies in this case, by using activity-based costing.

Activity-based costing is a costing method that assigns indirect costs to activities and to the products based on each product’s use of activities. Activity-based costing is based on the premise: Products consume activities; activities consume resources.

Activity-based costing identifies the activities generating costs and assigns costs to those activities. Take the earlier Justin example. By focusing on Justin’s activities, management could learn what caused costs and find ways to improve Justin’s efficiency. Suppose that by studying Justin’s activities, management learns he spends 40% of his time answering questions about movies, 40% of his time selling tickets, and 20% doing nothing. Based on this information, management could think about better ways to use Justin’s time. By improving their signs and posting information about the movies, management could reassign Justin to other tasks.

Closely related to activity-based costing is the notion of activity-based management (ABM). Using activity-based management, managers identify which activities consume resources. The focus is then to effectively manage costly activities with the goal of reducing costs and improving quality. Consider Justin and the movie theater again. Using activity-based management, managers would identify what Justin did with his time and perhaps find ways to help him become more efficient.

Let’s look at a company that makes clothing. The product does not cost less under one system or another. Our problem is that no cost system measures costs perfectly. We are able to trace some costs directly to the product. For example, we are pretty accurate in measuring the cost of denim, which is a direct material, in each of our shirts, pants, jackets, and so forth.

ACTIVITY-BASED COSTING AND MANAGEMENT

Suppose you go to a movie theater that has five screens showing five different movies. Jerome Justin works for the movie theater selling tickets for all five movies. Suppose management wants to know the cost of selling tickets per movie and asks you to assign Justin’s wages to each of the five movies. How would you assign his wages?

You could simply divide Justin’s wages by the number of movies and allocate 20 per cent of his salary to each movie. Or you could figure out how many tickets he sold to each movie, and allocate his wages on the basis of ticket sales. For example, if 50 per cent ofthe ticket sales were for Avatar, you might allocate 50 per cent of Justin’s wages to Avatar. You probably also could think of additional ways to allocate Justin’s wages. No matter how we allocate Justin’s wages, his wages would not be directly traceable to one of the movies if he sold tickets for all five movies. In short, the allocation of Justin’s wages to a particular movie is at least somewhat arbitrary because alternative methods could allocate different amounts of Justin’s wages to each movie. Justin’s wages would be indirect costs to the different movies because his wages could not be directly assigned to any one of the movies.

By definition, the allocation of indirect costs is at least somewhat arbitrary. Nevertheless, accountants have discovered that they can improve the ways costs are assigned, such as to movies in this case, by using activity-based costing.

Activity-based costing is a costing method that assigns indirect costs to activities and to the products based on each product’s use of activities. Activity-based costing is based on the premise: Products consume activities; activities consume resources.

Numerous companies, such as HP, Caterpillar, and IBM, have implemented activity-based costing. Activity-based costing (ABC) has revealed startling information in these companies. For example, after installing new costing methods, one well-known company found that one of its products, a printed circuit board, was generating negative margins of 46 per cent.

Activity-based costing identifies the activities generating costs and assigns costs to those activities. Take the earlier Justin example. By focusing on Justin’s activities, management could learn what caused costs and find ways to improve Justin’s efficiency. Suppose that by studying Justin’s activities, management learns he spends 40 per cent of his time answering questions about movies, 40 per cent of his time selling tickets, and 20 per cent doing nothing. Based on this information, management could think about better ways to use Justin’s time. By improving their signs and posting information about the movies, management could reassign Justin to other tasks.

Closely related to activity-based costing is the notion of activity-based management (ABM). Using activity-based management, managers identify which activities consume resources. The focus is then to effectively manage costly activities with the goal of reducing costs and improving quality. Consider Justin and the movie theater again. Using activity-based management, managers would identify what Justin did with his time and perhaps find ways to help him become more efficient.

Let’s illustrate by looking at a textile company that makes jeans. We will use this company as a basis to demonstrates important issues about the difficulty with traditional cost allocation methods and the advantages of activity-based costing.

The product does not cost less under one system or another. Our problem is that no cost system measures costs perfectly. We are able to trace some costs directly to the product. For example, we are pretty accurate in measuring the cost of denim, which is a direct material, in each of our shirts, pants, jackets, and so forth.

Overhead costs are another matter. Overhead includes costs like electricity to run machines and salaries of product designers and inspectors. All these costs are allocated to products. We know quality control inspectors cost money, but we do not know how much of that cost is caused by a particular jacket or pair of pants. So we make some assumptions about the relation between products and overhead costs. For example, we typically allocate overhead based on machine-hours required to stitch and fasten snaps. While that is probably a reasonable way to allocate the costs of electricity to run machines, its not a desirable way to allocate the cost of quality control inspectors.

overhead allocation is somewhat arbitrary (it is based on an estimate only), how will activity-based costing help?

Activity-based costing provides more accurate information because we can identify which activities cause costs, and we can determine the cost of the activity. Activity-based costing identifies and measures the costs of performing the activities that go into a product much better than traditional cost methods. For example, if a particular jacket requires 10 inspections for a production run of 1,000 jackets, we figure out the cost of those inspections and assign that cost to the production run for this particular jacket.

But exactly how would activity-based costing help us cut production costs?

Once we identify activities that cause costs, we can eliminate or modify costly activities. For example, if we find that a jacket requires too many costly inspections, we could redesign the jacket to reduce the need for inspections. Our current cost system allocates all overhead costs, including inspection costs, to products based on machine-hours. We really do not know how much it costs to make an inspection and how much inspection cost is required by each product.

Because activity-based costing provides more information, it takes more time than traditional cost systems. New accounting methods sound great in theory, but there must be enough benefit from improved management decisions to justify the additional work required to provide numbers.

Key points about activity-based costing:

  1. The allocation of indirect costs is at least somewhat arbitrary, even using sophisticated accounting methods.
  2. Activity-based costing provides more detailed measures of costs than traditional allocation methods.
  3. Activity-based costing can help marketing people by providing more accurate product cost numbers for decisions about pricing and which unprofitable products the company should eliminate.
  4. Production also benefits because activity-based costing provides better information about the cost of each activity. In practice, ABC helps managers identify cost-causing activities. To manage costs, production managers learn to manage the activities that cause costs.
  5. Activity-based costing provides more information about product costs than traditional methods but requires more record-keeping. Managers must decide whether the benefits or improved decisions justify the additional record-keeping cost.
  6. Installing activity-based costing requires teamwork among accountants, production managers, marketing managers, and other nonaccounting people.

Next, we discuss the methods used for activity-based costing and illustrate them with an example.

4.2 Activity Based Costing Method

TRADITIONAL COSTING METHOD

In a traditional costing method, we calculate one plantwide allocation rate or we could calculate an overhead allocation rate for each department. We have a three step process:

Step 1: Determine the basis for allocating overhead or indirect costs. These can be anything a company decides but most common are direct labor cost, direct labor hours, direct material usage or machine hours.

Step 2: Calculated a predetermined overhead rate using estimates. This is typically calculated at the end of the year to be used during the following year. The formula we use for this is:

Predetermined Overhead Rate (POHR) = Estimated Overhead
Estimated Base (or cost driver)

Step 3: Apply overhead throughout the period using the actual amount of our base and the predetermined overhead rate (POHR) calculated in step 2. We calculate this as:

Applied Overhead = Actual amount of base x POHR

This video will discuss the differences between the traditional costing method and activity based costing.

Traditional costing method example

Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.

High Challenge Company allocated manufacturing overhead costs to the two products for the month of January. Department A had estimated overhead of $2,000,000 and used 20,000 machine hours. High Challenge has decided to allocate overhead on the basis of machine hours.

  • The predetermined overhead rate of $100 per machine hour is calculated as:

    Predetermined Overhead Rate (POHR) = Estimated Overhead $2,000,000
      Estimated Base (or cost driver) 20,000 machine hours
  • At the end of January, High Challenge had used 1,500 machine hours for the Touring bicycle product line and 500 machine hours for the Mountain bicycle product line. Overhead would be allocated to each product as follows (use the POHR calculated above at $100 per machine hour):

    Touring Bicycle Mountain Bicycle
    $150,000 $50,000
    (1,500 machine hours x $100 per hour) (500 machine hours x $100 per hour)

METHODS USED FOR ACTIVITY-BASED COSTING

Activity-based costing requires accountants to use the following four steps:

1. Identify the activities that consume resources and assign costs to those activities. Purchasing materials would be an activity, for example.

2. Identify the cost drivers associated with each activity. A cost driver is an activity or transaction that causes costs to be incurred. For the purchasing materials activity, the cost drivers could be the number of orders placed or the number of items ordered. Each activity could have multiple cost drivers.

3. Compute a cost rate per cost driver unit. The cost driver rate could be the cost per purchase order, for example.

4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product. For example, the cost per purchase order times the number of orders required for Product A for the month of December would measure the cost of the purchasing activity for Product A for December.

The next section describes these four steps.

Step 1 is often the most interesting and challenging part of the exercise. This step requires people to understand all of the activities required to make the product. Imagine the activities involved in making a simple product like a pizza—ordering, receiving and inspecting materials, making the dough, putting on the ingredients, baking, and so forth. Or imagine the activities involved in making a complex product such as an automobile or computer.

One of the lessons of activity-based costing has been that the more complex the business, the higher the indirect costs. Imagine that each month you produce 100,000 gallons of vanilla ice cream and your friend produces 100,000 gallons of 39 different flavors of ice cream. Further, assume your ice cream is sold only in one liter containers, while your friend sells ice cream in various containers. Your friend has more complicated ordering, storage, product testing (one of the more desirable jobs, nevertheless), and packing in containers. Your friend has more machine setups, too. Presumably, you can set the machinery to one setting to obtain the desired product quality and taste. Your friend has to set the machines each time a new flavor is produced. Although both of you produce the same total volume of ice cream, it is not hard to imagine that your friend’s overhead costs would be considerably higher.

In Step 2, we identify the cost drivers. In the table below, we present several examples of the cost drivers companies use. Most cost drivers are related to either the volume of production or to the complexity of the production or marketing process.

Cost driver Cost of assigned cost driver
Miles driven Automobile costs
Machine-hours Electricity to run machines
Customers served Overhead in a bank
Flight hours  Airplane maintenance costs 
Number of customers  Selling costs 

In deciding which cost drivers to use, managers consider these three factors:

  • Causal relation. Choosing a cost driver that causes the cost is ideal. For example, suppose students in biology classes are messier than students in history classes. As a result, the university does more maintenance per square foot in biology classrooms and labs than in history classrooms. Further, it is possible to keep track of the time maintenance people spend cleaning classrooms and labs. The university could assign maintenance costs based on the time spent in history classrooms and in biology classrooms and labs, respectively, to the history and biology departments.
  • Benefits received. Choose a cost driver so costs are assigned in proportion to benefits received. For example, if the physics department in a university benefits more from the university’s supercomputer than the German department does, the university should select a cost driver that recognizes such differences in benefits. The cost driver could be the number of faculty and/or students in each department who use the computer.
  • Reasonableness. Some costs that cannot be linked to products based on causality or benefits received are assigned on the basis of reasonableness.

For step 3, we need to calculate the activity rates. These are calculated using the same formula for predetermined overhead rate (POHR) that we used for traditional costing. In general, predetermined rates for allocating indirect costs to products are computed as follows:

Predetermined Overhead Rate (POHR) = Estimated Overhead
Estimated Base (or cost driver)

This formula applies to all indirect costs, whether manufacturing overhead, administrative costs, distribution costs, selling costs, or any other indirect cost.

In Step 4, we first define the notion of an activity center. An activity center is a unit of the organization that performs some activity. For example, the costs of setting up machines would be assigned to the activity center that sets up machines. This means that each activity has associated costs. When the cost driver is the number of inspections, for example, the company must keep track of the cost of inspections.

Workers and machines perform activities on each product as it is produced. Accountants allocate costs to products by multiplying each activity’s indirect cost rate by the volume of activity used in making the product. The formula we will use for each activity is:

Applied Overhead = Actual amount of activity cost driver x activity POHR

ACTIVITY-BASED COSTING EXAMPLE

Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.

In using activity-based costing, the company identified four activities that were important cost drivers and a cost driver used to allocate overhead. These activities were (1) purchasing materials, (2) setting up machines when a new product was started, (3) inspecting products, and (4) operating machines.

Accountants estimated the overhead and the volume of events for each activity. For example, management estimated the company would purchase 100,000 pieces of materials that would require overhead costs of $200,000 for the year. These overhead costs included salaries of people to purchase, inspect, and store materials. Setting up machines for a new product would need 400 setups and overhead of $800,000. The company would have 4,000 inspections and overhead of $400,000. Finally, running machines would cost $600,000 for 20,000 machine hours.

These estimates were made last year and will be used during all of the current year. In practice, companies most frequently set rates for the entire year, although some set rates for shorter periods, such as a quarter.

Look at the overhead rates computed for the four activities in the table below. Note that the total overhead for current year is $2,000,000 using activity-based costing, just as it was using a traditional costing method. The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products. The primary difference between activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of activities used to assign overhead costs to products. Traditional allocation uses just one activity, such as machine-hours. Activity-based costing used four activities in this case. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. We used four to keep the illustration as simple as possible.

The activity cost rates (predetermined overhead rates) are calculated as follows:

Activity Cost Driver (activity) Overhead Cost Estimated Units   Rate
Purchasing Materials Pieces of materials $ 200,000 100,000 pieces $ 2 per piece
Machine Setups Machine setups 800,000 400 setups 2,000 per setup
Inspections Inspection hours 400,000 4,000 inspect. hours 100 per inspect. hour
Running Machine Machine hours 600,000 20,000 mach. Hours 30 per machine hour
Total Overhead   $ 2,000,000      

For January, the High Challenge Company has the following information about the actual number of cost driver units for each of the two products:

  Touring Mountain
Purchasing Materials 6,000 pieces 4,000 pieces
Machine Setups 10 setups 30 setups
Inspections 200 hours 200 hours
Running Machine 1,500 hours 1,500 hours

Multiplying the actual activity events for each product times the predetermined rates computed earlier resulted in the overhead allocated to the two products:

    Touring   Mountain
Purchasing Materials $ 12,000 (6,000 pieces x $2 per piece) $ 8,000 (4,000 pieces x $2 per piece)
Machine Setups 20,000 (10 setups x $2,000 per setup) 60,000 (30 setups x $2,000 per setup)
Inspections 20,000 (200 hours x $100 per hour) 20,000 (200 hours x $100 per hour)
Running Machine 45,000 (1,500 hours x $30 per hour) 15,000 (500 hours x $30 per hour)
Total Overhead $ 97,000   $ 103,000  

Now we can compare the overhead allocated to the two product lines using the traditional method and activity-based costing, as follows:

  Touring bicycles Mountain bicycles
Traditional method $150,000 $50,000
Activity-based costing 97,000 103,000

Notice how the total overhead for the month of January is the same at $200,000 but the amount allocated to each product is different.

Analysis More overhead is allocated to the lower volume mountain bicycles using activity-based costing. The mountain bicycles are allocated more overhead per unit primarily because activity-based costing recognizes the need for more setups for mountain bicycles and for as many inspection hours for the more specialized mountain bicycles as for the higher volume touring bicycles. By failing to assign costs to all of the activities, touring bicycles were subsidizing mountain bicycles. Many companies have found themselves in similar situations. Activity-based costing has revealed that low-volume, specialized products have been the cause of greater costs than managers had realized.

Here is a video example of activity based costing:

4.3 Accounting in the Headlines

WHAT ARE POTENTIAL COST DRIVERS FOR AN ABC SYSTEM AT VIRGIN AMERICA?

After several years of losses, Virgin America recently announced that it anticipates a profit for 2013. Although the company is expecting a profit for 2013, it still is not out of the woods. Critics have called for greater cost control at Virgin America.

The following table contains selected financial and other data for Virgin America for 2012.

Virgin America
Selected financial data
For Twelve Months Ended December 31, 2012
Partial income statement:   (000s omitted)
Operating revenues $ 1,332,837
Other expenses:    
Aircraft fuel   537,501
Aircraft rent   221,275
Wages and salaries   176,216
Aircraft maintenance   74,459
Landing fees   110,165
Sales and marketing   107,136
Guest services   50,448
Depreciation   11,260
Other   76,110
Total operating expenses $ 1,364,570
Operating income/loss $ (31,733)
     
Selected data:
Available seat miles (millions)   12,545
Departures   56,362
Aircraft in service   51
Guests (thousands)   6,219
Load factor (% of seats filled) 79.0%  
Fuel gallons consumed (thousands)   161,404

Financial data source here.

Questions

1. For each of the expenses listed in the income statement, select a cost driver from the drivers listed under “Selected data.” Provide rationale for your choice of each of the drivers.

2. Are there any expenses you would group together into a single pool? Why or why not?

3. How could Virgin America use these cost pools and activity-based costing information internally?

Cost Behavior and Cost-Volume-Profit Analysis

5.1 Cost Behavior Vs. Cost Estimation

Cost-Behavior Patterns

There are four basic cost-behavior patterns: fixed, variable, mixed (semivariable), and step, which would appear graphically as shown below.

Cost patters

The relevant range is the range of production or sales volume over which the assumptions about cost behavior are valid. Often, we describe them as time-related costs.

A graph depicting the relevant range would look like this:

relevant range

Fixed costs remain constant (in total) over some relevant range of output. Depreciation, insurance, property taxes, and administrative salaries are examples of fixed costs. Recall that so-called fixed costs are fixed in the short run, but not necessarily in the long run. For example, a local high-tech company did not lay off employees during a recent decrease in business volume because the management did not want to hire and train new people when business picked up again. Management treated direct labor as a fixed cost in this situation. Although volume decreased, direct-labor costs remained fixed.

In contrast to fixed costs, variable costs vary (in total) directly with changes in volume of production or sales. In particular, total variable costs change as total volume changes. If pizza production increases from 100 10-inch pizzas to 200 10-inch pizzas per day, the amount of dough required per day to make 10-inch pizzas would double. The dough is a variable cost of pizza production. Direct materials and sales commissions are variable costs.

Direct labor is a variable cost in many cases. If the total direct-labor cost increases as the volume of output increases and decreases as volume decreases, direct labor is a variable cost. Piecework pay is an excellent example of direct labor as a variable cost. In addition, direct labor is frequently a variable cost for workers paid on an hourly basis—as the volume of output increases, more workers are hired. However, sometimes the nature of the work or management policy does not allow direct labor to change as volume changes, and direct labor can be a fixed cost.

Mixed costs have both fixed and variable characteristics. A mixed cost contains a fixed portion of cost incurred even when the facility is idle, and a variable portion that increases directly with volume. Electricity is an example of a mixed cost. A company must incur a certain cost for basic electrical service. As the company increases its volume of activity, it runs more machines and runs them longer. The firm also may extend its hours of operation. As activity increases, so does the cost of electricity.

Managers usually separate mixed costs into their fixed and variable components for decision-making purposes. They include the fixed portion of mixed costs with other fixed costs, while assuming that the variable part changes with volume. We will look at ways to separate fixed and variable components of a mixed cost later in the chapter.

A step cost remains constant at a certain fixed amount over a range of output (or sales). Then, at certain points, the step costs increase to higher amounts. In graphic form, step costs look like stair steps.

Supervisors’ salaries are an example of a step cost when companies hire additional supervisors as production increases. For instance, the local McDonald’s restaurant has one supervisor until sales exceed 100 meals during the lunch hour. If sales regularly exceed 100 meals during that hour, the company adds a second supervisor. The supervisor costs will remain the same for 0–100 meals served that hour. When the number of meals served is 101–200, the supervisor cost goes up to reflect two supervisors. Step costs will increase by the same amount for each new cost or step. Step costs are sometimes labeled as step variable costs (many small steps) or step fixed costs (only a few large steps). In graphic form, a step cost would appear as:

step cost

Although we have described four different cost patterns (fixed, variable, mixed, and step), we simplify our discussions in this chapter by assuming that managers can separate mixed and step costs into fixed and variable components, using cost-estimation techniques.

Many costs do not vary in a strictly linear relationship with volume. Rather, costs may vary in a curvilinear pattern—a 10% increase in volume may yield an 8% change in total variable costs at lower output levels and an 11% change in total variable costs at higher output levels. We show a curvilinear cost pattern below.

curvilinear

One way to deal with a curvilinear cost pattern is to assume a linear relationship between costs and volume within some relevant range. Within that relevant range, the total cost varies linearly with volume, at least approximately. Outside of the relevant range, we presume the assumptions about cost behavior may be invalid.

Costs rarely behave in the simple way that would make life easy for decision-makers. Even within the relevant range, the assumed cost behavior is usually only approximately linear. As decision-makers, we have to live with the fact that cost estimates are not as precise as physical or engineering measurements.

5.2 Fixed and Variable Costs

Fixed Costs

Fixed costs remain in TOTAL but change per unit, based on the actual amount of production.

Examples of fixed costs include monthly rent, mortgage or car payments, employee salary, depreciation calculated under the straight-line method, and insurance.

Variable Costs

Variable costs remain the same PER UNIT, but CHANGE in total.

Variable costs for a manufacturer would include things like direct labor of hourly workers, other wage employees, direct materials, applied overhead, sales commissions, and depreciation under the units-of-production method.

5.3 Mixed Costs

Mixed Costs

Mixed costs are costs that contain a portion of both fixed and variable costs. Common examples include utilities and even your cell phone! You may be charged a fixed amount each month for data usage or text messages allowed; but when you exceed your limit, you are charged a set amount (variable cost) based on each text message or gigabyte of data you use over your limit.

A mixed cost would look like this in a graph:

mixed costs

Next, we will look at how we can estimate the fixed and variable portions of a mixed cost for accounting analysis.

5.4 Accounting in the Headlines: Costs

Are the costs of owning a car fixed, variable, or mixed?

car-costsAccording to a recent news article in the Wall Street Journal (“Mercedes or Ford, It Costs a Lot More Than You Think,” Wall Street Journal, Sunday Journal, March 15, 2014), the average consumer spends more than $760 a month on his/her vehicle and related expenses.

  • Purchase price of the car
  • Finance charges on car loan
  • Gas
  • Oil changes
  • Routine maintenance
  • Tires
  • Insurance
  • License plate/registration
  • SiriusXM Radio subscription
  • Car washes
  • Garage/parking
  • Parking tickets
  • Speeding tickets
  • Value of car owner’s time spent commuting

Questions

  1. Which of the costs above would most likely be variable with respect to the number of miles the car owner drives?
  2. Which of the costs above would most likely be fixed with respect to the number of miles the car owner drives?
  3. Which of the costs above would most likely be mixed with respect to the number of miles the car owner drives?

5.5 Cost-Volume-Profit Analysis In Planning

Cost-Volume-Profit Analysis In Planning

Companies use cost-volume-profit (CVP) analysis (also called break-even analysis) to determine what effects changes in their selling prices, costs, and/or volume will have on profits in the short run. A careful and accurate CVP analysis requires knowledge of costs and their fixed or variable behavior as volume changes.

A cost-volume-profit chart is a graph that shows the relationships among sales, costs, volume, and profit. Look at illustration below. The illustration shows a cost-volume-profit chart for Video Productions, a company that produces DVDs. Each DVD sells for $20. The variable cost per DVD is $12, and the fixed costs per month are $40,000.

cvp chart

The total cost line represents the fixed costs of $40,000 plus $12 per unit. Thus, if Video Productions produces and sells 6,000 DVDs, the company’s total costs are $112,000, made up of $40,000 fixed costs and $72,000 total variable costs ($72,000 = $12 per unit × 6,000 units produced and sold).

The total revenue line shows how revenue increases as volume increases. Total revenue is $120,000 for sales of 6,000 DVDs ($20 per unit × 6,000 units sold). In the chart, we demonstrate the effect of volume on revenue, costs, and net income, for a particular price, variable cost per unit, and fixed cost per period.

At each volume, one can estimate the company’s profit or loss. For example, at a volume of 6,000 units, the profit is $8,000. We can find the net income by either constructing an income statement or using the profit equation. The contribution-margin income statement gives the following results for a volume of 6,000 units:

Revenue $120,000
Less: variable costs     72,000
Contribution margin $  48,000
Less: Fixed costs     40,000
Net income $    8,000

We have introduced a new term in this income statement—the contribution margin. The contribution margin is the amount by which revenue exceeds the variable costs of producing that revenue. We can calculate it on a per-unit or total sales volume basis. On a per-unit basis, the contribution margin for Video Productions is $8 (the selling price of $20 minus the variable cost per unit of $12).

Contribution Margin = Sales − Variable Cost

The contribution margin indicates the amount of money remaining after the company covers its variable costs. This remainder contributes to the coverage of fixed costs and to net income. In Video Production’s income statement, the $48,000 contribution margin covers the $40,000 fixed costs and leaves $8,000 in net income.

You can also calculate a contribution-margin ratio by using the following formula:

Contribution Margin RATIO  =  Sales − Variable Cost 
Sales

Profit Equation

The profit equation is just like the income statement, except that it presents the analysis in a slightly different form. According to the profit equation:

Net income = Revenue − Total variable costs − Fixed costs

For Video Productions, the profit equation looks like this:

Net income = $120,000 − $72,000 − $40,000
Net income = $8,000

The CVP chart above shows cost data for Video Productions in a relevant range of output from 500 to 10,000 units. Recall that the relevant range is the range of production or sales volume over which the basic cost-behavior assumptions hold true. For volumes outside these ranges, costs behave differently and alter the assumed relationships. For example, if Video Productions produced and sold more than 10,000 units per month, it might be necessary to increase plant capacity (thus incurring additional fixed costs) or to work extra shifts (thus incurring overtime charges and other inefficiencies). In either case, the assumed cost relationships would no longer be valid.

The contribution-margin income statement is used quite frequently because it separates fixed and variable costs to allow a company to see what it can directly change and what it cannot change.

5.6 Break Even Point for a Single Product

Finding the Break-Even Point

A company breaks even for a given period when sales revenue and costs charged to that period are equal. Thus, the break-even point is that level of operations at which a company realizes no net income or loss.

A company may express a break-even point in dollars of sales revenue or number of units produced or sold. No matter how a company expresses its break-even point, it is still the point of zero income or loss. To illustrate the calculation of a break-even point, we will work with the previous company, Video Productions.

Before we can begin, we need two things from the previous page: Contribution Margin per Unit and Contribution Margin RATIO. These formulas are:

Contribution Margin per Unit  = Sales Price − Variable Cost per Unit
Contribution Margin Ratio  =  Contribution Margin (Sales − Variable Cost) 
Sales

Break-Even in Units

Recall that Video Productions produces DVDs selling for $20 per unit. Fixed costs per period total $40,000, while variable cost is $12 per unit. We compute the break-even point in units as:

BE Units  =
                  Fixed Costs                  
Contribution Margin per Unit

Video Productions’ contribution margin per unit is $8 ($20 selling price per unit − $12 variable cost per unit). The break-even point in units would be calculated as:

BE Units =                   Fixed Costs                    $40,000  =  5,000 units
Contribution Margin per unit $8

The result tells us that Video Productions breaks even at a volume of 5,000 units per month. We can prove that to be true by computing the revenue and total costs at a volume of 5,000 units. Revenue = (5,000 units × $20 sales price per unit) = $100,000. Total costs = $100,000 ($40,000 fixed costs + $60,000 variable costs  calculated as $12 per unit × 5,000 units).

Look at the cost-volume-profit chart below and note that the revenue and total cost lines cross at 5,000 units—the break-even point. Video Productions has net income at volumes greater than 5,000, but it has losses at volumes less than 5,000 units.

cvp chart

Break-Even in Sales Dollars

Companies frequently think of volume in sales dollars instead of units. For a company such as GM that makes Cadillacs and certain small components, it makes no sense to think of a break-even point in units. GM breaks even in sales dollars.

The formula to compute the break-even point in sales dollars looks a lot like the formula to compute the break-even point in units, except that we divide fixed costs by the contribution-margin ratio instead of the contribution margin per unit.

The contribution-margin ratio expresses the contribution margin as a percentage of sales. To calculate this ratio, divide the contribution margin per unit by the selling price per unit, or total contribution margin by total revenues. Video Production’s contribution margin ratio is:

Contribution
Margin Ratio
=  Contribution margin  =   $8   =  0.4, or 40%
Sales $20

Or, referring to the income statement in which Video Productions had a total contribution margin of $48,000 on revenues of $120,000, we compute the contribution-margin ratio as contribution margin $48,000 ÷ Revenues $120,000 = 0.40, or 40%.

That is, for each dollar of sales, there is $0.40 left over after variable costs to contribute to covering fixed costs and generating net income.

Using this contribution-margin ratio, we calculate Video Production’s break-even point in sales dollars as:

BE in Sales Dollars =                 Fixed Costs                 =  $40,000  =  $100,000
Contribution Margin RATIO 0.40

The break-even volume of sales is $100,000 (can also be calculated as break-even point in units 5,000 units × sales price $20 per unit). At this level of sales, fixed costs plus variable costs equal sales revenue, as shown here:

Revenue $100,000 (5,000 units × $20 per unit)
Less: variable costs      60,000 (5,000 units × $12 per unit)
Contribution margin      40,000 (100,000 − 60,000)
Less: Fixed costs      40,000
Net Income  $           0

Margin of Safety

If a company’s current sales are more than its break-even point, it has a margin of safety equal to current sales minus break-even sales. The margin of safety is the amount by which sales can decrease before the company incurs a loss. For example, assume that Video Productions currently has sales of $120,000 and its break-even sales are $100,000. The margin of safety is $20,000, computed as follows:

Margin of safety = Current sales − Break-even sales

Margin of safety = $120,000 − $100,000 = $20,000

Sometimes people express the margin of safety as a percentage, called the margin-of-safety rate or just margin-of-safety percentage. The margin-of-safety rate is equal to:

Margin-of-Safety Percent  =  Current Sales − Break-even Sales 
Current Sales

Using the data just presented, we compute the margin-of-safety rate is $20,000 ÷ 120,000 = 16.67%.

This means that sales volume could drop by 16.67% before the company would incur a loss.

Targeted Profit or Income

You can also use this same type of analysis to determine how many sales units or sales dollars you would need to make a specific profit (very helpful!). The good news is that you have already learned the basic formula; we are simply changing it slightly. The formulas we will need are:

Units at Target Profit  =  Fixed Costs + Target Income 
Contribution Margin per Unit
Sales Dollars for Target Profit  =  Fixed Costs + Target Income 
Contribution Margin RATIO

These formulas look familiar (or they should!). They are the same formulas we used for break-even analysis, but this time we have added target income. If you think about it, it IS the same formula because at break-even our target income is ZERO.

Let’s look at another example. The management of a major airline wants to know how many seats must be sold on Flight 529 to make $8,000 in profit. To solve this problem, management must identify and separate costs into fixed and variable categories.

The fixed costs of Flight 529 are the same, regardless of the number of seats filled. Fixed costs include the fuel required to fly the plane, plus crew (with no passengers) to its destination; depreciation on the plane used on the flight; and salaries of required crew members, gate attendants, and maintenance and refueling personnel. Fixed costs are $12,000.

The variable costs vary directly with the number of passengers. Variable costs include snacks and beverages provided to passengers, baggage-handling costs, and the cost of the additional fuel required to fly the plane with passengers to its destination. Management would express each variable cost on a per-passenger basis. Variable costs are $25 per passenger.

Tickets are sold for $125 each. The contribution margin is $100 ($125 sales − $25 variable), and the contribution-margin ratio is 80% ($100 contribution margin ÷ $125 sales). We can calculate the units and sales dollars required to make $8,000 in profit by:

Units at
Target Profit  =
 Fixed Costs + Target Income  =  12,000 + 8,000  =  $20,000  =  200 tickets
Contribution Margin per unit $100 $100

The sales dollars required could be calculated as break-even units of 200 tickets × $125 sales price per ticket = $25,000, or by using the following formula:

Sales Dollars
for Target Profit =
 Fixed Costs + Target Income  =  12,000 + 8,000  =  $20,000  =  $25,000
Contribution Margin RATIO 0.80 0.80

Management can also use its knowledge of cost-volume-profit relationships to determine whether to increase sales-promotion costs in an effort to increase sales volume or to accept an order at a lower-than-usual price. In general, the careful study of cost behavior helps management plan future courses of action.

5.7 Break Even Point for Multiple Products

Break Even Point for Multiple Products

Although you are likely to use cost-volume-profit analysis for a single product, you will more often use it in multi-product situations. The easiest way to use cost-volume-profit analysis for a multi-product company is to use dollars of sales as the volume measure. For CVP purposes, a multi-product company must assume a given product mix or sales mix. Product (or sales) mix refers to the proportion of the company’s total sales for each type of product sold.

To understand the computation of the break-even point for Wonderfood, a multi-product company that makes three types of cereal, assume the following historical data. (Percent is a percentage of sales. For each product, take the amount ÷ sales and multiply by 100 to get the percentage).

Use the scroll bar at the bottom of the table to see all of the data.

Product 1 Product 2 Product 3 Total
Amount Percent Amount Percent Amount Percent Amount Percent
Sales  60,000 100%  30,000 100%  10,000 100% 100,000 100%
Less: variable costs  40,000   67%  16,000   53%    4,000   40%   60,000   60%
Contribution margin  20,000   33%  14,000   47%    6,000   60%    40,000   40%

We use the data in the total columns to compute the break-even point. The contribution-margin ratio is 40% (total contribution margin $40,000 ÷ total sales $100,000). Assuming the product mix remains constant and fixed costs for the company are $50,000, break-even sales are $125,000, computed as follows:

BE in Sales Dollars  =                 Fixed Costs                  $50,000 
=  $125,000
Contribution Margin RATIO 0.40

[To check our answer: ($125,000 break-even sales × 0.40 contribution-margin ratio) − $50,000 fixed costs = $0 net income.]

Because what we found in our example for Wonderfood is a total, we need to determine how much sales would be needed by each product to break even. To find the three product-sales totals, we multiply total sales dollars by the percent of product (or sales) mix for each of the three products. The product mix for products 1, 2, and 3 is 60:30:10, respectively. That is, out of the $100,000 total sales, there were sales of $60,000 for product 1, $30,000 for product 2, and $10,000 for product 3. An easy way to calculate product or sales mix is to divide each product’s sales by total sales, as in the following table:

  Sales Sales Mix
Product 1   60,000 60% (60,000 ÷ 100,000)
Product 2   30,000 30% (30,000 ÷ 100,000)
Product 3   10,000 10% (10,000 ÷ 100,000)
Total Sales 100,000 100%

We can calculate the amount each product needs to sell by multiplying the total break-even sales required by the sales mix for each product. This is calculated as:

Sales Mix Sales at Break-Even
Product 1   60% $ 75,000 (125,000 × 60%)
Product 2   30%    37,500 (125,000 × 30%)
Product 3   10%    12,500 (125,000 × 10%)
Total Sales 100%  125,000  

Be aware! Predicting sales mix can be extremely difficult. If we know we need $125,000 in sales to break even but the sales mix is different from what we budgeted, the numbers will appear quite different. If the sales mix is different from our estimate, the break-even point will not be the same.

5.8 Cost-Volume-Profit Analysis Summary

Assumptions Made in Cost-Volume-Profit Analysis

To summarize, the most important assumptions underlying CVP analysis are:

  • Selling price, variable cost per unit, and total fixed costs remain constant through the relevant range. This means that a company can sell more or fewer units at the same price and the company has no change in technical efficiency as volume changes.
  • In multi-product situations, the product mix is known in advance.
  • Costs can be accurately classified into their fixed and variable portions.

Critics may call these assumptions unrealistic in many situations, but they greatly simplify the analysis.

CVP Graph

cvp chart

5.9 Accounting in the Headlines: Breakeven

What Happens to the Break-Even Point When Sports Illustrated Lays Off All Six Staff Photographers and Uses Freelancers Instead?

sports-illustratedSports Illustrated announced in late January 2015 that it would be laying off all six of its staff photographers. Instead, it will be using freelance photographers around the world. Sports Illustrated is one of 90 magazines owned by Time Inc. (TIME). Published 56 times a year, Sports Illustrated is read by over 23 million people each week.

Questions

  1. What type of cost would staff photographers be for Sports Illustrated (fixed, variable, or mixed)?
  2. What type of cost would the freelance photographers be for Sports Illustrated?
  3. What is likely to happen to the break-even point for Sports Illustrated due to the switch to using freelance photographers?
  4. What are some disadvantages of Sports Illustrated’s decision to outsource its photography?

Variable and Absorption Costing

6.1 Absorption Costing

Absorption Costing

Absorption costing, also called full costing, is what you are used to under Generally Accepted Accounting Principles. Under absorption costing, companies treat all manufacturing costs, including both fixed and variable manufacturing costs, as product costs. Remember, total variable costs change proportionately with changes in total activity, while fixed costs do not change as activity levels change. These variable manufacturing costs are usually made up of direct materials, variable manufacturing overhead, and direct labor. The product costs (or cost of goods sold) would include direct materials, direct labor, and overhead. The period costs would include selling, general, and administrative costs.

The following diagram explains the cost flow for product and period costs.

absorp

The product cost, under absorption costing, would be calculated as:

Direct Materials
+ Direct Labor
+ Variable Overhead
+ Fixed Overhead
= Total Product Cost

You can calculate a cost per unit by taking the total product costs ÷ total units PRODUCED. Yes, you will calculate a fixed overhead cost per unit as well, even though we know that fixed costs do not change in total but they do change per unit. We will assign a cost per unit for accounting reasons. When we prepare the income statement, we will use the multi-step income-statement format.

For our purposes, the absorption income statement will contain:

Sales
− Cost of Goods Sold
= Gross Profit
Operating Expenses:
     Selling Expenses
     + General and Admin. Expenses
     = Total Expenses
= Net Operating Income

Gross profit is also referred to as gross marginNet operating income is Gross profit − Total operating expenses and is also called Income before taxes. Let’s look at an example.

Bradley Company had the following information for May:

  • Direct materials $13,000
  • Direct labor $15,000
  • Variable overhead $5,000
  • Fixed overhead $6,000
  • Fixed selling expenses $15,000
  • Variable selling expenses $0.20 per unit
  • Administrative expenses $12,000
  • 10,000 units produced
  • 9,000 units sold (1,000 remain in ending finished-goods inventory)
  • Sales price $8 per unit

First, we need to calculate the absorption product cost per unit:

Direct Materials $13,000
+ Direct Labor $15,000
+ Variable Overhead $  5,000
+ Fixed Overhead $  6,000
= Total Product Cost $39,000
÷ Total Units Produced ÷ 10,000
= Product cost per unit      $3.90

Next, we can use the product cost per unit to create the absorption income statement. We will use the UNITS SOLD on the income statement (not units produced) to determine sales, cost of goods sold, and any other variable-period costs.

Bradley Company
Income Statement (Absorption)
For Month Ended May 31
Sales (9,000 × $8 per unit) $72,000
− Cost of Goods Sold (9,000 × $3.90 per unit)    35,100  
= Gross Profit    36,900
Operating Expenses:    
     Selling Expenses (15,000 fixed +
     variable 0.20 × 9,000 units sold)
   16,800  
     + General and Admin. Expenses    12,000  
     = Total Expenses    28,800
= Net Operating Income $8,100

Remember the following under absorption costing:

  • Typically used for financial reporting (GAAP).
  • ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed and variable overhead).
  • Can be misleading, because some costs are not affected by products.
  • Fixed manufacturing overhead costs are applied to units PRODUCED, not just units sold.
  • Income statement shows Sales − Cost of Goods sold = Gross Margin (or Gross Profit) − Operating Expenses = Net Income, and is based on the number of units SOLD.

6.2 Variable Costing

Variable Costing

Variable costing (also known as direct costing) treats all fixed manufacturing costs as period costs to be charged to expense in the period received. Under variable costing, companies treat only variable manufacturing costs as product costs. The logic behind this expensing of fixed manufacturing costs is that the company would incur such costs whether a plant was in production or idle. Therefore, these fixed costs do not specifically relate to the manufacture of products.

Product costs, under variable costing, include the VARIABLE costs only, like direct materials, direct labor, and variable overhead. Fixed overhead would not be included as a product cost! We calculate product cost per unit as:

Direct Materials
+ Direct Labor
+ Variable Overhead
= Total Product Cost
÷ Total Units Produced
= Product Cost per Unit

The income statement we will use is not Generally Accepted Accounting Principles, so it is not typically included in published financial statements outside the company. This contribution-margin income statement would be used for internal purposes only. You should remember that the contribution-margin income statement separates variable costs and fixed costs (whether product or period—it does not matter) and calculates a contribution margin (this is sales − variable costs). Now, let’s continue with our example, the Bradley Company.

Bradley Company had the following information for May:

  • Direct materials $13,000
  • Direct labor $15,000
  • Variable overhead $5,000
  • Fixed overhead $6,000
  • Fixed selling expenses $15,000
  • Variable selling expenses $0.20 per unit
  • Administrative expenses $12,000
  • 10,000 units produced
  • 9,000 units sold (1,000 remain in ending finished-goods inventory)
  • Sales price $8 per unit

First, we will calculate the variable cost product cost per unit:

Direct Materials $13,000
+ Direct Labor $15,000
+ Variable Overhead $  5,000
= Total Product Cost $33,000
÷ Total Units Produced ÷ 10,000
= Product cost per unit $     3.30

Next, we calculate the contribution-margin-format income statement under variable costing:

Bradley Company
Income Statement (Variable)
For Month Ended May 31
Sales (9,000 × $8 per unit)   $72,000
Variable Costs:    
     Cost of goods sold (9,000 × $3.30 per unit) 29,700  
     Selling expenses (9,000 × $0.20 per unit)   1,800  
     Total variable costs     31,500
Contribution Margin     40,500
Fixed Costs:    
     Fixed overhead (fixed portion only)   6,000  
     Selling expenses (fixed portion only)  15,000  
     Administrative expenses   12,000  
     Total Fixed expenses     33,000
Net Operating Income     $7,500

In variable costing, it is important to remember the following points:

  • ONLY includes variable costs, meaning costs that increase with volume.
  • Does not include FIXED costs because volume levels do not change these costs (fixed costs treated as period costs, not product costs).
  • Can provide more accurate information for decision-makers because costs are better tied to production levels.
  • Can be applied to ALL costs and not just product costs.
  • Uses Contribution-Margin Income Statement showing Sales − VARIABLE expenses = Contribution Margin − Fixed Expenses = Net Income and is based on the number of units SOLD.

6.3 Comparing Absorption and Variable Costing

Comparing Absorption and Variable Costing

In comparing the two income statements for Bradley, we notice that the cost of goods sold is $3.90 per unit under absorption and $3.30 per unit under variable costing. The income reported under each statement is off by $600 because of this difference ($8,100 under absorption and $7,500 under variable). Let’s review how these costs were calculated:

Absorption Variable
Direct Materials $13,000 $13,000
+ Direct Labor $15,000 $15,000
+ Variable Overhead $  5,000 $ 5,000
+ Fixed Overhead $  6,000 do not include
= Total Product Cost $39,000 $33,000
÷ Total Units Produced ÷ 10,000 ÷ 10,000
= Product cost per unit      $3.90      $3.30

Because fixed-overhead cost is given to each unit produced under the absorption-costing method, the 1,000 units remaining in inventory carry forward some of May’s fixed costs into the next period. The variable-costing method treats the fixed overhead as relating to May only and not to any specific units. Ending inventory would be calculated as:

Absorption Variable
$3,900 (1,000 units ×
$3.90 cost)
$3,300 (1,000 units ×
$3.30 cost)

These differences are due to the treatment of fixed manufacturing costs. Under absorption costing, each unit in ending inventory carries $0.60 of fixed overhead cost as part of product cost. At the end of the month, Bradley has 1,000 units in inventory. Therefore, ending inventory under absorption costing includes $600 of fixed manufacturing overhead costs ($0.60 × 1,000 units) and is valued at $600 more than under variable costing.

absopr var

Under variable costing, companies charge off, or expense, all the fixed manufacturing costs during the period rather than deferring their expense and carrying them forward to the next period as part of inventory cost. Therefore, $6,000 of fixed manufacturing costs appear on the variable-costing income statement as an expense, rather than $5,400 ($6,000 fixed overhead costs − $600 fixed manufacturing included in inventory) under absorption costing. Consequently, income before income taxes under variable costing is $600 less than under absorption costing because more costs are expensed during the period.

Finally, remember that the difference between the absorption costing and variable costing methods is solely in the treatment of fixed manufacturing overhead costs and income-statement presentation. Both methods treat selling and administrative expenses as period costs. Regarding selling and administrative expenses, the only difference is their placement on the income statement and the segregation of variable and fixed selling and administrative expenses. Variable selling and administrative expenses are not part of product cost under either method.

As a general rule, relate the difference in net income under absorption costing and variable costing to the change in inventories. Assuming a relatively constant level of production, if inventories increase during the year, production exceeded sales and reported income before federal income taxes is less under variable costing than under absorption costing. Conversely, if inventories decreased, then sales exceeded production, and income before income taxes is larger under variable costing than under absorption costing.

Variable costing is not currently acceptable for income measurement or inventory valuation in external financial statements that must comply with generally accepted accounting principles (GAAP) in the United States. However, managers often use variable costing for internal company reports.

Summary

  1. Product costs are calculated differently under each method:
Absorption Variable
Direct Materials Include Include
Direct Labor Include Include
Overhead:
     Variable Overhead Include Include
     Fixed Overhead Include DO NOT include
Total Product Costs Sum Sum
÷ Total Units Produced ÷ Total Units Produced ÷ Total Units Produced
Product Cost per Unit = Cost per unit = Cost per unit

2.  Income-statement formats are different under each method (both use units sold for variable expenses):

  • Absorption uses standard GAAP income statement of Sales − Cost of Goods Sold = Gross Profit − Operating Expenses = Net Operating Income.
  • Variable uses a contribution-margin income statement of Sales − Variable Costs = Contribution Margin − Fixed Expenses = Net Operating Income.

3.  Net income on the two reports can be different if units produced do not equal units sold.

License and Attribution

The content in this course has been adapted from the following resources, which are available under the licenses described below.

Accounting Principles: A Business Perspective: Volume 1, Financial Accounting by James Don Edwards and Roger H. Hermanson is available under a Creative Commons Attribution 3.0 Unported License.

Accounting Principles: A Business Perspective: Volume 2, Managerial Accounting by James Don Edwards, Roger H. Hermanson, and Susan D. Ivancevich is available under a Creative Commons Attribution 3.0 Unported License.

Financial Accounting is an adaptation from Accounting Principles: A Business Perspective: Volume 1, Financial Accounting by James Don Edwards and Roger H. Hermanson. The current work is available under a Creative Commons Attribution 4.0 International License. © 2015, Lumen Learning. It was developed in conjunction with Debra Porter, Tidewater Community College, www.tcc.edu.

Managerial Accounting is an adaptation from Accounting Principles: A Business Perspective: Volume 2, Managerial Accounting by James Don Edwards, Roger H. Hermanson, and Susan D. Ivancevich. The current work is available under a Creative Commons Attribution 4.0 International License. © 2016, Lumen Learning. It was developed in conjunction with Debra Porter, Tidewater Community College, www.tcc.edu.