Cost-Volume-Profit Analysis, Absorption Costing, and Variable Costing

Flashcards covering key concepts of Cost-Volume-Profit (CVP) Analysis, Absorption Costing, and Variable Costing from lecture notes.

What is absorption costing?

Absorption costing (also known as full costing) is the traditional approach to product costing that treats all manufacturing components (direct material, direct labor, variable overhead, and fixed overhead) as inventoriable or product costs in accordance with financial reporting standards.

How are non-manufacturing expenses treated under absorption costing?

Expenses incurred in non-manufacturing areas are considered period costs and expensed in a manner that properly matches with revenue.

Which product costing model and expense flow is depicted in this diagram?

The Absorption Costing Model, showing product costs flowing through Work in Process and Finished Goods to Cost of Goods Sold on the income statement.

What is variable costing?

Variable costing (also known as direct costing) is a cost accumulation method that includes only variable production costs (direct material, direct labor, and variable overhead) as product or inventoriable costs, while treating fixed manufacturing overhead as a period cost.

Which product costing model and expense flow is depicted in this diagram?

The Variable Costing Model, showing fixed manufacturing overhead and fixed nonmanufacturing expenses treated directly as period costs.

What are the two basic differences between absorption costing and variable costing?

1. The treatment of fixed overhead (FOH) for product costing purposes (product cost in absorption vs. period cost in variable costing).
2. The presentation of costs on the income statement (by function in absorption costing vs. by behavior first in variable costing).

What is Product Contribution Margin (PCM)?

Product Contribution Margin is Sales ($S$) minus the Variable Cost of Goods Sold ($VCGS$). It indicates how much revenue is available to cover all period expenses and potentially provide net income.

What is Total Contribution Margin (TCM)?

Total Contribution Margin is Product Contribution Margin ($PCM$) minus Variable Non-manufacturing Period Expenses ($VNME$). It represents the difference between total revenues and total variable expenses.

What income statement relationship equation is illustrated in this diagram?

The formula representation of a variable costing (contribution) income statement, showing $S - VCGS = PCM$ and $PCM - VNME = TCM$.

Why is variable costing disallowed for external financial reporting by authoritative bodies like ISAB, FASB, and SEC?

Authoritative bodies believe absorption costing provides external parties with a more informative picture of earnings than variable costing.

How does the relationship between production volume and sales volume affect operating income under absorption costing versus variable costing?

1. If production = sales: Absorption Income = Variable Income.
2. If production > sales: Absorption Income > Variable Income.
3. If production < sales: Absorption Income < Variable Income.

What is Cost-Volume-Profit (CVP) analysis?

CVP analysis is a managerial decision-making tool that helps managers understand the interrelationships among product prices, volume or level of activity, per unit variable costs, total fixed costs, and the mix of products sold.

What is the contribution margin?

The contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. It is the amount available to cover fixed expenses and then provide profit for the period.

How is the Contribution Margin Ratio (CM-ratio) calculated?

$\text{CM-ratio} = \frac{\text{Contribution Margin}}{\text{Sales}}$ or $\text{Contribution Margin Ratio} = 1 - \text{Variable Cost Ratio}$

What is the break-even point (BEP)?

The break-even point is the level of activity where total sales revenue equals total expenses (total variable costs plus total fixed costs), or where total contribution margin equals total fixed expenses, resulting in an operating income of zero.

What are the three alternative approaches to determining the break-even point?

1. Equation technique
2. Contribution margin technique
3. Graphical method

What is the formula for break-even point in units using the contribution margin technique?

$\text{BEP (in units)} = \frac{\text{Fixed Expenses}}{\text{Unit Contribution Margin}}$ where Unit Contribution Margin = $P - V$.

What is the formula for break-even point in sales birrs using the contribution margin technique?

$\text{BEP (in sales birrs)} = \frac{\text{Fixed Expenses}}{\text{CM Ratio}}$ where CM Ratio = $\frac{P - V}{P}$.

What is Sensitivity Analysis in CVP?

Sensitivity analysis is a 'what if' technique that examines how a result (such as operating income) will change if original predicted data are not achieved or if underlying assumptions change.

What concept is represented by the formula shown in this image?

The formula for the Margin of Safety: $\text{Total Sales} - \text{Break Even Sales} = \text{Margin of Safety}$.

How is the Margin of Safety Ratio computed?

$$\text{Margin of Safety Ratio} = \frac{\text{Margin of Safety in Birrs}}{\text{Total Sales}}$$

How does income tax affect Net Income Before Tax (NIBT)?

$\text{NIAT} = \text{NIBT} \times (1 - \text{tax rate})$, meaning $\text{NIBT} = \frac{\text{NIAT}}{1 - \text{tax rate}}$. To achieve a target after-tax income, a firm must earn a higher before-tax income.

What is sales mix?

Sales mix (or revenue mix) is the relative proportions or combinations of quantities of products that comprise total sales in a multi-product firm.

What is the formula for break-even point in units for a multi-product company?

$\text{BEP (in units)} = \frac{\text{Total Fixed Expenses}}{\text{Weighted Average CM}}$ where Weighted Average CM = $\frac{\sum (\text{CM}_i \times n_i)}{\sum n_i}$.

What are the key underlying assumptions required for CVP analysis to be valid?

1. Costs are linear within the relevant range and strictly divided into fixed and variable components.
2. Revenue behavior is linear (unit price is constant).
3. Sales mix remains constant in multi-product companies.
4. Inventories do not change (units produced equal units sold).
5. Money value remains constant over time.