Chapter 5 Power Point Review

Chapter 5: Cost-Volume-Profit (CVP) Analysis

Learning Objectives

• LO 1: Explain variable, fixed, and mixed costs and the relevant range.

• LO 2: Apply the high-low method to determine components of mixed costs.

• LO 3: Prepare a CVP income statement to find contribution margin.

• LO 4: Compute break-even point using three approaches.

• LO 5: Determine required sales for target net income and margin of safety.

Cost Behavior Analysis (LO 1)

• Definition: The study of how specific costs respond to changes in business activity levels.

  • Key Points:

    • Some costs fluctuate (variable), while others do not (fixed).

    • It helps management in operational planning and decision-making.

    • Applicable across various business types.

• Activity Levels: Can be measured by:

  • Sales dollars (e.g., retail)

  • Miles driven (e.g., trucking)

  • Room occupancy (e.g., hotels)

  • Dance classes taught (e.g., dance studios)

Components of Costs (LO 1)

Variable Costs

• Characteristics:

  • Costs vary in total and directly with changes in activity level.

  • Unit variable costs remain constant regardless of activity level.

• Example: Damon Company’s camera costs increase with production, $10 per camera.

Fixed Costs

• Characteristics:

  • Costs remain constant in total regardless of activity level within relevant range.

  • Unit fixed costs decrease as activity increases.

• Examples: Property taxes, rent, supervisory salaries, etc.

Mixed Costs

• Definition: Costs that contain both variable and fixed components.

• Characteristics: Alter in total but not proportionately with activity changes.

Relevant Range (LO 1)

• Definition: The range of activity where cost relationships hold true, typically linear.

• Nonlinear Behavior: Some fixed costs might not change over certain activity levels; variable costs can be curvilinear.

High-Low Method Overview (LO 2)

• Purpose: To classify mixed costs by assessing high and low activity levels.

• Equation for Unit Variable Cost:

  • (Change in Cost) / (Change in Activity) = Unit Variable Cost

• Example Calculation for Metro Transit Company:

  • Data: High cost $63,000 at 50,000 miles, low cost $30,000 at 20,000 miles.

  • Result: Unit variable costs = $1.10 per mile.

Contribution Margin (LO 3)

• Definition: Revenue remaining after deducting variable costs.

• CVP Income Statement: Used internally, distinguishes costs as fixed or variable, reports contribution margin.

• Key Calculation Example: For Vargo Electronics:

  • Selling price per cell phone = $500

  • Variable costs = $300

  • Contribution margin = $200.

Break-Even Analysis (LO 4)

• Purpose: Identifies the sales level at which total revenues equal total costs.

• Methods:

  • Mathematical Equation

  • Contribution Margin Technique

  • Graphical Method

Break-Even Equation for Units

• Formula: Fixed Costs / Unit Contribution Margin = Break-Even Units

Break-Even Equation for Dollars

• Formula: Fixed Costs / Contribution Margin Ratio = Break-Even Sales Dollars

Target Net Income and Margin of Safety (LO 5)

• Target Net Income: Minimum sales volume necessary to achieve a designated profit.

• Formula for Required Sales:

  • Sales = Variable Costs + Fixed Costs + Target Net Income

• Margin of Safety: Difference between actual or expected sales and break-even sales, indicating the buffer available before loss occurs.

Key Review Questions and Answers

• Variable and Fixed Costs: Variable costs change with activity levels; fixed costs stay the same in total.

• Contribution margin: Represents the remaining revenue after variable costs are subtracted, important for covering fixed costs and generating profit.