Chapter 10Chapter 10

Cost Analysis for Management Cost Analysis for Management Decision MakingDecision Making

Learning ObjectivesLearning Objectives

LO1LO1 Compute net income under the Compute net income under the variable variable costing and absorption costing costing and absorption costing methods.methods.

LO2LO2 Discuss the merits and limitations of Discuss the merits and limitations of variable costing.variable costing.

LO3LO3 Define the concept of segment Define the concept of segment profitability analysis and explain the profitability analysis and explain the distinction between direct and indirect distinction between direct and indirect costs.costs.

Learning ObjectivesLearning Objectives

LO4LO4 Compute the break-even point and the Compute the break-even point and the target volume needed to earn a certain target volume needed to earn a certain profit for both single- and multi-product profit for both single- and multi-product firms.firms.

LO5LO5 Calculate the contribution margin ratio Calculate the contribution margin ratio and the margin of safety ratio.and the margin of safety ratio.

LO6LO6 Discuss the impact of income tax on Discuss the impact of income tax on break-even and target-volume break-even and target-volume computations.computations.

Learning ObjectivesLearning Objectives

LO7LO7 Use differential analysis techniques Use differential analysis techniques to to make special decisions.make special decisions.

LO8LO8 Identify the appropriate techniques Identify the appropriate techniques to to analyze and control the distribution analyze and control the distribution costs incurred in selling and delivering costs incurred in selling and delivering products.products.

Variable CostingVariable Costing

The cost of manufacturing a product The cost of manufacturing a product includes only variable manufacturing costs.includes only variable manufacturing costs.

Fixed factory overhead is a period cost and Fixed factory overhead is a period cost and is expensed on each month’s income is expensed on each month’s income statement.statement.

The difference between sales and variable The difference between sales and variable cost of goods sold is termed contribution cost of goods sold is termed contribution margin.margin.

Variable Costing (cont.)Variable Costing (cont.)

Direct MaterialDirect Labor

Variable Manufacturing OH

Fixed Manufacturing OHSelling Costs

Administrative Costs

Inventory Accountson Balance Sheet

Cost of Goods Sold WhenFinished Goods are Sold

Expense Accounts onIncome Statement

Product Costs Period Costs

Absorption CostingAbsorption Costing

Assigns both fixed and variable Assigns both fixed and variable manufacturing costs to the product.manufacturing costs to the product.

Absorption method will report a higher cost Absorption method will report a higher cost of goods sold due to the inclusion of the of goods sold due to the inclusion of the fixed factory overhead.fixed factory overhead.

The difference between sales revenue and The difference between sales revenue and cost of goods sold is termed gross margin.cost of goods sold is termed gross margin.

Absorption Costing Absorption Costing (cont.)(cont.)

Direct MaterialDirect Labor

Variable Manufacturing OHFixed Manufacturing OH

Selling CostsAdministrative Costs

Inventory Accounts onBalance Sheet

Cost of Goods SoldWhen Finished Goods

are Sold

Expense Accounts onIncome Statement

Product Costs Period Costs

Merits and Limitations of Merits and Limitations of Variable CostingVariable Costing

This method highlights the relationship between This method highlights the relationship between sales and variable production costs.sales and variable production costs.

May be easier for members of management who May be easier for members of management who are not formally trained in accounting.are not formally trained in accounting.

Variable costing is not a generally accepted Variable costing is not a generally accepted method of inventory costing for external purposes method of inventory costing for external purposes because total costs are not matched with sales because total costs are not matched with sales revenue and does not include fixed factory revenue and does not include fixed factory overhead in the work in process and finished overhead in the work in process and finished goods inventories.goods inventories.

Segment Reporting for Segment Reporting for Profitability AnalysisProfitability Analysis

A segment of a company may be a A segment of a company may be a division, a product line, a sales territory, division, a product line, a sales territory, or another identifiable unit.or another identifiable unit.

This analysis requires that all costs be This analysis requires that all costs be classified into one of two categories:classified into one of two categories: Direct costs – can be traced to the Direct costs – can be traced to the

segment being analyzed.segment being analyzed. Indirect costs – cannot be identified Indirect costs – cannot be identified

directly with a specific segment.directly with a specific segment.

Segment Reporting for Segment Reporting for Profitability Analysis (cont.)Profitability Analysis (cont.)

A company’s segment report isolates A company’s segment report isolates costs, variable and fixed, that can be costs, variable and fixed, that can be charged directly to the segments.charged directly to the segments.

Costs may be direct costs in one Costs may be direct costs in one segment and indirect costs in another segment and indirect costs in another segment.segment.

Cost-Volume-Profit (CVP) Cost-Volume-Profit (CVP) AnalysisAnalysis

Technique that uses the degrees of cost Technique that uses the degrees of cost variability for measuring the effect of variability for measuring the effect of changes in volume on resulting profits.changes in volume on resulting profits.

It is assumed that fixed costs will remain It is assumed that fixed costs will remain the same in total within a range of the same in total within a range of production volume in which the firm production volume in which the firm expects to operate.expects to operate.

Limitations of CVP Limitations of CVP AnalysisAnalysis

CVP analysis assures that all factors except CVP analysis assures that all factors except volume will remain constant for a given period of volume will remain constant for a given period of time.time.

In some cases, costs are relatively unpredictable In some cases, costs are relatively unpredictable except over very limited ranges of activity.except over very limited ranges of activity.

Anticipated results depend on the stability of the Anticipated results depend on the stability of the CVP relationships as they have been CVP relationships as they have been established.established.

Break-Even AnalysisBreak-Even Analysis

The break-even point is the point at The break-even point is the point at which sales revenue covers all costs to which sales revenue covers all costs to manufacture and sell the product, but manufacture and sell the product, but there is no profit.there is no profit.

Costs must be segregated according to Costs must be segregated according to their degree of variability.their degree of variability.

Break-Even Point Break-Even Point CalculationsCalculations

Sales revenue (to break even) = Cost to Sales revenue (to break even) = Cost to manufacture + Selling and Administrative manufacture + Selling and Administrative CostsCosts

Sales revenue (to break even) = Fixed Sales revenue (to break even) = Fixed manufacturing and selling and manufacturing and selling and administrative costs + Variable administrative costs + Variable manufacturing and selling and manufacturing and selling and administrative costsadministrative costs

Break-Even Point Break-Even Point Calculations (cont.)Calculations (cont.)

Break-even sales volume (dollars) = Total Break-even sales volume (dollars) = Total fixed costs / Contribution margin ratiofixed costs / Contribution margin ratio

Break-even volume (dollars) = Total fixed Break-even volume (dollars) = Total fixed costs / 1 – (Variable costs/Sales revenue)costs / 1 – (Variable costs/Sales revenue)

Break-even sales volume = Total fixed Break-even sales volume = Total fixed cost / Unit contribution margincost / Unit contribution margin

Margin of SafetyMargin of Safety

Indicates the amount that sales can Indicates the amount that sales can decrease before the company will suffer decrease before the company will suffer a loss.a loss.

Margin of safety ratio = (Total sales – Margin of safety ratio = (Total sales – Break-even sales) / Total salesBreak-even sales) / Total sales

Differential AnalysisDifferential Analysis

Differential analysis is a study that highlights the Differential analysis is a study that highlights the significant cost and revenue data alternatives.significant cost and revenue data alternatives.

The designated purpose for which a cost measurement The designated purpose for which a cost measurement is to be made should be included in the cost analysis.is to be made should be included in the cost analysis.

Where there is excess capacity, only the differential Where there is excess capacity, only the differential costs per unit should be considered in producing costs per unit should be considered in producing additional units.additional units.

Differential costs do not include fixed factory overhead Differential costs do not include fixed factory overhead costs.costs.

May be used in make-or-buy decisions.May be used in make-or-buy decisions.

Accept or Reject a Accept or Reject a Special OrderSpecial Order

Many companies follow a practice of Many companies follow a practice of contribution pricing, meaning accepting a contribution pricing, meaning accepting a selling price as long as it exceeds selling price as long as it exceeds variable cost, thus contributing some variable cost, thus contributing some positive contribution margin in times of positive contribution margin in times of excess capacity.excess capacity.

Make-or-Buy DecisionsMake-or-Buy Decisions

Unused plant capacity might be utilized Unused plant capacity might be utilized to manufacture a finished part that was to manufacture a finished part that was purchased in the past.purchased in the past.

This analysis will determine the savings This analysis will determine the savings that may be realized.that may be realized.

Distribution CostsDistribution Costs

Efficient control of all costs covers both the Efficient control of all costs covers both the production costs and the costs incurred to production costs and the costs incurred to sell and deliver the product.sell and deliver the product.

Accountants must answer questions Accountants must answer questions concerning the spreading of selling and concerning the spreading of selling and administrative expenses to the different administrative expenses to the different products, sales offices, salespersons, and products, sales offices, salespersons, and each separate order.each separate order.