Cost Volume Profit Formulas Assignment Satisfaction

MANAGEMENT ACCOUNTING CONCEPTS AND TECHNIQUES

By Dennis Caplan, University at Albany (State University of New York)

Glossary:

Absorption costing: A calculation of product costs that includes all manufacturing costs: labor, materials, variable overhead and fixed overhead. Absorption costing is required under GAAP. Alternatives are variable costing and throughput costing.

Accounting rate of return (ARR): A capital budgeting performance measure that divides the average income from the project by the average book investment in the project, where these averages are over the life of the project.

Activity-based costing (ABC): A costing system characterized by the use of multiple overhead pools, each with its own allocation base, and by the choice of cost drivers for the allocation bases.

Actual costing system: A costing system that determines costs by using actual prices and quantities of inputs. The term is used to distinguish actual costing from costing systems that rely on budgeted numbers, such as a normal costing system or a standard costing system. The implicit assumption throughout financial accounting is that the accounting information reported is not materially different from what would be reported under an actual costing system.

Asset turnover ratio: A divisional or company-wide performance measure. At the divisional level, it is calculated as divisional revenues divided by divisional investment.

Balanced scorecard: A performance measurement tool and performance management system that includes nonfinancial measures as well as traditional financial measures.

Basic profit equation: The statement that:

profits = (sales price - variable cost) x units sold - fixed costs.

This equation forms the basis for cost-volume-profit analysis. The term (but not the formula) is specific to this book.

Batch-level costs: Costs for which the number of batches run is a key cost driver. These costs change in a more-or-less linear fashion with the number of batches run. Batch-level costs are a typical part of the cost hierarchy in a batch manufacturing environment.

Bilateral tax treaties: An agreement between two nations that determines how each nation will tax multinational companies that conduct business in both countries.

Book rate of return: Synonymous with accounting rate of return.

Breakeven analysis: Cost-volume-profit analysis under the assumption of zero profits. Usually, it is the determination of the volume of unit sales required to earn zero profits

Budget:A plan for the future, expressed in quantitative terms.

Committed costs: Costs that will occur in the future, and that cannot be avoided.

Common costs: Cost of resources that benefit multiple parts of the organization. The term also refers to costs incurred up to the split-off point, in a joint product manufacturing process.

Contribution margin: Sales minus variable costs. The contribution margin can be calculated either for an individual unit (in which case it is sometimes called the unit contribution margin) or for all sales activity for a given period. See also the following entry.

Contribution margin income statement: An income statement that subtracts variable costs (variable cost-of-goods-sold plus variable period costs) to derive contribution margin, and then subtracts fixed costs to derive operating income. An alternative income statement format is a gross margin income statement.

Conversion costs: All manufacturing costs other than direct materials.

Cost: Resources sacrificed to achieve a specific objective.

Cost accounting: This term is sometimes used synonymously with management accounting, and sometimes used to refer to the accounting system and methods used to determine and track the cost of inventory in manufacturing and merchandising firms.

Cost allocation: The assignment of overhead costs to the cost object. The term also refers to the assignment of common costs to joint products, and the assignment of service department costs to user departments.

Cost allocation base: A quantitative characteristic shared by multiple cost objects that is used to allocate overhead costs among the cost objects. A cost allocation base can be a financial measure or a nonfinancial measure. Common cost allocation bases in a manufacturing setting are direct labor hours, machine hours, and direct labor dollars.

Cost center: A responsibility center of the organization that is held responsible for the costs that it incurs, but not for revenues or capital investments. A factory is a likely cost center, as is the human resources department.

Cost driver: A cost driver is an economic concept. It is something that increases costs: if the organization incurs more of the driver, the organization incurs more costs. Most cost objects have multiple cost drivers. Typical cost drivers for the production of blue jeans include the price of fabric, sewing operator time, and electric rates.

Cost hierarchy: A grouping of costs according to functional or operational levels within the organization that serve as key cost drivers. In a manufacturing environment, the hierarchy often consists of the overall facility, then products made in that facility, then batches of product, and then individual units.

Cost object: Anything that management of the organization wants to know the cost of. For manufacturing firms, typical cost objects are products and facilities. For service sector companies, typical cost objects are the delivery of services to specific clients.

Cost pool: A grouping of overhead cost items for the purpose of allocating those costs to cost objects. Often, an attempt is made to ensure that the costs in each cost pool are homogenous.

Cost-plus contract: A sales contract in which the sales price is a function of the cost of making the product or providing the customer the service.

Depreciation tax shield: The reduction in tax expense in any given year due to the reduction in income that arises from the recognition of depreciation expense on capital assets.

Differential costs: Synonymous with relevant costs.

Direct cost: Costs that can be traced to the cost object in an economically feasible way. Direct costs are distinguished from overhead costs.

Direct costing: Synonymous with variable costing. The term is seldom used anymore.

Direct method: A method of allocating service department costs to user departments that, for simplicity, ignores services provided by service departments to other service departments.

Discount rate: A finance term that represents a measure of the time value of money.

Downstream division: The buying division in a transfer pricing scenario.

Downward demand spiral: The decline in sales that occurs when sales prices are raised to cover the higher fixed-cost-per-unit that occurs from either an increase in fixed overhead or an earlier decline in sales. The process repeats itself, as the subsequent decline in sales may prompt another price increase.

Efficiency variance: The difference between actual costs and budgeted costs that is due solely to the difference between the quantity of inputs actually used for the output achieved, and the quantity of inputs that should have been used for the output achieved.

Equivalent units: A concept used to facilitate the valuation of work-in-process by costing partially finished units as a percentage of the cost of finished units, where the percentage is determined by the stage of completion of the units in WIP. An equivalent unit represents the resources necessary to complete one unit, even though those resources might have been incurred to bring two units halfway to completion, or four units one-quarter of the way to completion, etc.

Expenses: Costs charged against revenue in a particular accounting period.

Facility-level costs: Costs that are fixed with respect to the facility, and are not associated with a particular product or production line in the facility. Facility-level costs are typically identified as part of the cost hierarchy.

FIFO (First-in, First-out): An inventory flow assumption that the first units made are the first units sold (i.e., the oldest units in inventory are the units sold). Alternative inventory flow assumptions are LIFO and the weighted average method.

Financial accounting: Accounting information and financial reports prepared for users external to the organization, such as investors, creditors, regulators and stock analysts. Financial accounting is distinguished from management accounting.

Fixed cost: A cost that is not expected to change, in total, due to changes in the level of activity (e.g., production or sales) within the relevant range.

Flexible budget: A “budget” prepared afterthe end of the period that multiplies the originally-budgeted cost (or revenue) per unit by the actual units made (or sold). A flexible budget answers the question: what would I have budgeted, if I had known how many units I would have made or sold.

Flexible budget variance: A performance measurement tool that compares actual costs (revenues or profits) to the costs (revenues or profits) in the flexible budget.

Full costing: In this textbook, full costing is synonymous with absorption costing. More generally, full costing can also refer to the inclusion of nonmanufacturing as well as manufacturing costs in the determination of product costs.

Generally Accepted Accounting Principles (GAAP): Financial accounting and reporting standards promulgated by a regulatory or self-regulatory body that are mandatory for external reporting purposes for companies that meet certain criteria. GAAP for public companies is promulgated by the Financial Accounting Standards Board, with oversight from the SEC.

Goal congruence: The alignment of the incentives of managers with the incentives of shareholders. More generally, the term refers to aligning incentives of any two parties in a principal-agent relationship, which includes any setting in which authority and responsibility have been delegated.

Gross margin income statement: An income statement that subtracts cost-of-goods-sold from revenue to derive gross margin, and then subtracts period costs to derive operating income. Virtually all income statements prepared for financial accounting purposes are gross margin income statements. An alternative income statement format is a contribution margin income statement.

Hurdle rate: A targeted rate of return set by senior management to communicate to managers in the company the criterion by which to accept or reject a capital project proposal.

Idle capacity variance: A term used synonymously with the volume variance when capacity is the denominator-level concept in the fixed overhead rate.

Indirect costs: Synonymous with overhead costs.

of (IMA): The most important professional association of management accountants in the . The IMA is headquartered in , , and has local chapters throughout the

Intermediate product: A product made by one part of a company and used by another part of the same company in its production process. Transfer prices are often used to “price” internal sales of intermediate products.

Internal rate of return (IRR): A capital budgeting performance measure that represents the discount rate required to achieve a net present value of zero for the project.

Inventoriable costs: Costs that are debited to inventory for either external or internal reporting purposes. For manufacturing firms, inventoriable costs are either the complete set, or a subset of manufacturing costs.

Investment center: A responsibility center of the organization that is held responsible for revenues, costs and capital investments. Investment centers are highly-autonomous units of the organization, with substantial decision-making authority. A division is a likely investment center.

Investment turnover ratio: Synonymous with asset turnover ratio.

Joint costs: Synonymous with common costs in the context of joint products.

Just-in-time (JIT): A manufacturing practice characterized by maintaining inventories at their lowest possible levels.

Lean:Lean production and lean manufacturing are umbrella terms that describe a company’s comprehensive effort to improve productivity, efficiency and customer satisfaction, and reduce waste and production lead times, through techniques such as just-in-time and total quality management. More recently, the term “lean” has been applied to similar initiatives that occur outside of the manufacturing setting (e.g., in the support functions of manufacturing companies or in service-sector companies). The term lean accounting describes an accounting system designed to support an organ­ization’s lean initiative, or to describe an accounting system that itself is “lean.”

LIFO (Last-in, First-out): An inventory flow assumption that the last units made are the first units sold. Alternative inventory flow assumptions are FIFO and the weighted average method.

Management accounting: Accounting information prepared for individuals in the organization, particularly managers, to assist them in planning, performance evaluation, and control. Management accounting is distinguished from financial accounting.

Managerial accounting: See management accounting.

Master budget: A comprehensive set of budgets for a given period that usually consists of a pro forma income statement and balance sheet and supporting schedules such as a cash budget and production budget.

Misapplied overhead: The difference between actual overhead incurred in a given period and overhead applied to cost objects during that period.

Mixed cost:A cost that is neither variable (in a linear fashion) nor fixed within the relevant range. Often, mixed costs are comprised of a variable component and a fixed component.

National Association of Accountants (NAA): The former name of the Institute of Management Accountants (IMA).

Negative externality: Costs imposed by companies on the public or specific third parties that do not arise from a contractual relationship. A classic example of a negative externality is pollution generated by a factory.

Net present value: A capital budgeting performance measure that discounts all future cash inflows and outflows associated with the capital project to the present, and then sums the present values of all inflows and outflows associated with the project.

Normal capacity: the level of facility activity that satisfies average customer demand over an intermediate period of time. It frequently averages over seasonal or cyclical fluctuations in demand.

Normal costing system: A costing system that tracks costs by using actual direct costs of the cost object, and applying overhead using a budgeted overhead rate and actual quantities of the allocation base incurred. The only difference between an actual costing system and a normal costing system is the use of budgeted overhead rates.

Operating profit percentage: Synonymous with return on sales (ROS).

cost: The profit foregone by selecting one alternative over another.

Overhead costs: Costs that are associated with the cost object, but cannot be traced to the cost object in an economically feasible way. Overhead costs are distinguished from direct costs.

Overhead rate: The ratio of overhead costs to the total quantity of the cost allocation base. This ratio is used to allocate overhead costs to cost objects.

Payback period: A capital budgeting performance measure that estimates the period of time required to recoup the initial investment in the asset.

Period costs: Costs that are expensed when incurred (subject to the principles of accrual accounting), because they cannot be associated with the manufacture of products.

Practical capacity: A measure of factory capacity (or other types of facility output) that allows for anticipated unavoidable operating interruptions and maintenance.

Price variance: In the context of variable costs, the price variance is the difference between actual costs and budgeted costs that is due solely to the difference between the actual price per unit of input and the budgeted price per unit of input. In the context of fixed overhead, the price variance is synonymous with the spending variance.

Prime costs: Synonymous with direct costs.

Product costs: Any cost that is associated with units of product for a particular purpose.

Production volume variance: See volume variance.

Product-level costs: Costs that are direct and fixed with respect to a particular product. Product-level costs are a typical part of the cost hierarchy.

Profit center: A responsibility center of the organization that is held responsible for the revenues and costs that it incurs, but not for capital investments. A product line is a likely profit center.

Pro forma financial statements: Financial statements projected for a future period based on budgeted or hypothetical levels of activity.

Quantity variance: The efficiency variance for direct materials. This variance is also called the usage variance.

Reciprocal method: A method of allocating service department costs to user departments that solves a set of simultaneous equations in order to fully account for services provided by service departments to other service departments.

Relevant costs: Costs that are relevant with respect to a particular decision. A relevant cost for a particular decision is one that changes if an alternative course of action is taken.

Relevant range: The range of activity (e.g., production or sales) over which fixed costs are fixed and variable costs are variable. In other words, a fixed cost is called fixed if it behaves as a fixed cost within the relevant range, even if it behaves as a semi-variable cost over a wider range of activity than specified by the relevant range. Similarly, a variable cost is called variable if it is linear in output over the relevant range, even if linearity no longer holds outside of the relevant range.

Residual income: A divisional or company-wide performance measure that subtracts a charge for the cost of capital from after-tax operating income. Residual income represents an attempt to use accounting information to approximate economic profits.

Responsibility center: A department, division, or any area of activity that is tracked separately by the accounting system, and that is under the control of a manager who is responsible for the performance of the center.

Return of investment (ROI): A divisional or company-wide performance measure. At the divisional level, it is calculated as divisional income divided by divisional investment.

Return on assets (ROA): A company-wide performance measure that is calculated as income divided by total assets. When applied to a division within a company, the same calculation is sometimes called return on investment (ROI).

Return on equity (ROE): A company-wide performance measure that is calculated as income divided by equity.

Return on sales (ROS): A divisional or company-wide performance measure. It is calculated as income divided by revenue.

Semi-variable costs: Synonymous with mixed costs.

Separable costs: Costs incurred by joint products after the split-off point.

Sequential method: Synonymous with the step-down method.

Spending variance: With respect to variable overhead, the spending variance is analogous to the price variance for variable direct costs. With respect to fixed overhead, the spending variance is the difference between actual fixed costs and budgeted fixed costs.

Split-off point: The point in a joint manufacturing process at which joint products take on separate identities. Costs incurred prior to this point are common costs. Costs incurred on joint products after the split-off point are separable costs.

Standard cost: A budgeted cost, usually stated on a per-unit basis, and usually based on a rigorous determination of the quantities of inputs required to produce the output, and the prices of those inputs.

Standard costing system: A costing system that tracks product costs using standard costs during the period, and makes appropriate adjustments for the differences between actual costs and standard costs at the end of the period. Most manufacturing firms use standard costing systems.

Standard quantity: Budgeted inputs to produce one unit of output. Alternatively, the budgeted inputs to produce any specified level of output, particularly the level of output actually achieved during the period.

Static budget: A budget that is based on projected levels of activity, prior to the start of the period. It is the “original” budget for the period, not updated as information about the period becomes known.

Static budget variance: The difference between actual revenues or costs for a period, and revenues or costs as originally budgeted for the period and as reported in the static budget.

Step-down method: A method of allocating service department costs to user departments that accounts for some of the services provided by service departments to other service departments. Service department costs are allocated one at a time, and each service department’s costs are allocated to user departments and to any service departments the costs of which have not yet been allocated.

Sunk cost: Costs that were incurred in the past.

Super-variable costing: Synonymous with throughput costing.

Target costing: The determination of the per-unit variable cost necessary to achieve desired profits, followed by efforts by those responsible for product design and manufacturing to achieve the desired per-unit cost.

Theoretical capacity: A measure of factory capacity (or other types of facility output) that assumes 100% efficiency all of the time. It is a performance benchmark, but generally not an attainable standard.

Theory of constraints: A relatively new operations management tool that increases production throughput and decreases inventory levels by identifying bottleneck operations and increasing throughput at those operations.

Throughput costing: A calculation of product costs that includes only direct materials. All conversion costs are treated as period expenses. More traditional alternatives are absorption costing and variable costing.

Throughout margin: An income statement subtotal that arises when throughput costing is used (see previous entry). The subtotal is revenues minus cost-of-goods-sold, where cost-of-goods-sold consists of only direct materials associated with units sold.

Total quality management (TQM): The practice of eliminating defects in raw materials and the production process. More generally, the practice of eliminating defects in all aspects of the organization’s value chain. TQM is synonymous with zero defect programs.

Transfer price: The amount that one part of a company charges another part of the same company for goods or services. Often, the term is used in connection with intermediate products that are manufactured by one division, and used by another division in its manufacturing process.

Triple-bottom-line: An external reporting method and format that reports the firm’s performance separately along each of three dimensions: financial, environmental and social.

Unit contribution margin: The per-unit sales price minus per-unit variable costs.

Unit-level costs:Costs for which the number of units produced is a key cost driver. These costs change in a more-or-less linear fashion with the number of units produced. Unit-level costs are a typical part of the cost hierarchy in a manufacturing environment.

Upstream division: The selling division in a transfer pricing scenario.

Usage variance: The efficiency variance for direct materials. This variance is also called the quantity variance.

Value chain:The sequence of activities that creates value in an organization.

Variable cost: A cost that varies in a linear fashion with the level of activity (e.g., production or sales) within the relevant range.

Variable costing: A calculation of product costs that includes all direct manufacturing costs and variable manufacturing overhead, but not fixed manufacturing overhead. Under variable costing, fixed manufacturing overhead is treated as a period cost. Alternatives are absorption costing and throughput costing.

Volume variance: In this book, this term refers only to the fixed overhead volume variance. This variance is the difference between budgeted fixed overhead and the amount of fixed overhead allocated to production using a standard costing system. As such, it is a function of actual production volume relative to the denominator used in the fixed overhead rate. Beyond this book, the term volume variance sometimes refers to the sales volume variance, which is the difference between budgeted revenue and actual revenue that is due solely to sales volume differing from budgeted volume.

Wage rate variance: The price variance in the context of direct labor costs. It is the difference between actual costs and budgeted costs that is due solely to the difference between the actual average wage rate and the budgeted average wage rate.

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Management Accounting Concepts and Techniques; copyright 2006; most recent update: November 2010

For a printer-friendly version, contact Dennis Caplan at dcaplan@uamail.albany.edu

Cost Volume Profit Analysis

A CVP Model is based on managerial economics and is a part of cost accounting. It takes vital decisions related to the short term functions of business. One of the important constraints of the CVP Analysis is the point where the total cost and total revenue are equal. At this point there is no profit or loss to the business. This is same as the Break-even Analysis. It works throughout on the BEP strategy. CVP Analysis has the same assumptions as that of Break-even point. It is just that the BEP lays down the initial steps and the CVP gives a detailed insight to the subject.

The components of CVP Analysis are:

  • Level or volume of activity
  • Unit selling prices
  • Variable cost per unit
  • Total fixed costs

CVP assumes the following:

  • Constant sales price;
  • Constant variable cost per unit;
  • Constant total fixed cost;
  • Units sold equal units produced.
  • Contribution stands for sales minus variable costs.

One of the main methods of calculating CVP is profit–volume ratio which is (contribution /sales)*100 ; this gives us profit–volume ratio. Therefore it gives us the profit added per unit of variable costs.

Basic graph

The basic graph of CVP Analysis is also just like the Break-even analysis. The CVP is also a linear graph only because of its assumptions which remain constant and make the graph linear i.e. a straight line. During the formation of the graph the basic assumption is that whatever is produced is ultimately sold i.e. the no. of units produced = no. of units sold.

The basis of graph can be understood with the following explanation:

In symbols, TC = TFC+ V X X TR = P X X Where, TC = Total costs TFC = Total fixed costs V = Unit variable cost (variable cost per unit) X = Number of units TR = S = Total revenue = Sales P = (Unit) sales price

Profit is computed as TR-TC; it is a profit if positive, a loss if negative.

Break down

Cost and sales can be further understood by breaking up Cost and Revenue further. The format shows the format of calculation of contribution and final profit.

ParticularsAmount
SalesXXX
Less: Variable Cost(XXX)
ContributionXXX
Less: Fixed Cost(XXX)
EBITXXX

The various formulae for analysis of break-even point are;

where,

P/V Ratio = (Contribution/Sales) *100.

3. Margin of Safety = Margin of safety = (current output - breakeven output)
Margin of safety shows the strength of the business. It shows where the business stands how safe its functions are. It shows if the business is above the Break-even point i.e. earning profit; or below the Break-even point i.e. incurring losses.

4. Margin of safety% = (current output - breakeven output)/current output × 100

Analysis of Break-even Point:

The CVP Graph can be visualized as follows:

This diagram shows the use of CVP Analysis. In the diagram it is clearly visible that one sale covers only the fixed costs and one covers both fixed costs as well as variable costs. The point of sales where only fixed costs are covered is called shut-down point whereas the point where the sales intersect with the total cost i.e. Fixed as well as variable; that point is called break-even point. Any sale beyond the break-even point will determine the profits for the firm.

Applications:

CVP Analysis helps in the computation and easy applicability of the Break- even analysis. It is a useful tool in ascertaining the best possible functions for the business and also evaluates the short term policies of the business.

Following are the fields where CVP Analysis is used:

  1. Price Fixation
  2. Accepting Special Order and Exploring Additional Markets
  3. Profit Planning
  4. Key Factors or Limiting Factor
  5. Sales Mix Decisions
  6. Make or Buy Decisions
  7. Adding or Dropping Decisions
  8. Suspension of Activities

Limitations:

  1. It takes into consideration the cost side only. It does not study the sale variable on the products. This is a shortcoming as the cost does not influence the working of the business all alone.
  2. This system assumes that the fixed costs remain constant which is not entirely true in the short run. All the costs tend to fluctuate in the short run.
  3. It assumes whatever is produced gets sold which is not true in practical life. It assumes that the cost of production of every unit is the same which might not hold true.
  4. Segregation of Fixed cost and variable cost is a daunting task.

Therefore, a business’s functioning is highly reliable on the proper formation of policies. The applicability of CVP analysis is important from the point of view of business. This needs to be implemented very carefully and with deep analysis. This can get complicated at times but we are here to help you at assignmenthelp.net where you can contact us at anytime and we will help you with your queries and helping you out with your assignments. We respect that you can’t lose on marks and that is why we are here to provide you with the best facilities and qualitative results. You can also take online classes from the best tutors. We believe in providing the best services for your satisfaction. We serve our clients with good and satisfying work and with complete dedication.

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