ACC 5301 VII

ACC 5301, Management Applications of Accounting 1

Course Learning Outcomes for Unit III Upon completion of this unit, students should be able to:

2. Apply accounting concepts to the creation of accounting information and reports. 2.2 Prepare cost-volume-profit analysis reports.

3. Analyze accounting information used to make strategic business decisions.

3.7 Compare and contrast full (absorption) and variable costing.

Required Unit Resources Chapter 4: Cost-Volume-Profit Analysis, pp. 4-1 – 4-27 Chapter 5: Variable Costing, pp. 5-1 – 5-13

Unit Lesson

Introduction Welcome to Unit III. In this unit, we will be looking at cost-volume-profit analysis and how this is related to several key management tasks; planning, controlling, and decision-making. In this unit, we will also look at how the costs we have identified (variable and fixed) are reported under both full (absorption) and variable costing and how inventory levels effect net income under both of these methods.

Cost Identification Variable costs and fixed costs: We are going to start off with a short review of variable and fixed costs and how these costs change in total and per unit. Remember, fixed costs remain the same in total regardless of the level of production while the per unit cost decreases as more units are produced because those fixed cost are spread over more items.

Variable costs, remember, will increase or decrease in total with the level of production while the per-unit cost remains the same. This is because the more units that are produced, the more it will cost the company in total for those units, but each unit still costs the same amount regardless of how many are produced.

UNIT III STUDY GUIDE

Cost-Volume-Profit and Variable Costing

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Mixed costs: We are going to add to our previous cost discussion the idea of mixed costs. These costs, as the name implies, have an element of both fixed and variable costs. As you can see from the chart, there is a fixed cost of $200 per week, but the more units produced above a certain level would allow the employee to receive additional pay for those additional units (variable costs). For example, let's say you receive a base salary of $200 per week for up to 10 units produced, and in addition to that base salary, you receive an additional amount if you produce more than the 10 items. In this example, if you produce 20 items, you still receive your $200 (fixed amount) plus an additional $200 (variable amount) for a total of $400 that week. As you can see, the more you produce, the more money you will make. Regardless of the number of items you produce each week, you will still receive the $200 base pay per week. Why is it important to know the classification for the various costs within a company? It is important so that managers can properly estimate the costs and perform a cost-volume-profit analysis. Keep in mind, most managers within the company only have control over their own department or unit. Therefore, costs involved in the negotiation of the rent contract for the factory would not be within the authority of the factory floor supervisor. The factory floor supervisor would, however, have control over the effectiveness of his or her workers and the efficient use of materials needed to make products within his or her department.

Cost-Volume-Profit Analysis A cost-volume-profit analysis is an evaluation method that looks at the relationship between the level of activity within the organization, the costs within the organization, and the profit of the organization (Jiambalvo, 2020). The basic equation to determine profit is: Sales - Costs=Profit Taking this equation one step further when dealing with cost-volume-profit analysis is: (Selling price per unit * number of units sold) - (Variable costs per unit * number of units sold) - Total fixed = Profit

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As you can see by expanding our basic equation, we now take into account the number of units sold and break down our costs by variable and fixed costs. This leads us to a couple of important calculations related to cost-volume-profit analysis, break-even point, and contribution margin. Break-even point: One important use of a cost-volume- profit analysis is to determine the break-even point. This allows managers to calculate out how many products or dollars they need to sell so they do not make money, but they do not lose money. In other words, this helps guide production for the company. If the company sells above the break-even point (where costs and revenue meet), it will make a profit, but if it sells below the break-even point, then the company will incur a loss. The chart to the side shows the relationship between fixed and variable costs as well as sales revenue. As you can see, the break-even point is where sales and costs intersect on the chart. Contribution margin: Another important calculation in this unit is the contribution margin. This calculation shows how much of a "contribution" a product is making per unit to income based on variable costs only. This means that fixed costs are not calculated into the equation. The calculation is: Selling price per unit - Variable cost per unit = Contribution margin For example, if a product sells for $100 but costs $60 to make, the contribution margin in $40 per unit. Keep in mind, this calculation does not include fixed costs (like rent, CEO's salary, etc.). The contribution margin does give the managers a basic idea if they are selling the product for more than the cost to make it. Remember, a company may make more than one product or provide more than one service, so this technique can be used for each product or service to make sure each one is profitable. By using the cost-volume-profit techniques, a manager can determine how many products to make in order to break even (no profit or no loss) and determine if the product or products the company sells are selling above the cost to make the product, the contribution margin. By using just these two techniques, managers can plan how many products to make, control the cost to make those products, and make decisions that will allow the company to be profitable.

Full (Absorption) and Variable Cost Reporting Looking at our other topic for this unit, full (absorption) and variable cost reporting, we are going to compare and contrast these two reporting methods. Let's first look at the format of the two reports as pictured below (Jiambalvo, 2020):

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Both reports show sales, costs and net income. The difference between the two reports is how the variable and fixed costs are displayed on the reports. On full or absorption costing, fixed and variable costs are not broken down; the costs are all included in total regardless of their status as fixed or variable costs. Keep in mind, this is the only reporting method that is acceptable for GAAP (Generally Accepted Accounting Principles) for external reporting. This means that if the company needed to prepare a statement for a governmental or regulatory agency or even a bank to get a loan, it would need to report using absorption costing. However, as a manger, full (absorption) costing does not break down the costs into fixed and variable costs. In other words, as we noted previously, a manager has more control over variable costs, and full costing does not show the breakdown of costs that would enable a manager to better plan and control costs. Looking at variable costing, you can see that, while the information is the same, there is a clear breakdown of the variable and fixed costs. Managers can now look to see how they can better control costs within their responsibilities. For example, we noted that the factory supervisor typically does not have control over fixed costs such as rent. By using the variable costing statement, the factory supervisor can clearly see which costs he or she can control (variable costs) and find ways to minimize these costs.

Effects of Production on Cost Reporting In our example above, we assumed that all 4,000 units produced were sold. This is why net income for both full (absorption) and variable costing showed the same amount. Now, let's take a look at what happens when inventory increases or decreases under variable costing. In this first example, only 3,800 units were sold, so that left 200 units in inventory unsold. The chart below shows the effect on net income when not all of the units produced are sold. As you can see, the net income under variable costing is less than the net income under full (absorption) costing.

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In our final example below, when the company sells more than it produces, in this case 4,200 units, net income for variable costing is higher than the net income for full (absorption costing). This means that the company is selling units that were left in inventory from a prior month.

Conclusion In this unit, we have discussed cost-volume-profit techniques that are useful to managers for planning production and sales, controlling costs, and making decisions. The two main techniques we have looked at are calculating break-even and contribution margin. These calculations provide managers the tools they need to not only look at how many items they should be producing but also what it is costing them to produce those products. This unit also looked at the two different costing reports; full (absorption) and variable costing. As we discussed, these two methods have advantages and disadvantages. For example, while variable costing makes it clearer to see the breakdown between variable and fixed costs, variable costing can also be used to manipulate income based on changes in inventory levels.

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Reference Jiambalvo, J. (2020). Managerial accounting (7th ed.). Wiley.

https://bookshelf.vitalsource.com/#/books/9781119577706

Suggested Unit Resources View the following video by accessing the Unit III Additional Unit Resources folder in the unit. The video Whole Foods: Cost-Volume-Profit Analysis will demonstrate how cost-volume-profit analysis techniques can be used at Whole Foods. You can access a transcript for this video by hovering over the PDF button at the bottom of the video and then clicking on the word “Transcript.” Alternatively, you can click on the “cc” button at the bottom of the video to turn on closed captions.

Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. After watching the video Whole Foods: Cost-Volume-Profit Analysis in the Suggested Unit Resources, you may want to answer the three questions in the Unit III Questions resource . Note that the "View the Video" link referenced in each question is the same Whole Foods: Cost-Volume-Profit Analysis video linked above.