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Principles of Cost Accounting 15 th edition Edward J. Van. Derbeck © 2011 Cengage Principles of Cost Accounting 15 th edition Edward J. Van. Derbeck © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1

Chapter 10 Cost Analysis for Management Decision Making 2 Chapter 10 Cost Analysis for Management Decision Making 2

Learning Objectives LO 1 Compute net income under variable and absorption costing. LO 2 Learning Objectives LO 1 Compute net income under variable and absorption costing. LO 2 Discuss the merits and limitations of variable costing. LO 3 Define segment profitability and distinguish between direct and indirect costs. 3

Learning Objectives (cont. ) LO 4 Compute the break-even point and the target volume Learning Objectives (cont. ) LO 4 Compute the break-even point and the target volume needed to earn a certain profit. LO 5 Calculate the contribution margin ratio and the margin of safety ratio. LO 6 Discuss the impact of income tax on break-even computations. 4

Learning Objectives (cont. ) LO 7 Use differential analysis to make special decisions. LO Learning Objectives (cont. ) LO 7 Use differential analysis to make special decisions. LO 8 Identify techniques for analyzing and controlling distribution costs. 5

Variable Costing (also known as Direct Costing) n n n The cost of manufacturing Variable Costing (also known as Direct Costing) n n n The cost of manufacturing a product includes only variable manufacturing costs. Fixed factory overhead is classified as a period cost and is expensed on each month’s income statement. The difference between sales and all variable costs is termed contribution margin. 6

Variable Costing (cont. ) Direct Material Direct Labor Variable Manufacturing OH Fixed Manufacturing OH Variable Costing (cont. ) Direct Material Direct Labor Variable Manufacturing OH Fixed Manufacturing OH Selling Costs Administrative Costs Product Costs Inventory Accounts on Balance Sheet Cost of Goods Sold When Finished Goods are Sold Period Costs Expense Accounts on Income Statement 7

Absorption Costing (also known as Full Costing) n n n Assigns both fixed and Absorption Costing (also known as Full Costing) n n n Assigns both fixed and variable manufacturing costs to the product. Absorption method will report a higher cost of goods sold due to the inclusion of the fixed factory overhead. The difference between sales revenue and cost of goods sold is termed gross margin. 8

Absorption Costing (cont. ) Direct Material Direct Labor Variable Manufacturing OH Fixed Manufacturing OH Absorption Costing (cont. ) Direct Material Direct Labor Variable Manufacturing OH Fixed Manufacturing OH Selling Costs Administrative Costs Product Costs Inventory Accounts on Balance Sheet Period Costs Cost of Goods Sold when Finished Goods are Sold Expense Accounts on Income Statement 9

Merits and Limitations of Variable Costing n n n This method highlights the relationship Merits and Limitations of Variable Costing n n n This method highlights the relationship between sales and all variable costs. May be easier for members of management who are not formally trained in accounting. Variable costing is not a generally accepted method of inventory costing for external purposes because total costs are not matched with sales revenue and does not include fixed factory overhead in the work in process and finished goods inventories. 10

Segment Reporting for Profitability Analysis n n A segment of a company may be Segment Reporting for Profitability Analysis n n A segment of a company may be a division, a product line, a sales territory, or another identifiable unit. This analysis requires that all costs be classified into one of two categories: Direct costs – can be traced to the segment being analyzed. n Indirect costs – cannot be identified directly with a specific segment. n 11

Segment Reporting for Profitability Analysis (cont. ) n n A company’s segment report isolates Segment Reporting for Profitability Analysis (cont. ) n n A company’s segment report isolates costs, variable and fixed, that can be directly traced to the segments. Costs may be direct costs in one segment and indirect costs in another segment. 12

Cost-Volume-Profit (CVP) Analysis n n Technique that uses the degrees of cost variability for Cost-Volume-Profit (CVP) Analysis n n Technique that uses the degrees of cost variability for measuring the effect of changes in volume on resulting profits. It is assumed that fixed costs will remain the same in total within a range of production volume in which the firm expects to operate, known as the relevant range. 13

Limitations of CVP Analysis n n n CVP analysis assumes that all factors except Limitations of CVP Analysis n n n CVP analysis assumes that all factors except volume will remain constant for a given period of time. In some cases, costs are relatively unpredictable except over very limited ranges of activity. Anticipated results depend on the stability of the CVP relationships as they have been established. 14

Break-Even Analysis n n The break-even point is the point at which sales revenue Break-Even Analysis n n The break-even point is the point at which sales revenue covers all costs to manufacture and sell the product, but there is no profit. Costs must be segregated according to their degree of variability. 15

Break-Even Point Calculations n Sales revenue (to break even) = Cost to manufacture + Break-Even Point Calculations n Sales revenue (to break even) = Cost to manufacture + Selling and administrative costs n Sales revenue (to break even) = Fixed manufacturing and selling and administrative costs + Variable manufacturing and selling and administrative costs 16

Break-Even Point Calculations (cont. ) n Break-even sales volume (dollars) = Total fixed costs Break-Even Point Calculations (cont. ) n Break-even sales volume (dollars) = Total fixed costs / Contribution margin ratio n Break-even sales volume (dollars) = Total fixed costs / 1 – (Variable costs/Sales revenue) n Break-even sales volume (units) = Total fixed cost / Unit contribution margin 17

Margin of Safety n n Indicates the amount that sales can decrease before the Margin of Safety n n Indicates the amount that sales can decrease before the company will suffer a loss. Margin of safety (dollars) = Sales revenue – Break-even sales revenue n Margin of safety ratio = Margin of safety / Sales 18

Effect of Income Tax on Break-Even Point and Net Income n Pre-tax income = Effect of Income Tax on Break-Even Point and Net Income n Pre-tax income = After-tax income / 1 – Tax rate n Target volume (units) = {Fixed costs + [Target after-tax income / (1 – Tax rate)] } / Unit contribution margin n Target volume (dollars) = {Fixed costs + [Target after-tax income / (1 – Tax rate)] } / Contribution margin ratio 19

Differential Analysis n n n Differential analysis is a study that highlights the significant Differential Analysis n n n Differential analysis is a study that highlights the significant cost and revenue data alternatives. The designated purpose for which a cost measurement is to be made should be included in the cost analysis. Where there is excess capacity, only the differential costs per unit should be considered in producing additional units. Generally, differential costs do not include fixed factory overhead costs. May be used in make or buy decisions. 20

Accept or Reject a Special Order n Many companies follow a practice of contribution Accept or Reject a Special Order n Many companies follow a practice of contribution pricing, meaning accepting a selling price as long as it exceeds variable cost, thus contributing some positive contribution margin in times of excess capacity. 21

Make or Buy n n Unused plant capacity might be utilized to manufacture a Make or Buy n n Unused plant capacity might be utilized to manufacture a finished part that was purchased in the past. This analysis will determine the savings that may be realized. 22

Distribution Costs n n n Efficient control of all costs should cover distribution costs Distribution Costs n n n Efficient control of all costs should cover distribution costs as well as production costs. Distribution costs include the costs incurred to sell and deliver the product. Accountants must devote more time to the study of distribution costs to answer questions concerning the spreading of selling and administrative expenses to each type of product sold, sales offices, salespersons, and each separate order. 23