CHAPTER 4

The Road Traveled
Chapters 1 – 3 laid the foundation for our study of how accounting information is used in business. In Chapter 1 we discovered how businesses are organized, the functions of business, and how accounting has evolved to meet the changing needs of business. Chapter 2 added to this foundation as we examined the four basic business processes (business organization and strategy, operating, capital resources, and performance evaluation and management. We examined the balanced scorecard as a means of performance evaluation. In addition, we looked at the importance of internal control in business. Chapter 3 examined the processes within the operating process: (1) revenue, (2) expenditure, and (3) conversion. In addition, we studied cost/revenue behavior.

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Chapter 4 explains the difference among product, nonproduct, unit-related, batch-related, product-sustaining, and facility-sustaining costs. In Chapter 4 we examine two decision-making models (1) cost-volume-profit, and (2) relevant variable analysis. Both these models rely on the cost/revenue behavior concepts developed in Chapter 3. /

The Road Ahead

Chapters 4 – 6 examine the role of accounting information in planning operating activities. Regardless of the type of business (Chapter 1), all businesses must plan their operations. They must plans the activities in the four basic business processes and understand how these process fit together (Chapter 2). Businesses plan the activities that occur in the revenue, expenditure, and conversion processes (Chapter 3). Chapter 4 examines two models used for making operating decisions. In Chapter 5 we consider the business organization and strategy planning that impacts operating decisions. Finally in Chapter 6 we examine the planning and budgeting of operating processes.

Key Points

Costs are defined as product or nonproduct depending on why they were incurred.
Costs are defined as unit-related, batch-related, product-sustaining, or facility-sustaining depending on how they vary with the operating activity.
CVP analysis assumes that all variable costs vary with the number of units produced (purchased) and sold.
Relevant variable analysis assumes that relevant costs must occur in the future and must differ among alternatives.
There are three common short-term decisions made using relevant variable analysis:
  • Make-or-buy (outsourcing)
  • Accept-or-reject (special order)
  • Keep-or-replace (product mix)

DISCUSSION OUTLINE

Chapter 4 discussion should focus on three specific areas. First, students should comprehend the differences between product and nonproduct costs and the differences among unit-related, batch-related, product-sustaining, and facility-sustaining costs. Students should explore the CVP model as a short-term model that assumes costs vary only with units produced and sold. Finally students should examine the relevant variable analysis model for making short-term operating decisions.

In Chapter 1 we learned the basic business functions (service, merchandising, and manufacturing). In Chapter 2 we explored the activities involved in the four basic business processes. In Chapter 3 we examined the activities in the operating sub-processes (revenue, expenditure, conversion) and how costs/revenues vary with operating activity. How are these ideas related to Chapter 4?

Chapter 4 looks at the types of costs incurred in service, merchandising, and manufacturing companies. We examine two models for making operating decisions and we use the concepts of fixed, variable, and mixed cost/revenue developed in Chapter 3.

What is the purpose and assumptions of the CVP model?

  • Purpose—to explore the relationships among costs, volumes, and profits
  • Assumptions—linear relationships—selling price constant per unit sold, variable cost constant per unit purchased or made, fixed cost constant in total, units produced is the same as units sold, and sales mix is constant

How does CVP define total revenue, total cost, and breakeven?

  • Total revenue—selling price multiplied by units sold
    (SP * Q)
  • Total cost—variable cost multiplied by units produced (purchased) plus fixed costs
    (VC * Q + FC)
  • Breakeven—total revenue equals total costs, profit equals zero
    (SP * Q) – (VC * Q) – FC = 0
  • Contribution margin
  • SP – VC
  • Breakeven = CM * Q – FC = 0
  • Target profit before taxes
  • CM * Q – FC = P
  • Target profit after taxes
  • CM * Q – FC = P/(1 – tax rate)

Contribution Margin Approach is a quicker way to calculate it?

  • FC + P/CM = Q
  • Contribution margin approach to determine
    target profit after taxes
  • FC + (BTP/[1-tax rate])/CM = ATP

What is Sensitivity Analysis?

  • Process of changing the key variables (but not the assumptions) in CVP analysis to determine how sensitive the CVP relationships are to change.
  • Change in selling price
  • Increase—decreases breakeven
  • Decrease—increases breakeven
  • Change in variable cost
  • Increase—increases breakeven
  • Decrease—decreases breakeven
  • Change in fixed cost
  • Increase—increases breakeven
  • Decrease—decreases breakeven
  • Change in tax rate
  • No impact on breakeven

How are product costs different than nonproduct costs?

  • Product costs are incurred in connection with the conversion process. They are associated with producing the product.
  • Nonproduct costs are incurred in connection with the revenue and expenditure processes. They are associated with selling the product and administering the company.

How are product costs classified?

  • Direct materials—the cost of the primary materials, must be traceable and expensive enough to warrant tracing
  • Direct labor—the cost of laborers actually making the product
  • Manufacturing overhead—all manufacturing costs that are not classified as direct materials or direct labor, including indirect materials and labor, utilities, rent, depreciation, etc.

What levels of activities are typically associated with cost behavior?

  • Unit-related costs—costs that vary with units
  • Batch-related costs—costs that vary with the number of batches, regardless of the number of units in the batch
  • Product-sustaining costs—costs that vary with the number of product lines, regardless of the number of units or batches associated with the product line
  • Facility-sustaining costs—costs incurred to maintain operating capacity, these costs do not vary in the short- term

Product / Nonproduct
Unit-related / Materials / Commissions
Batch-related / Set ups / Ordering
Product-sustaining / Research & development / Advertising
Facility-sustaining / Rental of equipment / CEO salary

What two characteristics are required for a variable to be relevant for decision making?

  • Must occur in the future
  • Must differ among alternatives

What is the difference among sunk, opportunity, and incremental costs and why are they important?

  • Sunk costs—past costs, never relevant to short-term decisions
  • Opportunity costs—benefit foregone, always relevant to short-term decisions
  • Incremental costs (and revenues)—additional cost (revenue) associated with a decision, relevant if the amount differs among alternatives
  • These distinctions are important because it helps the decision maker determine what is relevant to a particular decision situation.

How are the 4 levels of activities (unit, batch, product, and facility) related to relevant variable analysis?

  • Depending on the situation, unit-related, batch-related, and product-sustaining costs may be relevant.
  • Facility-sustaining costs are considered fixed and, therefore, generally not relevant to short-term decision making.

What are the types of short-term decisions most often faced by businesses?

  • Accept-or-reject decisions—the company must determine whether to sell products to a customer at a reduced price, we determine the incremental profit associated with the order
  • Make-or-buy decisions—the company must determine whether to outsource a particular activity, we determine the relevant cost to make and compare to the relevant cost to buy
  • Keep-or-drop decisions—the company must determine whether to keep a seemingly unprofitable product, we determine the relevant profit (loss) associated with the product line in question

Lecture Examples

1.A certain company sells its only product for $12 per unit. The variable costs to produce the product are $7 per unit and it costs approximately $1 per unit for selling and administrative costs. The fixed costs of production are $400,000 per period and the fixed selling and administrative costs are $200,000 per year. The company is subject to a 30 percent tax rate. Answer the following questions.

a.What is the breakeven point in units?

b.What is the breakeven point in dollars?

c.How many units must be sold to earn a profit of $70,000 before tax?

d.How many units must be sold to earn a profit of $70,000 after tax?

e.If the variable costs increase 10 percent, what increase is necessary in selling price to maintain the same breakeven point in units?

f.If the fixed costs increase, what is the effect on breakeven? On contribution margin per unit?

g.If the tax rate increases, what is the effect on breakeven? On contribution margin per unit?

Answer:

a.SP = $12; VC = $8; CM = $4; FC = $600,000

$600,000/4 = 150,000

b.CM = $4; SP = $12; CM % = 33.3333%

$600,000/33.3333% = $1,800,000

c.($600,000 + $70,000)/4 = 167,500

d.$70,000/(1 - .3) = $100,000

($600,000 + $100,000)/4 = 175,000

e.To maintain the same breakeven point, CM must remain the same.

VC = $8.80; CM = $4; therefore SP = $12.80

f.If fixed costs increase, breakeven increases. Fixed costs do not affect contribution margin per unit.

g.Tax rate increases do not affect breakeven or contribution margin per unit.

2.A company has been approached by a supplier with an offer to provide 25,000 units of a production part for $9 per unit. If the company accepts the offer its direct materials costs are expected to decrease by 60 percent, its direct labor costs are expected to decrease by 30 percent, and its unit-related overhead is expected to decrease by 20 percent. A recent per unit cost report when 25,000 units were produced is shown below:

Direct materials$10

Direct labor 2

Manufacturing overhead 8

Total cost$20

An analysis of manufacturing overhead reveals that overhead consists of unit-related and facility-sustaining overhead. Facility-sustaining overhead consists of depreciation and other fixed items and is approximately $150,000 per period. If the company accepts the supplier’s offer, it will use the released production facilities to produce another product with an expected contribution of $60,000 per period. Should the company accept or reject the supplier’s offer?

Answer:

Total overhead $8 * 25,000 = $200,000

Less facility-sustaining overhead 150,000

Unit-related overhead$ 50,000

Unit-related overhead per unit$50,000/25,000 = $2

Relevant variablesMakeBuy

Direct materials$10.00$ 4.00 ($10 * .4)

Direct labor 2.00 1.40 ($2 * .7)

Unit-related overhead 2.00 1.60 ($2 * .8)

Purchase price -0- 9.00

Relevant cost per unit$14.00$16.00

* Number of units25,00025,000

Total relevant unit cost$350,000$400,000

Opportunity cost 60,000 -0-

Total relevant cost$410,000$400,000BUY

3.A company has been approached by a customer with an offer to buy 10,000 units of product but the customer wants a discount of 25 percent off the normal selling price. The company has the capacity to fill the customer’s order. A recent profit report is shown below:

Sales (500,0000 units)$6,000,000

Cost of goods sold 4,200,000

Gross margin$1,800,000

Selling and administrative cost 1,000,000

Profit$ 800,000

Unit-related cost of goods sold is 40 percent of the current selling price while unit-related selling and administrative costs are 10 percent of the current selling price. To fill the customer’s order, one additional production run will be required at a cost of $6,000. An additional purchase order will be required at a cost of $500, and shipping costs to the customer will be $800. Should the company accept the customer’s order?

Answer:

Current selling price = $6,000,000/500,000 = $12

Unit-related cost of goods sold = $12 * .4 = $4.80

Unit-related selling and administrative cost = $12 * .1 = $1.20

Proposed selling price = $12 * .75 = $9

Relevant variablesAcceptReject

Proposed selling price$9.00$0.00

Cost of goods sold 4.80 0.00

Selling and administrative 1.20 0.00

Contribution margin$3.00$0.00

* Number of units requested10,00010,000

Total contribution margin$30,000$0

Additional batch costs:

Production run( 6,000) -0-

Ordering( 500) -0-

Shipping( 800) -0-

Relevant profit$22,700$0ACCEPT

4.A merchandising company currently sells three products—A, B, and C. Product profit reports for the last period are shown below:

Product A / Product B / Product C
Sales / $100,000 / $200,000 / $150,000
Less: cost of goods sold / 60,000 / 120,000 / 90,000
Gross margin / 40,000 / 80,000 / 60,000
Less: selling and administrative costs / 50,000 / 60,000 / 55,000
Profit / ($10,000) / $20,000 / $5,000

A cost analysis reveals that cost of goods sold varies proportionately with sales (60%). Selling and administrative costs are $120,000 plus 10% of sales. The $120,000 of facility-sustaining selling and administrative cost will continue regardless of how many product lines the company maintains.

Should the company keep or drop its existing product lines?

Answer:

If Product A is dropped:

Revenues lost$100,000

Costs saved:

Cost of goods sold$60,000

Selling & administrative 10,000

$70,000

Since the revenues lost exceed the costs saved, the company should keep Product A.

Chapter 4 lecture notes f091