Accounting Chapter 21

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<ul><li><p>Cost-Volume-Profit Analysis</p><p>Chapter 21</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p></li><li><p>Learning Objectives</p><p>Determine how changes in volume affect costs</p><p>Calculate operating income using contribution margin and contribution margin ratio</p><p>Use cost-volume-profit (CVP) analysis for profit planning</p><p>Use CVP analysis to perform sensitivity analysis</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p></li><li><p>Learning Objectives</p><p>Use CVP analysis to calculate margin of safety, operating leverage, and multiproduct breakeven points</p><p>Distinguish between variable costing and absorption costing (Appendix 21A) </p><p>Compute operating income using variable costing and absorption costing (Appendix 21A)</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>*</p></li><li><p>Learning Objective 1</p><p>Determine how changes in volume affect costs</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>*</p></li><li><p>Types of costs</p>Variable costsFixed costsMixed costs<p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Managers need to know how a businesss costs are affected by changes in its volume of activity, such as number of products produced and sold, in order to make good decisions about the business. Lets look at three different types of costs: variable costs, fixed costs, and mixed costs.</p><p>*</p></li><li><p>Variable Costs<br>Batteries in Tablets</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p>Number of Tablets ProducedVariable Costper TabletTotal Variable Cost0 tablets$55$025 tablets551,37550 tablets552,75075 tablets554,125100 tablets555,500<p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Variable costs are costs that increase or decrease in total in direct proportion to increases or decreases in the volume of activity. Volume is the measure or degree of an activity of a business action that affects costs. In other words, the more volume, the more cost is incurred.</p><p>Using Smart Touch Learning as an example, the direct materials that are used to make the tablets are a variable cost. For example, each tablet requires one battery at a cost of $55 per battery. This chart shows the cost for batteries at various levels of activity.</p><p>As you can see, the total variable cost of batteries increases proportionately as the number of tablets produced increases. But the battery cost per tablet does not change.</p><p>*</p></li><li><p>Total Variable Costs</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Exhibit 21-1 graphs total variable cost for batteries as the number of tablets produced increases from 0 to 100.</p><p>If Smart Touch Learning does not produce any tablets, it incurs no battery cost. Therefore, the total variable cost line begins at the bottom left corner. This point is called the origin, and it represents zero volume and zero cost. The slope of the variable cost line is the change in battery cost (on the vertical axis) divided by the change in the number of tablets produced (on the horizontal axis). The slope of the graph equals the variable cost per unit. In this case, the slope of the variable cost line is $55 per tablet.</p><p>The graph in Exhibit 21-1 shows how the total variable cost of batteries varies directly with the number of tablets produced. But again, note that the per tablet cost remains constant at $55.</p><p>Direct materials, such as batteries, are a variable cost. Direct labor is also a variable cost. Manufacturing overhead usually includes both variable and fixed costs. Next, we will examine fixed costs.</p><p>*</p></li><li><p>Total Fixed Costs</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>In contrast to variable costs, fixed costs are costs that do not change in total over wide ranges of volume of activity. Some common fixed costs include rent, salaries, property taxes, and depreciation. </p><p>Exhibit 21-2 graphs Smart Touch Learnings depreciation on the manufacturing plant and equipment. The company has these fixed costs regardless of the number of tablets produced.</p><p>Smart Touch Learning incurs $12,000 of depreciation each month, and the number of monthly tablets produced is between 0 and 100. As we can see in Exhibit 21-2, fixed costs are graphed as a flat line that intersects the cost axis at $12,000 because Smart Touch Learning will incur the same $12,000 of fixed costs regardless of the number of tablets produced during the month.</p><p>*</p></li><li><p>Fixed Costs</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p>TotalFixed CostsNumber of Tablets ProducedFixed Costper Tablet$12,00025 tablets$48012,00050 tablets24012,00075 tablets16012,000100 tablets120<p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>This chart shows the total fixed cost at various levels of activity. Note that total fixed cost does not change, but the fixed cost per tablet depends on the number of tablets produced. If Smart Touch Learning produces 25 tablets, the fixed cost per tablet is $480 ($12,000 total fixed cost divided by 25 tablets). If the number of tablets produced doubles to 50 tablets, the fixed cost per tablet is cut in half to $240 ($12,000 total fixed cost divided by 50 tablets). </p><p>Therefore, the fixed cost per tablet is inversely proportional to the number of tablets. In other words, as the number of tablets increases, the fixed cost per tablet decreases.</p><p>*</p></li><li><p>Characteristics of<br>Variable and Fixed Costs</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Exhibit 21-3 provides a summary of the characteristics of variable and fixed costs.</p><p>*</p></li><li><p>Mixed Costs<br>Cell Phone</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p>$100 per month plus $0.10 for each minute of useNumber of Minutes UsedTotal Fixed CostTotal Variable CostTotal Cost100 minutes$100$10$110200 minutes10020120300 minutes10030130400 minutes10040140500 minutes10050150<p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Costs that have both variable and fixed components are called mixed costs. For example, Smart Touch Learnings cell phone provider charges $100 per month to provide the service plus $0.10 for each minute of use. If the cell phone is used for 100 minutes, the company will bill Smart Touch Learning $110 ($100 of fixed cost per month plus the variable cost of 100 minutes at $0.10 per minute).</p><p>The table shows the cost for the cell phone at different levels of activity.</p><p>*</p></li><li><p>Mixed Costs</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Exhibit 21-4 graphs Smart Touch Learnings cell phone costs. It can separate its cell phone bill into fixed and variable components. The $100 monthly charge is a fixed cost because it is the same no matter how many minutes the company uses the cell phone. The $0.10-per-minute charge is a variable cost that increases in direct proportion to the number of minutes of use. If Smart Touch Learning uses the phone for 100 minutes, its total variable cost is $10 (100 minutes at $0.10 per minute). If it doubles the use to 200 minutes, total variable cost also doubles to $20 (200 minutes at $0.10 per minute), and the total bill rises to $120 ($100 plus $20).</p><p>*</p></li><li><p>Manufacturing Equipment Maintenance Costs</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p>Number of Tablets ProducedTotal MaintenanceCost1st Quarter360 tablets$1,7202nd Quarter415 tablets1,8303rd Quarter480 tablets1,9604th Quarter240 tablets1,480<p>Highest Volume</p><p>Lowest Volume</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>When companies have mixed costs, it is helpful to separate the costs into their variable and fixed components so managers can use the information to make planning and control decisions. An easy method to separate mixed costs into variable and fixed components is the high-low method. This method requires you to identify the highest and lowest levels of activity over a period of time. </p><p>To illustrate the high-low method, we will look at the maintenance costs for Smart Touch Learnings manufacturing equipment. Looking at the data for the year, we identify the quarter with the highest activity (the third quarter with 480 tablets) and the quarter with the lowest activity (the fourth quarter with 240 tablets).</p><p>*</p></li><li><p>High-Low Method<br>Step 1</p><p>Step 1: Identify the highest and lowest levels of activity, and calculate the variable cost per unit.</p><p>Variable cost per unit = Change in total cost / Change in volume of activity</p><p>= (Highest cost Lowest cost) / (Highest volume Lowest volume)</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Step 1 of the high-low method is to identify the highest and lowest levels of activity, and calculate the variable cost per unit. Weve identified the high and low levels of activity. We now calculate the variable cost per unit by using this formula. The change in total cost is divided by the change in the volume of activity. In other words, the difference between the high and low costs is divided by the difference between the high and low volumes of activity.</p><p>*</p></li><li><p>High-Low Method<br>Step 1</p><p>Step 1: Identify the highest and lowest levels of activity, and calculate the variable cost per unit.</p><p>Variable cost per unit = Change in total cost / Change in volume of activity</p><p>= (Highest cost Lowest cost) / (Highest volume Lowest volume)</p><p>= ($1,960 $1,480) / (480 tablets 240 tablets)</p><p>= $480 / 240 tablets</p><p>= $2 per tablet</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>The result is a cost of $2 per tablet.</p><p>*</p></li><li><p>High-Low Method<br>Step 2</p><p>Step 2: Calculate the total fixed cost.</p><p>Total fixed cost = Total mixed cost Total variable cost</p><p>= Total mixed cost (Variable cost per unit Number of units)</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Step 2 is to calculate the total fixed cost by subtracting the total variable cost from the total mixed costs. To do this, we must calculate the total variable cost as the variable cost per unit multiplied by the number of units.</p><p>*</p></li><li><p>High-Low Method<br>Step 2</p><p>Step 2: Calculate the total fixed cost.</p><p>Total fixed cost = Total mixed cost Total variable cost</p><p>= Total mixed cost (Variable cost per unit Number of units)</p><p>= $1,960 ($2 per tablet 480 tablets)</p><p>= $1,960 $960</p><p>= $1,000</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>Here, we use the high volume of 480 tablets and its total mixed cost of $1,960 in the formula. The result is a fixed cost of $1,000. Note that you can also use the lowest volume and its mixed cost in this formula to calculate the same $1,000 total fixed cost.</p><p>*</p></li><li><p>High-Low Method<br>Step 3</p><p>Step 3: Create and use an equation to show the behavior of a mixed cost.</p><p>Total mixed cost = (Variable cost per unit Number of units) + Total fixed cost</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>The final step of the high-low method is to create and use an equation to show the behavior of a mixed cost. The total fixed costs is equal to the total variable cost, which is variable cost per unit multiplied by the number of units, plus the total fixed cost.</p><p>*</p></li><li><p>High-Low Method<br>Step 3</p><p>Step 3: Create and use an equation to show the behavior of a mixed cost.</p><p>Total mixed cost = (Variable cost per unit Number of units) + Total fixed cost</p><p>Total manufacturing maintenance cost = ($2 per tablet Number of tablets) + $1,000</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>In this case, the maintenance costs are equal to $2 per tablet multiplied by the number of tablets plus $1,000.</p><p>*</p></li><li><p>Estimated manufacturing equipment maintenance cost at 400 tablets</p><p>Total manufacturing maintenance cost= ($2 per tablet Number of tablets) + $1,000</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>We can then use this formula to predict the manufacturing equipment maintenance costs if 400 tablets are produced.</p><p>*</p></li><li><p>Estimated manufacturing equipment maintenance cost at 400 tablets</p><p>Total manufacturing maintenance cost= ($2 per tablet Number of tablets) + $1,000</p><p>= ($2 per tablet 400 tablets) + $1,000</p><p>= $1,800</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>When the volume activity is 400 tablets, we would expect the maintenance costs to be $1,800.</p><p>The high-low method provides a rough estimate of fixed and variable costs that can be used for planning purposes. The high and low activity volumes become the relevant range, which is discussed in the next section. Managers find the high-low method to be quick and easy, but there are other more complex methods that provide better estimates. One of these methods is regression analysis, which can be completed using spreadsheet software, such as Excel. This method is illustrated in more advanced accounting textbooks, such as cost accounting textbooks.</p><p>*</p></li><li><p>Relevant Range</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>21-*</p><p>Copyright 2014 Pearson Education, Inc. Publishing as Prentice Hall</p><p>The relevant range is the range of volume where total fixed costs remain constant and the variable cost per unit remains constant. To estimate costs, managers need to know the relevant range because total fixed costs can differ from one relevant range to another, and the variable cost per unit can differ in various relevant ranges.</p><p>Exhibit 21-5 shows fixed cost for Smart Touch Learning over three different relevant ranges. If the company expects to produce 2,400 tablets next year, the relevant range is between 2,000 and 4,000 tablets, and managers will plan for fixed costs of $144,000. To produce more than 4,000 tablets, Smart Touch Learning will have to expand the company. This will increase total fixed costs for added rent, supervisory salaries, and equipment costs. Exhibit 21-5 shows that total fixed cost increases to $216,000 as the relevant range shifts to this higher band of volume. Conversely, if the com...</p></li></ul>

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