This chapter discusses absorption and variable costing approaches and how they differ in classifying and presenting costs. It also covers cost-volume-profit analysis, which examines the relationship between sales revenue, costs, and production volume. Companies use cost-volume-profit analysis to calculate break-even points, set target profits, and answer "what-if" questions. The underlying assumptions are that costs and revenues remain constant and that the company operates within a relevant range.

1. Cost Accounting
Traditions and Innovations
Barfield, Raiborn, Kinney
Chapter 11
Absorption/Variable Costing and
Cost-Volume-Profit Analysis

2. Learning Objectives (1 of 2)
• Explain the different approaches to cost
accumulation and cost presentation
• Contrast absorption and variable costing
• Describe how changes in sales and/or
production levels affect net income under
absorption and variable costing
• Explain how companies use cost-volume-
profit analysis

3. Learning Objectives (2 of 2)
• Explain cost-volume-profit analysis for
single-product and multiproduct firms
• Describe how businesses use margin of
safety and operating leverage concepts
• List the underlying assumptions of cost-
volume-profit analysis
• (Appendix) Construct break-even charts and
profit-volume graphs

4. Absorption Vs. Variable Costing
Absorption or Full
• GAAP
• Classify by Function
– Cost of goods sold
– Selling expense
– Administrative
expense
Variable or Direct
• Not GAAP
• Classify by Behavior
– Variable
– Fixed

5. Absorption Vs. Variable Costing
Absorption or Full
• Product costs
– Direct material
– Direct labor
– Variable mfg. overhead
– Fixed mfg. overhead
• Period costs
– Selling
– General
– Administrative
Variable or Direct
• Product costs
– Direct material
– Direct labor
– Variable mfg. overhead
• Period Costs
– Fixed mfg. overhead
– Selling
– General
– Administrative

6. Income Statement
Absorption Costing
Sales
Less: Cost of Goods Sold
Gross Profit
Less: Operating Expenses
Net Income
Product Costs
Direct Material
Direct Labor
Fixed and Variable
Mfg. Overhead
Period Costs
Selling, General,
Administrative

7. Income Statement
Variable Costing
Sales
Less:Variable Cost of Goods Sold
Product Contribution Margin
Less: Variable Operating Expenses
Contribution Margin
Less:Fixed Mfg. Overhead
Less:Fixed Operating Expenses
Net Income
Direct Material
Direct Labor
Variable Mfg.
Overhead
Selling,
General,
Administration
Selling
General
Administrative

8. Difference in Income
Absorption Vs. Variable
• No change in inventory level
– Absorption Income = Variable Income
• Increase in inventory level
– Absorption Income > Variable Income
– Phantom Profits
• Decrease in inventory level
– Absorption Income < Variable Income

9. Cost-Volume-Profit Analysis
• Relationship of
– Revenue
– Costs
– Volume changes
– Taxes
– Profits
• Applies to
– Manufacturers
– Wholesalers
– Retailers
– Service Industries

10. Cost-Volume-Profit Analysis
• Compute the break-even point
• Calculate the level of sales necessary to
achieve a target profit
• Set sales price
• Answer “what-if” questions

11. Cost-Volume-Profit Assumptions
• Company is operating within the relevant
range
• Revenue per unit remains constant
• Variable costs per unit remain constant
• Total fixed costs remain constant
• Mixed costs are separated into variable and
fixed elements

12. Equations
• Break-even point
Total Revenues = Total Costs
Total Revenues - Total Costs = Zero Profit
• Contribution Margin (CM)
Sales Price - Variable Cost = CM per unit
Revenue - Total Variable Costs = CM in total

13. Break-Even Formula - Units
Total Fixed Costs
Sales Price (per unit) - Variable Cost (per unit)
$100,000
12 - 4 = 12,500 units
If fixed costs are $100,000, unit sales price is $12, and
unit variable cost is $4, the break-even point is 12,500 units
Contribution
Margin

14. Break-Even Formula - Dollars
Total Fixed Costs
Sales Price (per unit) - Variable Cost (per unit)
Sales Price (per unit)
If fixed costs are $100,000, unit sales price is $12, and
unit variable cost is $4, the break-even point is $150,000
$100,000
12 - 4 = $150,000
12
Contribution
Margin
Ratio

15. Income Statement Proof
Sales
Less Total variable costs
Contribution Margin
Less Total fixed costs
Profit before taxes
$ 150,000 (12,500 * 12)
(50,000) (12,500 * 4)
$ 100,000
(100,000)
-0-
If fixed costs are $100,000, unit sales price is $12, and
unit variable cost is $4, the break-even point is 12,500 units

16. Using Cost-Volume-Profit Analysis
• Setting a target profit
– Enter before-tax profit in numerator
$100,000 + $30,000
12 - 4 = $195,000
12
If fixed costs are $100,000, unit sales price is $12,
unit variable cost is $4, and the desired before-tax
profit is $30,000, the required sales are $195,000

17. Using Cost-Volume-Profit Analysis
• Setting a target profit
– Convert after-tax profit to before-tax profit
Before-tax profit = After-tax profit
1 - tax rate
$36,000
= 1 - 40%
$60,000
At a 40% tax rate, an after-tax profit of $36,000
equals a before-tax profit of $60,000

18. • Setting a target profit
– Convert after-tax profit to before-tax profit
– Enter before-tax profit in numerator
If fixed costs are $100,000, unit sales price is $12,
unit variable cost is $4, and the desired after-tax
profit is $36,000, the required sales are $240,000
$100,000 + $60,000
12 - 4 = $240,000
12
Using Cost-Volume-Profit Analysis

19. Income Statement Proof
Sales
Less Total variable costs
Contribution Margin
Less Total fixed costs
Profit before taxes
Income taxes
Profit after taxes
$ 240,000 (20,000 * 12)
(80,000) (20,000 * 4)
$ 160,000
(100,000)
$ 60,000
(24,000) (60,000 * 40%)
$ 36,000
If fixed costs are $100,000, unit sales price is $12,
unit variable cost is $4, and the desired after-tax
profit is $36,000, the required sales are $240,000

20. Using Cost-Volume-Profit Analysis
• Variable profit related to number of units sold
• X = FC / (CMu - PuBT)
Sales
Volume
Total
Fixed
Cost
Contribution
Margin
Ratio
Variable Amount
of Profit Before
Tax per Unit

21. Incremental Analysis
• Changes in revenues, costs, and/or volume
• Break-even point increases when
– fixed costs increase
– sales price decreases
– variable costs increases

22. Multiproduct
Cost-Volume-Profit Analysis
• Assumes a constant product sales mix
• Contribution margin is weighted on the
quantities of each product included in the
“bag” of products
• Contribution margin of the product making
up the largest proportion of the bag has the
greatest impact on the average contribution
margin of the product mix

23. Multiproduct
Cost-Volume-Profit Analysis
3 2
Sales mix
Contribution
margin per unit
$2 $1
FC = $8,000
“The Bag”
Three units of spray for every two units of liquid

24. Multiproduct
Cost-Volume-Profit Analysis
3 2
Sales mix
Contribution
margin per unit
$2 $1
$8000
3($2) + 2($1) = 1,000 “bags”
Breakeven

25. Multiproduct
Cost-Volume-Profit Analysis
3 2
Sales mix
x 1,000
3,000
x 1,000
2,000
Breakeven “bag”
Breakeven units
To break even
sell 3,000 sprays and 2,000 liquids

26. Margin of Safety
• Budgeted (or actual) sales after the break-even
point
• Indication of risk

27. Margin of Safety
• Units
Actual units - break-even units
• Dollars
Actual sales dollars - break-even sales dollars
• Percentage
Margin of Safety in units or dollars
Break-even units or sales in dollars

28. Operating Leverage
• Relationship of variable and fixed costs
• Effect on profits when volume changes
• Cost structure strongly influences the
impact changes in volume have on profits

29. Operating Leverage
High Operating Leverage
• Low variable costs
• High fixed costs
• High contribution margin
• High break-even point
• Sales after break-even
have greater impact on
profits
Low Operating Leverage
• High variable costs
• Low fixed costs
• Low contribution margin
• Low break-even point
• Sales after break-even
have lesser impact on
profits

30. Degree of Operating Leverage
• Measures how a percentage change in sales
will affect profits
• Degree of Operating Leverage
Contribution Margin
Profit Before Taxes
• When margin of safety is small, the degree
of operating leverage is large

31. Cost-Volume-Profit Assumptions
• Company is operating within the relevant
range
• Revenue and variable cost per unit are
constant
• Total contribution margin increases
proportionally with increases in unit sales
• Total fixed costs remain constant
• Mixed costs are separated into variable and
fixed elements

32. Cost-Volume-Profit Assumptions
• No change in inventory (production equals
sales)
• No change in capacity
• Sales mix remains constant
• Anticipated price level changes included in
formulas
• Labor productivity, production technology,
and market conditions remain constant

33. Additional Considerations
• Are they fixed costs or long-term variable
costs?
• Quality improvements may violate
assumptions
– increase costs during implementation
– increase productivity
– decrease costs
– adjust sales price

34. Traditional CVP Graph
Total
$
Activity Level
Fixed Costs

35. Traditional CVP Graph
Total
$
Activity Level
Fixed Costs
Total Costs

36. Traditional CVP Graph
Total
$
Activity Level
Total Costs
Variable Costs

37. Traditional CVP Graph
Total
$
Activity Level
Total Costs
Total Revenues

38. Traditional CVP Graph
Total
$
Activity Level
Total Costs
Total Revenues
BEP
Loss
Profit

39. Contemporary CVP Graph
Total
$
Activity Level
Variable Costs

40. Contemporary CVP Graph
Total
$
Activity Level
Total Revenues
Variable Costs
Contribution Margin

41. Contemporary CVP Graph
Total
$
Activity Level
Total Revenues
Total Costs
Total Variable Costs

42. Contemporary CVP Graph
Total
$
Activity Level
Total Revenues
Total Costs
Total Variable Costs
BEP

43. Profit-Volume Graph
$
Activity Level

44. Profit-Volume Graph
$
Activity Level
Fixed Costs

45. Profit-Volume Graph
$
Activity Level
Fixed Costs
BEP

46. Profit-Volume Graph
$
Activity Level
Fixed Costs
BEP

47. Questions
• What is the difference between absorption
and variable costing?
• How do companies use cost-volume-profit
analysis?
• What are the underlying assumptions of
cost-volume-profit analysis?