Absorption/Variable Costing and Cost-Volume-Profit Analysis

Variable Costing and Absorption Costing cost accumulation approach determines which manufacturing costs are recorded as part of product cost. cost presentation approach focuses on how costs are shown on external financial statements or internal management reports Absorption costing treats the costs of all manufacturing components (direct material, direct labor, variable overhead, and fixed overhead) as inventoriable or product costs in accordance with generally accepted accounting principles (GAAP). Absorption costing is also known as full costing. Functional classification is a group of costs that were all incurred for the same principal purpose. Functional classifications include categories such as cost of goods sold, selling expense, and administrative expense. In contrast, variable costing is a cost accumulation method that includes only variable production costs (direct material, direct labor, and variable overhead) as product or inventoriable costs. Variable costing has also been known as direct costing. Sales (S) minus variable cost of goods sold is called product contribution margin (PCM) and indicates how much revenue is available to cover all period expenses and potentially to provide net income. Total contribution margin (TCM) is the difference between total revenues and total variable expenses. This amount indicates the dollar figure available to contribute to the coverage of all fixed expenses, both manufacturing and nonmanufacturing. After fixed expenses are covered, any remaining contribution margin provides income to the company. A variable costing income statement is also referred to as a contribution income statement. Phantom profits are temporary absorption-costing profits caused by producing more inventory than is sold. When sales increase to eliminate the previously produced inventory, the phantom profits disappear.

break-even point (BEP), which is that level of activity, in units or dollars, at which total revenues equal total costs. At breakeven, the companys revenues simply cover its costs; thus, the company incurs neither a profit nor a loss on operating activities. Relevant range: A primary assumption is that the company is operating within the relevant range of activity specified in determining the revenue and cost information used in each of the following assumptions. Revenue: Revenue per unit is assumed to remain constant; fluctuations in per unit revenue for factors such as quantity discounts are ignored. Thus, total revenue fluctuates in direct proportion to level of activity or volume. Variable costs: On a per-unit basis, variable costs are assumed to remain constant. Therefore, total variable costs fluctuate in direct proportion to level of activity or volume. Note that assumed variable cost behavior is the same as assumed revenue behavior. Variable production costs include direct material, direct labor, and variable overhead; variable selling costs include charges for items such as commissions and shipping. Variable administrative costs may exist in areas such as purchasing. Fixed costs: Total fixed costs are assumed to remain constant and, as such, per unit fixed cost decreases as volume increases. (Fixed cost per unit would increase as volume decreases.) Fixed costs include both fixed manufacturing overhead and fixed selling and administrative expenses. Mixed costs: Mixed costs must be separated into their variable and fixed elements before they can be used in CVP analysis. Any method (such as regression analysis) that validly separates these costs in relation to one or more predictors can be used. After being separated, the variable and fixed cost components of the mixed cost take on the assumed characteristics mentioned above. Contribution margin (CM), which can be defined on either a per-unit or total basis. Contribution margin per unit is the difference between the selling price per unit and the sum of variable production, selling, and administrative costs per unit. Unit contribution margin is constant because revenue and variable cost have been defined as remaining constant per unit. Total contribution margin is the difference between total revenues and total variable costs for all units sold. This amount fluctuates in direct proportion to sales volume. Contribution margin (CM) ratio. The CM ratio is calculated as contribution margin divided by revenue and indicates what proportion of revenue remains after variable costs have been covered. The contribution margin ratio represents that portion of the revenue dollar remaining to go toward covering fixed costs and increasing profits. The CM ratio can be calculated using either per-unit or total revenue minus variable cost information. Subtracting the CM ratio from 100 percent gives the variable cost (VC) ratio, which represents the variable cost proportion of each revenue dollar.

Cost-volume-profit (CVP) analysis Examining shifts in costs and volume and their resulting effects on profit is called cost-volume-profit (CVP) analysis. This analysis is applicable in all economic sectors, including manufacturing, wholesaling, retailing, and service industries. CVP can be used by managers to plan and control more effectively because it allows them to concentrate on the relationships among revenues, costs, volume changes, taxes, and profits.

Cost Volume Profit analysis (CVP) is one of he most hallowed, and yet one of the simplest, analytical tools in management accounting. [CVP provides a financial overview that] allows managers to examine the possible impacts of a wide range of strategic decisions. Those decisions can include such crucial areas as pricing policies, product mixes, market expansions or contractions, outsourcing contracts, idle plant usage, discretionary expense planning, and a variety of other important considerations in the planning process. Given the broad range of contexts in which CVP can be used, the basic simplicity of CVP is quite remarkable. Armed with just three inputs of datasales price, variable cost per unit, and fixed costsa managerial analyst can evaluate the effects of decisions that potentially alter the basic nature of a firm.
BEFORE TAX

Margin of safety in units = Actual units - Break-even units Margin of safety in $ = Actual sales in $ - Break-even sales in $ Margin of safety % =Margin of safety in units Actual unit sales or Margin of safety % = Margin of safety in $ Actual sales $ Operating leverage. The relationship of a companys variable and fixed costs is reflected in its operating leverage. Cost structure, or the relative composition of its fixed and variable costs, strongly influences the degree to which its profits respond to changes in volume. Degree of operating leverage (DOL) measures how a percentage change in sales from the current level will affect company profits. In other words, it indicates how sensitive the company is to sales volume increases and decreases. The computation providing the degree of operating leverage factor is Degree of Operating Leverage = Contribution Margin Profit before Tax

Profits are treated in the break-even formula as additional costs to be covered. The inclusion of a target profit changes the formula from a break-even to a CVP equation. X= (FC +Profit Before Tax) (R- VC) or X = (FC + PBT) CM where PBT = fixed amount of profit before taxes
AFTER TAX

Income tax represents a significant influence on business decision making. Managers need to be aware of the effects of income tax in choosing a target profit amount. A company desiring to have a particular amount of net income must first determine the amount of income that must be earned on a before-tax basis, given the applicable tax rate. The CVP formulas that designate a fixed after-tax net income amount are: PBT = PAT + [(TR)(PBT)] and R(X) - VC(X) - FC = PAT + [(TR)(PBT)] where PBT = fixed amount of profit before tax PAT = fixed amount of profit after tax TR = tax rate PAT is further defined so that it can be integrated into the original CVP formula: PAT = PBT - [(TR)(PBT)] or PBT = PAT (1 - TR) Incremental analysis is a process focusing only on factors that change from one course of action or decision to another. As related to CVP situations, incremental analysis is based on changes occurring in revenues, costs, and/or volume. In a multiproduct company, the CM ratio is weighted on the quantities of each product included in the bag of products. This weighting process means that the contribution margin ratio of the product making up the largest proportion of the bag has the greatest impact on the average contribution margin of the product mix. Margin of safety (MS) is the excess of a companys budgeted or actual sales over its break-even point. It is the amount that sales can drop before reaching the breakeven point and, thus, it provides a measure of the amount of cushion from losses.

UNDERLYING ANALYSIS

ASSUMPTIONS

OF

CVP

CVP analysis is a short-run model that focuses on relationships among several items: selling price, variable costs, fixed costs, volume, and profits. This model is a useful planning tool that can provide information on the impact on profits when changes are made in the cost structure or in sales levels. However, the CVP model, like other human-made models, is an abstraction of reality and, as such, does not reveal all the forces at work. It reflects reality but does not duplicate it. Although limiting the accuracy of the results, several important but necessary assumptions are made in the CVP model. These assumptions follow. 1. All revenue and variable cost behavior patterns are constant per unit and linear within the relevant range. 2. Total contribution margin (total revenue _ total variable costs) is linear within the relevant range and increases proportionally with output. This assumption follows directly from assumption 1. 3. Total fixed cost is a constant amount within the relevant range. 4. Mixed costs can be accurately separated into their fixed and variable elements. Although accuracy of separation may be questioned, reliable estimates can be developed from the use of regression analysis or the high-low method (discussed in Chapter 3). 5. Sales and production are equal; thus, there is no material fluctuation in inventory levels. This assumption is necessary because of the allocation of fixed costs to inventory at potentially different rates each year. This assumption requires that variable costing information be available. Because both CVP and variable costing focus on cost behavior, they are distinctly compatible with one another. 6. There will be no capacity additions during the period under consideration. If such additions were made, fixed (and, possibly, variable) costs would change. Any changes in fixed or variable costs would violate assumptions 1 through 3.

7. In a multiproduct firm, the sales mix will remain constant. If this assumption were not made, no weighted average contribution margin could be computed for the company. 8. There is either no inflation or, if it can be forecasted, it is incorporated into the CVP model. This eliminates the possibility of cost changes. 9. Labor productivity, production technology, and market conditions will not change. If any of these changes occur, costs would change correspondingly and selling prices might change. Such changes would invalidate assumptions 1 through 3. These assumptions limit not only the volume of activity for which the calculations can be made, but also the time frame for the usefulness of the calculations to that period for which the specified revenue and cost amounts remain constant. Changes in either selling prices or costs will require that new computations be made for break-even and product opportunity analyses. The nine assumptions listed above are the traditional ones associated with costvolume-profit analysis. An additional assumption must be noted with regard to the distinction of variable and fixed costs. Accountants have generally assumed that cost behavior, once classified, remained constant over periods of time as long as operations remained within the relevant range. Thus, for example, once a cost was determined to be fixed, it would be fixed next year, the year after, and 10 years from now. Break-even chart can be prepared to graph the relationships among revenue, volume, and the various costs. The break-even point on a break-even chart is located at the point where the total cost and total revenue lines cross. Two approaches can be used to prepare break-even charts: the traditional approach and the contemporary approach. A third graphical presentation, the profit-volume graph, is closely related to the break-even chart.

The master budget is normally prepared for a year and detailed by quarters and months within those quarters. Some companies use a process of continuous budgeting. For companies using continuous budgeting, this generally means that an ongoing 12month budget is presented by successively adding a new budget month (12 months into the future) as each current month expires. Budget slack is the intentional underestimation of revenues and/or overestimation of expenses. Slack can be incorporated into the budget during the development process in a participatory budget. A participatory budget is developed through joint decision making by top management and operating personnel. However, slack is not often found in imposed budgets. Imposed budgets are prepared by top management with little or no input from operating personnel. After the budget is developed, operating personnel are informed of the budget goals and constraints. Budget manual, which is a detailed set of information and guidelines about the budgetary process. The manual should include: 1. statements of the budgetary purpose and its desired results; 2. a listing of specific budgetary activities to be performed; 3. a calendar of scheduled budgetary activities; 4. sample budgetary forms; and 5. original, revised, and approved budgets.

Responsibility Accounting and Transfer Pricing in Decentralized Organizations

The degree of centralization can be viewed as a continuum. It reflects a chain of command, authority and responsibility relationships, and decision-making capabilities. In a completely centralized firm, a single individual (usually the company owner or president) performs all major decision making and retains full authority and responsibility for that organizations activities.
ADVANTAGES

The Master Budget

The process of formalizing plans and translating qualitative narratives into a documented, quantitative format is called budgeting. The end result of this process is a budget, which expresses an organizations commitment to planned activities and resource acquisition and use. Such a commitment is based on predictions, protocols, and a collective promise to accomplish the agreed-on results. Budgeting is an important part f an organizations entire planning process. As with other planning activities, budgeting helps provide a focused direction or path chosen from many alternatives. Management generally indicates the direction chosen through some accounting measure of financial performance, such as net income, earnings per share, or sales level expressed in dollars or units . An operating budget is expressed in both units and dollars. When an operating budget relates to revenues, the units presented are expected to be sold, and the dollars reflect selling prices. Financial budgets, which indicate the funds to be generated or consumed during the budget period. Financial budgets include cash and capital budgets as well as projected or pro-forma financial statements.

Helps top management recognize and develop managerial talent Allows managerial evaluated performance to be comparatively

Can often lead to greater job satisfaction Makes the accomplishment of organizational goals and objectives easier Allows the use of management by exception

DISADVANTAGES May result in a lack of goal congruence or suboptimization Requires more effective communication abilities May create personnel difficulties upon introduction Can be extremely expensive

Goal congruence exists when the personal goals of the decision maker, the goals of the decision makers unit, and the goals of the broader organization are mutually supportive and consistent. Suboptimization is a situation in which individual managers pursue goals and objectives that are in their own and/or their segments particular interests rather than in the companys best interests. Because of their greater degree of flexibility in financial decisions, managers of profit and investment centers (to be discussed later in the chapter) must remember that their operations are integral parts of the entire corporate structure. Therefore, all actions taken should be in the best long-run interest of both the responsibility center and the organization. A responsibility accounting system is an important tool in making decentralization work effectively by providing information to top management about the performance of organizational subunits. A responsibility accounting system produces responsibility reports that assist each successively higher level of management in evaluating the performances of its subordinate managers and their respective organizational units. In a decentralized company, the cost object is an organizational unit such as a division, department, or geographical region. The cost object under the control of a manager is called a responsibility center .

to make decisions about all matters affecting their organizational units and to be judged on the outcomes of those decisions. Microprofit center must have measurable output that can be expressed either as market value based or as artificial revenue. A center is designated as a real microprofit center if its output has a market value. A microprofit center for which a surrogate of market value must be used to measure output revenue is known as a pseudo microprofit center. An organizations support areas consist of both service and administrative departments. A service department is an organizational unit (such as central purchasing, personnel, maintenance, engineering, security, or warehousing) that provides one or more specific functional tasks for other internal units. Administrative departments perform management activities that benefit the entire organization and include the personnel, legal, payroll, and insurance departments, and organization headquarters. Costs of service and administrative departments are referred to collectively as service department costs, because corporate administration services the rest of the company.

Reasons for Service Department Cost Allocations

All service department costs are incurred, in the long run, to support production or service-rendering activities. An organization producing no goods or performing no services has no need to exist; thus, it also would have no need for service departments. Conversely, as long as operating activities occur, there is a need for service department activity. The conclusion can therefore be drawn that service department costs are merely another form of overhead that must be allocated to revenue generating departments and, finally, to units of product or service. The three objectives of cost allocation are full cost computation, managerial motivation, and managerial decision making. Each of these objectives can be met if service department costs are assigned to revenue-producing departments in a reasonable manner. Exhibit 1810 presents the reasons for and against allocating service department costs in relationship to each allocation objective; some of the positive points follow. Exhibit 1810
OBJECTIVE: TO COMPUTE FULL COST Reasons for: 1. Provides for cost recovery. 2. Instills a consideration of support costs in production managers. 3. Reflects productions fair share of costs. 4. Meets regulations in some pricing instances. Reasons against: 1. Provides costs that are beyond production managers control. 2. Provides arbitrary costs that are not useful in decision making. 3. Confuses the issues of pricing and costing. Prices should be set high enough for each product to provide a profit margin that should cover all nonproduction costs. OBJECTIVE: TO MOTIVATE MANAGERS Reasons for: 1. Instills a consideration of support costs in production managers. 2. Relates individual production units profits to total company profits.

BASIC TYPES OF RESPONSIBILITY CENTERS Cost Centers

In a cost center, the manager has the authority only to incur costs and is specifically evaluated on the basis of how well costs are controlled. Theoretically, revenues cannot exist in a cost center because the unit does not engage in revenue producing activity. Cost centers commonly include service and administrative departments. For example, the equipment maintenance center in a hospital may be a cost center because it does not charge for its services, but it does incur costs.

Revenue Centers

A revenue center is strictly defined as an organizational unit for which a manager is accountable only for the generation of revenues and has no control over setting selling prices or budgeting costs. In many retail stores, the individual sales departments are considered independent units, and managers are evaluated based on the total revenues generated by their departments. Departmental managers, however, may not be given the authority to change selling prices to affect volume, and often they do not participate in the budgeting process. Thus, the departmental managers might have no impact on costs.

Investment Centers
An investment center is an organizational unit in which the manager is responsible for generating revenues and planning and controlling expenses. In addition, the centers manager has the authority to acquire, use, and dispose of plant assets in a manner that seeks to earn the highest feasible rate of return on the centers asset base. Many investment centers are independent, freestanding divisions or subsidiaries of a firm. This independence gives investment center managers the opportunity

3. Reflects usage of services on a fair and equitable basis. 4. Encourages production managers to help service departments control costs. 5. Encourages the usage of certain services. Reasons against: 1. Distorts production divisions profit figures because allocations are subjective. 2. Includes costs that are beyond production managers control. 3. Will not materially affect production divisions profits. 4. Creates interdivisional ill will when there is lack of agreement about allocation base or method. 5. Is not cost beneficial. OBJECTIVE: TO COMPARE ALTERNATIVE COURSES OF ACTION Reasons for: 1. Provides relevant information in determining corporatewide profits generated by alternative actions. 2. Provides best available estimate of expected changes in costs due to alternative actions. Reasons against: 1. Is unnecessary if alternative actions will not cause costs to change. 2. Presents distorted cash flows or profits from alternative actions since allocations are arbitrary.

revenue-producing areas); the ranking ends with the service department providing the least service to all but the revenueproducing areas. The algebraic method of allocating service department costs considers all departmental interrelationships and reflects these relationships in simultaneous equations.

TRANSFER PRICING
Transfer prices (or prices in a chargeback system) are internal charges established for the exchange of goods or services between responsibility centers of the same company. Although a variety of transfer prices may be used for internal reporting purposes, intracompany inventory transfers should be presented on an external balance sheet at the producing segments actual cost. Internal transfers would be eliminated for external income statement purposes altogether. Thus, if transfers are sold at an amount other than cost, any intersegment profit in inventory, expense, and/or revenue accounts must be eliminated.

Cost-Based Transfer Prices

A differential cost is one that differs in amount among the alternatives being considered.

A cost-based transfer price is, on the surface, an easily understood concept until one realizes the variations that can exist in the definition of the term cost. Different companies use different definitions of cost in conjunction with transfer pricing. These definitions range from variable production cost to absorption cost plus additional amounts for selling and administrative costs (and, possibly, opportunity cost) of the selling unit. Another consideration in a cost-based transfer price is whether actual or standard cost is used. Actual costs may vary according to the season, production volume, and other factors, whereas standard costs can be specified in advance and are stable measures of efficient production costs. For these two reasons, standard costs provide a superior basis for transfer pricing. When standard costs are used, any variances from standard are borne by the selling segment because otherwise the selling divisions efficiencies or inefficiencies are passed on to the buying division.

Market-Based Transfer Prices

Direct method assigns service department costs to revenueproducing areas with only one set of intermediate cost pools or allocations. Cost assignment under the direct method is made using one specific cost driver to the intermediate pool; for example, personnel department costs are assigned to production departments (the intermediate-level pools) based on the number of people in each production department. The step method of cost allocation considers the interrelationships of the service departments before assigning indirect costs to cost objects. Although a specific base is also used in this method, the step method employs a ranking for the quantity of services provided by each service department to other areas. This benefits-provided ranking lists service departments in an order that begins with the one providing the most service to all other corporate areas (both nonrevenue-producing and

To eliminate the problems of defining cost, some companies simply use a market price approach to setting transfer prices. Market price is believed to be an objective, arms-length measure of value that simulates the selling price that would be offered and paid if the subunits were independent, autonomous companies. If a selling division is operating efficiently relative to its competition, it should be able to show a profit when transferring products or services at market prices. Similarly, an efficiently operating buying division should not be troubled by a market-based transfer price because that is what it would have to pay for the goods or services if the alternative of buying internally did not exist.

Negotiated Transfer Prices

Because of the problems associated with both cost- and marketbased prices, negotiated transfer prices are often set through a process of bargaining between the selling and purchasing unit managers. Such prices are typically below the normal market purchase price of the buying unit, but above the sum of the selling units incremental and opportunity costs. A negotiated price meeting these specifications falls within the range limits of the transfer pricing rules.

Dual Pricing
Because a transfer price is used to satisfy internal managerial objectives, a dual pricing arrangement can be used to provide for different transfer prices for the selling and buying segments. Such an arrangement lets the selling division record the transfer of goods or services at a market or negotiated market price and the buying division to record the transfer at a cost-based amount. Use of dual prices would provide a profit margin on the goods transferred and thus reflects a profit for the selling division. The arrangement would also provide a minimal cost to the buying division. Dual pricing eliminates the problem of having to divide the profits artificially between the selling and buying segments and allows managers to have the most relevant information for both decision making and performance evaluation.

Transfer prices are useful when service departments provide distinct, measurable benefits to other areas or provide services having a specific cause-and-effect relationship.

Advantages of Service Transfer Prices

Selecting a Transfer Pricing System

Setting a reasonable transfer price is not an easy task. Everyone involved in the process must be aware of the positive and negative aspects of each type of transfer price and be responsive to suggestions of change if needed. The determination of the type of transfer pricing system to use should reflect the organizational units characteristics as well as corporate goals. No single method of setting a transfer price is best in all instances. Also, transfer prices are not intended to be permanent; They are frequently revised in relation to changes in costs, supply, demand, competitive forces, and other factors. Flexibility by the selling segment to increase a transfer price when reduced productive capacity is present and to increase a transfer price when excess productive capacity exists is a strong management lever. Regardless of what method is used, a thoughtfully set transfer price will provide an appropriate basis for the calculation and evaluation of segment performance, the rational acquisition or use of goods and services between corporate divisions, the flexibility to respond to changes in demand or market conditions, and a means of motivation to encourage and reward goal congruence by managers in decentralized operations. Transfer prices for services can take the same forms as those for products: cost based, market based, negotiated, or dual. Traditionally, these transfer prices are most often negotiated between buyer and seller. This is especially true for services because the value is often qualitativeexpertise, reliability, convenience, and responsivenessand can only be assessed judgmentally from the perspective of the parties involved. The type of transfer price to use should depend on the cost and volume level of the service as well as whether comparable substitutes are available. Examples include the following: Market-based transfer prices are effective for common, standardized services that are high-cost, high-volume services such as storage and transportation. Negotiated transfer prices are useful for customized services that are high cost, high-volume services such as risk management and specialized executive training. Cost-based or dual transfer prices are generally chosen for services that are low-cost, low-volume services such as temporary maintenance and temporary office staff assistance. A company should weigh the advantages and disadvantages of service transfer prices before instituting such a transfer policy.

Disadvantages of Service Transfer Prices Promotes development of services more beneficial to users
Relates to cost of services provided; must justify transfer price established Promotes making a service department a profit center rather than a cost center and thus provides more performance evaluation measures

Transfer prices for services do have certain disadvantages, including the following: There can be (and most often is) disagreement among organizational unit man-agers as to how the transfer price should be set. Implementing transfer prices in the accounting system requires additional organizational costs and employee time. Transfer prices do not work equally well for all departments or divisions. For example, service departments that do not provide measurable benefits or cannot show a distinct cause-and-effect relationship between cost behavior and service use by other departments should not attempt to use transfer prices. The transfer price may cause dysfunctional behavior among organizational units or may induce certain services to be under- or overutilized.

TRANSFER SETTINGS

PRICES

IN

MULTINATIONAL

Because of the differences in tax systems, customs duties, freight and insurance costs, import/export regulations, and foreignexchange controls, setting transfer prices for products and services becomes extremely difficult when the company is engaged in multinational operations. In addition, as shown in , the internal and external objectives of transfer pricing policies differ in multinational enterprises (MNEs).