Chapter 10 Cost Estimation and CostVolume-Profit Relationships James Forte/National Geographic/Getty Images Learning Objectives eps81189_10_c10.indd 207 • Understand the significance of cost behavior to decision making and control. • Identify the interacting elements of cost-volume-profit analysis. • Explain the break-even formula and its underlying assumptions. • Calculate the effect on profits of changes in selling prices, variable costs, or fixed costs. • Calculate operating leverage, determine its effects on changes in profit, and understand how margin of safety relates to operating leverage. • Find break-even points and volumes that attain desired profit levels when multiple products are sold in combination. • Obtain cost functions by account analysis and the high-low method. 12/20/13 9:45 AM Introduction CHAPTER 10 Chapter Outline Introduction 10.1 Significance of Cost Behavior to Decision Making and Control    Decision Making    Planning and Control    Trends in Fixed Costs 10.2 Cost-Volume-Profit (CVP) Analysis    Basics of CVP Analysis    A Desired Pretax Profit    A Desired Aftertax Profit 10.3 Graphical Analysis    The Break-Even Chart    Curvature of Revenue and Cost Lines    The Profit-Volume Graph 10.4 Analysis of Changes in CVP Variables    Sales Volume    Variable Costs    Price Policy    Fixed Costs    Ethical Considerations When Changing CVP Variables 10.5 Measures of Relationship Between Operating Levels and Break-Even Points    Operating Leverage    Margin of Safety 10.6 The Sales Mix 10.7 Cost Estimation    Account Analysis    High-Low Method    Ethical Considerations in Estimating Costs    Other Issues for Cost Estimation Introduction M anagers need to understand cost behavior and cost estimation to be in a better position to plan, make decisions, and control costs. As we discussed in Chapter 9, cost behavior describes the relationship between costs and an activity as the level of activity increases or decreases. Determining cost behavior is important to management’s eps81189_10_c10.indd 208 12/20/13 9:45 AM Section 10.1 Significance of Cost Behavior to Decision Making and Control CHAPTER 10 understanding of overhead costs, marketing costs, and general and administrative expenses, as well as for proper implementation of budgets and budgetary controls. With knowledge of cost behavior, managers can also estimate how costs are affected as future activity levels change, which can lead to better decisions. In addition, knowledge of cost behavior can assist managers in analyzing the interactions among revenues, costs, and volume for profit-planning purposes. These interactions are covered later in this chapter. 10.1 Significance of Cost Behavior to Decision Making and Control T o understand more fully the significance of a manager’s analysis of cost behavior, we look at three areas: decision making, planning and control, and trends in fixed costs. Decision Making Cost behavior affects the decisions management makes. Variable costs are the incremental or differential costs in most decisions. Fixed costs change only if the specific decision includes a change in the capacity requirement, such as more floor space. Cost-based pricing requires a good understanding of cost behavior because fixed costs pose conceptual problems when converted to per unit amounts. Fixed costs per unit assume a given volume. If the volume turns out to be different from what was used in determining the cost-based price, the fixed cost component of the total cost yields a misleading price. Managers must know which costs are fixed, as well as anticipated volume, to make good pricing decisions. Planning and Control A company plans and controls variable costs differently than it plans and controls fixed costs. Variable costs are planned in terms of input/output relationships. For example, for each unit produced, the materials cost consists of a price per unit of materials times the number of units of materials; the labor cost consists of the labor rate times the number of labor hours. Once operations are underway, levels of activities may change. The input/output relationships identify changes in resources necessary to respond to the change in activity. If activity levels increase, this signals that more resources (materials, labor, or variable overhead) are needed. If activity levels decrease, the resources are not needed, and procedures can be triggered to stop purchases and reassign or lay off workers. In cases where more materials or labor time are used than are necessary in the input/ output relationship, inefficiencies and waste are in excess of the levels anticipated, and managers must investigate causes and eliminate or reduce the financial impact of the unfavorable variances. Fixed costs, on the other hand, are planned on an annual basis, if not longer. Control of fixed costs is exercised at two points in time. The first time is when the decision is made to incur a fixed cost. Management evaluates the necessity of the cost and makes the decision to move forward or reject the proposal. Once fixed costs are incurred, another point of control enters, that being the daily decision of how best to use the capacity provided by the cost. For example, a university makes a decision to build a new classroom and faculty eps81189_10_c10.indd 209 12/20/13 9:45 AM Section 10.2 Cost-Volume-Profit (CVP) Analysis CHAPTER 10 office building. That decision is the first point of control. After construction, control is implemented in using the building to its maximum capacity. This will occur if classes are scheduled throughout the day and evening. Another difference in the planning and control of variable and fixed costs is the level at which costs are controllable. Variable costs can be controlled at the lowest supervisory level. Fixed costs are often controllable only at higher managerial levels. Trends in Fixed Costs Organizations are finding that an increasing portion of their total costs are fixed costs. The following are a few of the more critical changes taking place. Implementation of more automated equipment is replacing variable labor costs and a major share of the variable overhead costs. Thus, fixed costs are becoming a more significant part of total costs. Costs associated with the additional automated equipment such as depreciation, taxes, insurance, and fixed maintenance charges are substantially higher. Some industries, like steel and automobile, are becoming essentially fixed cost industries, with variable costs playing a less important role than was once the case. In most healthcare businesses, automation cannot replace labor, so this is not necessarily a trend throughout healthcare. This trend does impact people working in the pharmaceutical and medical equipment industries. But fixed costs are rising in medical facilities, as medical equipment needed for patient care increases in price. Staffing costs can be more variable, as some facilities do use temporary or contracted staff to have more flexibility in costs. Another factor that has helped to increase fixed costs significantly in a manufacturing environment is the movement in some industries toward a guaranteed annual wage for production workers. Employees who were once hourly wage earners are now becoming salaried. With the use of more automated equipment, the workers of a company may not represent “touch labor,” that is, work directly on the product. Instead, the production worker may merely observe that the equipment is operating as it should and is properly supplied with materials or may monitor production by means of a television screen. The production line employee is handling more of the functions normally associated with indirect labor, and the cost is a fixed cost. 10.2 Cost-Volume-Profit (CVP) Analysis T he separation of fixed costs from variable costs contributes to an understanding of how revenues, costs, and volume interact to generate profits. With this understanding, managers can perform any number of analyses that fit into a broad category called cost-volume-profit (CVP) analysis or, more commonly, break-even analysis. Examples of such analyses include finding the: 1. patient volume required to break even; 2. dollars of sales (i.e., fees from procedures performed) needed to achieve a specified profit level; eps81189_10_c10.indd 210 12/20/13 9:45 AM CHAPTER 10 Section 10.2 Cost-Volume-Profit (CVP) Analysis 3. effect on profits if selling prices and variable costs increase or decrease by a specific amount per unit; and 4. increase in selling price needed to cover a projected fixed cost increase. CVP analysis, as its name implies, examines the interaction of factors that influence the level of profits. Although the name gives the impression that only cost and volume determine profits, several important factors exist that determine whether we have profits or losses and whether profits increase or decrease over time. The key factors appear in the basic CVP equation: (Selling price)(Sales volume) 2 (Unit variable cost)(Sales volume) 2 Total fixed cost 5 Pretax profit. The basic CVP equation is merely a condensed income statement, in equation form, where total variable costs (Unit variable cost 3 Sales volume) and total fixed costs are deducted from total sales revenues (Selling price 3 Sales volume) to arrive at pretax profit. This equation, as well as other variations that will be discussed later, appears as formula (1) in Figure 10.1. Figure 10.1: Formulas for CVP analysis 1. Basic CVP equation: (p – v)x – FC = PP 2. CVP equation taxes: [(p – v)x – FC](1 – t) = AP 3. Break-even point in units: FC (p – v) 4. Break-even point in dollars: FC CM% 5. Target pretax profit, in dollars: FC + PP p–v 6. Target pretax profit, in units: FC + PP CM% 7. Target aftertax profit, in units: 8. Target aftertax profit, in dollars: AP (1 – t) p–v FC + = FC + PP p–v AP (1 – t) FC + PP = CM% CM% FC + Where: FC = Fixed cost dollars p = Selling price per unit v = Variable cost per unit CM% = Contribution margin ration (p – v) / p AP = Aftertax profit PP = Pretax profit t = Income tax rate x = Sales volume in units eps81189_10_c10.indd 211 12/20/13 9:45 AM Section 10.2 Cost-Volume-Profit (CVP) Analysis CHAPTER 10 The excess of total sales revenue over total variable cost is called the contribution margin or, more precisely, variable contribution margin. From the basic CVP equation, we see that the contribution margin contributes to covering fixed costs as well as generating net income. The contribution margin, as well as the contribution margin ratio, often plays an important role in CVP analysis. The latter measure is the ratio of the contribution margin to total sales revenue (or, equivalently, the ratio of the contribution margin per unit to the selling price). Before proceeding, several fundamental assumptions are made to strengthen CVP analysis: 1. Relevant range—CVP analysis is limited to the company’s relevant range of activity; 2. Cost behavior identification—fixed and variable costs can be identified separately; 3. Linearity—the selling price and variable cost per unit are constant across all sales levels within the company’s relevant range of activity; 4. Equality of production and sales—all units are produced and sold and inventory changes are ignored; 5. Activity measure—the primary cost driver is volume of units; and 6. Constant sales mix—the sales of each product in a multiproduct firm are a constant percentage. Assumptions 1, 2, and 3 are straightforward. Assumption 4 is required because if sales and production are not equal, then some amount of variable and fixed costs are treated as assets (inventories) rather than expenses. As long as inventories remain fairly stable between adjacent time periods, this assumption does not seriously limit the applicability of CVP analysis. Regarding assumption 5, factors other than volume may drive costs, as we have discussed earlier in this chapter, and as we will discuss further in later chapters. Costs that vary with cost drivers other than volume can be added to the fixed-cost component. Assumption 6 is discussed in detail later in this chapter. In many cases, these assumptions are and must be violated in real-world situations, but the basic logic and analysis adds value. While our discussion may appear to presume that CVP analysis is applicable only to companies that sell physical products, these techniques are just as applicable to service organizations. Basics of CVP Analysis CVP analysis is often called break-even analysis because of the significance of the break-even point, which is the volume where total revenue equals total costs. It indicates how many units of product must be sold or how much revenue is needed to at least cover all costs. All break-even analyses can be approached by using formula (1) and by creating its derivations, as shown in Figure 10.1. Each unit of product sold is expected to yield revenue in excess of its variable cost and thus contribute to the recovery of fixed costs and provide a profit. The point at which profit is zero indicates that the contribution margin is equal to the fixed costs. Sales volume must increase beyond the break-even point for a company to realize a profit. eps81189_10_c10.indd 212 12/20/13 9:45 AM CHAPTER 10 Section 10.2 Cost-Volume-Profit (CVP) Analysis Let’s look at CVP relationships in the context of Felsen Medical Supplies, a wholesale distributor of healthcare supplies. Assume that price and costs for one of its products, back braces, are as follows: Dollars per Unit Selling price $ Variable cost Percentage of Selling Price 25 100% 15 60% 10 40% Contribution margin $ Total fixed cost $100,000 Each product sold contributes $10 to covering fixed costs and the creation of a profit. Hence, the company must sell 10,000 back braces to break even. The 10,000 back braces sold will result in a total contribution margin of $100,000, equaling total fixed cost. The break-even point can be calculated by using the basic CVP equations that appear as formulas (3) and (4) in Figure 10.1. For Felsen Medical Supplies, the break-even point is determined as follows: Break-even point in units 5 Total fixed cost/Contribution margin per unit 5 $100,000/$10 per unit 5 10,000 units. A break-even point measured in sales dollars can be computed by directly using formula (4) of Figure 10.1, as follows: Total fixed cost/Contribution margin ratio 5 Break-even point in sales dollars $100,000/0.40 5 $250,000. To use this in a service environment, such as a medical clinic, the sales price would be the net fee expected from patient and insurer, the variable costs would be those costs that change as the clinic provides the services, such as medical supplies directly related to the treatment and personnel costs. The fixed costs would be the medical equipment and furnishings needed to provide patient care, as well as some portion of the costs to run the facility, such as utilities, rent, administrative, and so on. Most medical clinics will set a certain overhead cost for this calculation. If you don’t have a usable fixed cost for your department, check with your accounting liaison to find out how to determine fixed costs in order to do this calculation. eps81189_10_c10.indd 213 12/20/13 9:45 AM Section 10.2 Cost-Volume-Profit (CVP) Analysis CHAPTER 10 A Desired Pretax Profit In business, only breaking even is not satisfactory, but the break-even relationships do serve as a base for profit planning. If we have a target profit level, we can insert that number into the basic CVP equation. This yields the following general formulas, which appear as formulas (5) and (6) in Figure 10.1: (Total fixed cost 1 Pretax profit)/Contribution margin ratio 5 Sales dollars required (Total fixed cost 1 Pretax profit)/Contribution margin per unit 5 Unit sales required. Continuing with the Felsen Medical Supplies illustration, suppose that Enoch Goodfriend, the president, had set a profit objective of $200,000 before taxes. The units and revenues required to attain this objective are determined as follows: ($100,000 1 $200,000)/$10 5 30,000 back braces or ($100,000 1 $200,000)/0.40 5 $750,000. A Desired Aftertax Profit The profit objective may be stated as a net income after income taxes. Rather than changing with volume of units, income taxes vary with profits after the break-even point. When income taxes are to be considered, the basic CVP equation is altered using formulas (2), (7), and (8) in Figure 10.1. Formula (7) works as follows: Target aftertax profit in units 5 (Fixed costs 1 (Aftertax profit/(1 2 Tax rate)))/Contribution margin per unit. Formula (8) yields the sales dollars needed to earn the desired aftertax profit. Suppose Enoch Goodfriend had budgeted a $105,000 aftertax profit and that the income tax rate was 30%. We use the above general formulas to obtain the following volume and sales: ($100,000 1 ($105,000/(1 2 0.30)))/$10 5 25,000 back braces or ($100,000 1 ($105,000/(1 2 0.30)))/0.40 5 $625,000. eps81189_10_c10.indd 214 12/20/13 9:45 AM CHAPTER 10 Section 10.3 Graphical Analysis 10.3 Graphical Analysis T otal sales dollars and total costs at different sales volumes can be estimated and plotted on a graph. The information shown on the graph can also be given in conventional reports, but it is often easier to grasp the fundamental facts when they are presented in graphic or pictorial form. Let’s look at two common forms of graphical analysis—the break-even chart and the profit-volume graph. The Break-Even Chart Dollars are shown on the vertical scale of the break-even chart, and the units of product to be sold are shown on the horizontal scale. The total costs are plotted for the various quantities to be sold and are connected by a line. This line is merely a combination of the fixed and variable cost diagrams from Chapter 9. Total sales at various levels are similarly entered on the chart. The break-even point lies at the intersection of the total revenue and total cost lines. Losses are measured to the left of the break-even point; the amount of the loss at any point is equal to the dollar difference between the total cost line and the total revenue line. Profit is measured to the right of the break-even point and, at any point, is equal to the dollar difference between the total revenue line and the total cost line. This dollar difference equals the contribution margin per unit multiplied by the volume in excess of the breakeven point. In Figure 10.2, a break-even chart has been prepared for Felsen Medical Supplies using the following data associated with sales levels between 5,000 and 30,000 back braces. Number of Back Braces Produced and Sold 5,000 10,000 15,000 20,000 25,000 30,000 $125,000 $250,000 $375,000 $500,000 $635,000 $750,000 Variable 75,000 150,000 225,000 300,000 375,000 450,000 Fixed 100,000 100,000 100,000 100,000 100,000 100,000 Total cost 175,000 250,000 325,000 400,000 475,000 550,000 Profit (loss) $(50,000) 0 $ 50,000 $100,000 $150,000 $200,000 Total revenue Cost: eps81189_10_c10.indd 215 12/20/13 9:45 AM CHAPTER 10 Section 10.3 Graphical Analysis Figure 10.2: Break-even chart $800 Total revenue line Dollars (in Thousands) 700 600 Profit area 500 Break-even point 400 300 Total cost line Loss area 200 Variable cost Fixed cost 100 5 10 15 20 25 30 Number of Back Braces (in Thousands) Curvature of Revenue and Cost Lines In some cases, revenues and costs cannot be represented by straight lines. If more units are to be sold, management may have to reduce selling prices. Under these conditions, the revenue function is a curve instead of a straight line. Costs may also be nonlinear depending on what changes take place as volume increases. The cost curve may rise slowly at the start, then more steeply as volume is expanded. This occurs if the variable cost per unit becomes higher as more units are manufactured. Also, fixed costs might change as volume increases. For example, volume increases might cause a jump in supervision, equipment, and space costs. Therefore, it may be possible to have two break-even points, as shown in Figure 10.3. eps81189_10_c10.indd 216 12/20/13 9:45 AM CHAPTER 10 Section 10.3 Graphical Analysis Figure 10.3: Break-even chart with two break-even points Dollars Break-even point Break-even point ine el nu e rev tal o T e lin st o c tal To Units of Product Sold The Profit-Volume Graph A profit-volume (P/V) graph is sometimes used in place of, or along with, a break-even chart. Data used in the earlier illustration of a break-even chart in Figure 10.2 have also been used in preparing the P/V graph shown in Figure 10.4. In general, profits and losses appear on the vertical scale; units of product, sales revenue, and/or percentages of capacity appear on the horizontal scale. A horizontal line is drawn on the graph to separate profits from losses. The profit or loss at each of various sales levels is plotted. These points are then connected to form a profit line. The slope of the profit line is the contribution margin per unit if the horizontal line is stated as units of product and is the contribution margin ratio if the horizontal line is stated as sales revenue. eps81189_10_c10.indd 217 12/20/13 9:45 AM CHAPTER 10 Section 10.4 Analysis of Changes in CVP Variables Figure 10.4: Profit-volume graph Profit line Losses Profits (Thousands of Dollars) $200 Break-even point 100 0 $125 $250 100 $375 $500 $625 $750 25 30 Revenue (Thousands of Dollars) 200 5 10 15 20 Number of Back Braces (in Thousands) The break-even point is the point where the profit line intersects the horizontal line. Dollars of profit are measured on the vertical scale above the line, and dollars of loss are measured below the line. The P/V graph may be preferred to the break-even chart because profit or loss at any point is shown specifically on the vertical scale. However, the P/V graph does not clearly show how cost varies with activity. Break-even charts and P/V graphs are often used together, thus obtaining the advantages of both. 10.4 Analysis of Changes in CVP Variables B reak-even charts and P/V graphs are convenient devices to show how profit is affected by changes in the factors that impact profit. For example, if unit selling price, unit variable cost, and total fixed cost remain constant, how many more units must be sold to realize a greater profit? Or, if the unit variable cost can be reduced, what additional profit can be expected at any given volume of sales? The effects of changes in sales volume, unit variable cost, unit selling price, and total fixed cost are discussed in the following paragraphs. In all these cases, the starting point for analysis is the CVP formulas in Figure 10.1. Sales Volume For some companies, substantial profits depend on high sales volume. For example, if each unit of product is sold at a relatively low contribution margin, then high profits are a function of selling in large quantities. This is more significant when the fixed cost is high. eps81189_10_c10.indd 218 12/20/13 9:45 AM Section 10.4 Analysis of Changes in CVP Variables CHAPTER 10 For an illustration, consider a company that handles a product with a selling price of $1 per unit. Assume a variable cost of $0.70 per unit and a fixed cost of $180,000 per year. The contribution margin, therefore, is $0.30 per unit ($1 2 $0.70). Before any profit is realized, the company must sell enough units for the total contribution margin to recover the fixed cost. Therefore, 600,000 units must be sold just to break even: $180,000 4 $0.30 5 600,000 units. For every unit sold in excess of 600,000, a $0.30 profit before tax is earned. In such a situation, the company must be certain that it can sell substantially more than 600,000 units to earn a reasonable profit on its investment. When products sell for relatively high contribution margins per unit, the fixed cost is recaptured with the sale of fewer units, and a profit can be made on a relatively low sales volume. Suppose that each unit of product sells for $1,000 and that the variable cost per unit is $900. The fixed cost for the year is $180,000. The contribution margin ratio is only 10%, but this is equal to $100 from each unit sold. The break-even point will be reached when 1,800 units are sold. The physical quantity handled is much lower than it was in the preceding example, but the same principle applies. More than 1,800 units must be sold if the company is to produce a profit. A key relationship between changes in volume and pretax profit is the following: Contribution margin per unit 2 Change in sales volume 5 Change in net income. This relationship presumes that the contribution margin per unit remains unchanged when the sales volume changes. It also presumes that fixed costs have not been changed. Suppose that Enoch Goodfriend of Felsen Medical Supplies wishes to know how the sale of an additional 500 back braces would impact profits. The above relationship reveals that net income would increase by $5,000 ($10 contribution margin per unit 3 500 units). Variable Costs The relationship between the selling price of a product and its variable cost is important in any line of business. Even small savings in variable cost can add significantly to profits. A reduction of a fraction of a dollar in the unit cost becomes a contribution to fixed cost and profit. If 50,000 units are sold in a year, a $0.10 decrease in the unit cost becomes a $5,000 increase in profit. Conversely, a $0.10 increase in unit cost decreases profit by $5,000. Management is continually searching for opportunities to make even small cost savings. What appears trivial may turn out to be the difference between profit and loss for the year. In manufacturing, it may be possible to save on materials cost by using cheaper materials that are just as satisfactory. Using materials more effectively can also result in savings. Improving methods of production may decrease labor and overhead costs per unit. A small savings in unit cost can give a company a competitive advantage. If prices must be reduced, the low-cost producer will usually suffer less. At any given price and fixed cost structure, the low-cost producer will become profitable more quickly as sales volume increases. eps81189_10_c10.indd 219 12/20/13 9:45 AM CHAPTER 10 Section 10.4 Analysis of Changes in CVP Variables The following operating results of three companies show how profit is influenced by changes in the variable cost pattern. Each of the three companies sells 100,000 units of one product line at a price of $5 per unit. Each has an annual fixed cost of $150,000. Company A can manufacture and sell each unit at a variable cost of $2.50. Company B has found ways to save costs and can produce each unit for a variable cost of $2, while Company C has allowed its unit variable cost to rise to $3. Company A Company B Company C Number of units sold 100,000 100,000 100,000 Unit selling price $ $ $ 5.00 5.00 5.00 Unit variable cost 2.50 2.00 3.00 Unit contribution margin 2.50 3.00 2.00 Contribution margin ratio 50% 60% 40% Total sales revenue $500,000 $500,000 $500,000 Total variable cost $250,000 $200,000 $300,000 Total contribution margin 250,000 300,000 200,000 Fixed cost 150,000 150,000 150,000 Income before income tax $100,000 $150,000 $ 50,000 A difference of $0.50 in unit variable cost between Company A and Company B or between Company A and Company C adds up to a $50,000 difference in profit when 100,000 units are sold. The low-cost producer has a $1 per unit profit advantage over the high-cost producer. If sales volume should fall to 60,000 units per company, Company B would have a profit of $30,000, Company A would break even, and Company C would suffer a loss of $30,000. The same results are shown in the break-even chart in Figure 10.5. eps81189_10_c10.indd 220 12/20/13 9:45 AM CHAPTER 10 Section 10.4 Analysis of Changes in CVP Variables Figure 10.5: Effects of variable cost changes Total revenue line $500 Dollars (in Thousands) Company C, total cost line Company A, total cost line 400 Company B, total cost line 300 200 Fixed cost line 100 20 40 60 80 100 Units of Product (in Thousands) The fixed cost line for each company is drawn at $150,000, the amount of the fixed cost. When 40,000 units are sold, a difference of $20,000 occurs between each total cost line. The lines diverge as greater quantities are sold. At the 100,000-unit level, the difference is $50,000 between each total cost line. Company B can make a profit by selling any quantity in excess of 50,000 units, but Company C must sell 75,000 units to break even. With its present cost structure, Company C will have to sell in greater volume if it is to earn a profit equal to profits earned by Company A or Company B. Company C is the inefficient producer in the group and, as such, operates at a disadvantage. When there is enough business for everyone, Company C will earn a profit, but will most likely earn less than the others. When business conditions are poor, Company C will be more vulnerable to losses. Price Policy One of the ways to improve profit is to get more sales volume; to stimulate sales volume, management may decide to reduce prices. Bear in mind, however, that if demand for the product is inelastic or if competitors also reduce prices, volume may not increase at all. Moreover, even if the price reduction results in an increase in sales volume, the increase may not be enough to overcome the handicap of selling at a lower price. This point is often overlooked by optimistic managers who believe that a small increase in volume can compensate for a slight decrease in price. eps81189_10_c10.indd 221 12/20/13 9:45 AM CHAPTER 10 Section 10.4 Analysis of Changes in CVP Variables Price cuts, like increases in unit variable costs, decrease the contribution margin. On a unit basis, price decreases may appear to be insignificant, but when the unit differential is multiplied by thousands of units, the total effect may be tremendous. Many more units may need to be sold to make up for the difference. Company A, for example, hopes to increase profit by stimulating sales volume; to do so, it plans to reduce the unit price by 10%. The following tabulation portrays its present and contemplated situations: Present Situation Contemplated Situation Selling price $5.00 $4.50 Variable cost 2.50 2.50 Contribution margin $2.50 $ 2.00 Contribution margin ratio 50% 44.4% At present, one half of each revenue dollar can be applied to fixed cost and profit. When revenues are twice the fixed cost, Company A will break even. Therefore, 60,000 units yielding revenues of $300,000 must be sold if fixed cost is $150,000. But when the price is reduced, less than half of each dollar can be applied to fixed cost and profit. To recover $150,000 in fixed cost, unit sales must be 75,000 ($150,000 divided by the $2 contribution margin per unit). Thus, to overcome the effect of a 10% price cut, unit sales must increase by 25%: (75,000 2 60,000) 4 60,000 5 25% increase. Similarly, revenue must increase to $337,500 (75,000 units 3 $4.50 per unit). This represents a 12.5% increase, as follows: ($337,500 2 $300,000) 4 $300,000 5 12.5% increase. Not only must total revenue be higher, but with a lower price, more units must also be sold to obtain that revenue. A break-even chart showing these changes appears in Figure 10.6. eps81189_10_c10.indd 222 12/20/13 9:45 AM CHAPTER 10 Section 10.4 Analysis of Changes in CVP Variables Figure 10.6: Effects of price reduction Total revenue line, price $4.50 e $5 $500 e, p To re ve nu e lin 400 line To ta l Dollars (in Thousands) r ic st co tal 300 200 Fixed cost line 100 30 60 90 120 150 Units of Product (in Thousands) The present pretax income of $100,000 can still be earned if 125,000 units are sold. This is obtained using formula (5) of Figure 10.1: ($150,000 1 $100,000) 4 $2 5 125,000 units. Fixed Costs A change in fixed cost has no effect on the contribution margin. Increases in fixed cost are recovered when the contribution margin from additional units sold is equal to the increase in fixed cost. Presuming that the contribution margin per unit remains unchanged, the following general relationship holds: (Contribution margin per unit 3 Change in sales volume) 2 Change in fixed cost 5 Change in net income. Suppose Enoch Goodfriend estimates that, if he spends an additional $30,000 on advertising, he should be able to sell an additional 2,500 back braces. The above equation reveals that profits would decrease by $5,000 or [($10 3 2,500) 2 $30,000]. Because fixed cost is not part of the contribution margin computation, the slope of the total cost line on a break-even chart is unaffected by changes in fixed cost. The new total cost line is drawn parallel to the original line, and the vertical distance between the two lines, at any point, is equal to the increase or the decrease in fixed cost. eps81189_10_c10.indd 223 12/20/13 9:45 AM Section 10.5 Measures of Relationship Between Operating Levels and Break-Even Points CHAPTER 10 The break-even chart in Figure 10.7 shows the results of an increase in fixed cost from $100,000 to $130,000 at Felsen Medical Supplies. Under the new fixed cost structure, the total cost line shifts upward, and, at any point, the new line is $30,000 higher than it was originally. To break even or maintain the same profit as before, Felsen Medical Supplies must sell 3,000 more back braces. Figure 10.7: Effects of an increase in fixed cost Dollars (in Thousands) $500 Total cost line, fixed cost $130,000 400 Total revenue line 00 0,0 300 st l co a Tot 200 ed , fix line 10 st $ co Fixed cost line, $130,000 Fixed cost line, $100,000 100 5 10 15 20 25 30 Units of Product (in Thousands) Decreases in fixed cost would cause the total cost line to shift downward. The total contribution margin can decline by the amount of the decrease in fixed cost without affecting profit. The lower sales volume now needed to maintain the same profit can be calculated by dividing the unit contribution margin into the decrease in fixed cost. Ethical Considerations When Changing CVP Variables Managers are often under pressure to reduce costs—both variable and fixed costs. Many companies have downsized in recent years by eliminating jobs and even closing plants. Managers must be careful not to cut costs in an unethical manner. Changing a price can also involve ethical issues. For instance, immediately after a hurricane hit southern Florida several years ago, some sellers of building supplies were accused of “price gouging.” 10.5 Measures of Relationship Between Operating Levels and Break-Even Points C ompanies want to know where they are with respect to the break-even point. If they are operating around the break-even point, management may be more conservative in its approach to implementing changes and mapping out new strategies. On the other hand, if they are operating well away from the break-even point, management will be eps81189_10_c10.indd 224 12/20/13 9:45 AM Section 10.5 Measures of Relationship Between Operating Levels and Break-Even Points CHAPTER 10 more aggressive because the downside risk is not as great. Two measures that relate to this distance between a break-even point and the current or planned operating volume are operating leverage and margin of safety. These measures are the subject of the following sections. Operating Leverage Operating leverage measures the effect that a percentage change in sales revenue has on pretax profit. It is a principle by which management in a high fixed cost industry with a relatively high contribution margin ratio (low variable costs relative to sales revenue) can increase profits substantially with a small increase in sales volume. We typically call this measure the operating leverage factor or the degree of operating leverage, and it is computed as follows: Contribution margin 5 Operating leverage factor. Net income before taxes As profit moves closer to zero, the closer the company is to the break-even point. This will yield a high operating leverage factor. As sales volume increases, the contribution margin and pretax profit both increase; consequently, the operating leverage factor becomes progressively smaller. Hence, the operating leverage factor is related to the distance between the break-even point and a current or expected sales volume. With an increase in sales volume, profits will increase by the percentage increase in sales volume multiplied by the operating leverage factor. Suppose Felsen Medical Supplies is currently selling 15,000 back braces. With its unit contribution margin of $10 and fixed costs of $100,000, its operating leverage factor is 3, computed as follows: 1 15,000 2 1 10 2 150,000 5 5 3. 1 15,000 2 1 10 2 2 100,000 50,000 At a sales volume of 15,000, if sales volume can be increased by an additional 10%, profit can be increased by 30%: Percentage increase in sales volume 10 Percentage increase inpretax profit 30% 3 Operating leverage factor 3 5 . A 10% increase in sales volume will increase sales from 15,000 units to 16,500 units. Operating leverage suggests that the pretax profit should be $65,000 ($50,000 3 1.3). Indeed, when we deduct the $100,000 fixed cost from the new contribution margin of $165,000 (16,500 3 $10), we obtain a pretax profit of $65,000. eps81189_10_c10.indd 225 12/20/13 9:45 AM CHAPTER 10 Section 10.6 The Sales Mix A company with high fixed costs will have to sell in large volume to recover the fixed costs. However, if the company also has a high contribution margin ratio, it will move into higher profits very quickly after the break-even volume is attained. Hence, a fairly small percentage increase in sales volume (computed on a base that is already fairly large) will increase profits rapidly. Margin of Safety The margin of safety is the excess of actual (or expected) sales over sales at the break-even point. The excess may also be computed as a percentage of actual (or expected) sales. The margin of safety, expressed either in dollars or as a percentage, shows how much sales volume can be reduced without sustaining losses. The formulas for calculating margin of safety are: Margin of safety in dollars 5 Actual (or expected) sales 2 Break-even sales Margin of safety in percentage form 5 Margin of safety in dollars . Actual 1 or expected 2 sales For our purposes, margin of safety is the percentage form. Therefore, unless otherwise specified, a reference to margin of safety will mean a percentage. Recall that the break-even sales level for Felsen Medical Supplies was $250,000. At an actual sales level of 15,000 back braces, its safety margin is one-third, calculated as follows: 1 15,000 2 1 $25 2 2 $250,000 $125,000 5 5 33% or 1/3. 1 15,000 2 1 $25 2 $375,000 Note that one-third is the reciprocal of the operating leverage factor computed earlier for Felsen Medical Supplies. The margin of safety will always be the reciprocal of the operating leverage factor. 10.6 The Sales Mix W hen selling more than one product line, the relative proportion of each product line to the total sales is called the sales mix. With each product line having a different contribution margin, management will try to maximize the sales of the product lines with higher contribution margins. However, a sales mix results because limits on either sales or production of any given product line may exist. When products have their own individual production facilities and fixed costs are specifically identified with the product line, cost-volume-profit analysis is performed for each eps81189_10_c10.indd 226 12/20/13 9:45 AM CHAPTER 10 Section 10.6 The Sales Mix product line. However, in many cases, product lines share facilities, and the fixed costs relate to many products. For such a situation, cost-volume-profit analysis requires averaging of data by using the sales mix percentages as weights. Consequently, a break-even point can be computed for any assumed mix of sales, and a break-even chart or P/V graph can be constructed for any sales mix. Let’s consider cost-volume-profit analysis with a sales mix. Suppose that Bijan’s Discount Eyeglasses offers three eyeglass options: regular, sunglasses, and bifocals. Assume that the following budget is prepared for these three product lines. Fixed costs are budgeted at $500,000 for the period: Contribution Margin Sales Volume (Units) Price per Unit Unit Variable Cost Dollars Ratio Regular 20,000 $50 $20 $30 60% Sunglasses 10,000 50 30 20 40% Bifocals 10,000 50 40 10 20% Total 40,000 Product Lines The break-even point in units is computed using a weighted average contribution margin as follows: Product Lines Contribution Margin per Unit Sales Mix Proportions Weighted Contribution Margin Regular 50% 3 $30 5 $15.00 Sunglasses 25% 3 20 5 5.00 Bifocals 25% 3 10 5 2.50 Weighted contribution margin $22.50 Fixed cost $500,000 5 5 22,222 total units. Weighted contribution margin $22.50 The detailed composition of this overall break-even point of 22,222 units (and contribution margins at this level) is as follows: eps81189_10_c10.indd 227 12/20/13 9:45 AM CHAPTER 10 Section 10.6 The Sales Mix Product Sales Mix Lines Proportions No. of Units Total Units Margin per Unit Contribution Margin Regular 50% 3 22,222 5 11,111 3 $30 5 $333,330 Sunglasses 25% 3 22,222 5 5,556 3 20 5 111,120 Bifocals 25% 3 22,222 5 5,556 3 10 5 55,560 Break-even contribution margin* $500,010 * Approximately equal to fixed cost of $500,000. Difference is due to rounding. To obtain the sales revenue at the break-even point directly, we calculate it as we did earlier in the chapter. Simply divide the weighted contribution margin ratio into the fixed costs. Individual product line revenues will be total revenues multiplied by individual sales mix proportions. Continuing with our illustration, we have: Product Lines Regular Sunglasses Bifocals 20,000 10,000 10,000 40,000 Revenues $1,000,000 $500,000 $500,000 $2,000,000 Variable cost 400,000 300,000 400,000 1,100,000 $ 600,000 $200,000 $100,000 $ 900,000 Units (number of glasses) Contribution margin Total 500,000 Less fixed cost $ 400,000 Budgeted net income before taxes As shown in the following calculations, the weighted contribution margin ratio is 45%, and revenue at the break-even point is $1,111,111. Total contribution margin Total revenues 5 $900,000 5 45% $2,000,000 Fixed cost $500,000 5 5 $1,111,111 Weighted contribution margin ratio 45% Another way to obtain the number of eyeglasses needed to break even is by using an equations approach. Let r represent the number of regular glasses, s represent the number of sunglasses, and b represent the number of bifocals. The following equation is an extension of the basic CVP equation to this scenario with multiple products: $30r 1 $20s 1 $10b 5 $500,000. eps81189_10_c10.indd 228 12/20/13 9:45 AM CHAPTER 10 Section 10.6 The Sales Mix Next, we need to write the equation in terms of one variable rather than three by using the information from the sales mix proportions. Since there are half as many sunglasses and bifocals sold, we can rewrite the equation as follows: $30d 1 $20(0.5d) 1 $10(0.5d) 5 $500,000. Solving this equation, we obtain d 5 11,111, and therefore, s 5 b 5 0.5(11,111) 5 5,556. These are the same numbers of eyeglasses we derived earlier. If the actual sales mix changes from the budgeted sales mix, the break-even point and other factors of cost-volume-profit analysis may change. Suppose that Bijan’s Discount Eyeglasses actually operated at the budgeted capacity with fixed costs of $500,000. The unit selling prices and variable costs were also in agreement with the budget. Yet, with the same volume of 40,000 units and total revenue of $2,000,000, the pretax profit was considerably lower than anticipated. The difference was due to a changed sales mix. Assume the following actual results: Sale Volume (Units) Unit Contribution Margin Total Contribution Margin Revenue Regular 5,000 $30 $150,000 $ 250,000 Sunglasses 20,000 20 400,000 1,000,000 Bifocals 15,000 10 150,000 750,000 Total 40,000 $700,000 $2,000,000 Product Lines Less fixed cost (500,000) Actual net income after taxes $200,000 Instead of earning $400,000 before taxes, the company earned only $200,000. Sales of sunglasses and bifocals, the less profitable products, were much better than expected. At the same time, sales of the best product line, regular, were less than expected. As a result, the total contribution margin was less than budgeted, so net income before taxes was also less than budgeted. One way to encourage the sales force to sell more of the high contribution margin lines is to compute sales commissions on the contribution margin rather than on sales revenue. If sales commissions are based on sales revenue, a sales force may sell a high volume of less profitable product lines and still earn a satisfactory commission. But if sales commissions are related to contribution margin, the sales force is encouraged to strive for greater sales of more profitable products and, in doing so, will help to improve total company profits. eps81189_10_c10.indd 229 12/20/13 9:45 AM CHAPTER 10 Section 10.7 Cost Estimation 10.7 Cost Estimation C ost estimation is the process of determining a cost relationship with activity for an individual cost item or grouping of costs. We typically express this relationship as an equation that reflects the cost behavior within the relevant range. In Chapter 9, we referred to this equation as a cost function: a 1 b(X). The dependent variable (Y) of the equation is what we want to predict (i.e., costs, in our case). The independent variable (X) (i.e., the activity) is used to predict the dependent variable. The cost function can be written as follows: Y 5 a 1 b(X). This equation states that Y, the total cost, is equal to a value a plus a factor of variability applied to the activity level X. The value a represents the fixed cost. The factor b represents the change in Y in relation to the change in X (i.e., the variable cost per unit of activity). Although a number of techniques exist for estimating a cost-to-activity relationship, we will discuss two techniques: (1) account analysis and (2) high-low method. Account Analysis In account analysis, accountants estimate variable and fixed cost behaviors of a particular cost by evaluating information from two sources. First, the accountant reviews and interprets managerial policies with respect to the cost. Second, the accountant inspects the historical activity of the cost. All cost accounts are classified as fixed or variable. If a cost shows semivariable or semifixed cost behavior, the analyst either (1) makes a subjective estimate of the variable and fixed portions of the cost or (2) classifies the account according to the preponderant cost behavior. Unit variable costs are estimated by dividing total variable costs by the quantity of the cost driver. As an example, suppose for cost control purposes the managing partner of Azran & Associates, a medical equipment delivery company, wishes to estimate the drivers’ truck expenses as a function of miles driven. Costs for the past quarter, during which 58,000 miles were driven, are classified as follows: Item eps81189_10_c10.indd 230 Cost Classification Fuel $ 3,200 Variable Depreciation 11,200 Fixed Insurance 3,900 Fixed Maintenance 1,800 Variable Parking 2,100 Fixed 12/20/13 9:45 AM Section 10.7 Cost Estimation CHAPTER 10 The fixed costs total $17,200, while the variable cost per mile is 8.62 cents [($3,200 1 $1,800) 4 58,000]. Hence, the cost function would be expressed as: Y 5 $17,200 1 $.0862 (X). The managing partner believes that costs should be stable for the coming quarter for which the brokers’ auto travel budget would be 65,000 miles. Accordingly, the truck expenses should total $22,803 [$17,200 1 ($.0862 3 65,000)]. The managing partner intends to investigate any significant deviation from this total cost. Account analysis is fairly accurate for determining cost behavior in many cases. Vendor invoices, for instance, show that direct materials have a variable cost behavior; leasing costs are fixed. A telephone bill is a semivariable cost. One portion is fixed for the minimum monthly charge, and the remainder may be variable with usage. Account analysis has limited data requirements and is simple to implement. The judgment necessary to make the method work comes from experienced managers and accountants who are familiar with the operations and management policies. Because operating results are required for only one period, this method is particularly useful for new products or situations involving rapid changes in products or technologies. The two primary disadvantages of this method are its lack of a range of observations and its subjectivity. Using judgment generates two potential issues: (1) Different analysts may develop different cost estimates from the same data, and (2) the results of analysis may have significant financial consequences for the analyst; therefore, the analyst will likely show self-serving estimates. Another potential weakness in the method is that data used in the analysis may reflect unusual circumstances or inefficient operations, as is likely to occur with new products. These factors then become incorporated in the subsequent cost estimates. This method is also dependent on the quality of the detailed chart of accounts and transaction coding. High-Low Method Another method for obtaining rough approximations to fixed and variable costs is the high-low method. The first step is to list the observed costs for various levels of activity from the highest level in the range to the lowest. This method chooses observations associated with the highest and the lowest activity levels, not the highest and lowest costs. The second step is to divide the difference in activity between the highest and the lowest levels into the difference in cost for the corresponding activity levels in order to arrive at the variable cost rate. As an example, suppose a manager for Edlin’s Home Nurse Services wishes to estimate supplies costs as input for bidding on jobs. Its costs of supplies for several recent jobs, along with the hours of activity, are as follows: eps81189_10_c10.indd 231 12/20/13 9:45 AM CHAPTER 10 Section 10.7 Cost Estimation High Low Hours of Activity Supplies Cost 95 $397 90 377 87 365 82 345 78 329 75 317 66 281 58 239 50 217 The difference in hours is 45 (95 2 50), and the difference in cost is $180 ($397 2 $217). The variable supplies cost per hour is computed below: Cost at highest activity 2 Cost at lowest activity Highest activity 2 Lowest activity 5 $180 5 45 $4 Variable cost per hour. The fixed cost is estimated by using the total cost at either the highest or lowest level and subtracting the estimated total variable cost for that level: Total fixed cost 5 Total cost at highest activity 2 (Variable cost per unit 3 Highest activity) or Total fixed cost 5 Total cost at lowest activity 2 (Variable cost per unit 3 Lowest activity). If the variable cost is calculated correctly, the fixed cost will be the same at both the high and low points. For the above illustration, the calculation of total fixed cost is as follows: Total fixed cost 5 $397 2 ($4 Variable cost per hour 3 95 hours) 5 $397 2 $380 5 $17 or Total fixed cost 5 $217 2 ($4 Variable cost per hour 3 50 hours) 5 $217 2 $200 5 $17. eps81189_10_c10.indd 232 12/20/13 9:45 AM Section 10.7 Cost Estimation CHAPTER 10 The cost function that results from the high-low method is: Y 5 $17 1 $4 (X). If Edlin’s manager forecasts that a particular job would require 75 hours, then the bid would include an estimate of $317 for supplies cost. Occasionally, either the highest or lowest activity or the cost associated with one of those points is obviously an outlier to the remaining data. When this happens, use the next highest or lowest observation that appears to align better with the data. Sometimes only two data points are available, so, in effect, these are used as the high and low points. The high-low method is simple and can be used in a multitude of situations. Its primary disadvantage is that two points from all of the observations will only produce reliable estimates of fixed and variable cost behavior if the extreme points are representative of the points in between. Otherwise, distorted results may occur. If enough quality data are available, statistical techniques can provide more objective cost estimates than we have discussed thus far. Ethical Considerations in Estimating Costs All cost estimation methods involve some degree of subjectivity. With account analysis, managers judgmentally classify costs. With the high-low method, one must decide whether the high and low points are representative data points. The subjectivity inherent in cost estimation can lead to biased cost estimates. Indeed, in certain instances, incentives exist for managers to bias cost estimates. In developing budgets or cost-based prices, managers may want to overestimate costs. In developing proposals for projects or programs, incentives may exist to underestimate costs. Managers must take care not to use subjectivity as an opportunity to act unethically. Other Issues for Cost Estimation An overriding concern with any cost estimation technique is that of extrapolating beyond the relevant range of activity. Cost behavior may change drastically once the activity falls below or rises above the relevant range. For instance, assume the relevant range of activity for Edlin’s Home Nurse Services is 40 to 100 hours. We wish to predict the supplies cost for the coming time period, during which 130 hours of activity are expected. Since this level is above the relevant range, the cost function we derived earlier may not be appropriate to use. We have presumed that our cost data are suitably represented by a straight line (linear) and not by a curve. In some situations, the linear relationship may not be appropriate. Costs, for example, may not increase at a constant rate but instead may change at an increasing or a decreasing rate as the measure of activity increases. Hence, the cost data would be represented by a curve rather than a straight line. The shape of the line or curve can be revealed by plotting a sufficient amount of data for various volumes of activity. eps81189_10_c10.indd 233 12/20/13 9:45 AM CHAPTER 10 Section 10.7 Cost Estimation Case Study: Mendel Medical Supplies Company Mendel Medical Supplies Company produces four basic medical disposable paper product lines at one of its plants: headrest paper sheets, headrest paper rolls, exam table rolls, and face cradle covers. Materials and operations vary according to the line of product. The market has been relatively good. The demand for its products has been growing steadily, and, with the implementation of the Affordable Healthcare Act, demand could increase dramatically. The plant superintendent, Marlene Herbert, while pleased with the prospects for increased sales, is concerned about costs: “Our big problem now is the high fixed cost of production. As we have automated our operation, we have experienced increases in fixed overhead and even variable overhead. And, we will have to add more equipment since it appears that we need even more plant capacity. We are operating over our normal capacity as it is. “The headrest paper sheets market concerns me. We may have to discontinue that market. Our specialty printing is driving up the variable overhead to the point where we may not find it profitable to continue with that line at all.” Cost and price data for the next fiscal quarter are as follows: Exam Table Rolls Headrest Paper Rolls Headrest Paper Sheets Face Cradle Covers Estimated sales volume in units 30,000 120,000 45,000 80,000 Selling prices $14.00 $7.00 $12.00 $8.50 Materials costs $ 6.00 $4.50 $ 3.60 $2.50 Variable overhead includes the cost of hourly labor and the variable cost of equipment operation. The fixed plant overhead is estimated at $420,000 for the quarter. Direct labor, to a large extent, is salaried; the cost is included as a part of fixed plant overhead. The superintendent’s concern about the eventual need for more capacity is based on increases in production that may reach and exceed the practical capacity of 60,000 machine hours. In addition to the fixed plant overhead, the plant incurs fixed selling and administrative expenses per quarter of $118,000. “I share your concern about increasing fixed costs,” the supervisor of plant operations replies. “We are still operating with about the same number of people we had when we didn’t have this sophisticated equipment. In reviewing our needs and costs, it appears to me that we could cut fixed plant overhead to $378,000 a quarter without doing any violence to our operation. This would be a big help.” (continued) eps81189_10_c10.indd 234 12/20/13 9:45 AM CHAPTER 10 Key Terms Case Study: Mendel Medical Supplies Company (continued) “You may be right,” Herbert responds. “We forget that we have more productive power than we once had, and we may as well take advantage of it. Suppose we get some hard figures that show where the cost reductions will be made.” Data with respect to production per machine hour and the variable cost per hour of producing each of the products are given as follows: Exam Table Rolls Headrest Paper Rolls Headrest Paper Sheets Face Cradle Covers Units per hour 6 10   5 4 Variable overhead per hour $9.00 $6.00 $12.00 $8.00 “I hate to spoil things,” the vice president of purchasing announces. “But the cost of our materials for exam table rolls is now up to $7. Just got a call about that this morning. Also, headrest paper sheet materials will be up to $4 a unit.” “On the bright side,” the vice president of sales reports, “we have firm orders for 35,000 rolls of exam table sheets, not 30,000 as we originally figured.” Case Study Exercises 1. 2. 3. From all original estimates given, prepare estimated contribution margins by product line for the next fiscal quarter. Also, show the contribution margins per unit. Prepare contribution margins as in part (1) with all revisions included. For the original estimates, compute each of the following: a. break-even point for the given sales mix. b. margin of safety for the estimated sales volume. 4. For the revised estimates, compute each of the following: a. break-even point for the given sales mix. b. margin of safety for the estimated sales volume. 5. Comment on Herbert’s concern about the variable cost of the headrest paper sheets. Key Terms eps81189_10_c10.indd 235 account analysis A method of estimating fixed and variable costs by classifying accounts into one of these two categories. break-even chart A graph showing cost and revenue functions together with a break-even point. break-even analysis An approach that examines the interaction of factors that influence the level of profits. break-even point The point where total revenues equal total costs. contribution margin ratio Contribution margin divided by sales revenues. 12/20/13 9:45 AM CHAPTER 10 Review Questions cost estimation Determining expected or predicted costs. cost-volume-profit analysis An approach that examines the interaction of factors that influence the level of profits. independent variable The item that is being used to predict or estimate another item. margin of safety The difference between sales revenue and the break-even point. dependent variable The item one is attempting to estimate or predict from one or more other variables. operating leverage Using fixed costs to obtain higher percentage changes in profits as sales change. high-low method An approach for estimating costs that uses only two data points. profit-volume (P/V) graph A break-even chart that uses profits for the vertical axis. sales mix A combination of sales proportions from the various products. Review Questions The following questions relate to several issues raised in the chapter. Test your knowledge of these issues by selecting the best answer. (The odd-numbered answers appear in the answer appendix.) 1. Identify the interrelated factors that are important to profit planning. 2. If the total fixed cost and the contribution margin per unit of product are given, explain how to compute the number of units that must be sold to break even. 3. If the total fixed cost and the percentage of the contribution margin to sales revenue are given, explain how to compute the sales revenue at the break-even point. 4. Can two break-even points exist? If so, describe how the revenue and cost lines would be drawn on the break-even chart. 5. Is it possible to compute the number of units that must be sold to earn a certain profit after income tax? Explain. 6. What does the slope of the P/V graph represent? 7. Define “margin of safety.” How is a margin of safety related to operating leverage? 8. Why is cost estimation so important? 9. Describe the two major steps involved in the account analysis method of cost estimation. eps81189_10_c10.indd 236 12/20/13 9:45 AM CHAPTER 10 Exercises 10. Describe the steps for preparing an estimate of fixed and variable costs using the scattergraph and visual fit method. 11. Describe the high-low method of cost estimation. Exercises 1. Break-even point and changes in fixed costs. Spira Medical Supplies sells a set of grab bars for bathrooms for $50. The variable costs are 60% of revenue. The fixed costs amounted to $120,000 per year. Last year, the store sold 7,500 of these grab bars. During the current year, Spira plans to sell 8,700 sets of grab bars, and fixed costs will increase by $36,000. a. What was the break-even point last year? b. This year, the break-even point will increase by how many grab bars? 2. Break-even analysis and cost changes. At Houston Medical Supplies, the following costs are known for 10,000 units: Selling price $13 per unit Variable costs    5 per unit Fixed costs    6 per unit The operations manager, Wendy Solon, is thinking of buying new equipment to automate certain operations. The new equipment will add $20,000 to fixed costs and cut variable costs by $2 per unit. a. What is the current break-even point in units? b. By what number of units will the break-even point change, and in what direction? Why would you or would you not advise the manager to add this new equipment? 3. Changes to break-even variables. Brasch Eyeglass Company sees its profit picture changing. Variable cost will increase from $4 per unit to $4.50. Competitive pressures will allow prices to increase only by $0.30 per unit to $8. Fixed costs ($200,000) and sales volume (60,000 units) likely will remain constant. a. What will likely happen to the break-even point? b. To maintain the same profit level, fixed costs will have to change to what amount? c. To maintain the same profit level, volume will have to change to what amount? 4. Break-even point and variable cost increase. Lydia Perl, the owner of Schloss Medical Supplies in Frankfurt, Germany, is concerned about increased costs to purchase a hardware item that is sold by the company through one of its retail outlets. This year the variable cost per unit of product was €28. Next year, the eps81189_10_c10.indd 237 12/20/13 9:45 AM CHAPTER 10 Exercises variable cost is expected to increase to €32 per unit. The selling price per unit, however, cannot be increased and will remain at €39 per unit. The fixed costs amount to €90,000. a. What was the break-even point in units of product this year? b. What was the break-even point in revenues for this year? c. How many units of product must be sold next year to break even? d. How much revenue will generate break-even volume for next year? 5. Effects of changes in volume and costs. Marnie’s Discount Eyeglasses sells glasses that have a contribution margin ratio of 35% of $440,000 annual sales (40,000 units). Annual fixed expenses are $95,000. a. Calculate the change in net income if sales were to increase by 850 units. b. The store manager, Laura Romain, believes that if the advertising budget were increased by $18,000, annual sales would increase by $75,000. Calculate the additional net income (or loss) if the advertising budget is increased. c. Laura Romain believes that the present selling price should be cut by 15% and the advertising budget should be raised by $12,000. She predicts that these changes would boost unit sales by 30%. Calculate the predicted additional net income (or loss) if these changes are implemented. 6. Break-even point and profits. Sheila Hershey has noticed that a demand for basic wheelchairs is increasing. Medical supply outlets are charging from $400 to $600 for a wheelchair. Sheila believes that she can manufacture and sell a dependable wheelchair that will serve the purpose for $210. The cost per wheelchair of materials, labor, and variable overhead is estimated at $110. The fixed costs consisting of rent, insurance, taxes, and depreciation are estimated at $25,000 for the year. She already has orders for 180 wheelchairs and has established contacts that should result in the sale of 150 additional wheelchairs. a. How many wheelchairs must Sheila make and sell to break even? b. How much profit can be made from the expected production and sale of 330 wheelchairs? c. How many wheelchairs are needed for a profit objective of $11,000? 7. Target profit and taxes. Fiszon, Inc. had the following results for October: Fixed Variable Sales ($200 per unit) Total $600,000 Cost of sales $180,000 $360,000 (540,000) Net income before taxes $ 60,000 Taxes (40%) $ 24,000 Net income after taxes $ 36,000 a. For net income to be $60,000 after taxes in November, what will Fiszon’s sales in units need to be? eps81189_10_c10.indd 238 12/20/13 9:45 AM Problems CHAPTER 10 8. Multiple product analysis. The Lane Division of Stefan Medical Products, Inc. manufactures and sells two grades of grab bars. The contribution margin bar of Lite-Weight aluminum is $25, and the contribution margin per roll of HeavyDuty stainless steel is $75. Last year, this division manufactured and sold the same amount of each grade of grab bar. The fixed costs were $675,000, and the profit before income taxes was $540,000. During the current year, 14,000 rolls of Lite-Weight grab bars were sold, and 6,000 rolls of Heavy-Duty grab bars were sold. The contribution margin per roll for each line remained the same; in addition, the fixed cost remained the same. a. How many bars of each grade of grab bar were sold last year? b. Assuming the same sales mix experienced in the current year, compute the number of units of each grade of grab bar that should have been sold during the current year to earn the $540,000 profit that was earned last year. 9. Cost segregation by high-low method. Betty Grus provides nursing services in her area. She uses a motor home for transportation and lodging. She recognizes that travel costs with the motor home are relatively high and would like to estimate costs so that she can decide how far she can travel and still operate at a profit. Records from one round trip of 150 miles show that the total cost was $320. On another round trip of 340 miles, the total cost was $472. A local round trip of 50 miles cost $240. She is convinced that the time and cost for trips of more than 300 miles are too high unless the sales potential is very high. a. Calculate the variable cost per mile and the fixed cost per trip by the high-low method. Problems 1. Costs estimations and break-even points. Rodbell Outpatient Surgery Center removes gallstones at the price of $30,000. In 2013, the company performed 145 surgeries at an average price of $30,000 per surgery. Variable costs were $18,000 per surgery, and total fixed costs were $1,200,000. In 2014, fixed costs are expected to increase to $1,350,000, while variable costs should decline to $16,000 per surgery due to a new source of materials and supplies. The company forecasts a 20% increase in number of surgeries for 2014; however, the average price charged to customers is not planned to change. The 2015 forecast is for 20 more surgeries than in 2014, and fixed costs are expected to jump by $240,000 more than in 2014. The average price and variable cost is not expected to change from 2014. Instructions a. For 2013, calculate the number of surgeries needed to break even. b. For 2014, calculate the operating leverage factor. c. Determine the expected amount of profit change from 2014 to 2015. eps81189_10_c10.indd 239 12/20/13 9:45 AM CHAPTER 10 Problems 2. CVP with changes in prices and costs. Data with respect to a basic product line sold by Carson Medical Supply Stores are as follows: Selling price per unit $50 Cost per unit 30 Contribution margin per unit $20 The fixed costs for the year are $360,000. The income tax rate is 40%. Instructions a. Determine the number of units that must be sold in order to break even. b. If a profit before income taxes of $270,000 is to be earned, how many units of product must be sold? c. If a profit after income taxes of $180,000 is to be earned, how many units of product must be sold? d. If the selling price per unit is reduced by 10%, how many units must be sold to earn a profit of $8 per unit before income taxes? e. Assume that the selling price remains at $50. How many units must be sold to earn a profit of $8 per unit before income taxes if the variable cost per unit increases by 10%? f. Why does a 10% decrease in the selling price have more effect on the contribution margin than a 10% increase in the variable unit cost? 3. Break-even comparisons. Dan and Elaine Miller, owners of Senior Day Care want to know potential maximum profits and the break-even occupancy for the operation. Senior Day Care is a low-cost operation to attract families who need help with elderly relatives on low budgets. A study of costs shows a difference between summer and winter operations. Swimming pool maintenance adds to summer costs while utilities (heat and light) add to winter costs. Variable costs have been determined on the basis of cost per patient per day and are as follows: Cost per Room eps81189_10_c10.indd 240 Laundry $1.90 Heat and light (summer) 1.10 Heat and light (winter) 2.20 Repairs 0.75 Supplies 1.60 Taxes and insurance 3.60 Maintenance 1.50 Pool maintenance (summer only) 0.60 12/20/13 9:45 AM CHAPTER 10 Problems Fixed costs per month have been estimated as follows: Staffing $14,000 Management 17,000 Desk service 2,700 Repairs and maintenance 1,600 Taxes 1,430 Insurance 1,120 Heat and light 1,000 Depreciation— building 26,000 Depreciation— furnishings 12,500 Pool maintenance and personnel (summer only) 1,800 Senior Day Care can handle 300 patients and charges $40 per room per day. Summer is relatively short and is defined as June, July, and August. All other months are designated as winter months. A month consists of 30 days for making calculations. Maximum capacity for a month would be 9,000 patient days (300 patients 3 30 days). Instructions a. Compare the maximum operating net incomes that can be expected for a summer month versus a winter month. b. How do the break-even points (in terms of room days) compare for summer versus winter? Also, state the break-even points as percentages of total capacity. c. Based on signed contracts with ongoing patients and normal expectations, Senior Day Care plans for 5,000 patient days in August. Determine the estimated operating income for August. Also, determine the percentage of capacity expected for August. 4. CVP with a sales mix. Sharon Medical Supplies Show rents four types of booths to exhibitors, providing them with space, tables, chairs, and some prefestival publicity. Stan Harris, the show organizer, has indicated that the booth rental fee is three times the amount of variable costs associated with the particular type of booth. Harris expects that the show will incur fixed costs of $9,200. The number of booths expected to be rented this year, as well as the related variable costs, are: eps81189_10_c10.indd 241 12/20/13 9:45 AM CHAPTER 10 Problems Variable Cost per Booth Number of Booths 8’ 3 10’ $25 15 10’ 3 12’ 28 10 10’ 3 15’ 30 20 15’ 3 15’ 35 5 Booth Size Instructions a. Assuming that booths are rented according to the expected mix, determine the number of each type of booth that needs to be rented for the festival to break even. 5. Account analysis. The following is a partial list of account titles appearing in the chart of accounts for Lee Caplan Medical Equipment: a. Direct Materials b. Supervisory Salaries—Factory c. Heat, Light, and Power—Factory d. Depreciation on the Building e. Depreciation on Equipment and Machinery (units-of-production method) f. Janitorial Labor g. Repair and Maintenance Supplies h. Pension Costs (as a percentage of employee wages and salaries) i. FICA Tax Expense (employer’s share) j. Insurance on Property k. Sales Commission l. Travel Expenses—Sales m. Telephone Expenses—General and Administrative n. Magazine Advertising o. Bad Debt Expense p. Photocopying Expense q. Audit Fees r. Dues and Subscriptions s. Depreciation on Furniture and Fixtures (double-declining-balance method) t. Group Medical and Dental Insurance Expense Instructions a. Discuss each account title in terms of whether the account represents a variable, fixed, or semivariable cost. b. For accounts designated as variable or semivariable, indicate the most likely cost driver with which the cost varies. c. Explain the problems associated with using the account analysis approach to establish cost behavior patterns. eps81189_10_c10.indd 242 12/20/13 9:45 AM CHAPTER 10 Problems 6. High-low method. Kathleen Otwell, a medical insurance claims adjuster for Shoenfield Casualty Company, notes that the cost to process a claim has both fixed and variable components. She believes that she can estimate costs more accurately if she can separate the costs into their variable and fixed components. The monthly record of the number of claims and the costs for the past year is as follows: Number of Claims Cost January 120 $20,600 February 134 20,670 March 142 20,710 April 156 20,780 May 160 20,800 Number of Claims Cost June 220 21,100 July 250 21,250 August 330 21,650 September 114 20,570 October 280 21,400 November 274 21,370 December 230 21,150 Month Month Instructions a. Estimate the variable costs per claim and the fixed costs per month by the high-low method. eps81189_10_c10.indd 243 12/20/13 9:45 AM eps81189_10_c10.indd 244 12/20/13 9:45 AM Chapter 5 Inventory iStock/Thinkstock Learning Objectives eps81189_05_c05.indd 81 • Understand the basics of recording inventory purchases and sales. • Understand the typical categories of inventory and their contents. • Understand how an expanded income statement presentation can enhance reporting usefulness. • Explain how inventory costs are allocated to inventory and costs of goods sold and the importance of this allocation to income measurement. • Know how to apply FIFO, LIFO, and moving average inventory-costing assumptions. • Apply specific identification and lower-of-cost-or-market concepts. 12/20/13 9:28 AM Introduction CHAPTER 5 Chapter Outline Introduction 5.1 Categories of Inventory Inventory Costs Freight Consigned Goods Critical Thinking About Inventory Cost 5.2 Cost Assignment 5.3 Perpetual Systems First-In, First-Out Last-In, First-Out The Average Cost Approach 5.4 Comparing Methods Specific Identification Lower-of-Cost-or-Market Adjustments 5.5 The Importance of Accuracy Introduction Y ou may think that since you are working in a healthcare environment and not selling products, you don’t have to worry about inventory costing and management. In reality, even the smallest medical office has inventory. Physicians give shots and need to hold inventory of the inoculations that will be given to patients. If your office provides sample medications, you need to track and account for that inventory even if the patients don’t pay for it. Almost everything you do in patient care requires medical supplies that can be directly allocated to each patient. Some things, such as bandages, are not cost effective to bill per patient, but other things, such as medications, will likely be billed on a patient-bypatient basis. In some healthcare settings, such as an oncology practice where expensive medical treatments are done in the office using medications that can cost hundreds, if not thousands, of dollars, inventory management becomes critical. Therefore, in a medical environment, medications and other items used in patient care are goods to be sold, even if they aren’t being sold in the traditional way. Essentially, they become the costs of services sold. A medical office can’t provide an inoculation without first paying costs of buying that inoculation and having it shipped to the practice. eps81189_05_c05.indd 82 12/20/13 9:28 AM CHAPTER 5 Introduction  How hard could it be to account for inventory? The basic concept is very simple. When you buy inventory, you record the purchase of the asset, 2-10-XX Inventory 10,000.00 Accounts payable 10,000.00 Purchased $10,000 of inventory on account Then, when the inventory is resold, two entries are needed—one to record the sales proceeds and another to remove the inventory and charge it to an expense category called Cost of Goods Sold. Cost of Goods Sold is not common in most healthcare environments, but you will see it used in some retail-type environments, such as the sale of medical equipment or pharmaceuticals. In most healthcare environments, the use of inventory is accounted for as a supplies expense. The following example is for an organization that does use Cost of Goods Sold: 3-15-XX Accounts receivable 15,000.00 Sales 15,000.00 Sold merchandise on account 3-15-XX Cost of goods sold 10,000.00 Inventory 10,000.00 To record the cost of merchandise sold This very basic approach would result in the following income statement results: Sales $15,000 Cost of goods or services sold 10,000 Gross profit $ 5,000 If the organization uses Supplies Expense to offset its use of Inventory, that the entry would look 3-15-XX Supplies expense Inventory To record the use of inventory for patient care In this the account, “Supplies Expense,” would be in the expense section of the income statement. eps81189_05_c05.indd 83 12/20/13 9:28 AM Section 5.1 Categories of Inventory CHAPTER 5 The gross profit is simply the net difference between the cost of inventory that has been sold and the sales proceeds. It is not the net income because it does not reflect all other costs of doing business. Of course, if inventory accounting were only this simple, there would be no need for a separate chapter. So, what issues could possibly arise to complicate the accounting for inventory? For starters, there are issues about what goods are appropriately included in inventory. What is the appropriate moment to conclude that a transaction has resulted in a sale? What costs, in addition to the direct purchase price, are to be placed into the inventory accounts? How do we attach costs to specific units sold when numerous identical units have been purchased at different costs on different dates, and we are not sure which physical units have actually been delivered to a customer? Suddenly, accounting for inventory appears to present a number of vexing challenges. This chapter helps sort out these issues and provides you with a sound understanding of the accounting principles you need to know to answer these types of questions and more. 5.1 Categories of Inventory T he very simple journal entry that opened this chapter contemplated a retail business model. The company bought goods from a supplier and resold those goods to customers at a higher price point. This is traditional retailing, which is a large segment of the economy but not the only segment. Some aspects of a medical practice may work this way. For example, a practice that sells supplements to its patients would operate that aspect of the practice as any retail store would. More likely, the inventory in a medical practice is sold as part of a treatment or procedure. For example, the medical practice may bill $100 for giving a patient an injection. The supplies for the injection may have cost $50 to purchase. So in this very simple example, the amount paid to the practice would be the revenue. The amount paid for the inoculation from the supplier would be the cost of goods or services sold. Some healthcare entities manufacture their goods, such as pharmaceutical firms or medical equipment providers. These types of companies also carry inventory on their books. Inventory Costs As a general rule, inventory should include all costs that are ordinary and necessary to put the goods in place and in condition for their resale. Inventory therefore includes the invoice price, shipping costs incurred when buying the goods, and similar costs. Costs like interest charges on money borrowed to buy inventory, storage costs, and insurance are not included in inventory accounts because they do not meet the general rule. Those costs are called carrying costs and are to be expensed in the period incurred. Freight Few people think deeply about how significant freight cost can be to the overall cost of bringing a product to market. It can be expressed in very simple terms. If you drive to the store for a gallon of milk costing $3 and spend $3 on gas to make the trip, how much did eps81189_05_c05.indd 84 12/20/13 9:28 AM Section 5.1 Categories of Inventory CHAPTER 5 the milk actually cost? If you were trying to categorize your milk in the refrigerator as an asset on an accounting balance sheet, would your report its cost at $3 or $6? Because of its significance, accountants have been very careful to describe fully a framework for the handling of freight costs. Developing an understanding of this framework begins with specific knowledge about freight terms. FOB is a common freight nomenclature. It is an abbreviation for “free on board.” What that really means is the point at which the ownership of goods shifts from the seller to the buyer. Thus, goods may be sold FOB shipping point. Once goods are shipped, they are deemed the property of the buyer. Equally important, the buyer must assume responsibility for payment of freight to the destination. Conversely, FOB destination means that the seller owns the goods until they are delivered and must bear the cost of shipping. The implications of freight terms should not be underestimated. There are two highly significant inventory accounting considerations that are directly affected by the FOB terms. First, goods sold FOB destination do not belong to the purchaser until they arrive at their final destination. Therefore, goods that have been purchased but not yet received would not be carried in the buyer’s balance sheet at the end of the accounting period. Similarly, no liability would be reported for the payment obligation. Conversely, goods purchased FOB shipping point that have been shipped by the seller should be reflected on the buyer’s balance sheet, even though they may not be in the buyer’s physical possession. In this case, the buyer needs to show both the inventory and related liability on its books. Accountants can face interesting challenges to determine the status of goods in transit at the end of each accounting period. The second major issue pertains to the freight cost. When the buyer assumes the freight cost (as with FOB shipping point), it is deemed to be an ordinary and necessary cost to put the goods in place and in condition for resale. As such, accountants will add freight-in to the cost of the inventory. Thus, the Inventory account will reflect both the invoice cost of the goods, along with any additional amounts for freight. You should be aware that freight-out incurred by a seller of goods faces a different accounting rule. Freight-out is treated like a sales expense and does not increase the cost of goods sold amount; instead, the freight out is subtracted from gross profit in calculating income. Consigned Goods On occasion, a supplier may approach a healthcare organization about stocking a particular product. The healthcare organization may be reluctant, not wanting to invest in inventory that may not be used for patient services. This negotiation may result in a consignment of inventory. A consignment is an agreement whereby the inventory’s owner, the consignor, places it with another party in the hope that the goods will be needed for patient care. The party holding physical possession is the consignee but not the legal owner. It must care for the goods and try to sell them to an end customer. The consignor surrenders physical custody but maintains legal ownership. The consignor would continue to carry the goods in its inventory records. Consigned goods pose a record-keeping challenge. Because physical custody does not represent ownership, it becomes difficult for both consignees and consignors to maintain proper accountability over consigned inventory. When the consignee sells consigned eps81189_05_c05.indd 85 12/20/13 9:28 AM CHAPTER 5 Section 5.1 Categories of Inventory goods to an end user, the consignee becomes obligated to remit a portion of the final sales price to the consignor. Otherwise, it is understood that the consignee reserves the right to return the inventory without obligation to make payment. Critical Thinking About Inventory Cost Consider that a business is likely to open a new accounting period with a carryover balance of inventory from the preceding period. This is probably rather obvious. Just because an accounting period has ended does not mean that unsold goods must be dumped. Instead, the ending balance of one period becomes the beginning inventory balance of the next. Figure 5.1 shows how a period’s beginning inventory, plus additional purchases, can be combined to represent the total goods available for sale. Some of the goods available for sale are sold and become cost of goods sold, and the unsold portion represents the ending inventory (which will carry forward into the next accounting period). To simplify wording, assume cost of goods or services sold in each instance, but we will simplify the rest of the chapter to just using “cost of goods sold.” In many healthcare environments, when inventory is used, it is offset by showing a “Supplies Expense.” Whether the use of inventory will be shown as a “Cost of Goods Sold” or a “Supplies Expense,” the basic concepts of managing inventory costs or expenses are similar. Figure 5.1: Goods available for sale Beginning inventory + Net purchases Ending inventory + Goods available for sale Cost of goods sold Figure 5.1 shows how goods available for sale must be split between ending inventory and cost of goods sold. Though a picture may be worth a thousand words, it is also true that accountants rarely communicate with images. Thus, the drawing is usually converted to a calculation format such as the following (all amounts are assumed for the time being): Beginning inventory $100,000 Plus: Purchases 450,000 Goods available for sale $550,000 Less: Ending inventory 50,000 Cost of goods sold $500,000 The Cost of Goods Sold may be a Supplies Expense in most healthcare environments. In the drawing, the units appear as physical units, but the natural commingling of homogeneous inventory sometimes makes it difficult or impossible to truly know which units are eps81189_05_c05.indd 86 12/20/13 9:28 AM Section 5.3 Perpetual Systems CHAPTER 5 which. Accountants therefore express inventory on the balance sheet in units of money rather than physical quantity descriptions. A critical factor in determining income is the allocation of the cost of goods available for sale between ending inventory and cost of goods sold. Accountants have a significant task to assess what cost attaches to ending inventory and what cost attaches to cost of goods sold, especially in light of the fact that the exact physical flow of goods is probably unknown. 5.2 Cost Assignment I t is unlikely that each unit of inventory will have the exact same cost. It can be impractical to trace the exact cost of each unit; even when possible, accountants do not require this association. Instead, accountants use inventory cost flow assumptions. These assumptions do not need to relate to the physical flow of the inventory. Thus, the inventory cost allocation approach is just a systematic approach for dealing with the question of what cost is to be attached to ending inventory and cost of goods sold. To illustrate this point, consider the case of Jill’s Medical Supplies. Jill’s Medical Supplies has a storage bin full of gauze rolls. As customers purchase rolls, Jill’s Medical Supplies randomly selects them from the bin. As Jill’s restocks, they dump newly purchased gauze rolls into the bin. The rolls are constantly being mixed up such that Jill’s has no way of knowing the exact purchase date or price of any particular roll remaining in the bin. During a recent period, the bin had an opening supply of 500 rolls and was restocked two different times. At each restocking, 500 rolls were added. The rolls in beginning inventory cost $2 per roll. The first restocking had a unit cost of $2.25. The final restocking was at $2.75. The bin was never allowed to empty completely. At the end of the period, the bin contains 125 rolls, probably including some from beginning inventory and each restocking event. What is the cost of the ending inventory? The answer to this important question will directly impact the calculation of not only ending inventory but also cost of goods sold (and therefore income). Jill’s must adopt an inventory-costing method. There are several cost flow assumptions to choose from. One is a first-in, first-out (FIFO) approach. Another is the last-in, first-out (LIFO) approach. The third method reflects a more complex average cost approach. These approaches will be discussed in the next section. The complexity arises because the average cost method is not just the simple average of the per-unit price but instead weights the cost by the number of units purchased at each price point. Thus, it is also known as a weighted-average concept. In the average cost example that follows, the weighted-average cost is recalculated each time there is a new purchase, resulting in a further refinement of its moniker as the moving-average method. 5.3 Perpetual Systems B efore more closely examining the accounting for Jill’s inventory under the FIFO, LIFO, and average cost approaches, it is first necessary to point out that inventory costs can either be accumulated on a real-time perpetual inventory system or occasionally updating via a periodic inventory system. As the name suggests, a perpetual system is one in eps81189_05_c05.indd 87 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems which inventory records are continuously updated for all inventory changes. As inventory is purchased, it is added into the Inventory account. As inventory is sold, it is subtracted from the Inventory accounts. A periodic system is one in which the Inventory accounts are only updated on designated intervals, such as at the end of each accounting period. At one time, accumulating and assigning costs on a perpetual basis was exceedingly difficult because of the extraordinarily tedious record keeping that ensues. Then, companies necessarily resorted to simplifying techniques that only periodically updated inventory records. Modern computers have allowed companies to adopt more sophisticated real-time, or perpetual, tracking of inventory. These systems greatly improve asset accountability and business decision making. With a perpetual system, each inventory purchase or sale transaction triggers an update of the inventory records and corporate general ledger. To begin to see how this operates, closely examine the details about Jill’s inventory purchases in Table 5.1. Table 5.1: Jill’s Medical Supplies inventory purchases Date Quantity Purchased Cost per Unit Total Cost Beginning balance July 1 500 $2.00 $1,000 Purchase 2 July 15 500 $2.25 $1,125 Purchase 3 July 24 500 $2.75 $1,375 In addition to information about the purchasing activity, we also need detailed information about Jill’s sales. Table 5.2 provides detailed sales data: Table 5.2: Jill’s Medical Supplies sales data Date Quantity Sold Sales Price per Unit Total Sales Sale 1 July 9 400 $4.00 $1,600 Sale 2 July 20 550 $4.50 $2,475 Sale 3 July 28 425 $5.00 $2,125 Overall, you will notice that Jill’s had 1,500 units available (500 1 500 1 500) and sold 1,375 units (400 1 550 1 425), leaving the remaining ending inventory on hand at the end of July at 125 units. We mustn’t lose sight of our accounting goals: to determine the total sales, total cost of goods sold, gross profit, and ending inventory balances to report in the financial statements. Making this determination will require an inventory cost flow assumption. Importantly, the cost flow assumption is used to describe the flow of the cost of goods through the accounting system. It is not necessary that a cost flow assumption actually correspond to a physical flow, but it useful to visualize a cost flow assumption by thinking about physical flow. In a healthcare setting, you would likely sell medications on a FIFO eps81189_05_c05.indd 88 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems basis. Medications can become outdated, and you want to use them before they expire. This is logical. On the other hand, if you sold crushed rock that was dumped in large stacks as it was processed and delivered via a loader scooping from the pile as it was sold, you can likely understand the LIFO cost flow concept. We will first perform Jill’s inventory calculations using a perpetual FIFO method. First-In, First-Out Table 5.3 shows the level of detail that is necessary to track the inventory correctly. Study this very carefully. Perhaps you can follow the logic by only tracking amounts in the table; if not, additional explanatory details are provided below the table. Remember, this is a FIFO example. When a sale occurs, the assumption is that the units sold were from the first, or earliest, available units: first-in, first-out. Table 5.3: FIFO inventory tracking Date Purchases Sales Cost of Goods Sold July 1 500 , $2.00 5 $1,000.00 July 9 July 15 Remaining Inventory Balance 400 , $4.00 5 $1,600.00 400 , $2.00 5 $800.00 500 , $2.25 5 $1,125.00 100 , $2.00 5 $ 200.00 100 , $2.00 5 $200.00 500 , $2.25 5 1,125.00 $1,325.00 July 20 550 , $4.50 5 $2,475.00 100 , $2.00 5 $200.00 50 , $2.25 5 $112.50 450 , $2.25 5 1,012.50 $1,212.50 July 24 500 , $2.75 5 $1,375.00 50 , $2.25 5 $112.50 500 , $2.75 5 1,375.00 $1,487.50 July 28 425 , $5.00 5 $2,125.00 50 , $2.25 5 $112.50 125 , $2.75 5 $343.75 375 , $2.75 5 1,031.25 $1,143.75 eps81189_05_c05.indd 89 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems Notice that a significant amount of detail is in tracking inventory using a perpetual approach; without computers, this becomes nearly impossible to do correctly when vast inventories and large volumes of transactions are involved. However, given a properly programmed computer, the task is inconsequential. Many businesses have a sufficient level of sophistication that inventory records are being updated as each sale is recorded at a point-of-sale terminal. Jill’s Medical Supplies could have such a terminal. Be sure to note exactly what is occurring on each date. For example, on July 20, 50 units remain after selling 550 units. This is determined by first noting that 600 units were on hand prior to the sale transaction (consisting of 100 units that are assumed to cost $2.00 each and 500 units that are assumed to cost $2.25 each). After removing 550 units from stock (assumed to consist of 100 units costing $2.00 and 450 units costing $2.25), only 50 remain at an assumed unit cost of $2.25. This cost analysis and allocation process must be repeated with each transaction that results in increasing or decreasing the inventory balance. With FIFO, keep in mind that the layers of inventory assumed to be sold are based on the chronological order in which they were purchased. The analysis provided within Table 5.3 provides a basis for actually recording the transactions into the general journal. Be sure to trace the amounts in the entries back into Table 5.3. Remember, Inventory is debited as purchases occur and credited as sales occur. Following are the necessary entries to record July’s activity: 7-9-XX Accounts receivable 1,600.00 Sales 1,600.00 Sold inventory on account 7-9-XX Cost of goods sold 800.00 Inventory 800.00 To record the cost of goods sold 7-15-XX Inventory 1,125.00 Accounts payable 1,125.00 Purchased inventory on account 7-20-XX Accounts receivable 2,475.00 Sales 2,475.00 Sold inventory on account 7-20-XX Cost of goods sold Inventory 1,212.50 1,212.50 To record the cost of goods sold eps81189_05_c05.indd 90 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems 7-24-XX Inventory 1,375.00 Accounts payable 1,375.00 Purchased inventory on account 7-28-XX Accounts receivable 2,125.00 Sales 2,125.00 Sold inventory on account 7-28-XX Cost of goods sold 1,143.75 Inventory 1,143.75 To record the cost of goods sold Using selected T-accounts in Exhibit 5.1, you can see how the preceding entries result in the appropriate account balances for sales ($6,200.00), cost of goods sold ($3,156.25), and the ending inventory ($343.75). Exhibit 5.1: T-accounts for sales, cost of goods sold, and inventory (FIFO) Sales Cost of Goods Sold Inventory 1,000.00 1,600.00 800.00 800.00 1,212.50 2,475.00 1,212.50 1,212.50 1,375.00 2,125.00 1,143.75 6,200.00 3,156.25 1,143.75 343.75 Last-In, First-Out Table 5.4 repeats the preceding facts but with the calculations applied on a LIFO basis. When a sale occurs, the assumption is that the units sold were from the last, or most recent, available units: last-in, first-out. eps81189_05_c05.indd 91 12/20/13 9:28 AM CHAPTER 5 Section 5.3 Perpetual Systems Table 5.4: LIFO inventory tracking Date Purchases Sales Cost of Goods Sold July 1 500 , $2.00 5 $1,000.00 July 9 July 15 Remaining…

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