Contribution Approach(direct costing)
Different from the Absorption approach(for GAAP, matching principle)
-takes fixed and variable costs into account for breakeven analysis
Formula: Revenue less: Variable Costs =Contribution Margin less: Fixed costs = Net Income
Contribution Margin Ratio
Contribution Margin / Revenue
Absorption Approach
- GAAP, matching principle
- Product costs are NOT expensed until they are sold as Cost of goods sold
Formula: Revenue less: Cost of Goods Sold = Gross Margin less: Operating Expenses = Net Income
Only difference between Contribution and Absorption Approach(other than format to get to net income)
Treatment of fixed factory overhead
- Under Absorption approach fixed factory overhead is a product cost(only expenses under GAAP when the unit is sold)
- Under Contribution approach fixed factory overhead is a period cost(not GAAP) and expensed immediately
Variable costing net income vs. Absorption costing net income
No change in inventory = same net income for both
Increase in inventory = Absorption net income is greater than variable net income
Decrease in inventory = Absorption net income is less than variable net income
- Absorption costing includes Fixed O/H per unit in inventory
- Variable costing excludes Fixed O/H per unit in inventory and treats it as a period cost
Breakeven Computation
Total fixed Costs/ Contribution Margin per unit* = Breakeven point
*Selling price of unit - variable cost per unit
Computing Breakeven in Sales Dollars
Method 1:Total Fixed Costs/ Contribution Margin Ratio* = Breakeven in Sales Dollars
*Contribution Margin/Sales
Method 2: If already know the Breakeven point in UNITS just multiply by Selling price per unit
Required Sales Volume for Target Formula
Sales = Fixed costs + Profit / Contribution Margin Ratio
Tax Considerations Formula
Earnings Before Tax x (1 - Tax Rate) = “target” Net Income
EBT x (1 - TR) = “target” NI
Predicting Profit Performance Formula
Page 10 B-2
Margin on Safety
- A cushion, excess sales over breakeven sales
- Margin of Safety percentage = Margin of Safety in dollars/ Total Sales
Incremental Costs
- also known as differential costs and prime costs
- are the additional costs to produce an additional amount of the unit over the present output and are therefore RELEVANT costs
Sunk Costs
Will not change, unavoidable costs because they occurred in the past and cannot be recovered as a result of the decision and are therefore considered IRRELEVANT costs
Opportunity Costs
Are the cost of foregoing the next best alternative, and are considered RELEVANT costs
Formula:
Controllable Costs
-are considered RELEVANT costs because they can be controlled by “this” level of management, and will change as a result of selecting different alternatives.
Uncontrollable Costs
-are considered IRRELEVANT since they were authorized by management at a “different” level of management
Marginal Costs(memorize)
include all variable costs AND any avoidable fixed costs
Special Order Decisions
- opportunities that require a firm to decide if a specially priced order should be accepted or rejected.
- accept if profitable, if Revenue > Relevant Costs
Capacity Issues
-applied to a “Special Order Decision”
Presumed Excess Capacity
-Accept if Selling Price > Relevant Costs(variable costs)
Presumed Full Capacity
-Accept if Selling Price > Relevant Costs(variable costs) + Opportunity Costs*
*Contribution Margin in $(Forgo)/Size Special Order = Opportunity cost per unit
^(Only relevant at full capacity)
Make vs. Buy
- if the relevant costs to make something including any opportunity costs is less than any purchases price, then the company should make the product
- fixed costs that are uncontrollable(unavoidable) should be ignored in the calculation for making the product
Sell or Process Further
- if incremental revenue is greater than the incremental cost, then the company will process further
- “joint costs” are sunk costs since they are already incurred and should be ignored
- Separable costs which occur after split-off point are relevant
Segment
A product line
Keep or drop a Segment
Drop the segment if the lost contribution margin is less than the avoidable fixed costs
- Any fixed costs that are controllable or avoidable are considered relevant
- IF they are unavoidable they should be ignored
Keep the segment if the lost contribution margin exceeds the avoidable fixed costs
Sensitivity Analysis
part of techniques for forecasting and projection
Slope ∆DV/∆IV = ∆Total Cost / ∆Volume = Variable Cost per unit
