Chapter 5 Supplemental Slides Cost Concepts Contribution Margin

Chapter 5: Supplemental Slides Cost Concepts, Contribution Margin and Cost Volume Profit Analysis

Cost Behavior • Cost behavior defines how a cost will react to changes in the level of business activity. • Activities that cause costs to be incurred are called cost drivers. Copyright © Houghton Mifflin Company. All rights reserved. 2

Variable Costs • Variable costs change in direct proportion to levels of business activity.

Fixed Costs • Fixed costs remain the same across different activity levels. Copyright ©

Mixed Costs • Mixed costs have both fixed and variable components. Cellular phone companies charge a fixed monthly base fee for a minimum level of service plus additional costs per unit over the limit. Copyright © Houghton Mifflin Company. All rights reserved. 5

Other Cost Concepts • Relevant range is the level of activity at which assumptions about cost behavior remain in effect. • Cost drivers are activities that cause costs to be incurred. Copyright © Houghton Mifflin Company. All rights reserved. 6

Direct vs. Indirect Costs • Direct costs – Can be easily and conveniently traced to a product or department – Example: The cost of plastic in the keyboard assembly department of a computer manufacturer • Indirect costs – Must be allocated in order to be assigned to a product or department – Example: The cost of national advertising for a computer company is indirect to a particular sale Copyright © Houghton Mifflin Company. All rights reserved. 7

Pricing Strategies • Premium pricing – Pricing goods and services higher than competitors • Cost leadership – Pricing goods and services lower than the competition • Cost-based pricing – Basing prices on some fixed percentage above costs Copyright © Houghton Mifflin Company. All rights reserved. 8

Cost-Volume-Profit Analysis • CVP analysis is a technique used to analyze the relationships among revenues, expenses, and profits at different sales levels. • Necessary data: – Sales price per unit sold – Sales volume – Variable cost per unit – Total fixed costs Copyright © Houghton Mifflin Company. All rights reserved. 9

Contribution Margin • The amount by which total sales exceed variable costs Sales – Variable Costs = Contribution Margin – Fixed Costs = Net Income Contribution Margin = Sales Price per Unit – Variable Cost per Unit Copyright © Houghton Mifflin Company. All rights reserved. 10

Breakeven Point • The breakeven point represents the level of sales in dollars or units at which the company’s profits are equal to zero. Breakeven Point in Units: Total Fixed Costs – Contribution Margin per Unit Breakeven point In Dollars: Total Fixed Costs – Contribution Margin Ratio Copyright © Houghton Mifflin Company. All rights reserved. 11

Breakeven Point • Consider the following information developed by an accountant at Out of Bounds Co. : Sales (500 skateboards) Less: Variable expenses Contribution margin Less: Fixed expenses Net Income Total $150, 000 $100, 000 $75, 000 $25, 000 Copyright © Houghton Mifflin Company. All rights reserved. Per Unit 300 100 200 Percent 100 33 67 12

Let’s calculate the breakeven point in units for Out of Bounds, Co. Sales (500 skateboards) Less: Variable expenses Contribution margin Less: Fixed expenses Net income Total 150, 000 100, 000 75, 000 25, 000 Per Unit 300 100 200 Percent 100 33 67 Fixed Expenses / Unit Contribution Margin = Breakeven point in units $75, 000 / 200 = $375 Copyright © Houghton Mifflin Company. All rights reserved. 13

Lowering the Breakeven Point • The breakeven point can be lowered by: – Decreasing variable costs – Decreasing fixed costs – Increasing sales prices Copyright © Houghton Mifflin Company. All rights reserved. 14

Multi-Product Breakeven Analysis • Sales mix is the relative proportion or percentage of total sales that each product or service represents. • Contribution margin for multiple products is determined using a weighted average. Copyright © Houghton Mifflin Company. All rights reserved. 15