Copyright 2014 Pearson Education Inc publishing as Prentice
Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 -1
Chapter 2 Introduction to Cost Behavior and Cost-Volume-Profit Relationships Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 -2
Chapter 2 Learning Objectives When you have finished studying this chapter, you should be able to: 1. Explain how cost drivers affect cost behavior. 2. Show changes in cost-driver levels affect variable and fixed costs. 3. Explain step- and mixed-cost behavior. 4. Create a cost-volume-profit (CVP) graph and understand the assumptions behind it. 5. Calculate break-even sales volume in total dollars and total units. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 -3
Chapter 2 Learning Objectives 6. Calculate sales volume in total dollars and total units to reach a target profit. 7. Differentiate between contribution margin and gross margin. 8. Explain the effects of sales mix on profits (Appendix 2 A). 9. Compute cost-volume-profit (CVP) relationships on an after-tax basis (Appendix 2 B). Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 -4
Cost Drivers and Cost Behavior Cost drivers are measures of activities that require the use of resources and thereby cause costs. Cost behavior is how the activities of an organization affect its costs. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 -5
Learning Objective 1 Cost Drivers and Cost Behavior Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 -6
Value Chain Functions, Costs, and Cost Drivers Value Chain Function Example Cost Drivers And Resource Costs Research and development • Salaries of sales personnel Number of new product proposals costs of market surveys • Salaries of product and process Complexity of proposed products engineers Design of products, services, and processes • Salaries of product and process Number of engineering hours engineers • Cost of computer-aided design equipment used to develop Number of distinct parts per product prototype of product for testing Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 -7
Value Chain Functions, Costs, and Cost Drivers Value Chain Function and Resource Costs Production • Labor wages • Supervisory salaries • Maintenance wages • Depreciation of plant and machinery, supplies • Energy cost Marketing • Cost of advertisements • Salaries of marketing personnel, travel costs, entertainment costs Example Cost Drivers Labor hours Number of people supervised Number of mechanic hours Number of machine hours Kilowatt hours Number of advertisements Sales dollars Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 -8
Value Chain Functions, Costs, and Cost Drivers Value Chain Function And Resource Costs Distribution • Wages of shipping personnel • Transportation costs including depreciation of vehicles and fuel Customer service • Salaries of service personnel • Costs of supplies, travel Example Cost Drivers Labor hours Weight of items delivered Hours spent servicing products Number of service calls Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 -9
Learning Objective 2 Variable and Fixed Cost Behavior A variable cost changes in direct proportion to changes in the cost-driver level. A fixed cost is not immediately affected by changes in the cost-driver level. Think of variable costs on a per-unit basis. Think of fixed costs on a total-cost basis. The per-unit variable cost remains unchanged regardless of changes in the cost-driver. Total fixed costs remain unchanged regardless of changes in the cost-driver. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 10
Cost Behavior of Variable and Fixed Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 11
Cost Behavior: Further Considerations Cost behavior depends on the decision context, the circumstances surrounding the decision for which the cost will be used. Cost behavior also depends on management decisions—management choices determine cost behavior. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 12
Relevant Range The relevant range is the limit of cost-driver activity level within which a specific relationship between costs and the cost driver is valid. Even within the relevant range, a fixed cost remains fixed only over a given period of time—usually the budget period. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 13
Fixed Costs and Relevant Range Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 14
Learning Objective 3 Step- and Mixed-Cost Behavior Patterns Step cost: A cost that changes abruptly at different intervals of activity because the resources and their costs come in indivisible chunks. Mixed Cost: A cost that contains elements of both fixed - and variable-cost behavior Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 15
Step-Cost Behavior Step cost treated as a fixed cost Step cost treated as a variable cost Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 16
Learning Objective 4 Cost-volume-profit (CVP) analysis Managers trying to evaluate the effects of changes in volume of goods or services produced might be interested in upward changes such as increased sales expected from increases in promotion or advertising. AND Managers might be interested in downward changes such as decreased sales expected due to a new competitor entering the market or due to a decline in economic conditions. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 17
CVP Scenario Cost-volume-profit (CVP) analysis is the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit). Per Unit Selling price Variable cost of each item Selling price less variable cost $1. 50 1. 20 $. 30 Percentage of Sales 100% 80 20% Monthly fixed expenses: Rent $3, 000 Wages for replenishing and servicing 13, 500 Other fixed expenses 1, 500 Total fixed expenses per month $18, 000 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 18
Cost-Volume-Profit Graph A $150, 000 138, 000 Net Income Dollars 120, 000 Net Income Area D 90, 000 Total 60, 000 Expenses B 18, 000 0 10 20 Break-Even Point 60, 000 units or $90, 000 Net Loss Area 30, 000 30 40 50 C Sale s 60 70 80 90 100 Variable Expenses Fixed Expenses Units (thousands) Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 19
Learning Objective 5 Break-Even Point The break-even point is the level of sales at which revenue equals expenses and net income is zero. Sales - Variable expenses - Fixed expenses Zero net income (break-even point) Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 20
Contribution Margin Method Contribution margin ratio Per Unit % Selling price $1. 50 Selling price 100 Variable costs 1. 20 Variable costs 80 Contribution margin $. 30 Contribution margin 20 $18, 000 fixed costs ÷ $. 30 = 60, 000 units (break even) Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 21
Contribution Margin Method 60, 000 units × $1. 50 (Sales Price) = $90, 000 in sales to break even $18, 000 fixed costs ÷ 20% (contribution-margin percentage) = $90, 000 of sales to break even Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 22
Equation Method Let N = number of units to be sold to break even. Variable Fixed Sales – Expenses = net income $1. 50 N – $1. 20 N – $18, 000 = 0 $. 30 N = $18, 000 ÷ $. 30 N = 60, 000 Units Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 23
Equation Method Let S = sales in dollars needed to break even. S –. 80 S – $18, 000 = 0. 20 S = $18, 000 ÷. 20 S = $90, 000 Shortcut formulas: Break-even = fixed expenses = $18, 000 = volume in units unit contribution margin. 30 60, 000 Break-even = fixed expenses = $18, 000 = $90, 000 volume in sales contribution margin ratio. 2 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 24
Learning Objective 6 Target Net Profit Managers use CVP analysis to determine the total sales, in units and dollars, needed to reach a target net profit. Target sales – variable expenses – fixed expenses target net income $1, 440 per month is the minimum acceptable net income. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 25
Target Net Profit Target sales volume in units = (Fixed expenses + Target net income) ÷ Contribution margin per unit Selling price Variable costs Contribution margin per unit $1. 50 1. 20 $. 30 ($18, 000 + $1, 440) ÷ $. 30 = 64, 800 units Target sales dollars = sales price X sales volume in units Target sales dollars = $1. 50 X 64, 800 units = $97, 200. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 26
Target Net Profit Contribution margin ratio Per Unit % Selling price 100 Variable costs 80 Contribution margin 20 Target sales volume in dollars = Fixed expenses + target net income contribution margin ratio Sales volume in dollars = 18, 000 + $1, 440 = $97, 200. 20 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 27
Nonprofit Application Suppose a city has a $100, 000 lump-sum budget appropriation to conduct a counseling program. Variable costs per prescription are $400 per patient per day. Fixed costs are $60, 000 in the relevant range of 50 to 150 patients. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 28
Nonprofit Application If the city spends the entire budget appropriation, how many patients can it serve in a year? Variable + Fixed Sales = expenses + expenses $100, 000 = $400 N + $60, 000 $400 N = $100, 000 – $60, 000 N = $40, 000 ÷ $400 N = 100 patients Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 29
Nonprofit Application If the city cuts the total budget appropriation by 10%, how many patients can it serve in a year? Budget after 10% Cut $100, 000 X (1 -. 1) = $90, 000 Variable + Fixed Sales = expenses + expenses $90, 000 = $400 N + $60, 000 $400 N = $90, 000 – $60, 000 N = $30, 000 ÷ $400 N = 75 patients Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 30
Operating Leverage Low leveraged firms have lower fixed costs and higher variable costs. Changes in sales volume will have a smaller effect on net income. Margin of safety = planned unit sales – break-even sales. How far can sales fall below the planned level before losses occur? Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 31
Operating Leverage Operating leverage: a firm’s ratio of fixed costs to variable costs. Highly leveraged firms have high fixed costs and low variable costs. A small change in sales volume = a large change in net income. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 32
Learning Objective 7 Contribution Margin and Gross Margin Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 33
Contribution Margin and Gross Margin Sales price – Cost of goods sold = Gross margin Sales price - all variable expenses = Contribution margin Per Unit Selling price $1. 50 Variable costs (acquisition cost) 1. 20 Contribution margin and gross margin are equal $. 30 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 34
Contribution Margin and Gross Margin Suppose the firm paid a commission of $. 12 per unit sold. Contribution Gross Margin Per Unit Sales $1. 50 Acquisition cost of unit sold 1. 20 Variable commission. 12 Total variable expense $1. 32 Contribution margin. 18 Gross margin $. 30 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 35
Learning Objective 8 Appendix 2 A Sales Mix Analysis Sales mix is the relative proportions or combinations of quantities of products that comprise total sales. If the proportions of the mix change, the cost-volume-profit relationships also change. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 36
Sales Mix Analysis Ramos Company Example Wallets (W) Key Cases (K) Sales in units 300, 000 75, 000 Sales @ $8 and $5 $2, 400, 000 $375, 000 Variable expenses @ $7 and $3 2, 100, 000 225, 000 Contribution margins @ $1 and $2 $ 300, 000 $150, 000 Fixed expenses Net income Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Total 375, 000 $2, 775, 000 2, 325, 000 $ 450, 000 180, 000 $ 270, 000 2 - 37
Sales Mix Analysis Let K = number of units of K to break even, and 4 K = number of units of W to break even. Break-even point for a constant sales mix of 4 units of W for every unit of K. sales – variable – fixed = zero net income expenses [$8(4 K) + $5(K)] – [$7(4 K) + $3(K)] – $180, 000 = 0 32 K + 5 K - 28 K - 3 K - 180, 000 = 0 6 K = 180, 000 K = 30, 000 W = 4 K = 120, 000 30, 000 K + 120, 000 W = 150, 000 total units (K + W). Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 38
Sales Mix Analysis If the company sells only key cases: break-even point = fixed expenses contribution margin per unit = $180, 000 $2 = 90, 000 key cases If the company sells only wallets: break-even point = fixed expenses contribution margin per unit = $180, 000 $1 = 180, 000 wallets Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 39
Sales Mix Analysis Suppose total sales were equal to the budget of 375, 000 units. However, Ramos sold only 50, 000 key cases And 325, 000 wallets. What is net income? Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 40
Sales Mix Analysis Ramos Company Example Wallets Key Cases (W) (K) Total Sales in units Sales @ $8 and $5 Variable expenses @ $7 and $3 Contribution margins @ $1 and $2 Fixed expenses Net income 325, 000 $ 2, 600, 000 2, 275, 000 $ 325, 000 50, 000 375, 000 $250, 000 $2, 850, 000 150, 000 2, 425, 000 $100, 000 $ Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 425, 000 180, 000 $ 245, 000 2 - 41
Learning Objective 9 Impact of Income Taxes Income taxes do not affect the break-even point. There is no income tax at a level of zero income. Income taxes affect the calculation of the volume required to achieve a specified after-tax target profit. Suppose that a company earns $1, 440 before Taxes and pays income tax at a rate of 40%. Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 42
Impact of Income Taxes Suppose the target net income after taxes was $864 Target income before taxes = Target after-tax net income 1 – tax rate Target income before taxes = $ 864 = $1, 440 1 – 0. 40 Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 43
Impact of Income Taxes Target sales - Variable expenses - Fixed expenses = Target after-tax net income ÷ (1 – tax rate) $1. 50 N - $1. 20 N - $18, 000 = $864 ÷ (1 – 0. 40) $. 30 N = $18, 000 + ($864/. 6) $. 18 N = $10, 800 + $864 = $11, 664 N = $11, 664/$. 18 N = 64, 800 units Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 44
Impact of Income Taxes Suppose target net income after taxes was $1, 440 $1. 50 N - $1. 20 N - $18, 000 = $1, 440 ÷ (1 – 0. 40) $. 30 N = $18, 000 + ($1, 440/. 6) $. 18 N = $10, 800 + $1, 440 = $12, 240 N = $12, 240/$. 18 N = 68, 000 units Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 45
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