Cost Behavior Analysis and Use Cost Volume Profit

Types of Cost Behavior Patterns Recall the summary of our cost behavior discussion from

The Activity Base Units produced Machine hours A measure of what causes the incurrence of a variable cost Miles driven Mc. Graw-Hill/Irwin Labor hours Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Variable Cost Minutes Talked Mc. Graw-Hill/Irwin PER UNIT Per Minute Telephone Charge Total Long

Step-Variable Costs Cost A resource that is obtainable only in large chunks (such as maintenance workers) and whose costs increase or decrease only in response to fairly wide changes in activity is known as a step-variable cost Volume Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Extent of Variable Costs The proportion of variable costs differs across organizations. For example. . . A public utility with large investments in equipment will tend to have fewer variable costs. A manufacturing company will often have many variable costs. A service company will normally have a high proportion of variable costs. A merchandising company usually will have a high proportion of variable costs like cost of sales. Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Fixed Cost TOTAL Monthly Rent Expense per Units sold Monthly Rent Expense Number of

Types of Fixed Costs Committed Discretionary Long-term, cannot be significantly reduced in the short term. May be altered in the short-term by current managerial decisions Examples Depreciation on Equipment and Real Estate Taxes Advertising and Research and Development Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

The Trend Toward Fixed Costs The trend in many industries is toward greater fixed costs relative to variable costs. As machines take over many mundane tasks previously performed by humans, “knowledge workers” are demanded for their minds rather than their muscles Mc. Graw-Hill/Irwin Knowledge workers tend to be salaried, highly-trained and difficult to replace. The cost to compensate these valued employees is relatively fixed rather than variable. Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Is Labor a Variable or a Fixed Cost? The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. In TURKEY, France, Germany, China, and Japan management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature. In the United States and the United Kingdom management has greater latitude. Labor costs are more variable in nature. Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Rent Cost in Thousands of Dollars Fixed Costs and Relevant Range Mc. Graw-Hill/Irwin 90 Relevant 60 Range 30 0 0 Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. 1, 000 2, 000 3, 000 Rented Area (Square Feet) Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Fixed Costs and Relevant Range How does this type of fixed cost differ from a stepvariable cost? Mc. Graw-Hill/Irwin Step-variable costs can be adjusted more quickly and. . . The width of the activity steps is much wider for the fixed cost. Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Mixed Costs A mixed cost has both fixed and variable components. Consider the example of utility cost. Total Utility Cost Y t d l a t o xe i m s co T Variable Cost per KW Activity (Kilowatt Hours) Mc. Graw-Hill/Irwin X Fixed Monthly Utility Charge Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Analysis of Mixed Costs Account Analysis and the Engineering Approach High Low Method Ordinary

The Contribution Format CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income. Used primarily for external reporting. Mc. Graw-Hill/Irwin Used primarily by management. Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

CVP Graph Dollars Break-even point (400 units or $200, 000 in sales) Total Sales

Contribution Margin Ratio The contribution margin ratio is: Total CM CM Ratio = Total sales Unit CM Unit selling price Each $1. 00 increase in sales results in a total contribution margin increase of 40¢. Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Changes in Fixed Costs and Sales Volume What is the profit impact if Racing can increase unit sales from 500 to 540 by increasing the monthly advertising budget by $10, 000? Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Changes in Fixed Costs and Sales Volume The Shortcut Solution Mc. Graw-Hill/Irwin Copyright ©

Change in Variable Costs and Sales Volume What is the profit impact if Racing can use higher quality raw materials, thus increasing variable costs per unit by $10, to generate an increase in unit sales from 500 to 580? Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Change in Fixed Cost, Sales Price and Volume What is the profit impact if Racing (1) cuts its selling price $20 per unit, (2) increases its advertising budget by $15, 000 per month, and (3) increases unit sales from 500 to 650 units per month? Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Change in Variable Cost, Fixed Cost and Sales Volume What is the profit impact if Racing (1) pays a $15 sales commission per bike sold instead of paying salespersons flat salaries that currently total $6, 000 per month, and (2) increases unit sales from 500 to 575 bikes? Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Change in Regular Sales Price If Racing has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers or fixed expenses, what price would it quote to the wholesaler if it wants to increase monthly profits by $3, 000? Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Change in Regular Sales Price Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies,

Break-Even Analysis Break-even analysis can be approached in two ways: 1. Equation method 2.

Equation Method Profits = (Sales – Variable expenses) – Fixed expenses OR Sales = Variable expenses + Fixed expenses + Profits At the break-even point profits equal zero Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Contribution Margin Method The contribution margin method has two key equations. Break-even point = in units sold Break-even point in total sales dollars = Mc. Graw-Hill/Irwin Fixed expenses Unit contribution margin Fixed expenses CM ratio Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Contribution Margin Method Break-even point in total sales dollars = Fixed expenses CM ratio $80, 000 = $200, 000 break-even sales 40% Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Target Profit Analysis The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit. Suppose Racing Bicycle Company wants to know how many bikes must be sold to earn a profit of $100, 000. Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

The Contribution Margin Approach The contribution margin method can be used to determine that 900 bikes must be sold to earn the target profit of $100, 000. Unit sales to attain = the target profit Fixed expenses + Target profit Unit contribution margin $80, 000 + $100, 000 = 900 bikes $200/bike Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

The Margin of Safety The margin of safety is the excess of budgeted (or actual) sales over the break -even volume of sales. Margin of safety = Total sales - Break-even sales The margin of safety can be expressed as % of sales Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Cost Structure and Profit Stability Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization’s cost structure. Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Cost Structure Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Operating Leverage • A measure of how sensitive net operating income is to percentage changes in sales. Degree of Contribution margin = operating leverage Net operating income Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Operating Leverage Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

The Concept of Sales Mix • Sales mix is the relative proportion in which a company’s products are sold. • Different products have different selling prices, cost structures, and contribution margins. Let’s assume Racing Bicycle Company sells bikes and carts and that the sales mix between the two products remains the same. Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.

Multi-product break-even analysis Racing Bicycle Co. provides the following information: Mc. Graw-Hill/Irwin $265, 000

Multi-product break-even analysis Break-even sales Fixed expenses = CM Ratio $170, 000 = 48.

Key Assumptions of CVP Analysis Selling price is constant. Costs are linear. In multi-product companies, the sales mix is constant. In manufacturing companies, inventories do not change (units produced = units sold). Mc. Graw-Hill/Irwin Copyright © 2006, The Mc. Graw-Hill Companies, Inc.