Introduction to Cost Behavior and CostVolume Relationships Cost
Introduction to Cost Behavior and Cost-Volume Relationships
Cost Drivers and Cost Behavior Traditional View of Cost Behavior Resource A Cost Driver = Units of Resource Output Resource B Cost Driver = Units of Resource Output Product or Service Cost Driver = Units of Final Product or Service Activity-Based View of Cost Behavior Resource A Cost Driver = Units of Resource Output Resource B Cost Driver = Units of Resource Output Activity A Cost Driver = Units of Activity Output Activity B Cost Driver = Units of Activity Output Product or Service Cost Driver = Output of Final Product or Service
Cost Drivers and Cost Behavior Any output measure that causes Cost behavior is how the activities the use of costly resources of an organization affect its costs. is a cost driver.
Value Chain Functions, Costs, and Cost Drivers Value Chain Function and Example Costs Example Cost Drivers Research and development • Salaries marketing research personnel Number of new product proposals costs of market surveys • Salaries of product and process engineers products Complexity of proposed Design of products, services, and processes • Salaries of product and process engineers hours Number of engineering • Cost of computer-aided design equipment product Number of parts per • Cost to develop prototype of product
Value Chain Functions, Costs, and Cost Drivers Value Chain Function and Example Costs Production • Labor wages • Supervisory salaries • Maintenance wages • Depreciation of plant and machinery supplies Energy cost Example Cost Drivers Labor hours Number of people supervised Number of mechanic hours Number of machine hours Kilowatt hours Marketing • Cost of advertisements Number of advertisements • Salaries of marketing personnel, Sales dollars travel costs, entertainment costs
Value Chain Functions, Costs, and Cost Drivers Value chain function and Example costs Distribution • Wages of shipping personnel • Transportation costs including depreciation of vehicles and fuel Customer service • Salaries of service personnel products • Costs of supplies, travel Example Cost Drivers Labor hours Weight of items delivered Hours spent servicing Number of service calls
Cost Classification and Cost Allocation In order to make meaningful decisions a manager must have cost data for each product, department and function of the business The problem with this is how to accurately define the costs and how to allocate the costs to the various products and departments The management accountant classifies costs into fixed and variable costs or direct and indirect costs These costs are then allocated as accurately as possible to the cost centres that generate them. In this way centres are made aware of their responsibility to control costs
Fixed, Variable and Semi- Variable Costs – expenses that alter in the short run to changes in output e. g. raw materials, packaging and components. They are payments for the use of inputs Fixed Costs – expenses that do not alter in the short run in relation to changes in output e. g. rent, insurance and depreciation. These costs are linked to time rather the level of business activity Semi Variable Costs – expenses that vary with output but not in direct proportion e. g. maintenance costs. They often comprise a fixed element and a variable element
Direct and Indirect Costs – costs that cannot be allocated accurately to a cost centre or product e. g. administration costs, management salaries or maintenance costs. Another term for this is overheads Direct Costs – costs that can be directly identified with a product or cost centre. They are mainly variable costs but can include some fixed costs e. g. the rent of a building solely used for one product. They are also referred to as prime costs
Total Cost – this is the addition of all fixed and variable costs (plus any semi-variable costs) Where fixed costs form a significant part of total costs it is important for a business to maximise sales so that the fixed cost element is spread across as many units as possible The total cost is used by the business to see how much finance is required for each level of output
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. 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.
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.
Relevant Range. . is a band of volume in which a specific relationship exists between cost and volume. Outside the relevant range, the cost either increases or decreases. A fixed cost is fixed only within a given relevant range and a given time span.
Total Monthly Fixed Costs and Relevant Range 115, 000 100, 000 60, 000 20 40 60 80 100 Relevant range 115, 000 100, 000 60, 000 20 40 60 80 100 Total Cost-Driver Activity in Thousands of Cases per Month
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). Selling price Variable cost of each item Selling price less variable cost Monthly fixed expenses: Rent Wages for replenishing and servicing Other fixed expenses Total fixed expenses per month Per Unit ¢ 1. 50 1. 20 ¢. 30 ¢ 3, 000 13, 500 1, 500 ¢ 18, 000 Percentage of Sales 100% 80 20%
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)
Break-Even Point Breakeven analysis is also known as cost-volume profit analysis Breakeven analysis is the study of the relationship between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of activity
Application Breakeven analysis can be used to determine a company’s breakeven point (BEP) Breakeven point is a level of activity at which the total revenue is equal to the total costs At this level, the company makes no profit
Assumption of breakeven point analysis Relevant range The relevant range is the range of an activity over which the fixed cost will remain fixed in total and the variable cost per unit will remain constant Fixed cost Total fixed cost are assumed to be constant in total Variable cost Total variable cost will increase with increasing number of units produced Sales revenue The total revenue will increase with the increasing number of units produced
Calculation method v Breakeven point v Target profit v Margin of safety v Changes in components of breakeven analysis
Breakeven point Contribution Margin Method Contribution is defined as the excess of sales revenue over the variable costs The total contribution is equal to total fixed cost
Formula Breakeven point = Fixed cost Contribution per unit Sales revenue at breakeven point = Breakeven point *selling price
Alternative method Sales revenue at breakeven point Contribution required to breakeven Contribution to sales ratio = Contribution per unit Selling price per unit Breakeven point in units = Sales revenue at breakeven point Selling price
Example Selling price per unit ¢ 12 Variable cost per unit ¢ 3 Fixed costs ¢ 45000 Required: Compute the breakeven point
Solution Breakeven point in units = Fixed costs Contribution per unit = ¢ 45000 ¢ 12 - ¢ 3 = 5000 units Sales revenue at breakeven point = ¢ 12 * ¢ 5000 = ¢ 60000
Alternative method Contribution to sales ratio ¢ 9 / ¢ 12 *100% = 75% Sales revenue at breakeven point = Contribution required to break even Contribution to sales ratio = ¢ 45000 75% = ¢ 60000 Breakeven point in units = ¢ 60000/ ¢ 12 = 5000 units
Contribution Margin Method Contribution margin Per Unit Selling price ¢ 1. 50 Variable costs 1. 20 Contribution margin ¢. 30 Contribution margin ratio Per Unit % Selling price 100 Variable costs 80 Contribution margin 20 ¢ 18, 000 fixed costs ÷ ¢. 30 = 60, 000 units (break even)
Contribution Margin Method 60, 000 units × ¢ 1. 50 = ¢ 90, 000 in sales to break even ¢ 18, 000 fixed costs ÷ 20% (contribution-margin percentage) = ¢ 90, 000 of sales to break even
Equation Method Let N = number of units to be sold to break even. Sales – variable expenses – fixed expenses = net income ¢ 1. 50 N – ¢ 1. 20 N – ¢ 18, 000 = 0 ¢. 30 N = ¢ 18, 000 ÷ ¢. 30 N = 60, 000 Units
Equation Method Let S = sales in Cedis needed to break even. S –. 80 S – ¢ 18, 000 = 0. 20 S = ¢ 18, 000 ÷. 20 S = ¢ 90, 000 Shortcut formulas: Break-even volume in units = fixed expenses unit contribution margin Break-even volume in sales = fixed expenses contribution margin ratio
Cost-Volume-Profit Graph A ¢ 150, 000 138, 000 Net Income 120, 000 Cedis C Sales Net Income Area D 90, 000 Total Expenses 60, 000 Net Loss Area 30, 000 B 18, 000 Break-Even Point 60, 000 units or ¢ 90, 000 Variable Expenses Fixed Expenses 0 10 20 30 40 50 60 Units (thousands) 70 80 90 100
Target profit
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 Let’s assume ¢ 1, 440 per month is the minimum acceptable net income.
Target Net Profit Target sales volume in units = (Fixed expenses + Target net income) ÷ Contribution margin per unit Selling price ¢ 1. 50 Variable costs 1. 20 Contribution margin per unit $. 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.
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
Work this out Selling price per unit ¢ 12 Variable cost per unit ¢ 3 Fixed costs ¢ 45000 Target profit ¢ 18000 Required: Compute the sales volume required to achieve the target profit
Solution No. of units at target profit Fixed cost + Target profit Contribution per unit 45, 000 + 18, 000 12 - 3 = 7, 000 units Required to sales revenue = 12 *7000 = 84, 000
Alternative method Required sales revenue Fixed cost + Target profit Contribution to sales ratio 45000 + 18000 75% = 84000 Units sold at target profit = 84000 /12 = 7000 units
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. 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?
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
Contribution Margin and Gross Margin Suppose the firm had to pay a commission of ¢. 12 per unit sold. Sales Acquisition cost of unit sold Variable commission Total variable expense Contribution margin Gross margin Contribution Margin Per Unit ¢ 1. 50 1. 20. 12 ¢ 1. 32. 18 Gross Margin Per Unit ¢ 1. 50 1. 20 ¢. 30
Nonprofit Application Suppose a city has a ¢ 100, 000 lump-sum budget appropriation to conduct a counseling program. Variable costs per prescription is ¢ 400 per patient per day. Fixed costs are ¢ 60, 000 in the relevant range of 50 to 150 patients.
Nonprofit Application If the city spends the entire budget appropriation, how many patients can it serve in a year? ¢ 100, 000 = ¢ 400 N + ¢ 60, 000 ¢ 400 N = ¢ 100, 000 – ¢ 60, 000 N = ¢ 40, 000 ÷ ¢ 400 N = 100 patients
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 = ¢ 400 N + ¢ 60, 000 ¢ 400 N = ¢ 90, 000 – ¢ 60, 000 N = ¢ 30, 000 ÷ ¢ 400 N = 75 patients
Sales Mix Analysis Sales mix is the relative proportions or combinations of quantities of products that comprise total sales.
Sales Mix Analysis Padus Company Example Wallets (W) Sales in units Sales @ ¢ 8 and ¢ 5 Variable expenses @ ¢ 7 and ¢ 3 Contribution margins @ $1 and $2 Fixed expenses Net income Key Cases (K) 300, 000 ¢ 2, 400, 000 2, 100, 000 ¢ 300, 000 75, 000 ¢ 375, 000 225, 000 ¢ 150, 000 Total 375, 000 ¢ 2, 775, 000 2, 325, 000 ¢ 450, 000 180, 000 ¢ 270, 000
Sales Mix Analysis Let K = number of units of K to break even, and 4 K = number of units of W to break even. Break-even point for a constant sales mix of 4 units of W for every unit of K. sales – variable expenses - fixed expenses = zero net income [¢ 8(4 K) + ¢ 5(K)] – [¢ 7(4 K) + ¢ 3(K)] – ¢ 180, 000 = 0 32 K + 5 K - 28 K - 3 K - 180, 000 = 0 6 K = 180, 000 K = 30, 000 W = 4 K = 120, 000
Sales Mix Analysis If the company sells only key cases: break-even point = fixed expenses contribution margin per unit = ¢ 180, 000 ¢ 2 = 90, 000 key cases If the company sells only wallets: break-even point = fixed expenses contribution margin per unit = ¢ 180, 000 ¢ 1 = 180, 000 wallets
Sales Mix Analysis Suppose total sales were equal to the budget of 375, 000 units. However, Padus sold only 50, 000 key cases And 325, 000 wallets. What is net income?
Sales Mix Analysis Padus Company Example Wallets (W) Sales in units Sales @ ¢ 8 and ¢ 5 Variable expenses @ ¢ 7 and ¢ 3 Contribution margins @ ¢ 1 and ¢ 2 Fixed expenses Net income Key Cases (K) 325, 000 50, 000 2, 600, 000 250, 000 2, 275, 000 150, 000 325, 000 100, 000 Total 375, 000 2, 850, 000 2, 425, 000 180, 000 245, 000
Impact of Income Taxes Suppose that a company earns ¢ 480 before taxes and pays income tax at a rate of 40%. What is the after-tax income?
Impact of Income Taxes Target income before taxes = Target after-tax net income 1 – tax rate Suppose the target net income after taxes was ¢ 288. Target income before taxes = ¢ 288 = ¢ 480 1 – 0. 40
Impact of Income Taxes Target sales – Variable expenses – Fixed expenses = Target after-tax net income ÷ (1 – tax rate) ¢. 50 N – ¢. 40 N – ¢ 6, 000 = ¢ 288 ÷ (1 – 0. 40) ¢. 10 N = ¢ 6, 000 + (¢ 288/. 6) ¢. 06 N = ¢ 3, 600 + ¢ 288 = ¢ 3, 888 N = ¢ 3, 888/$. 06 N = 64, 800 units
Impact of Income Taxes Suppose target net income after taxes was ¢ 480 ¢. 50 N – ¢. 40 N – ¢ 6, 000 = ¢ 480 ÷ (1 – 0. 40) ¢. 10 N = ¢ 6, 000 + (¢ 480/. 6) ¢. 06 N = ¢ 3, 600 + $ ¢ = ¢ 4080 N = ¢ 4, 080 ÷ ¢. 06 N = 68, 000 units
Margin of safety 55 © 2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 55
Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss. This can be expressed as a number of units or a percentage of sales 56
Formula Margin of safety = Budget sales level – breakeven sales level Margin of safety% = Margin of safety Budget sales level *100% 57
Sales revenue Total Cost/Revenue $ Profit BEP Total cost Sales (units) Margin of safety 58
Example The breakeven sales level is at 5000 units. The company sets the target profit at $18000 and the budget sales level at 7000 units Required: Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue 59
Margin of safety = Budget sales level – breakeven sales level = 7000 units – 5000 units = 2000 units Margin of safety% = Margin of safety Budget sales level = 2000 *100 % 7000 = 28. 6% *100 % The margin of safety indicates that the actual sales can fall by 2000 units or 28. 6% from the budgeted level before losses are incurred. 60
Changes in components of breakeven point 61 © 2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 61
Example Selling price per unit Variable price per unit Fixed costs Current profit $12 $3 $45000 $18000 62
If the selling prices is raised from $12 to $13, the minimum volume of sales required to maintain the current profit will be: Fixed cost + Target profit Contribution to sales ratio $45000 + $18000 = $13 - $3 = 6300 units 63
If the fixed cost fall by $5000 but the variable costs rise to $4 per unit, the minimum volume of sales required to maintain the current profit will be: Fixed cost + Target profit Contribution to sales ratio $40000 + $18000 $12 - $4 = 7, 250 units = 64
**More Costing At a production level of 5, 400 units, a project has total costs of $112, 500. The variable cost per unit is $9. 62. Assume the firm can increase production by 1, 000 units without increasing its fixed costs. What will the total costs be if 5, 900 units are produced? Production Level 1 Total Cost 1 Variable cost per unit Production Level 2 Total Cost = 5, 400 112, 500 9. 62 5, 900 [Total Cost 1 - (variable cost * PDL 1)] + (PDL 2 * Variable cost)] 117, 310
** More Break-even The Coffee Express has computed its fixed costs to be $0. 46 for every cup of coffee it sells given annual sales of 332, 440 cups. The sales price is $1. 89 per cup while the variable cost per cup is $0. 81. How many cups of coffee must it sell to break-even on a cash basis? Fixed Cost Sales Sale Price Variable Cost 0. 46 332, 440 1. 89 0. 81 Profit Margin 0. 62 Qcash Break-even Fixed Cost * Sales Sale price - Variable Cost 141, 595
Limitation of breakeven point 67 © 2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 67
Limitations of breakeven analysis Breakeven analysis assumes that fixed cost, variable costs and sales revenue behave in linear manner. However, some overhead costs may be stepped in nature. The straight sales revenue line and total cost line tent to curve beyond certain level of production 68
It is assumed that all production is sold. The breakeven chart does not take the changes in stock level into account Breakeven analysis can provide information for small and relatively simple companies that produce same product. It is not useful for the companies producing multiple products 69
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