Cost Behavior Analysis Cost Behavior Analysis … how costs react to changes in the level of business level of activity. Activity levels may be: Sales $$, % Occupancy, # Covers, # Miles, # Classes Some costs change … others remain the same. This allows costs to be classified as: variable, fixed, or mixed (part fixed part variable). Note … “cost per unit” vs “total costs”

Cost of a Slurpee Variable Costs Fixed Costs Slurpee Mix Cup Lid Straw Slurpee Machine

Variable costs vary in total, remain the same (constant) per unit. Slurpee Mix Cup Lid Straw Total Costs … vary directly and proportionately with changes in activity level. Unit Costs … remain the same (constant) regardless of activity. Variable costs vary in total, remain the same (constant) per unit.

Variable Cost Behavior Analysis Variable Costs “Behavior”

Fixed costs are constant in total, vary per unit. Slurpee Machine Total Costs … remain the same regardless of changes in the activity level. Unit Costs … varies inversely with activity. Cost “per unit” goes down with activity Fixed costs are constant in total, vary per unit.

Fixed Cost Behavior Analysis Illustration: Apple leases a factory building at $10,000 per month. Total Cost “Total Fixed Cost” for the Factory Rent will be: * $10,000 if 2,000 iPhones made, * $10,000 if 10,000 iPhones made. (Activity Index)

Fixed Cost Behavior Analysis Illustration: Apple leases a factory building at $10,000 per month. Per Unit “Fixed Cost Per Unit” for the Factory Rent will be: * $5 per unit if 2,000 iPhones made, * $1 per unit if 10,000 iPhones made. * Calculations: $10,000 total cost ÷ 2,000 iPhones = $5 per iPhone $10,000 total cost ÷ 10,000 iPhones = $1 per iPhone (Activity Index)

Fixed Cost Behavior Analysis Fixed Costs “Behavior”

Relevant Range The range of activity (“how busy”) a company expects to operate during a year. (the norm or usual) “Technically” all costs are variable if you ignore relevant range.

Mixed Cost Behavior Analysis Mixed Costs Costs with both variable & fixed cost elements. Change in total … but not proportionately with changes in activity. Ex: car rental: $20 per day (fixed) PLUS .10 per mile (variable)

Mixed Cost Behavior Analysis Break down Mixed Costs into: fixed & variable components. Use: High-Low Method … (only for mixed costs) High-Low uses the total costs incurred at both the high and the low levels of activity to classify mixed costs. The difference in costs between the high and low levels represents variable costs, since only variable costs change as activity levels change.

Mixed Cost Behavior Analysis Assume your weekly pay is based on: salary (fixed) + commission (variable). What part is “salary” (fixed) and What part is “commission” (variable) Day # Sold $ Earned Mon 10 70 Tues 20 Wed 13 85 Thurs Fri 17 105 Sat 24 140 Sun 21 125

Mixed Cost Behavior Analysis High-Low Method STEP 1: Determine variable cost per unit using formula: Activity Costs Day # Sold $ Earned Mon 10 70 Tues 20 Wed 13 85 Thurs Fri 17 105 Sat 24 140 Sun 21 125 (High$ – Low$) HighSold - LowSold $ 140 -20 120 20 -0 120 20 = $6 VARIABLE per unit units

Mixed Cost Behavior Analysis Apply the High-Low Method Illustration: Metro Bus Co. has these maintenance costs and mileage data for its fleet of buses over a 6-month period. Low High

Mixed Cost Behavior Analysis High-Low Method STEP 1: Determine variable cost per unit using formula: high - low costs high – low volume (activity)

Mixed Cost Behavior Analysis High-Low Method STEP 2: fixed cost - total variable cost at either the high or low activity level.

Mixed Cost Behavior Analysis High-Low Method STEP 2: fixed cost - total variable cost at either the high or low activity level.

Cost Behavior Analysis High-Low Method Maintenance costs = $8,000 per month plus $1.10 per mile. (Represented by formula): Maintenance costs = Fixed costs + ($1.10 x Miles driven) Ex: At 45,000 miles, estimated maintenance costs would be: Fixed $ 8,000 Variable ($1.10 x 45,000) 49,500 $57,500

Compute the variable & fixed cost elements. Do It! … Byrnes Company accumulates this data concerning a mixed cost, using units produced as the activity level. HIGH LOW Compute the variable & fixed cost elements. Variable cost: ($14,740 - $11,100) / (9,800 - 7,000) = $1.30 per unit Fixed cost: $14,740 - $12,740 ($1.30 x 9,800 units) = $2,000 or $11,100 - $9,100 ($1.30 x 7,000) = $2,000

$2,000 Estimate the total cost if the company produces 6,000 units. Total cost (6,000 units): $2,000 = $9,800 + (1.30 x 6,000) Fixed component + Variable component

Cost-Volume-Profit Analysis Cost-Volume-Profit (CVP) analysis is the study of the effects of changes of costs and volume on profits. Important in profit planning Critical factor in management decisions as Setting selling prices, Determining product mix, and Maximizing use of production facilities.

Cost-Volume-Profit Analysis Basic Components of C-V-P

Traditional Income Statement GAAP required for external reporting (Revenue – Expenses = Net Income) GAAP required for external reporting

Sales – Variable Costs = CM CVP Income Statement Same net income as a traditional income statement. For internal use only … not for public (per GAAP) Classifies costs & expenses as fixed or variable. Reports contribution margin in the statement. Contribution Margin – amount of revenue remaining after deducting variable costs. Sales – Variable Costs = CM

Traditional Income Statement Cost-Volume-Profit Analysis Ex: Vargo Video produces camcorders. Relevant data for June: Traditional Income Statement Revenues (1,600 x $500 ea) …. 800,000 - Expenses (480,000 + 200,000) …. 680,000 Net Income …………………….. 120,000

Cost-Volume-Profit Analysis Ex: Vargo Video produces camcorders. Relevant data for June: CVP Income Statement (1,600 x $300)

Cost-Volume-Profit Analysis Contribution Margin per Unit Contribution Margin must cover ALL fixed costs THEN profit (the “contribution” to net income).

(Revenue – Variable – Fixed Expenses = Breakeven Point) When Revenue exactly equals ALL costs (Revenue – Variable – Fixed Expenses = Breakeven Point) Where loss ends and profit begins. The point at which a business, product or project becomes financially viable. Expressed as “Dollars” or “Units”.

Cost-Volume-Profit Analysis Break-Even Analysis Process of finding the break-even point where total revenues equal total costs (both fixed and variable). Can be computed or derived from a mathematical equation, by using contribution margin, or from a cost-volume profit (CVP) graph. Expressed either in sales units or in sales dollars.

Cost-Volume-Profit Analysis CVP Income Statement

Break-Even Analysis Mathematical Equation Mathematical Equation Break-even occurs where total sales equal variable costs plus fixed costs; i.e., net income is zero Mathematical Equation Computation of break-even point in units.

Break-Even Analysis Mathematical Equation “Profit Planning” Using the formula for the break-even point, simply include the desired net income as a factor.

Cost-Volume-Profit Analysis Ex: Vargo Video produces camcorders. Relevant data for June: CM per unit

Cost-Volume-Profit Analysis Contribution Margin Ratio Shows the percentage of each sales dollar available to apply toward fixed costs and profits. Formula for contribution margin ratio is:

Cost-Volume-Profit Analysis Contribution Margin Ratio If current sales are $500,000 what is the effect of a $100,000 (200-unit) increase in sales.

Break-Even Analysis Contribution Margin Technique To get Break-Even point in units, use CM per unit

Break-Even Analysis Contribution Margin Technique To get Break-Even point in dollars, use CM ratio.

Target Net Income Contribution Margin “Profit Planning” To determine the required sales in units for Vargo Video:

Target Net Income Contribution Margin “Profit Plannning” To determine the required sales in dollars for Vargo Video:

Cost-Volume-Profit Analysis Margin of Safety Difference between actual (or projected) sales and the sales at the break-even point. Measures the “cushion” if expected sales fail to materialize. May be expressed in dollars or as a ratio. Assuming actual/expected sales are $750,000:

The higher the dollars or %, the greater the margin of safety. Cost-Volume-Profit Analysis Margin of Safety Ratio Divide the margin of safety in $$ by the actual or sales. Assuming actual/expected sales are $750,000: The higher the dollars or %, the greater the margin of safety.