Profit Planning and Decision Making Chapter 4 Profit Planning and Decision Making

Major Topics in Chapter 4 Cost Behavior Fixed, variable, mixed, and semi-variable costs The importance of the relevant range Break-Even Analysis Contribution margin analysis for break-even and target profit levels. Interpreting break-even charts Finding the break-even point and target profit levels using formulas. Uses, assumptions, and limitations

Topics to Skip in Chapter 4 Skip Cash Break-Even (pp. 149-150) Controllable vs. Non-Controllable Costs (p. 157) Direct vs. Indirect Costs (pp. 157-158) Relevant costs (pp. 145-146) Break-even wedges (pp. 155-156)

The Importance of Understanding Cost Behavior If the behavior of costs can be understood, costs can be predicted at different levels of activity (operations)

Variable Costs – vary in direct proportion with changes in some activity.

An Example of Variable Cost Note: the total long distance telephone bill is based on how many minutes are used. Total Long Distance Telephone Bill Minutes Talked

Per Minute Telephone Charge Variable Cost Per Unit The cost per long distance minute (unit) used is constant. For example, 5 cents per minute. Per Minute Telephone Charge Minutes Talked

Fixed Costs – remain constant at varying levels of some activity

An Example of Fixed Cost Your monthly basic telephone bill probably does not change when you make more local calls. Monthly Basic Telephone Bill Number of Local Calls

Monthly Basic Telephone Bill per Local Call Fixed Cost Per Unit The average cost per local call decreases as more local calls are made. Monthly Basic Telephone Bill per Local Call Number of Local Calls

Trend Toward Fixed Costs Increased automation. Increase in salaried knowledge workers who are difficult to train and replace. Implications Managers are more “locked-in” with fewer decision alternatives. Planning becomes more crucial because fixed costs are difficult to change with current operating decisions.

Types of Fixed Costs Fixed Costs Committed Discretionary Examples Long-term, cannot be reduced in the short term. Discretionary May be altered in the short-term by current managerial decisions Keep in mind that this depends on the time period under investigation – e.g. airline capacity. Examples Depreciation on Buildings and Equipment Examples Advertising and Research and Development

Mixed Costs: Contain an element of both fixed and variable cost – text classifies as ‘semi-variable’

Another Semi-Variable Cost Pattern Total cost remains constant within a narrow range of activity. Cost Activity

Cost Behavior Patterns It is important to understand how fixed and variable costs behave in total, and per unit. Let’s pick up from where we left off in chapter 2 with an over view of cost behavior.

The Relevant Range The range of activity for which estimates of cost are likely to be accurate.

Purpose of CVP If we understand how costs and revenues behave – we can make predictions. That is what CVP analysis is all about: how revenues, variable costs, and fixed costs interact over changes in sales volume. CVP is built off of the Contribution Income Statement

The Contribution Format An application of cost behavior is re-casting the income statement into a contribution format The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

The Contribution Format Used primarily for external reporting. Used primarily by management.

Simplified Example Assume the following facts for the hotdog stand: Price of a hotdog (p): $ 1.00 Variable cost/dog (vc): $ 0.30 Fixed cost per month (FC): $50.00 Contribution margin approach illustrated

CVP Analysis Some acronyms: FC = fixed costs VC = variable costs TC = total costs CM = contribution margin Q = #units (sold or produced)

Graphical Representation of CVP Total cost vs. Total revenue (text) CM vs. FC (not in text)

Assumptions of CVP [and limitations] Selling price is constant throughout the entire relevant range. Costs are linear throughout the entire relevant range. Limitations Classifying cost and revenue behavior is not easy. Multiple product lines make CVP analysis tough.

Quick Review Question #1 At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Contribution Margin per unit is? $65 $75 $175 $30

Quick Review Answer #1 $65 $75 $175 $30 At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Contribution margin per unit is? $65 $75 $175 $30

Quick Review Question #2 At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Break-Even Point is? 1,000 units 1,083 units 2,000 units None of these

Quick Review Answer #2 1,000 units 1,083 units 2,000 units At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Break-Even Point is? 1,000 units 1,083 units 2,000 units None of these

Quick Review Question #4 At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Expected sales are 4,200 units. What is profit expected to be? Answer here: _________________

Quick Review Answer #4 Answer here: $143,000 At Winford Corp., the selling price per unit for lawn mowers is $120, variable cost per unit is $55. Fixed costs are $130,000. Expected sales are 4,200 units. What is profit expected to be? Answer here: $143,000