Chapter 5

Merchandisers Cost of Goods Sold Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Merchandisers and Manufacturers Sales commissions and shipping costs Service Organizations Supplies and travel Examples of normally variable costs Examples of normally fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salaries Depreciation, Advertising

The cost of putting on a conference is partly based on the number of people attending and the number of lunches served. Number of people served Total cost of meals $

The cost per meal served is constant. For example, $50 per plate. People Served Cost Per Plate Food Charge Total cost of meals

Activity Cost Unit cost remains constant within some range of activity. $

The cost to rent the conference room is probably fixed and does not change when you sign up more attendees. Number of People Conference Room Rental Cost

The fixed cost per person decreases as more people sign up to attend. Number of People Conference Room Cost per Person

Activity Cost Total cost increases to a new higher cost for the next higher range of activity. $

Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost. Continue

Rent Cost in Thousands of Dollars 0 1,000 2,000 3,000 Rented Area (Square Feet) Relevant Range 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.

Activity Total Cost Economist’s Curvilinear Cost Function

Activity Total Cost Economist’s Curvilinear Cost Function Accountant’s Straight-Line Approximation (constant unit variable cost)

Activity Total Cost Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost) Economist’s Curvilinear Cost Function A straight line closely approximates a curvilinear variable cost line within the relevant range.

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

A mixed cost has both fixed and variable components. Consider the following electric utility example.

Fixed Costs of Overhead Lights Variable Electric Usage for Machines Activity (Kilowatt Hours) Total Utility Cost X Y Total mixed cost

Total mixed cost Y = a + bX Fixed Costs of Overhead Lights Variable Utility Charge Activity (Kilowatt Hours) Total Utility Cost X Y

Fixed Costs of Overhead Lights Activity (Kilowatt Hours) Total Utility Cost Total mixed cost Y = a + bX bX a X Y Variable Electric Usage for Machines

Engineering Approach Account Analysis Scattergraph Method Least-Square Regression Method High-Low Method

Each account is classified as either variable or fixed based on the analyst’s knowledge of how the account behaves.

Cost estimates are based on an evaluation of production methods, and material, labor and overhead requirements.

 Uses the total costs incurred at both the high and the low levels of activity.  The change in costs between the high and low levels represents variable costs, since only variable costs change as activity levels change.

WiseCo recorded the following production activity and maintenance costs for two months: Using these two levels of activity, compute:  the variable cost per unit;  the fixed cost; and then  express the costs in equation form Y = a + bX.

 Unit variable cost = Change in cost Change in units The High-Low Method

 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

The High-Low Method  Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600

 Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit  Fixed cost = Total cost – Total variable cost Fixed cost = $9,700 – ($0.90 per unit × 9,000 units) Fixed cost = $9,700 – $8,100 = $1,600  Total cost = Fixed cost + Variable cost (Y = a + bX) Y = $1,600 + $0.90X The High-Low Method

If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the commission per unit (variable portion)? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the commission per unit (variable portion)? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit The High-Low Method

If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the commission per unit (variable portion)? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the commission per unit (variable portion)? a. $0.08 per unit b. $0.10 per unit c. $0.12 per unit d. $0.125 per unit The High-Low Method $4,000 ÷ 40,000 units = $0.10 per unit

If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the salary (fixed) portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the salary (fixed) portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 The High-Low Method

If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the salary (fixed) portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 If sales salaries and commissions are $10,000 when 80,000 units are sold and $14,000 when 120,000 units are sold, what is the salary (fixed) portion of sales salaries and commissions? a. $ 2,000 b. $ 4,000 c. $10,000 d. $12,000 The High-Low Method

The Scattergraph Method Plot the data points on a graph (total cost vs. activity) * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y

The Scattergraph Method Draw a line through the data points with about an equal numbers of points above and below the line * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y

The Scattergraph Method Estimated fixed cost = $10, * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y The slope of this line is the variable unit cost. (Slope is the change in total cost for a one unit change in activity).

The Scattergraph Method Slope = Change in cost Change in units Horizontal distance is the change in activity * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000’s of Units Produced X Y Vertical distance is the change in cost.

 Accountants and managers may use computer software to fit a regression line through the data points.  The cost analysis objective is the same: Y = a + bx Least-squares regression also provides a statistic, called the adjusted R 2, that is a measure of the goodness of fit of the regression line to the data points.

Total Cost Activity * * * * * * * * * * R 2 is the percentage of the variation in total cost explained by the activity. R 2 for this relationship is near 100% since the data points are very close to the regression line. X Y

 Considers the interrelationships among the five components of CVP analysis:

 Behavior of both costs and revenues is linear throughout the relevant range of the activity index  All costs can be classified as either variable or fixed with reasonable accuracy  Changes in activity are the only factors that affect costs  All units produced are sold  When more than one type of product is sold, the sales mix will remain constant

CVP analysis is all about Contribution Margin.

The contribution margin format emphasizes cost behavior. Contribution margin covers fixed costs and provides for income.

Used primarily for external reporting. Used primarily by management.

Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted.

CM goes to cover fixed expenses.

After covering fixed costs, any remaining CM contributes to income.

For each additional unit Wind sells, $200 more in contribution margin will help to cover fixed expenses and profit.

Each month Wind must generate at least $80,000 in total CM to break even.

If Wind sells 400 units in a month, it will be operating at the break-even point.

If Wind sells one additional unit (401 bikes), net income will increase by $200.

The break-even point can be defined either as:  The point where total sales revenue equals total expenses (variable and fixed). or  The point where total contribution margin equals total fixed expenses.

The contribution margin ratio is: For Wind Bicycle Co. the ratio is: Contribution margin Sales CM Ratio = $200 $500 = 40%

At Wind, each $1.00 increase in sales revenue results in a total contribution margin increase of 40¢. If sales increase by $50,000, what will be the increase in total contribution margin?

A $50,000 increase in sales revenue

A $50,000 increase in sales revenue results in a $20,000 increase in CM. ($50,000 × 40% = $20,000)

Wind is currently selling 500 bikes per month. The company’s sales manager believes that an increase of $10,000 in the monthly advertising budget would increase bike sales to 540 units. Should we authorize the requested increase in the advertising budget?

. Sales increased by $20,000, but net income decreased by $2,000. $80,000 + $10,000 advertising = $90,000

The Shortcut Solution

Break-even analysis can be approached in two ways:  Equation method  Contribution margin method.

Profits = Sales – (Variable expenses + Fixed expenses) Sales = Variable expenses + Fixed expenses + Profits OR At the break-even point profits equal zero.

Here is the information from Wind Bicycle Co.:

We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 Where: Q = Number of bikes sold $500 = Unit sales price $300 = Unit variable expenses $80,000 = Total fixed expenses

We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = 400 bikes

We can also use the following equation to compute the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + $80,000 + $0 Where: X = Total sales dollars 0.60 = Variable expenses as a percentage of sales $80,000 = Total fixed expenses

We can also use the following equation to compute the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $200,000

The contribution margin method is a variation of the equation method. Fixed expenses Unit contribution margin = Break-even point in units sold Fixed expenses CM ratio = Break-even point in total sales dollars

Viewing CVP relationships in a graph gives managers a perspective that can be obtained in no other way. Consider the following information for Wind Co.:

Fixed expenses Units Dollars Total Expenses

Units Dollars Total Sales

Units Dollars Break-even point Profit Area Loss Area

Suppose Wind Co. wants to know how many bikes must be sold to earn a profit of $100,000. We can use our CVP formula to determine the sales volume needed to achieve a target net profit figure.

Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $100,000 $200Q = $180,000 Q = 900 bikes

We can determine the number of bikes that must be sold to earn a profit of $100,000 using the contribution margin approach. Fixed expenses + Target profit Unit contribution margin = Units sold to attain the target profit $80,000 + $100,000 $200 = 900 bikes

Excess of budgeted (or actual) sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred. Margin of safety = Total sales - Break-even sales Let’s calculate the margin of safety for Wind.

Wind has a break-even point of $200,000. If actual sales are $250,000, the margin of safety is $50,000 or 100 bikes.

The margin of safety can be expressed as 20 percent of sales. ($50,000 ÷ $250,000)