Copyright © by Houghton Miffin Company. All rights reserved.1 Financial & Managerial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson Multimedia Slides by: Harry Hooper Santa Fe Community College

Copyright © by Houghton Miffin Company. All rights reserved.2 Chapter 20 Cost Behavior Analysis

Copyright © by Houghton Miffin Company. All rights reserved.3 1. Define cost behavior and explain how managers use this concept in the management cycle. 2. Identify specific types of variable and fixed cost behavior, and discuss how operating capacity and relevant range relate to cost behavior. 3. Define mixed cost, and use the high-low method to separate the variable and fixed components of a mixed cost. LEARNING OBJECTIVES

Copyright © by Houghton Miffin Company. All rights reserved.4 4. Define cost-volume-profit analysis and discuss how managers use this analysis. 5. Compute a breakeven point in units of output and in sales dollars, and prepare a breakeven graph. 6. Define contribution margin and use the concept to determine a company’s breakeven point for a single product and for multiple products. LEARNING OBJECTIVES

Copyright © by Houghton Miffin Company. All rights reserved.5 7. Apply cost-volume-profit analysis to estimated levels of future sales and to changes in costs and selling prices. 8. Apply cost-volume-profit analysis to a service business. LEARNING OBJECTIVES

Copyright © by Houghton Miffin Company. All rights reserved.6 Cost Behavior Patterns OBJECTIVE 1 Define cost behavior and explain how managers use this concept in the management cycle.

Copyright © by Houghton Miffin Company. All rights reserved.7 Cost Behavior u Cost behavior refers to how costs respond to changes in volume or activity. 4 Some costs vary with volume or operating activity. 4 Others remain fixed as volume changes. 4 Some costs exhibit characteristics between these two extremes.

Copyright © by Houghton Miffin Company. All rights reserved.8 The Management Cycle Planning Managers use their knowledge of cost behavior to estimate future costs and impact of operational changes on future profitability. Executing Managers use assumptions about cost behavior in almost every decision they make. Reviewing and Reporting Managers must understand cost behavior when reviewing operations and preparing reports. Variable costing income statements are used to support decision-making in many situations.

Copyright © by Houghton Miffin Company. All rights reserved.9 The Use of Cost Behavior in the Management Cycle

Copyright © by Houghton Miffin Company. All rights reserved.10 A. A.1.Some costs vary with volume or operating activity. 2.Others remain fixed as volume changes.Discussion Q. Q.What are the two extremes concerning cost behavior discussed in this chapter?

Copyright © by Houghton Miffin Company. All rights reserved.11 The Behavior of Variable Costs OBJECTIVE 2 Identify specific types of variable and fixed cost behavior, and discuss how operating capacity and relevant range relate to cost behavior.

Copyright © by Houghton Miffin Company. All rights reserved.12 The Behavior Variable Costs u Total costs that change in direct proportion to changes in productive output are called variable costs. 4 On a per unit basis, variable costs remain constant as volume changes.

Copyright © by Houghton Miffin Company. All rights reserved.13 Variable Costs u Examples of variable costs: 4 Direct materials. 4 Direct and indirect labor (hourly). 4 Operating supplies. 4 Sales commissions.

Copyright © by Houghton Miffin Company. All rights reserved.14 Examples of Variable, Fixed, and Mixed Costs

Copyright © by Houghton Miffin Company. All rights reserved.15 Operating Capacity u Operating Capacity can be expressed in several ways, including: 4 Total labor hours. 4 Total machine hours. 4 Total units of output.

Copyright © by Houghton Miffin Company. All rights reserved.16 Operating Capacity u Operating Capacity: u Operating Capacity: The upper limit of an organization’s productive output capability, given existing resources. u Theoretical Capacity: u Theoretical Capacity: Maximum productive output possible over a given period of time. u Practical Capacity: u Practical Capacity: Theoretical capacity reduced by normal, expected work stoppages.

Copyright © by Houghton Miffin Company. All rights reserved.17 Operating Capacity u Excess Capacity: u Excess Capacity: Extra machinery and equipment available when regular facilities are being repaired or when expected volume is greater. u Normal Capacity: u Normal Capacity: Average annual operating capacity needed to meet expected sales demand.

Copyright © by Houghton Miffin Company. All rights reserved.18 Measures of Capacity u Each variable cost should be related to an appropriate measure of capacity. u Example: operating costs may relate to machine hours used or total units produced.

Copyright © by Houghton Miffin Company. All rights reserved.19 Measures of Capacity u Management accountants must aggregate variable costs that have the same activity base to facilitate estimation of future costs. u Relate costs to the most logical or causal factor. u The traditional definition of variable costs assumes a linear relationship exists between costs and the measure of capacity chosen.

Copyright © by Houghton Miffin Company. All rights reserved.20 A Common Variable-Cost Behavior Pattern: Linear Relationship

Copyright © by Houghton Miffin Company. All rights reserved.21 Linear and Nonlinear Cost Relationships u Many costs vary with operating activity in a nonlinear fashion. u Examples: 4 Costs of computer usage. 4 Costs of power consumption. u Cost behavior of nonlinear costs can be approximated within the relevant range using a linear approximation technique.

Copyright © by Houghton Miffin Company. All rights reserved.22 Other Variable Cost Behavior Patterns: Nonlinear Relationships

Copyright © by Houghton Miffin Company. All rights reserved.23 Relevant Range u The relevant range is the span of activity in which a company expects to operate and in which, it is assumed, total fixed cost and per unit variable costs are constant.

Copyright © by Houghton Miffin Company. All rights reserved.24 The Relevant Range and Linear Approximation

Copyright © by Houghton Miffin Company. All rights reserved.25 Fixed Costs u Fixed costs are costs that remain constant in total within a relevant range of volume or activity. Examples of fixed costs are: 4 Depreciation. 4 Rent. 4 Supervisory salaries. 4 Property taxes. u Unit fixed costs vary inversely with changes in volume.

Copyright © by Houghton Miffin Company. All rights reserved.26 A Common Fixed-Cost Behavior Pattern

Copyright © by Houghton Miffin Company. All rights reserved.27 A. A.1. Direct materials. 2. Direct and indirect labor (hourly). 3. Operating supplies. 4. Sales commissions.Discussion Q. Q.What are examples of variable costs?

Copyright © by Houghton Miffin Company. All rights reserved.28 Mixed Costs OBJECTIVE 3 Define mixed cost, and use the high-low method to separate the variable and fixed components of a mixed cost.

Copyright © by Houghton Miffin Company. All rights reserved.29 Mixed Costs u Mixed costs have both variable and fixed cost components. u Part of the cost changes with volume or usage, and part of the cost is fixed over time. u Examples: 4 Utility costs 4 Some telephone costs

Copyright © by Houghton Miffin Company. All rights reserved.30 Behavior Patterns of Mixed Costs: Telephone Costs

Copyright © by Houghton Miffin Company. All rights reserved.31 The High-Low Method of Separating Costs u A scatter diagram is a chart of plotted points that helps determine if there is a linear relationship between a cost item and its related activity measure. u Use the High-Low Method if a scatter diagram suggests a linear relationship, and the highest and lowest points are representative of the data set.

Copyright © by Houghton Miffin Company. All rights reserved.32 Scatter Diagram of Machine Hours and Electricity Costs

Copyright © by Houghton Miffin Company. All rights reserved.33 The High-Low Method Step 1: Calculate the variable cost per activity base Unit Variable Cost =highest “y” value – lowest “y” value “x” value at highest “y” – “x” value at lowest “y”

Copyright © by Houghton Miffin Company. All rights reserved.34 The High-Low Method Step 2: Calculate the Total Fixed Costs Total Fixed Costs = Total Costs – Total Variable Costs = highest “y” value – (unit variable cost times “x” value at highest “y”)

Copyright © by Houghton Miffin Company. All rights reserved.35 The High-Low Method Step 3: Calculate the formula to estimate the total costs within the relevant range Total Cost per Month = Total Fixed Costs + Unit Variable Cost per activity base x Number of Units

Copyright © by Houghton Miffin Company. All rights reserved.36 A. A. Part of the cost changes with volume or usage. Part of the cost is fixed over the period.Discussion Q. Q.What are the characteristics of a mixed cost?

Copyright © by Houghton Miffin Company. All rights reserved.37 Cost-Volume-Profit Analysis OBJECTIVE 4 Define cost-volume-profit analysis and discuss how managers use this analysis.

Copyright © by Houghton Miffin Company. All rights reserved.38 Cost-Volume-Profit Anlysis u Cost-Volume-Profit Analysis is defined as the examination of cost behavior patterns that underlie the relationships among cost, volume of output and profit.

Copyright © by Houghton Miffin Company. All rights reserved.39 Cost-Volume-Profit Analysis u Cost-volume-profit analysis is used primarily as a planning and control tool for: 4 Projecting net income at different activity levels. 4 Measuring the performance of a department within a company. 4 Assisting in the analysis of decision alternatives. 4 Planning and controlling operations more effectively.

Copyright © by Houghton Miffin Company. All rights reserved.40 Cost-Volume-Profit Analysis The C-V-P Formula Sales Revenue Fixed Costs Total Variable Costs S VC FC S = VC + FC + Net Income

Copyright © by Houghton Miffin Company. All rights reserved.41 Some Uses of C-V-P Analysis: u Calculate net income when sales volume is known. u Decide the level of sales necessary to reach a net income target. u Budgeting. u Product pricing. u Product mix analysis. u Adding or dropping a product line. u Accepting special orders.

Copyright © by Houghton Miffin Company. All rights reserved.42 A. A. Projecting net income. Measuring departmental performance. Analysis of decision alternatives. Discussion Q. Q. What are the management uses of cost-volume-profit analysis?

Copyright © by Houghton Miffin Company. All rights reserved.43 Breakeven Analysis OBJECTIVE 5 Compute a breakeven point in units of output and in sales dollars, and prepare a breakeven graph.

Copyright © by Houghton Miffin Company. All rights reserved.44 The Breakeven Point u The breakeven point is the point of zero profit, that is where total revenues equal total costs. S = VC + FC 4 Breakeven dollars equal breakeven units times the selling price per unit. S = (Unit VC x # Units) + FC

Copyright © by Houghton Miffin Company. All rights reserved.45 The Breakeven Graph u Normally, a loss area, profit area, and breakeven point are shown. u At zero volume, net loss equals fixed costs. u At breakeven, total costs equal total revenue.

Copyright © by Houghton Miffin Company. All rights reserved.46 Graphic Breakeven Analysis: Dakota Products, Inc. Net Income Area

Copyright © by Houghton Miffin Company. All rights reserved.47 A. A. Breakeven dollars equal breakeven units times the selling price per unit.Discussion Q. Q.What is the formula for breakeven dollars?

Copyright © by Houghton Miffin Company. All rights reserved.48 Contribution Margin OBJECTIVE 6 Define contribution margin and use the concept to determine a company’s breakeven point for a single product and for multiple products.

Copyright © by Houghton Miffin Company. All rights reserved.49 Contribution Margin u Contribution margin equals sales minus total variable costs. CM = S - VC u Contribution margin per unit equals selling price per unit minus variable cost per unit. u Profit equals Contribution Margin minus Fixed Costs Profit = CM – FC

Copyright © by Houghton Miffin Company. All rights reserved.50 Contribution Margin At the Breakeven Point (BP), profit = zero: CM – FC = 0 (CM per unit x BE units) – FC = 0 BE units = FC ÷ CM per unit

Copyright © by Houghton Miffin Company. All rights reserved.51 Multiple Products (Sales Mix) Sales Mix is the proportion of each product’s unit sales relative to the organization’s total unit sales. u Step 1:Complete the weighted-average contribution margin (WACM). 4 Multiply the CM for each product by its percentage of the sales mix. 4 Sum the results to give the WACM. u Step 2: Calculate the Weighted-Average Breakeven Point (WABP). 4 WABP = FC WACM u Calculate the breakeven point for each product. 4 Multiply the WABP by each product’s percentage of the sales mix.

Copyright © by Houghton Miffin Company. All rights reserved.52 A. A.Sales - Variable costs = Contribution margin - Fixed costs = Net income (loss)Discussion Q. Q.What is the calculation of net income (profit) when using the contribution format?

Copyright © by Houghton Miffin Company. All rights reserved.53 Planning Future Sales OBJECTIVE 7 Apply cost-volume-profit analysis to estimated levels of future sales and to changes in costs and selling prices.

Copyright © by Houghton Miffin Company. All rights reserved.54Cost-Volume-Profit u The contribution approach is extremely useful for profit planning. u Target sales in units = (FC + NI) (CM per unit) u Projected net income can be calculated, assuming changes in volume, selling price, and/or variable and fixed costs.

Copyright © by Houghton Miffin Company. All rights reserved.55 Limitations of C-V-P Analysis u The Breakeven point is a rough estimate of the number of units that must be sold in order to cover total costs. u Additional qualitative issues to support decision- making may include: 4 Will cost reductions reduce quality? 4 How can the business influence sales volume? 4 What is the elasticity of demand? 4 Information about product quality, reliability, quality of suppliers, availability of human and technical resources.

Copyright © by Houghton Miffin Company. All rights reserved.56 Assumptions Underlying C-V-P Analysis 1.The behavior of variable and fixed costs can be measured accurately. 2.Costs and revenues have a close linear approximation. 3.Efficiency and productivity hold steady within the relevant range of activity.

Copyright © by Houghton Miffin Company. All rights reserved.57 Assumptions Underlying C-V-P Analysis 4.Cost and price variables hold steady during the period being planned. 5.The product sales mix does not change during the period being planned. 6.Production and sales volume are roughly equal.

Copyright © by Houghton Miffin Company. All rights reserved.58 A. A.Target Sales Units = (FC + NI) / CM per unitDiscussion Q. Q.The contribution margin approach can be used for profit planning. What is the calculation to determine target sales units?

Copyright © by Houghton Miffin Company. All rights reserved.59 Applying C-V-P Analysis to a Service Business OBJECTIVE 8 Apply cost-volume-profit analysis to a service business.

Copyright © by Houghton Miffin Company. All rights reserved.60Cost-Volume-Profit u A service concern does not manufacture a physical product. u The cost per service rendered includes the following: 4 Professional (direct) labor costs. 4 Service overhead costs (may be fixed or variable).

Copyright © by Houghton Miffin Company. All rights reserved.61 Cost-Volume-Profit u A service business can separate mixed costs into their variable and fixed portions in order to: 1.Calculate a breakeven point. 2.Plan net income when changes in cost, volume, or price occur.

Copyright © by Houghton Miffin Company. All rights reserved.62 A. A.Separate mixed costs into their variable and fixed portions. Calculate a breakeven point. Plan net income when changes in cost, volume, or price occur.Discussion Q. Q.How can a service business use cost-volume-profit analysis?

Copyright © by Houghton Miffin Company. All rights reserved.63 OK, LET’S REVIEW… 1.Define cost behavior and explain how managers use this concept in the management cycle. 2.Identify specific types of variable and fixed cost behavior, and discuss how operating capacity and relevant range relate to cost behavior. 3.Define mixed cost, and use the high-low method to separate the variable and fixed components of a mixed cost.

Copyright © by Houghton Miffin Company. All rights reserved.64 CONTINUING OUR REVIEW… 4.Define cost-volume-profit analysis and discuss how managers use this analysis. 5.Compute a breakeven point in units of output and in sales dollars, and prepare a breakeven graph. 6.Define contribution margin and use the concept to determine a company’s breakeven point for a single product and for multiple products.

Copyright © by Houghton Miffin Company. All rights reserved.65 AND FINALLY… 7.Apply cost-volume-profit analysis to estimated levels of future sales and to changes in costs and selling prices. 8.Apply cost-volume-profit analysis to a service business.