CHAPTER 18 Cost Behavior & Cost-Volume-Profit Analysis

Cost Behavior In planning, we must understand how costs behave. For example, do costs change as production activity changes or do they stay the same?  __________– costs that increase as production activity increases (direct materials, direct labor)  __________– costs that stay the same over a range of activity levels (depreciation, rent) within a given time period.

Variable Costs Total Variable Cost Graph Total Costs $300,000 $250,000 $200,000 $150,000 $100,000 $50, Unit Variable Cost Graph $20 $15 $10 $5 0 Cost per Unit ,000 $ 50,000 $10 10, , , , , , , , , , Units Total Cost Produced Cost per Unit Units Produced (000)

Fixed Costs Total Fixed Cost Graph Total Costs 0 Unit Fixed Cost Graph Cost per Unit 50,000 $75,000 $ ,000 75, ,000 75, ,000 75, ,000 75, ,000 75, Units Total Cost Produced Cost per Unit $150,000 $125,000 $100,000 $75,000 $50,000 $25, $1.50 $1.25 $1.00 $.75 $.50 $ Units Produced (000)

Relevant Range Cost relationships remain stable only over some range of production activity. Outside that range the relationships may change. __________is the expected range of activity we are interested in.  We estimate the cost relationships within that range.  We cannot extrapolate outside the range.

Cost Behavior __________Costs  include both fixed and variable costs; we separate fixed from variable costs when perform cost-volume profit analysis. __________ Costs  fixed within a relevant range, but if total production increases significantly, total costs increase by a lump sum amount __________ Costs  increase at a non-constant rate as volume increases.

Mixed Costs Some costs have a _______ component and a __________ component. We can separate mixed costs into the two components using the ________________. FC $ activity Total costs Slope = VC/unit Equation of line : y = a + bx

Mixed Costs Total Mixed Cost Graph Total Costs 0 Total Machine Hours (000) $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5, Mixed costs are usually separated into their fixed and variable components for management analysis. Mixed costs are sometimes called semivariable or semifixed costs.

The objective is to classify all costs as either fixed or variable. Identifying and Measuring Cost Behavior

Measuring Cost Behavior: Scatter Diagram … A __________of past cost behavior may be helpful in analyzing mixed costs. Draw a line through the plotted data points so that about equal numbers of points fall above and below the line. Estimated fixed cost = 10, * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000s of Units Produced

Measuring Cost Behavior: Scatter Diagram … Variable Cost unit = Slope = Δ  in cost Δ  in units * Total Cost in 1,000’s of Dollars * * * * * * * * * Activity, 1,000s of Units Produced Horizontal distance is the change in activity. Vertical distance is the change in cost.

Measuring Cost Behavior High/Low Method Determine the __________ by finding the slope  change in ____ ÷ change in _____  (see prev. slide) Determine the __________ component  Using the high (or the low) point, plug in the cost (y), the activity (x), and the slope (VC/unit).  Solve for the y- intercept. Given the equation of the cost line, we can now use it to predict cost over some range of activity.

Mixed Costs: High-Low Method Actual costs incurred June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 ProductionTotal UnitsCost Highest level Lowest level Difference ProductionTotal UnitsCost Highest and lowest levels

Mixed Costs: High-Low Method Actual costs incurred ProductionTotal Units Cost Highest level2,100$61,500 Lowest level Difference ProductionTotal UnitsCost Highest and lowest levels June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250

Mixed Costs: High-Low Method Actual costs incurred ProductionTotal Units Cost Highest level2,100$61,500 Lowest level75041,250 Difference ProductionTotal UnitsCost Highest and lowest levels June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250

Mixed Costs: High-Low Method Actual costs incurred ProductionTotal Units Cost Variable cost per unit Difference in total cost Difference in production = Highest level2,100$61,500 Lowest level75041,250 Difference1,350$20,250 ProductionTotal UnitsCost Highest and lowest levels 1 June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250

Mixed Costs: High-Low Method Actual costs incurred June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 ProductionTotal Units Cost Variable cost per unit Difference in total cost Difference in production $20,250 1,350 units === ProductionTotal UnitsCost Highest and lowest levels 1 $15 Highest level2,100$61,500 Lowest level75041,250 Difference1,350$20,250

Mixed Costs: High-Low Method Actual costs incurred June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 ProductionTotal Units Cost Variable cost per unit Difference in total cost Difference in production $20,250 1,350 units $15 === Total cost =– Fixed cost Highest level2,100$61,500 Lowest level75041,250 Difference1,350$20,250 ProductionTotal UnitsCost Highest and lowest levels Variable cost per unit x Units of production 1 2

Mixed Costs: High-Low Method Actual costs incurred June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 ProductionTotal Units Cost Variable cost per unit Difference in total cost Difference in production $20,250 1,350 units $15 == = Total cost =– Fixed cost Highest level2,100$61,500 Lowest level75041,250 Difference1,350$20,250 ProductionTotal UnitsCost Highest and lowest levels Variable cost per unit x Units of production Highest level: $61,500 =– ( $15 x 2,100 ) = $30,

Mixed Costs: High-Low Method Actual costs incurred June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 ProductionTotal Units Cost Variable cost per unit Difference in total cost Difference in production $20,250 1,350 units $15 === Total cost =– Fixed cost Highest level2,100$61,500 Lowest level75041,250 Difference1,350$20,250 ProductionTotal UnitsCost Highest and lowest levels Variable cost per unit x Units of production Highest level: $61,500 =– ( $15 x 2,100 ) = $30,000 Lowest level: $41,250 =– ( $15 x 750 ) = $30,

Mixed Costs: High-Low Method Actual costs incurred June1,000$45,550 July1,50052,000 August2,10061,500 September1,80057,500 October75041,250 ProductionTotal Units Cost Variable cost per unit Difference in total cost Difference in production $20,250 1,350 units $15 === Total cost =– Fixed cost Highest level2,100$61,500 Lowest level75041,250 Difference1,350$20,250 ProductionTotal UnitsCost Highest and lowest levels Variable cost per unit x Units of production Highest level: $61,500 =– ( $15 x 2,100 ) = $30,000 Lowest level: $41,250 =– ( $15 x 750 ) = $30,

Cost-Volume-Profit & Breakeven Analysis Given our fixed and variable costs, we can use CVP techniques to help predict our profit at various activity levels. We define  __________= Sales – VC  __________= SP/unit – VC/unit  __________= CM/SP

Related Questions We can use this set of techniques to answer the following types of questions.  How many units do we need to sell to break even?  How much profit will we generate at a given level of sales?  If we want to earn a target profit, how many units do we need to sell?  If we change our sales price, what happens to our profitability?

Contribution margin is amount by which revenue exceeds the variable costs of producing the revenue. Computing Break-Even Point

How much contribution margin must this company have to cover its fixed costs (break even)? Answer: $24,000 P2 Computing Break-Even Point

How many units must this company sell to cover its fixed costs (i.e. to break even)? Answer: $24,000 ÷ $30 per unit = 800 units P2 Computing Break-Even Point

Breakeven Sales Sales = VC + FC + profit or Profit = Sales – VC – FC At breakeven, profit = 0  0 = (Sales – VC) – FC  0 = CM - FC  CM = FC or  (CM/unit)(units) = FC  And Breakeven Units = FC/(CM/unit)  Or Breakeven in $ = FC/(CM ratio)

Target Net Income You can use the CVP idea to determine how much we can sell to earn a desired profit.  Profit = Sales – VC – FC  Profit + FC = Sales – VC = CM = CM/unit(units)  Target Sales units = (FC + Profit) / CM/unit  Target Sales$ = (FC + Profit) / CM ratio

__________ is the amount by which sales can drop before the company incurs a loss. Margin of safety may be expressed as a percentage of expected sales. Margin of Safety Exh Margin of safety Expected sales - Break-even sales percentage Expected sales = C3

Breakeven for Multiple Products BE units = FC/(CM composite ), where CM composite = [(%A)CM A + (%B) CM B ]  The number of units that we get will be a combined unit of A and B together.  You then have to determine the number of A and B each that are actually sold.

Breakeven for Multiple Products - Example If FC = $100,000 and CM(a) = $40 and CM(b) = $20, and we sell 3 times as many units of B as A, what is the BE point? BE units = 100,000/[(0.25)($40) + (0.75)($20)] = 4,000 units A = (0.25)(4,000) or 1,000 units of A B = (0.75)(4,000) or 3,000 units of B

A measure of the extent to which fixed costs are being used in an organization. A measure of how a percentage change in sales will affect profits. Contribution margin Net income Degree of ____________________ = Operating Leverage

Contribution Margin Reporting We can recast the income statement to highlight the contribution margin. Sales - VC = CM - FC = operating income For Internal Reporting purposes only

The End!! Now, let’s look at the quick studies!