Day Seven Costing –Basic Issues 1.Cost volume profit 2.Operating Leverage 3. Transfer Pricing 4. Overhead - what and why?

Vanessa’s Cappuccino Express What is a cost?

Vanessa’s Cappuccino Express For decision makers what matters is the future. Predicting costs is a key component of a successful business. One important factor causing costs to vary is level of activity.

Fixed Cost - Total $ Activity Level

$ Variable Cost - Total

$ Activity Level Mixed Cost - Total

VOLUME Volume = level of activity… But this concept is flexible. Volume should be measurable and Should relate to changes in costs...

Fixed versus Variable? Not always easy…depends on point of view. Think of the passenger on the already scheduled flight….variable costs are minimal. But what about when the flight was originally scheduled?

Assumptions 1. Linear, constant costs 2. Costs only fixed or variable 3. Sales and Production are equal 4. No capacity additions during period 5. Sales mix remains constant 6. Inflation is ignored 7. Technological assumptions remain unchanged..productivity same.

CVP as a Flow Diagram Slide UR Fixed Costs Profits UVC Variable Costs Contribution C C

Equation Approach Sales revenue – Variable expenses – Fixed expenses = Profit ….

Equation Approach Assume Sales Price of $500 Variable cost/unit of $300 and Fixed Costs of $80,000 How many units must Curl Co. sell to break even?

Equation Approach ) ($500 × X) ($300 × X)– –$80,000 = 0 X = Break Even in units

Contribution Margin Approach CONTRIBUTION MARGIN = $500 - $300 or $200 per unit At Break Even the TOTAL CM is equal to Total FIXED Costs… or.. $200 x X = $80,000 X = Break Even in units

Contribution-Margin Approach = Break-even point (in units) [Fixed expenses [Unit contribution [ margin

Contribution-Margin Ratio We can calculate the break-even point in sales dollars rather than units by using the contribution- margin ratio. Fixed expense CM Ratio Break-even point (in sales dollars)=

Contribution-Margin Ratio Approach CM Ratio = Sales Price - Var Co Sales Price I.E. What % of the selling price is left after paying variable unit cost?

Contribution-Margin Ratio Approach CM Ratio = Sales Price - Var Cost Sales Price In our example, $500 - $300 = $200 CM. $200 is 40% of SP. Fixed Costs of $80,000, divided by 40% = ?

Cost-Volume-Profit Graphed Units Sold Sales in Dollars

Cost-Volume-Profit Graph Break-even point Units $$$$

 Increase selling price per unit (SP)  Decrease variable cost per unit (UVC)  Decrease fixed costs (TFC)  Increase volume (X) Improving Profit Performance Slide 16-19

Three more Important Cost Terms 1. Opportunity 2. Sunk 3. Differential or Incremental

Opportunity Cost The potential benefit that is given up when one alternative is selected over another. Example: If you were not attending college, you could be earning $15,000 per year. Your opportunity cost of attending college for one year is $15,000. Example: If you were not attending college, you could be earning $15,000 per year. Your opportunity cost of attending college for one year is $15,000.

Sunk Costs All costs incurred in the past that cannot be changed by any decision made now or in the future. All costs incurred in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions. Sunk costs should not be considered in decisions.

Sunk Costs Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost. Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.

Sunk Costs Examples….. Examples….. Beloved of politicians… Beloved of politicians… Knee Deep….. Knee Deep…..

Sunk Costs Basketball players Basketball players

Incremental Costs Costs that differ between alternatives. Example: You can earn $1,500 per month in your hometown or $2,000 per month in a nearby city. Your commuting costs are $50 per month in your hometown and $300 per month to the city. What is your incremental cost?

Incremental Costs Costs that differ between alternatives. Example: You can earn $1,500 per month in your hometown or $2,000 per month in a nearby city. Your commuting costs are $50 per month in your hometown and $300 per month to the city. What is your incremental cost? $300 - $50 = $250

Incremental or Diffferential or Marginal Costs Often these are related to Variable and Fixed patterns, i.e. they are driven by volume changes…. Another Boeing 757? Another Palm Pilot? Another Windows XT?

Marginal Costs and Average Costs The extra cost incurred to produce one additional unit. The total cost to produce a quantity divided by the quantity produced. Marginal and average costs are largely a function of cost behavior -- variable and fixed costs.

Cost Structure and Operating Leverage [The cost structure of an organization is the relative proportion of its fixed and variable costs. [Operating leverage is... l the extent to which an organization uses fixed costs in its cost structure. l greatest in companies that have a high proportion of fixed costs in relation to variable costs.

Operating Leverage The extent to which costs are fixed rather than variable Defined as … S - VC S - VC - FC

Operating Leverage The extent to which costs are fixed rather than variable … S - VC S - VC - FC What happens as FIXED Costs increase?

Operating Leverage S - VC = Cont Margin S - VC - FC = Income 1. Dependent on Current Sales, VC & FC, i.e. it is valid only for a point. 2. Shows how change in Sales will change Income…...

Measuring Operating Leverage A measure of how a percentage change in sales will affect profits. If Curl increases its sales by 10%, what will be the percentage increase in net income?

Measuring Operating Leverage S - VC S - VC - FC Operating leverage = $100,000 $20,000 = = 5

Measuring Operating Leverage A measure of how a percentage change in sales will affect profits.

Measuring Operating Leverage Let’s work it out…... Sales 250,000 x 1.10 = 275,000 Var cost = 60% or $150,000 X 1.10 (165,000) Cont margin = 110,000 Fixed Costs = ( 80,000) Net Income = 30,000

Cost or Revenue?? Operating Leverage - a Graphical Look

Cost Structure # 1

Cost Structure #2 Which is high and which is low leverage?

CVP Graph for High Leverage

CVP Graph for Low Leverage

Numerical Examples Hy Loe Sales$500,000$500,000 less VC( 100,000)( 350,000) = CM 400, ,000 less FC (340,000) (90,000) = Op Inc. 60,000 60,000 Leverage 400, ,000 60,000

Questions re Operating Leverage... Does H or L fit better: 1. Relatively low CM ratio 2. When sales are increasing, income increases more rapidly 3. When sales are decreasing, income will decrease slowly 4. Volatility of income as sales changes will be high

Questions re Operating Leverage... Does H or L fit better: 5. Break even point will often be lower 6. Margin of safety for a given level of sales will usually be higher 7. Latitude to management in times of economic stress is less 8. Appeals to those who like risk

5. Transfer Price The amount charged when one division sells goods or services to another division Battery DivisionAuto Division Batteries

The transfer price affects the profit measure for both the selling division and the buying division. A higher transfer price for batteries means... greater profits for the battery division. Auto DivisionBattery Division Transfer Pricing

lower profits for the auto division. The transfer price affects the profit measure for both the selling division and the buying division. Auto DivisionBattery Division Transfer Pricing A higher transfer price for batteries means...

General-Transfer-Pricing Rule Transfer price Additional outlay cost per unit incurred because goods are transferred Opportunity cost per unit to the organization because of the transfer =+

Goal Congruence. Conflicts may arise between the company’s interests and an individual manager’s interests when transfer- price-based performance measures are used.

Goal Congruence The ideal transfer price allows each division manager to make decisions that maximize the company’s profit, while attempting to maximize his/her own division’s profit.

Setting Transfer Prices The general rule….   Additional outlay.

Setting Transfer Prices The general rule….   Additional outlay.   Opportunity Cost

Setting Transfer Prices The General Rule   Additional outlay.   Opportunity Cost   Goal Congruence

The goal of Setting Transfer Prices The value placed on transfer goods is used to make it possible to transfer goods between divisions while allowing them to retain their autonomy.