1 PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2005 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc. Analyzing Cost Behavior Chapter M7

2 Objective 1 Describe how costs respond to changes in activity. Once you have completed this chapter, you should be able to:

3 Cost Behavior in Relation to Changes in Activity Levels Variable costs are costs that change in total with volume but remain fixed on a per-unit basis. Thus, variable costs go up as the level of activity (volume) rises.

4 Cost Behavior in Relation to Changes in Activity Levels Variable Cost Behavior Total Cost Activity Level

5 Cost Behavior in Relation to Changes in Activity Levels Fixed costs are costs that do not change in total with volume but vary on a per-unit basis. However, the cost per unit does vary with output because the cost is spread over a greater or lesser number of units.

6 Cost Behavior in Relation to Changes in Activity Levels Fixed Cost Behavior Total Cost Activity Level

7 Cost Behavior in Relation to Changes in Activity Levels Semivariable (or mixed costs) are a combination of variable and fixed costs. Total cost is a function of both variable and fixed costs; costs vary with output but cannot drop to zero as long as the company is in business.

8 Cost Behavior in Relation to Changes in Activity Levels Semivariable or Mixed Cost Behavior Total Cost Activity Level Fixed Variable Total

9 Cost Behavior in Relation to Changes in Activity Levels Step-pattern costs are costs that increase or decrease in total over a wide range of activity levels. However, these costs remain fixed over a narrow range of activity levels.

10 Cost Behavior in Relation to Changes in Activity Levels Step-Pattern Cost Behavior Total Cost Activity Level

11 A manager who must decide between manufacturing a component or buying that component from an outside source is facing a make or buy decision. Make or Buy Cost Analysis

12 Black & Blue is currently buying from an outside supplier the wheels it uses on its XR100 skateboards. The wheels cost $8.00 per board. The $8.00 unit cost is relevant. Make or Buy Cost Analysis

13 Relevant costs are costs that change under two or more decision alternatives. Make or Buy Cost Analysis

14 Make or Buy Cost Analysis Total Cost to make Cost to Make Direct materials (variable)$5.45$5.45 Direct labor (variable) Manufacturing overhead: Electricity (variable) Supplies (variable) Depreciation (fixed) Supervision costs (fixed) Total cost per unit$8.70$7.75 Total Relevant Cost to make Exhibit 5

15 Total Cost to make Cost to Make Direct materials (variable)$5.45$5.45 Direct labor (variable) Manufacturing overhead: Electricity (variable) Supplies (variable) Depreciation (fixed) Supervision costs (fixed) Total cost per unit$8.70$7.75 Total Relevant Cost to make Note that the two fixed manufacturing overhead costs are not relevant. Make or Buy Cost Analysis Exhibit 5

16 Total Cost to make Cost to Make Direct materials (variable)$5.45$5.45 Direct labor (variable) Manufacturing overhead: Electricity (variable) Supplies (variable) Depreciation (fixed) Supervision costs (fixed) Total cost per unit$8.70$7.75 Total Relevant Cost to make Make or Buy Cost Analysis Exhibit 5

17 Make $7.75 Out- source $8.00 Make! Make or Buy Cost Analysis

18 Objective 2 Explain what contribution margins and breakeven points are and how the contribution margin is reflected in a variable-costing income statement. Once you have completed this chapter, you should be able to:

19 Contribution Margin and the Variable- Costing Income Statement  Absorption costing assigns costs by function, separating the costs of manufacturing products from the costs of selling, administration, and other nonmanufacturing activities.  Variable costing assigns costs by their behavior, separating them into variable and fixed components.

20 Variable-Costing Income Statement Black & Blue Company Variable-Costing Income Statement For the Month Ended August 31, 2003 Sales revenue (1,000 skateboards)$26,000$26.00 Less variable expenses 15, Contribution margin$10,400$10.40 Less fixed expenses 6,000 Net income$ 4,400 TotalPer Unit Exhibit 6

21 Variable-Costing Income Statement Black & Blue Company Variable-Costing Income Statement For the Month Ended August 31, 2003 Sales revenue (1,000 skateboards)$26,000100% Less variable expenses 15,600 60% Contribution margin$10,40040% Less fixed expenses 6,000 Net income$ 4,400 %Total Exhibit 7

22 Variable-Costing Income Statement Contribution margin ratio = Contribution Margin Sales Contribution margin ratio = $10,400 $26,000 Contribution margin ratio = 40%

23 Objective 3 Use CVP analysis to determine the breakeven point in sales and the sales volume necessary to earn a target profit. Once you have completed this chapter, you should be able to:

24 Cost-volume-profit (CVP) analysis is the use of relationships among costs, volume, and profits to make managerial decisions. Total Cost Activity Level

25 Product prices Activity levels Variable costs Fixed costs Exhibit 8 CVP Analysis Marketing Strategy Pricing Policy Use of Resources

26 Breakeven-Point Analysis The Equations Method Sales – Total cost = Profits Sales – (Variable costs + Fixed costs) = Profits Sales = Variable costs + Fixed costs At break- even

27 Breakeven-Point Analysis The Equations Method Black & Blue sells its skateboards at $26 each. Each unit has variable costs of $15.40, and the company has fixed costs each month of $6,000. How many skateboards does the company have to sell each month to break even?

28 Selling price per unit x Units sold = (variable cost per unit x Units sold) + Fixed costs $26 x Units sold = ($15.10 x Units sold) + $6,000 $10.40 x Units sold = $6,000 $6,000 ÷ $10.40 = 577 units Breakeven-Point Analysis The Equations Method

29 Breakeven-Point Analysis The Unit-Contribution Method Breakeven unit sales volume = Selling price – Variable costs per unit per unit Fixed costs Breakeven unit sales volume = Unit contribution margin Fixed costs Breakeven unit sales volume = $10.40 $6, units per month =

30 Breakeven-Point Analysis The Unit-Contribution Method Breakeven in sales dollars = Contribution margin ratio Fixed costs Breakeven in sales dollars =.40 $6,000 Breakeven in sales dollars = $15,000 $10.40 ÷ $26.00

31 Target-Profit Analysis A target profit is the profit that a company wants to make over a given period. Black & Blue wants to earn a profit of $2,000 a month. How many skateboards would Black & Blue have to sell in a month to earn $2,000 a month?

32 Target-Profit Analysis Target profit = (Selling price per unit x Units sold) – (Variable cost per unit x Units sold) – Fixed costs $2,000 = ($26 per unit x Units sold) – ($15.60 x Units sold) – $6,000 $8,000 = $10.40 x Units sold Units sold =770 skateboards

33 Profit-Sensitivity Analysis Right now Black & Blue is selling 1,800 skateboards for $75 apiece at a variable cost per skateboard of $30. Suppose the company lowers the selling price to $24 and cuts variable cost per unit to $15. These changes could increase sales by 20 percent. Current skateboard sales: 1,000 per month

34 Profit-Sensitivity Analysis Profit = (Selling price per unit x Units sold) – (Variable cost per unit x unit sold) – Fixed costs Profit = ($24 x 1,200) – $(15 x 1,200) – $6,000 Profit = $28,800 – $18,000 – $6,000 Profit = $4,800

35 Cost Behavior and Operating Risk Operating Risk Operating risk is the risk that a drop in sales volume will cause a company to earn an unsatisfactory profit.

36 Cost Behavior and Operating Risk Discretionary Discretionary fixed costs are fixed costs that can be eliminated in the relatively short term.

37 Cost Behavior and Operating Risk Committed Committed fixed costs are fixed costs that cannot be eliminated in the relatively short term.

38 Objective 4 Calculate unit product cost using variable and absorption costing. Once you have completed this chapter, you should be able to:

39 Number of units produced in a period10,000 Variable costs per unit: Direct materials$5 Direct labor3 Variable manufacturing overhead2 Variable selling and admin. expenses2 Fixed costs per period: Fixed manufacturing overhead$50,000 Fixed selling and admin. expenses35,000 Number of units produced in a period10,000 Variable costs per unit: Direct materials$5 Direct labor3 Variable manufacturing overhead2 Variable selling and admin. expenses2 Fixed costs per period: Fixed manufacturing overhead$50,000 Fixed selling and admin. expenses35,000 Pricing Decisions: Unit Product Cost Continued Exhibit 9

40 Pricing Decisions: Unit Product Cost The Variable Unit Product Cost Direct materials costs per unit$ 5 Direct labor costs per unit3 Variable manufacturing overhead per unit 2 Total variable cost per unit$10 Exhibit 9

41 Pricing Decisions: Unit Product Cost The Absorption Costing Unit Product Cost Direct materials costs per unit$ 5 Direct labor costs per unit3 Variable manufacturing overhead per unit 2 Fixed manufacturing overhead per unit 5 Total variable cost per unit$15

42 Pricing Decisions: Unit Product Cost The difference between variable and absorption costing is the treatment of fixed manufacturing overhead.

43 Pricing Decisions: Unit Product Cost Variable costing treats fixed manufacturing overhead as a period expense. Absorption costing treats it as a product cost.

44 Performance Evaluation: Net Income Black & Blue Company Absorption Costing Sales (8,000 units x $25)$200,000 Cost of goods sold (8,000 x $10) + $40,000(120,000) Gross margin$ 80,000 Less administrative expenses ($35,000 + $20,000) 55,000 Net income$ 25,000 Exhibit 11

45 Performance Evaluation: Net Income Variable Costing Sales (8,000 units x $25)$200,000 Variable cost of goods sold (8,000 x $10) ( 80,000) Gross margin$120,000 Less fixed administrative expenses ($35,000 fixed + $20,000 variable)(55,000) Less fixed manufacturing overhead costs (50,000) Net income$ 15,000 Black & Blue Company Exhibit 11

46 Performance Evaluation: Net Income Black & Blue Company Net income, absorption costing$25,000 Less: fixed costs included in the ending inventory ($5 x 2,000) 10,000 Net income, variable costing$15,000 Reconciliation

47 Objective 5 Explain why costs are important for decision making in service companies. Once you have completed this chapter, you should be able to:

48 The cost of a car loan is more than the amount being borrowed. The loan application has to be printed and processed, the amount has to be updated each month, and a bad-debt assessment and the bank’s target profit have to be included in the pricing.

49 Measuring costs in service organizations is often more complex than a manufacturing organization.  Services do not have the tangible, physical nature of products.  Services often require many transactions that are carried out by a number of departments.

50 THE END Chapter M7

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