1. ACT 5060 – Accounting for Decision Makers
Chat # 3 – Cost Behavior & CVP Analysis
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2. Chat Outline Cost behavior Cost estimation Activity analysis
CVP analysis
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3. Cost Behavior Introduction
How does a cost change (if at all) when activity changes?
Traditional approach is to define activity in terms of units or volume of service
Alternative approach is to define activities more broadly
Used to predict costs at various activity levels
Used to assess risk (operating leverage)
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4. Cost Behavior Patterns
Focus on TOTAL costs (not unit)
Variable costs
Fixed costs
Mixed costs (Semi-variable)
Step costs
Classification depends on time frame, the activity, & relevant range of the activity
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5. More Detail on Fixed Costs
This is related to our budgeting discussion
Discretionary fixed costs (managed fixed costs) – decided on as part of budget process, so can be changed in short run
Committed fixed costs (capacity costs) – required to maintain current service or required under law / contract
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6. Cost Estimation
Using past data to identify cost behavior and predict future costs
Unsophisticated methods such as high-low method and scatter diagrams
More sophisticated methods such as simple regression and multiple regression
Be aware of impact of learning and changes in technology
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7. High-Low Method Use 2 data points to estimate variable and fixed costs
Estimated VC ratio = Change in Operating Costs / Change in Sales
Estimated fixed costs = Total costs – Estimated VC
Predict future costs based on estimated VC ratio, expected sales, & estimated fixed costs
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8. High-Low Example – Step 1
2012
2011
Net Sales
$61,093
$48,077
Total Operating Costs
$54,798
$43,494
Change in Op Costs
$11,304
Change in Net Sales
$13,016
Estimated VC ratio
86.85%
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9. High-Low Example – Step 2
2012
2011
Net Sales
$61,093
$48,077
Total Operating Costs
$54,798
$43,494
Estimated VC (86.85%)
$53,057
$41,754
Estimated FC
$1,741
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10. High-Low Example – Step 3
2012
Estimated 2013 Net Sales
$74,452
Estimated VC (86.85%)
$64,659
Estimated FC
$1,741
Estimated Total Operating Costs
$66,400
Actual 2013 Total Operating Costs
$65,899
Dollar Error
$501
Percentage Error
0.76%
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11. Activity Analysis
In some instances costs fluctuate based on something other than units or volume
Examples: Set-up costs, billing, and design costs
Predicting these costs based on units or volume is NOT ACCURATE!
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12. Activity Hierarchy
Unit-level activity – activity performed on each individual unit (variable cost)
Batch-level activity – activity performed once per batch or order
Product-level activity – activity performed for each product / service / customer, not individual batches or units
Facility-level activity – activity performed to maintain capacity (fixed cost)
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13. CVP Analysis
Impact of changes in volume (V) on costs (C) and profits (P)
Useful in planning process (What will profit be if we sell “x” units?)
Also useful in assessing risk (How will profits change if we sell “y” instead of “x” units?)
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14. CVP Analysis Assumptions
All costs can be classified as fixed or variable
There is only one driver of revenue & costs
Selling price, VC per unit, and FC are known and constant (within relevant range and time frame); means revenue and cost functions are linear
One product or constant sales mix
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15. Contribution Margin Different from gross margin!
CM per unit = Selling price – Total VC per unit
Total CM = Total revenue – Total VC
How much of selling price is left over after paying VC to contribute to fixed costs and profit?
CM ratio (%) = CM per unit / Selling price OR Total CM / Total revenue
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16. Break-Even Analysis Level of activity where OI = 0
Total revenue = Total costs
Contribution margin = Fixed costs
BEP (units) = Fixed costs / CM per unit
BEP (revenue) = Fixed costs / CM %
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17. BEP Example Selling Price $30 Variable production costs $6
Fixed production costs
$10,000
Administrative costs
$100,000
Advertising
$50,000
Sales commission
10%
Sales staff salaries
Total VC per unit $9
Total fixed costs
$210,000
CM ratio
70%
BEP (units)
10,000 units
BEP (revenue)
$300,000
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18. BEP Proof Revenue $300,000 Variable production costs $60,000
Sales commission
$30,000
Total variable costs
$90,000
Contribution margin
$210,000
Fixed production costs
$10,000
Administrative costs
$100,000
Advertising
$50,000
Sales staff salaries
Total fixed costs
Operating Income $0
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19. Profit Planning BEP is a special case of this
Add “target operating income” to numerator of breakeven formulas
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20. Target Op Income Example
Selling Price
$30
Total VC per unit $9
Total fixed costs
$210,000
Target OI
$84,000
Units required for TOI
14,000 units
Revenue required for TOI
$420,000
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21. Target Operating Income Proof
Revenue
$420,000
Variable production costs
$84,000
Sales commission
$42,000
Total variable costs
$126,000
Contribution margin
$294,000
Fixed production costs
$10,000
Administrative costs
$100,000
Advertising
$50,000
Sales staff salaries
Total fixed costs
$210,000
Operating Income
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22. Impact of Income Taxes
No impact on BEP, as taxes are $0 at the breakeven point
For target net income analysis, need to convert target net income into equivalent target operating income
TOI = TNI / (1 – tax rate)
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23. Target Net Income Example
Selling Price
$30
Total VC per unit $9
Total fixed costs
$210,000
Target net income
$63,000
Tax rate
40%
Equivalent TOI (63,000 / .6)
$105,000
Units required for TOI
15,000 units
Revenue required for TOI
$450,000
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24. Target Net Income Proof
Revenue..
$450,000
Variable production costs
$90,000
Sales commission
$45,000
Total variable costs
$135,000
Contribution margin
$315,000
Total fixed costs
$210,000
Operating Income
$105,000
Income taxes (40%)
$42,000
Net Income
$63,000
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25. Multiple Products Assume constant sales mix Two methods to solve
Overall CM ratio
Weighted-average (composite) CM
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26. Multiple Products Example
Product A
Product B
Selling price
$25
$75
VC per unit
$15
$35
CM per unit
$10
$40
CM ratio
40%
53.3%
Budgeted sales (units)
12,000
8,000
Sales mix (units)
60% (12/20)
40% (8/20)
Total FC
$330,000
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27. Multiple Products CM % Product A Product B TOTAL Revenue $300,000
$600,000
$900,000
Variable costs
$180,000
$280,000
$460,000
Contribution margin
$120,000
$320,000
$440,000
Fixed costs
$330,000
Operating Income
$110,000
Contribution margin %
48.89%
Sales mix (revenue)
33.3%
66.7%
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28. Multiple Products CM % - 2
Fixed costs
$330,000
Contribution margin %
48.89%
Total revenue to BE
$675,000
Product A Revenue (33.3%)
$225,000
Product B Revenue (66.7%)
$450,000
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29. Proof Product A Product B TOTAL Revenue $225,000 $450,000 $675,000
CM ratio
40%
53.3%
Contribution margin
$90,000
$240,000
$330,000
Fixed costs
Operating Income $0
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30. Weighted-Average CM Product A Product B TOTAL CM per unit $10 $40
Sales mix
60%
40%
Units in “bundle” 3 2
Total “bundle” CM
$30
$80
$110
Average “bundle” CM
$22 (110/5)
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31. Alternative Calculation
Product A
Product B
TOTAL
CM per unit
$10
$40
Sales mix
60%
40% $6
$16
Weighted-Average CM
$22
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32. Weighted Average CM - 2 Fixed costs $330,000 Weighted Average CM $22
BEP (units)
15,000
Product A Units (60%)
9,000
Product B Units (40%)
6,000
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33. Proof Product A Product B TOTAL BEP units 9,000 6,000 15,000 Revenue
$225,000
$450,000
$675,000
Variable costs
$135,000
$210,000
$345,000
Contribution margin
$90,000
$240,000
$330,000
Fixed costs
Operating Income $0
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34. Assessing Operating Leverage
Mix of variable and fixed costs
Degree of operating leverage
Generally, fixed costs are preferred at higher sales levels
Should also consider financial leverage
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35. DOL Example Units Sold 14,000 Contribution Margin $294,000
Operating Income
$84,000
Degree of Operating Leverage
3.5
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36. DOL Proof New Units Sold 15,400 Revenue $462,000
Variable Cost of Product
$92,400
Sales Commission
$46,200
($138,600)
Contribution Margin
$323,400
Total Fixed Costs
($210,000)
OPERATING INCOME
$113,400
Original Operating Income
$84,000
Change
35.00%
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37. DOL Proof - 2 New Units Sold 12,600 Revenue $378,000
Variable Cost of Product
$75,600
Sales Commission
$37,800
($113,400)
Contribution Margin
$264,600
Total Fixed Costs
($210,000)
OPERATING INCOME
$54,600
Original Operating Income
$84,000
Change
-35.00%
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38. CVP and Decision Making
How will revenues and costs change based on possible courses of action?
Should we reduce prices to generate more sales?
Should we advertise?
What price should we charge?
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39. Sensitivity Analysis
Since CVP based on estimates, good idea to assumptions change or are not met
Can help identify most critical assumptions and riskiness of alternatives
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