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Cost Classifications for Predicting Cost Behavior

How a cost will react to changes in the level of

business activity.

– Total variable costs change when activity changes.

– Total fixed costs remain unchanged when activity changes.

How a cost will react to changes in the level of

business activity.

– Total variable costs change when activity changes.

– Total fixed costs remain unchanged when activity changes.

Total Variable Cost

Your total long distance telephone bill is based on how many minutes you talk.

Minutes Talked

Tot

al L

ong

Dis

tanc

eT

elep

hone

Bill

Variable Cost Per Unit

Minutes Talked

Per

Min

ute

Tel

epho

ne C

harg

e

The cost per long distance minute talked is constant. For example, 10 cents per minute.

Total Fixed Cost

Your monthly basic telephone bill probably does not change when you make more local

calls.

Number of Local Calls

Mon

thly

Bas

ic

Tel

epho

ne B

ill

Fixed Cost Per Unit

Number of Local Calls

Mon

thly

Bas

ic T

elep

hone

B

ill p

er L

ocal

Cal

l

The average cost per local call decreases as more local calls are made.

Cost Classifications for Predicting Cost Behavior

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remainsas activity level changes. the same over wide ranges

of activity.

Fixed Total fixed cost remains Fixed cost per unit goesthe same even when the down as activity level goes up. activity level changes.

The Activity Base

A measure of the event that causes the incurrence of a

variable cost – a cost driver

A measure of the event that causes the incurrence of a

variable cost – a cost driver

Unitsproduced

Unitsproduced

Miles driven

Miles driven

Labor hours

Labor hours

Machine hours

Machine hours

Step-Variable Costs

Activity

Co

st

Total cost remainsconstant within anarrow range of

activity.

Total cost remainsconstant within anarrow range of

activity.

Step-Variable Costs

Activity

Co

st

Total cost increases to a new higher cost for the

next higher range of activity.

Total cost increases to a new higher cost for the

next higher range of activity.

RelevantRange

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

A straight line closely

approximates a curvilinear

variable cost line within the

relevant range.

Activity

To

tal

Co

st

Economist’sCurvilinear Cost

Function

The Linearity Assumption and the Relevant Range

Accountant’s Straight-Line Approximation (constant

unit variable cost)

Exh.5-4

Cost Behavior

MerchandisersCost of Goods Sold

MerchandisersCost of Goods Sold

ManufacturersDirect Material, Direct Labor, and Variable

Manufacturing Overhead

ManufacturersDirect Material, Direct Labor, and Variable

Manufacturing Overhead

Merchandisers and Manufacturers

Sales commissions and shipping costs

Merchandisers and Manufacturers

Sales commissions and shipping costs

Service Organizations Supplies and travel

Service Organizations Supplies and travel

Examples of normally variable costsExamples of normally variable costs

Examples of normally fixed costsExamples of normally fixed costs

Merchandisers, manufacturers, and service organizations

Real estate taxes, Insurance, Sales salariesDepreciation, Advertising

Merchandisers, manufacturers, and service organizations

Real estate taxes, Insurance, Sales salariesDepreciation, Advertising

ExamplesAdvertising and Research and Development

ExamplesAdvertising and Research and Development

ExamplesDepreciation on Buildings and

Equipment

ExamplesDepreciation on Buildings and

Equipment

Types of Fixed Costs

DiscretionaryMay be altered in the short-term by current managerial decisions

DiscretionaryMay be altered in the short-term by current managerial decisions

CommittedLong-term, cannot be reduced in the short

term.

CommittedLong-term, cannot be reduced in the short

term.

Ren

t C

ost

in

T

ho

usa

nd

s o

f D

oll

ars

0 1,000 2,000 3,000 Rented Area (Square Feet)

0

30

60

Fixed Costs and Relevant Range

90

Relevant

Range

Total cost doesn’t change for a wide range of activity,

and then jumps to a new higher cost for

the next higher range of activity.

Total cost doesn’t change for a wide range of activity,

and then jumps to a new higher cost for

the next higher range of activity.

Exh.5-6

Fixed Monthly

Utility Charge

Variable

Cost per KW

Activity (Kilowatt Hours)

To

tal

Uti

lity

Co

st

X

Y

A mixed cost has both fixed and variablecomponents. Consider the example of utility cost.

A mixed cost has both fixed and variablecomponents. Consider the example of utility cost.

Mixed Costs

Total mixed cost

Total Per UnitSales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$

Less: fixed expenses 80,000 Net operating income 20,000$

WIND BICYCLE CO.Contribution Income Statement

For the Month of June

The Basics of Cost-Volume-Profit (CVP) Analysis

Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been

deducted.

Total Per UnitSales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$

Less: fixed expenses 80,000 Net operating income 20,000$

WIND BICYCLE CO.Contribution Income Statement

For the Month of June

The Basics of Cost-Volume-Profit (CVP) Analysis

CM goes to cover fixed expenses.CM goes to cover fixed expenses.

Total Per UnitSales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$

Less: fixed expenses 80,000 Net operating income 20,000$

WIND BICYCLE CO.Contribution Income Statement

For the Month of June

The Basics of Cost-Volume-Profit (CVP) Analysis

After covering fixed costs, any remaining CM contributes to income.

The Contribution Approach

For each additional unit Wind sells, $200 more in contribution margin will help to

cover fixed expenses and profit.

The Contribution Approach

Each month Wind must generate at least $80,000 in total CM to break even.

The Contribution Approach

If Wind sells 400 units in a month, it will be operating at the break-even point.

Total Per UnitSales (401 bikes) 200,500$ 500$ Less: variable expenses 120,300 300 Contribution margin 80,200 200$

Less: fixed expenses 80,000 Net operating income 200$

WIND BICYCLE CO.Contribution Income Statement

For the Month of June

The Contribution Approach

If Wind sells one more bike (401 bikes), net

operating income will increase by $200.

CVP Relationships in Graphic Form

Viewing CVP relationships in a graph is often helpful. Consider the following information for Wind Co.:

Income 300 units

Income 400 units

Income 500 units

Sales 150,000$ 200,000$ 250,000$ Less: variable expenses 90,000 120,000 150,000 Contribution margin 60,000$ 80,000$ 100,000$ Less: fixed expenses 80,000 80,000 80,000 Net operating income (20,000)$ -$ 20,000$

Income 300 units

Income 400 units

Income 500 units

Sales 150,000$ 200,000$ 250,000$ Less: variable expenses 90,000 120,000 150,000 Contribution margin 60,000$ 80,000$ 100,000$ Less: fixed expenses 80,000 80,000 80,000 Net operating income (20,000)$ -$ 20,000$

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

- 100 200 300 400 500 600 700 800

CVP Graph

Fixed expenses

Units

Dol

lars Total Expenses

Total Sales

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

- 100 200 300 400 500 600 700 800

Units

Dol

lars

CVP Graph

Break-even point

Profit Area

Loss Area

Contribution Margin Ratio

The contribution margin ratio is:

For Wind Bicycle Co. the ratio is:

$ 80,000$200,000

= 40%

Total CMTotal sales

CM Ratio =

Contribution Margin Ratio

Or, in terms of units, the contribution margin ratio is:

For Wind Bicycle Co. the ratio is:

$200$500

= 40%

Unit CMUnit selling price

CM Ratio =

Contribution Margin Ratio

At Wind, each $1.00 increase in sales revenue results in a total contribution margin

increase of 40¢.

If sales increase by $50,000, what will be the If sales increase by $50,000, what will be the increase in total contribution margin? increase in total contribution margin?

Contribution Margin Ratio

400 Bikes 500 BikesSales 200,000$ 250,000$ Less: variable expenses 120,000 150,000 Contribution margin 80,000 100,000 Less: fixed expenses 80,000 80,000 Net operating income -$ 20,000$

400 Bikes 500 BikesSales 200,000$ 250,000$ Less: variable expenses 120,000 150,000 Contribution margin 80,000 100,000 Less: fixed expenses 80,000 80,000 Net operating income -$ 20,000$

A $50,000 increase in sales revenue

Changes in Fixed Costs and Sales Volume

Wind is currently selling 500 bikes per month. The company’s sales manager believes that an

increase of $10,000 in the monthly advertising budget would increase bike sales to 540 units.

Should we authorize the requested increase in the advertising budget?

Current Sales (500 bikes)

Projected Sales (540

bikes)

Sales 250,000$ 270,000$ Less: variable expenses 150,000 162,000 Contribution margin 100,000 108,000 Less: fixed expenses 80,000 90,000 Net operating income 20,000$ 18,000$

Current Sales (500 bikes)

Projected Sales (540

bikes)

Sales 250,000$ 270,000$ Less: variable expenses 150,000 162,000 Contribution margin 100,000 108,000 Less: fixed expenses 80,000 90,000 Net operating income 20,000$ 18,000$

Changes in Fixed Costs and Sales Volume

Sales increased by $20,000, but net operating income decreased by $2,000..

Sales increased by $20,000, but net operating income decreased by $2,000..

$80,000 + $10,000 advertising = $90,000$80,000 + $10,000 advertising = $90,000

Changes in Fixed Costs and Sales Volume

The Shortcut SolutionThe Shortcut Solution

Increase in CM (40 units X $200) 8,000$ Increase in advertising expenses 10,000 Decrease in net operating income (2,000)$

Increase in CM (40 units X $200) 8,000$ Increase in advertising expenses 10,000 Decrease in net operating income (2,000)$

Break-Even Analysis

Break-even analysis can be approached in three ways:

1. Graphical analysis.

2. Equation method.

3. Contribution margin method.

Equation Method

Profits = Sales – (Variable expenses + Fixed expenses)

Sales = Variable expenses + Fixed expenses + Profits

OR

At the break-even point profits equal zero.

Break-Even Analysis

Here is the information from Wind Bicycle Co.:

Total Per Unit PercentSales (500 bikes) 250,000$ 500$ 100%Less: variable expenses 150,000 300 60%Contribution margin 100,000$ 200$ 40%

Less: fixed expenses 80,000 Net operating income 20,000$

Total Per Unit PercentSales (500 bikes) 250,000$ 500$ 100%Less: variable expenses 150,000 300 60%Contribution margin 100,000$ 200$ 40%

Less: fixed expenses 80,000 Net operating income 20,000$

Equation Method

We calculate the break-even point as follows:

Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0

Where: Q = Number of bikes sold $500 = Unit selling price $300 = Unit variable expense $80,000 = Total fixed expense

Equation Method

We calculate the break-even point as follows:

Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $0$200Q = $80,000 Q = $80,000 ÷ $200 per bike Q = 400 bikes

Equation Method

We can also use the following equation to compute the break-even point in sales dollars.

Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $80,000 + $0 Where:

X = Total sales dollars 0.60 = Variable expenses as a % of sales $80,000 = Total fixed expenses

Equation Method

X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $80,000 ÷ 0.40 X = $200,000

We can also use the following equation to compute the break-even point in sales dollars.

Sales = Variable expenses + Fixed expenses + Profits

Contribution Margin Method

The contribution margin method is a variation of the equation method.

Fixed expensesUnit contribution margin

=Break-even point

in units sold

Fixed expenses CM ratio

=Break-even point intotal sales dollars

Target Profit Analysis

Suppose Wind Co. wants to know how many bikes must be sold to earn a profit of

$100,000.

We can use our CVP formula to determine the sales volume needed to achieve a target net

profit figure.

The CVP Equation

Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $100,000

$200Q = $180,000

Q = 900 bikes

The CVP Equation

Sales = Variable expenses + Fixed expenses + Profits

$500Q = $300Q + $80,000 + $100,000

$200Q = $180,000

Q = 900 bikes