1. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Chapter Five & Six Cost Behavior: Analysis and Use- Cost Volume Profit Relations

2. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Recall the summary of our cost behavior discussion from an earlier chapter. Types of Cost Behavior Patterns

3. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Activity Base A measure of what causes the incurrence of a variable cost Units produce d Miles driven Labor hours Machine hours

4. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Variable Cost Minutes Talked Total Long Distance Telephone Bill Minutes Talked Per Minute Telephone Charge TOTAL PER UNIT

5. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Step-Variable Costs step-variable cost A resource that is obtainable only in large chunks (such as maintenance workers) and whose costs increase or decrease only in response to fairly wide changes in activity is known as a step-variable cost. Volume Cost

6. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Extent of Variable Costs The proportion of variable costs differs across organizations. For example... A public utility with large investments in equipment will tend to have fewer variable costs. A manufacturing company will often have many variable costs. A merchandising company usually will have a high proportion of variable costs like cost of sales. A merchandising company usually will have a high proportion of variable costs like cost of sales. A service company will normally have a high proportion of variable costs. A service company will normally have a high proportion of variable costs.

7. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Fixed Cost Number of units sold Monthly Rent Expense Number of Local Calls Monthly Rent Expense per Units sold TOTAL PER UNIT

8. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Examples Advertising and Research and Development Examples Advertising and Research and Development Examples Depreciation on Equipment and Real Estate Taxes Examples Depreciation on Equipment and Real Estate Taxes Types of Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be significantly reduced in the short term. Committed Long-term, cannot be significantly reduced in the short term.

9. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Trend Toward Fixed Costs The trend in many industries is toward greater fixed costs relative to variable costs. As machines take over many mundane tasks previously performed by humans, “knowledge workers” are demanded for their minds rather than their muscles Knowledge workers tend to be salaried, highly-trained and difficult to replace. The cost to compensate these valued employees is relatively fixed rather than variable.

10. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Is Labor a Variable or a Fixed Cost? The behavior of wage and salary costs can differ across countries, depending on labor regulations, labor contracts, and custom. In TURKEY,France, Germany, China, and Japan management has little flexibility in adjusting the size of the labor force. Labor costs are more fixed in nature. In the United States and the United Kingdom management has greater latitude. Labor costs are more variable in nature.

11. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Rent Cost in Thousands of Dollars 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.

12. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin How does this type of fixed cost differ from a step- variable cost? Fixed Costs and Relevant Range Step-variable costs can be adjusted more quickly and... The width of the activity steps is much wider for the fixed cost.

13. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) Total Utility Cost X Y A mixed cost has both fixed and variable components. Consider the example of utility cost. Mixed Costs Total mixed cost

14. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Analysis of Mixed Costs Account Analysis and the Engineering Approach High Low Method Ordinary Least Squares Regression

15. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Contribution Format Used primarily for external reporting. Used primarily by management. CM is used first to cover fixed expenses. Any remaining CM contributes to net operating income.

16. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin CVP Graph Fixed Expenses Dollars Total ExpensesTotal Sales Units Break-even point (400 units or $200,000 in sales)

17. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Contribution Margin Ratio The contribution margin ratio is: Total CM Total sales CM Ratio = Each $1.00 increase in sales results in a total contribution margin increase of 40¢. Unit CM Unit selling price

18. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Changes in Fixed Costs and Sales Volume What is the profit impact if Racing can increase unit sales from 500 to 540 by increasing the monthly advertising budget by $10,000?

19. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Changes in Fixed Costs and Sales Volume The Shortcut Solution

20. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Change in Variable Costs and Sales Volume What is the profit impact if Racing can use higher quality raw materials, thus increasing variable costs per unit by $10, to generate an increase in unit sales from 500 to 580?

21. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Change in Fixed Cost, Sales Price and Volume What is the profit impact if Racing (1) cuts its selling price $20 per unit, (2) increases its advertising budget by $15,000 per month, and (3) increases unit sales from 500 to 650 units per month?

22. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Change in Variable Cost, Fixed Cost and Sales Volume What is the profit impact if Racing (1) pays a $15 sales commission per bike sold instead of paying salespersons flat salaries that currently total $6,000 per month, and (2) increases unit sales from 500 to 575 bikes?

23. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Change in Regular Sales Price If Racing has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers or fixed expenses, what price would it quote to the wholesaler if it wants to increase monthly profits by $3,000?

24. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Change in Regular Sales Price

25. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Break-Even Analysis Break-even analysis can be approached in two ways: 1.Equation method 2.Contribution margin method

26. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin CVP Graph Fixed Expenses Dollars Total ExpensesTotal Sales Units Break-even point (400 units or $200,000 in sales)

27. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Equation Method Profits = (Sales – Variable expenses) – Fixed expenses Sales = Variable expenses + Fixed expenses + Profits OR At the break-even point profits equal zero

28. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Contribution Margin Method The contribution margin method has two key equations. Fixed expenses Unit contribution margin = Break-even point in units sold Fixed expenses CM ratio = Break-even point in total sales dollars

29. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Contribution Margin Method Fixed expenses CM ratio = Break-even point in total sales dollars $80,00040% = $200,000 break-even sales

30. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Target Profit Analysis The equation and contribution margin methods can be used to determine the sales volume needed to achieve a target profit. Suppose Racing Bicycle Company wants to know how many bikes must be sold to earn a profit of $100,000.

31. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Contribution Margin Approach The contribution margin method can be used to determine that 900 bikes must be sold to earn the target profit of $100,000. Fixed expenses + Target profit Unit contribution margin = Unit sales to attain the target profit $80,000 + $100,000 $200/bike = 900 bikes

32. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Margin of Safety The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. Margin of safety = Total sales - Break-even sales The margin of safety can be expressed as % of sales

33. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

34. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Cost Structure and Profit Stability Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization’s cost structure.

35. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Cost Structure

36. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Operating Leverage A measure of how sensitive net operating income is to percentage changes in sales. Contribution margin Net operating income Degree of operating leverage =

37. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Operating Leverage

38. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin The Concept of Sales Mix Sales mix is the relative proportion in which a company’s products are sold. Different products have different selling prices, cost structures, and contribution margins. Let’s assume Racing Bicycle Company sells bikes and carts and that the sales mix between the two products remains the same.

39. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Multi-product break-even analysis Racing Bicycle Co. provides the following information: $265,000 $550,000 = 48.2% (rounded)

40. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Multi-product break-even analysis Fixed expenses CM Ratio Break-even sales $170,000 48.2% = $352,697 = =

41. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Key Assumptions of CVP Analysis  Selling price is constant.  Costs are linear.  In multi-product companies, the sales mix is constant.  In manufacturing companies, inventories do not change (units produced = units sold).

42. Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin End of Chapter 5 and 6