ACT 5060 – Accounting for Decision Makers Chat # 3 – Cost Behavior & CVP Analysis ACT 5060 Chat 3 Felo

Chat Outline Cost behavior Cost estimation Activity analysis CVP analysis ACT 5060 Chat 3 Felo

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) ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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% ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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% ACT 5060 Chat 3 Felo

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! ACT 5060 Chat 3 Felo

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) ACT 5060 Chat 3 Felo

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?) ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 % ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

Profit Planning BEP is a special case of this Add “target operating income” to numerator of breakeven formulas ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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) ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

Multiple Products Assume constant sales mix Two methods to solve Overall CM ratio Weighted-average (composite) CM ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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% ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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) ACT 5060 Chat 3 Felo

Alternative Calculation Product A Product B TOTAL CM per unit $10 $40 Sales mix 60% 40% $6 $16 Weighted-Average CM $22 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo

DOL Example Units Sold 14,000 Contribution Margin $294,000 Operating Income $84,000 Degree of Operating Leverage 3.5 ACT 5060 Chat 3 Felo

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% ACT 5060 Chat 3 Felo

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% ACT 5060 Chat 3 Felo

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? ACT 5060 Chat 3 Felo

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 ACT 5060 Chat 3 Felo