Introduction to Cost Behavior and Cost-Volume Relationships Chapter 2 Introduction to Cost Behavior and Cost-Volume Relationships

Learning Objective 1 Explain how cost drivers affect cost behavior.

Cost Behavior What is cost behavior? It is how costs are related to, and affected by, the activities of an organization.

Cost Drivers What are cost drivers? Output measures of resources and activities are called cost drivers.

Cost Drivers Production Example Example costs: Labor wages Supervisory salaries Maintenance wages Depreciation Energy Example cost drivers: Labor hours No. of people supervised No. of mechanic hours No. of machine hours Kilowatt hours

Cost Drivers How well the accountant does at identifying the most appropriate cost drivers determines how well managers understand cost behavior and how well costs are controlled.

Learning Objective 2 Show how changes in cost-driver activity levels affect variable and fixed costs.

Comparison of Variable and Fixed Costs A variable cost is a cost that changes in direct proportion to changes in the cost driver. A fixed cost is not immediately affected by changes in the cost driver.

Rules of Thumb Think of fixed costs as a total. Total fixed costs remain unchanged regardless of changes in cost-driver activity.

Rules of Thumb Think of variable costs on a per-unit basis. The per-unit variable cost remains unchanged regardless of changes in the cost-driver activity.

Relevant Range This rule of thumb holds true only within reasonable limits. The relevant range is the limit of cost-driver activity within which a specific relationship between costs and the cost driver is valid.

Relevant Range – $16,000 – $12,000 – Fixed Costs $8,000 – $4,000 $16,000 – $12,000 – $8,000 – $4,000 – Fixed Costs Relevant Range 0 500 1,000 1,500 2,000 2,500 Volume in Units

Learning Objective 3 Calculate break-even sales volume in total dollars and total units.

Cost-Volume-Profit Analysis (CVP) What is cost-volume-profit analysis? It is the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit).

CVP Scenario Per Unit Percentage Selling price $5 100 Variable cost 4 80 Difference $1 20 Total monthly fixed expenses = $8,000 Rent $2,000 Labor $5,500 Other $ 500

Break-Even (BE) Point The break-even point is the level of sales at which revenue equals expenses and net income is zero.

Margin of Safety The margin of safety shows how far sales can fall below the planned level before losses occur. Planned unit sales – Break-even unit sales = Margin of safety

Break-Even Point Techniques There are two basic techniques for computing break-even point: Contribution margin Equation

Contribution Margin Technique – to find BE in Units Per Unit Selling price $5 Variable cost 4 Contribution margin $1 $8,000 ÷ $1 = 8,000 units i.e. Fixed Cost ÷ Contribution per unit

Contribution Margin Technique - to find BE in $ 8,000 units × $5.00 = $40,000 i.e. BE point in units x Selling price per unit OR $8,000 ÷ 20% = $40,000 i.e. Fixed Cost ÷ Contribution to Sales ratio

Equation Technique Net income equals zero at the break-even point. Sales – Variable expenses – Fixed expenses = Zero net income (break-even point)

Equation Technique – to find BE in Units Let N = number of units to be sold to break even $5N – $4N – $8,000 = 0 $1N = $8,000 N = $8,000 ÷ $1 N = 8,000 Units

Equation Technique - to find BE in $ Let S = sales in dollars needed to break even S – 0.80S – $8,000 = 0 .20S = $8,000 S = $8,000 ÷ .20 S = $40,000

Learning Objective 4 Create a cost-volume-profit graph and understand the assumptions behind it.

Cost-Volume-Profit Graph Break even sales point 8,000 units or $40,000 Sales revenue line Total expense line Fixed expense line

Learning Objective 5 Calculate sales volume in total dollars and total units to reach a target profit.

Target Net Profit Managers can also use CVP analysis to determine the total sales, in units and dollars, needed to reach a target net profit.

Target Net Profit Contribution Margin Technique Target sales volume in units = Fixed expenses + Target net income Contribution margin per unit

Target Net Profit Equation Technique Target sales – Variable expenses – Fixed expenses = Target net income

Operating Leverage The ratio of fixed to variable costs is called operating leverage. In high leveraged companies, small changes in sales volume result in large changes in net income. Companies with less leverage are not affected as much by changes in sales volume.

Learning Objective 6 Calculate contribution margin and gross margin.

Contribution Margin and Gross Margin Gross margin (which is also called gross profit) is the excess of sales over the cost of goods sold. Contribution margin is the excess of sales over all variable costs.

Learning Objective 7 Explain the effects of sales mix on profits.

Effects of Sales Mix on Income Sales mix is the combination of products that a business sells.

Effects of Sales Mix on Income Avisha’s Dresses Example Selling price: $90 Less variable cost: 32 Equals contribution margin per dress: $58 Fixed costs = $96,000

Effects of Sales Mix on Income Assume that Avisha is considering selling blouses. This will not require any additional fixed costs. She expects to sell 2 blouses at $30 each for every dress she sells. The variable cost per blouse is $19. What is the new breakeven point?

Effects of Sales Mix on Income Contribution margin per blouse: $30 – $19 = $11 What is the contribution margin of the mix? $58 + (2 × $11) = $58 + $22 = $80

Effects of Sales Mix on Income $96,000 fixed costs ÷ $80 = 1,200 packages 1,200 × 2 = 2,400 blouses 1,200 × 1 = 1,200 dresses Total units = 3,600

Effects of Sales Mix on Income What is the breakeven in dollars? 2,400 blouses × $30 = $ 72,000 1,200 dresses × $90 = 108,000 $180,000

Effects of Sales Mix on Income What is the weighted-average budgeted contribution margin? Dresses: 1 × $58 + Blouses: 2 × $11 = $80 ÷ 3 = $26.67

Effects of Sales Mix on Income The break even point for the two products is: $96,000 ÷ $26.667 = 3,600 units 3,600 × 1/3 = 1,200 dresses 3,600 × 2/3 = 2,400 blouses

Effects of Sales Mix on Income Sales mix can be stated in sales dollars: Dresses Blouses Sales price $90 $60 Variable costs 32 38 Contribution margin $58 $22 Contribution margin ratio 64.4% 36.6%

Effects of Sales Mix on Income Assume the sales mix in dollars is 60% dresses and 40% blouses. Weighted contribution would be: 64.4% × 60% = 38.64% dresses 36.6% × 40% = 14.64% blouses 53.28%

Effects of Sales Mix on Income Break even sales dollars is $96,000 ÷ 53.28% = $180,000 (rounding) $180,000 × 60% = $108,000 dress sales $180,000 × 40% = $ 72,000 blouse sales

Learning Objective 8 Compute cost-volume-profit relationships on an after-tax basis.

Target Net Income and Income Taxes Management of Avisha’s Dresses would like to earn an after-tax income of $35,721. The tax rate is 30%. What is the target operating income? Target operating income = Target net income ÷ (1 – tax rate) TOI = $35,721 ÷ (1 – 0.30) TOI = $51,030

Target Net Income and Income Taxes How many units must she sell? Revenues – Variable costs – Fixed costs = Target net income ÷ (1 – tax rate) $90Q – $32Q – $96,000 = $35,721 ÷ 0.70 $58Q = $51,030 + $96,000 Q = $147,030 ÷ $58 Q = 2,535 dresses

Target Net Income and Income Taxes Revenues (2,535 × $90) $228,150 Variable costs (2,535 × $32) 81,120 Contribution margin: $147,030 Fixed costs: 96,000 Operating income: $ 51,030 Income taxes: ($51,030 × .30) 15,309 Net income $ 35,721 THE END