Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 1

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Introduction to Cost Behavior and Cost-Volume-Profit Relationships Chapter 2

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall When you have finished studying this chapter, you should be able to: 1. Explain how cost drivers affect cost behavior. 2. Show how changes in cost-driver levels affect variable and fixed costs. 3. Explain step- and mixed-cost behavior. 4. Create a cost-volume-profit (CVP) graph and understand the assumptions behind it. 5. Calculate break-even sales volume in total dollars and total units. Chapter 2 Learning Objectives

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Calculate sales volume in total dollars and total units to reach a target profit. 7. Differentiate between contribution margin and gross margin. 8. Explain the effects of sales mix on profits (Appendix 2A). 9. Compute cost-volume-profit (CVP) relationships on an after-tax basis (Appendix 2B). Chapter 2 Learning Objectives

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost Drivers and Cost Behavior Cost behavior is how the activities of an organization affect its costs. Cost drivers are measures of activities that require the use of resources and thereby cause costs.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost Drivers and Cost Behavior Learning Objective 1

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Value Chain Functions, Costs, and Cost Drivers Value Chain Function Example Cost Drivers And Resource Costs Research and development Salaries of sales personnel Number of new product proposals costs of market surveys Salaries of product and process Complexity of proposed products engineers Design of products, services, and processes Salaries of product and process Number of engineering hours engineers Cost of computer-aided design Number of distinct parts per equipment used to develop product prototype of product for testing

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Value Chain Functions, Costs, and Cost Drivers Value Chain Function Example Cost Drivers and Resource Costs Production Labor wages Labor hours Supervisory salaries Number of people supervised Maintenance wages Number of mechanic hours Depreciation of plant and machinery, Number of machine hours supplies Energy cost Kilowatt hours Marketing Cost of advertisements Number of advertisements Salaries of marketing personnel, Sales dollars travel costs, entertainment costs

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Value Chain Functions, Costs, and Cost Drivers Value Chain Function Example Cost Drivers And Resource Costs Distribution Wages of shipping personnel Labor hours Transportation costs including Weight of items delivered depreciation of vehicles and fuel Customer service Salaries of service personnel Hours spent servicing products Costs of supplies, travel Number of service calls

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Variable and Fixed Cost Behavior A variable cost changes in direct proportion to changes in the cost-driver level. A fixed cost is not immediately affected by changes in the cost-driver level. Think of variable costs on a per-unit basis. The per-unit variable cost remains unchanged regardless of changes in the cost-driver. Think of fixed costs on a total-cost basis. Total fixed costs remain unchanged regardless of changes in the cost-driver. Learning Objective 2

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost Behavior of Variable and Fixed

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost Behavior: Further Considerations Cost behavior depends on the decision context, the circumstances surrounding the decision for which the cost will be used. Cost behavior also depends on management decisions—management choices determine cost behavior.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Relevant Range The relevant range is the limit of cost-driver activity level within which a specific relationship between costs and the cost driver is valid. Even within the relevant range, a fixed cost remains fixed only over a given period of time—usually the budget period.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Fixed Costs and Relevant Range

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Step- and Mixed-Cost Behavior Patterns Step cost: A cost that changes abruptly at different intervals of activity because the resources and their costs come in indivisible chunks. Learning Objective 3 Mixed Cost: A cost that contains elements of both fixed- and variable- cost behavior

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Step-Cost Behavior Step cost treated as a fixed cost Step cost treated as a variable cost

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost-volume-profit (CVP) analysis Learning Objective 4 Managers trying to evaluate the effects of changes in volume of goods or services produced might be interested in upward changes such as increased sales expected from increases in promotion or advertising. AND Managers might be interested in downward changes such as decreased sales expected due to a new competitor entering the market or due to a decline in economic conditions.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall CVP Scenario Per Unit Percentage of Sales Selling price $ % Variable cost of each item Selling price less variable cost $.30 20% Monthly fixed expenses: Rent $3,000 Wages for replenishing and servicing 13,500 Other fixed expenses 1,500 Total fixed expenses per month $18,000 Cost-volume-profit (CVP) analysis is the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit).

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Cost-Volume-Profit Graph 18,000 30,000 90, , ,000 $150, Units (thousands) Dollars 60,000 Total Expenses Sales Net Income Area Break-Even Point 60,000 units or $90,000 Net Loss Area A C D B Fixed Expenses Variable Expenses Net Income

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Break-Even Point The break-even point is the level of sales at which revenue equals expenses and net income is zero. Sales - Variable expenses - Fixed expenses Zero net income (break-even point) Learning Objective 5

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Contribution Margin Method $18,000 fixed costs ÷ $.30 = 60,000 units (break even) Contribution margin Per Unit Selling price$1.50 Variable costs 1.20 Contribution margin$.30 Contribution margin ratio Per Unit % Selling price 100 Variable costs 80 Contribution margin 20

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Contribution Margin Method $18,000 fixed costs ÷ 20% (contribution-margin percentage) = $90,000 of sales to break even 60,000 units × $1.50 (Sales Price) = $90,000 in sales to break even

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Equation Method Variable Fixed Sales – Expenses – Expenses = net income $1.50N – $1.20N – $18,000 = 0 $.30N = $18,000 N = $18,000 ÷ $.30 N = 60,000 Units Let N = number of units to be sold to break even.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Equation Method S –.80S – $18,000 = 0.20S = $18,000 S = $18,000 ÷.20 S = $90,000 Let S = sales in dollars needed to break even. Shortcut formulas: Break-even = fixed expenses = $18,000 = 60,000 volume in units unit contribution margin.30 Break-even = fixed expenses = $18,000 = $90,000 volume in sales contribution margin ratio.2

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Target Net Profit Managers use CVP analysis to determine the total sales, in units and dollars, needed to reach a target net profit. Target sales – variable expenses – fixed expenses target net income $1,440 per month is the minimum acceptable net income. Learning Objective 6

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Target sales volume in units = (Fixed expenses + Target net income) ÷ Contribution margin per unit ($18,000 + $1,440) ÷ $.30 = 64,800 units Target Net Profit Selling price $1.50 Variable costs 1.20 Contribution margin per unit $.30 Target sales dollars = sales price X sales volume in units Target sales dollars = $1.50 X 64,800 units = $97,200.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Sales volume in dollars = 18,000 + $1,440 = $97, Target Net Profit Target sales volume in dollars = Fixed expenses + target net income contribution margin ratio Contribution margin ratio Per Unit % Selling price100 Variable costs 80 Contribution margin 20

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Nonprofit Application Suppose a city has a $100,000 lump-sum budget appropriation to conduct a counseling program. Variable costs per prescription are $400 per patient per day. Fixed costs are $60,000 in the relevant range of 50 to 150 patients.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall If the city spends the entire budget appropriation, how many patients can it serve in a year? Variable + Fixed Sales = expenses + expenses $100,000 = $400N + $60,000 $400N = $100,000 – $60,000 N = $40,000 ÷ $400 N = 100 patients Nonprofit Application

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Nonprofit Application If the city cuts the total budget appropriation by 10%, how many patients can it serve in a year? Variable + Fixed Sales = expenses + expenses $90,000 = $400N + $60,000 $400N = $90,000 – $60,000 N = $30,000 ÷ $400 N = 75 patients Budget after 10% Cut $100,000 X (1 -.1) = $90,000

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Operating Leverage Margin of safety = planned unit sales – break-even sales. How far can sales fall below the planned level before losses occur? Low leveraged firms have lower fixed costs and higher variable costs. Changes in sales volume will have a smaller effect on net income.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Operating Leverage Operating leverage: a firm’s ratio of fixed costs to variable costs. Highly leveraged firms have high fixed costs and low variable costs. A small change in sales volume = a large change in net income.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Contribution Margin and Gross Margin Learning Objective 7

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Contribution Margin and Gross Margin Sales price – Cost of goods sold = Gross margin Sales price - all variable expenses = Contribution margin Per Unit Selling price$1.50 Variable costs (acquisition cost) 1.20 Contribution margin and gross margin are equal$.30

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Contribution Margin and Gross Margin Contribution Gross Margin Margin Per Unit Per Unit Sales$1.50 $1.50 Acquisition cost of unit sold Variable commission.12 Total variable expense $1.32 Contribution margin.18 Gross margin $.30 Suppose the firm paid a commission of $.12 per unit sold.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Appendix 2A Sales Mix Analysis Sales mix is the relative proportions or combinations of quantities of products that comprise total sales. If the proportions of the mix change, the cost-volume-profit relationships also change. Learning Objective 8

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Sales Mix Analysis Ramos Company Example Sales in units 300,000 75, ,000 $8 and $5$2,400,000$375,000$2,775,000 Variable $7 and $3 2,100, ,000 2,325,000 Contribution $1 and $2$ 300,000$150,000$ 450,000 Fixed expenses 180,000 Net income$ 270,000 Wallets (W) Key Cases (K)Total

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Sales Mix Analysis Break-even point for a constant sales mix of 4 units of W for every unit of K. sales – variable – fixed = zero net income expense expenses [$8(4K) + $5(K)] – [$7(4K) + $3(K)] – $180,000 = 0 32K + 5K - 28K - 3K - 180,000 = 0 6K = 180,000 K = 30,000 W = 4K = 120,000 30,000K + 120,000W = 150,000 total units (K + W). Let K = number of units of K to break even, and 4K = number of units of W to break even.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Sales Mix Analysis If the company sells only key cases: break-even point = fixed expenses contribution margin per unit = $180,000 $2 = 90,000 key cases If the company sells only wallets: break-even point = fixed expenses contribution margin per unit = $180,000 $1 = 180,000 wallets

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Sales Mix Analysis Suppose total sales were equal to the budget of 375,000 units. However, Ramos sold only 50,000 key cases And 325,000 wallets. What is net income?

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Sales Mix Analysis Ramos Company Example Sales in units 325,000 50, ,000 $8 and $5$ 2,600,000 $250,000 $2,850,000 Variable $7 and $3 2,275, ,000 2,425,000 Contribution $1 and $2 $ 325,000 $100,000 $ 425,000 Fixed expenses 180,000 Net income $ 245,000 Wallets (W) Key Cases (K)Total

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Impact of Income Taxes Suppose that a company earns $1,440 before Taxes and pays income tax at a rate of 40%. Learning Objective 9 Income taxes do not affect the break-even point. There is no income tax at a level of zero income. Income taxes affect the calculation of the volume required to achieve a specified after-tax target profit.

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Impact of Income Taxes Target income before taxes = Target after-tax net income 1 – tax rate Target income before taxes = $ 864 = $1,440 1 – 0.40 Suppose the target net income after taxes was $864

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Impact of Income Taxes Target sales - Variable expenses - Fixed expenses = Target after-tax net income ÷ (1 – tax rate) $1.50N - $1.20N - $18,000 = $864 ÷ (1 – 0.40) $.30N = $18,000 + ($864/.6) $.18N = $10,800 + $864 = $11,664 N = $11,664/$.18 N = 64,800 units

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall Impact of Income Taxes Suppose target net income after taxes was $1,440 $1.50N - $1.20N - $18,000 = $1,440 ÷ (1 – 0.40) $.30N = $18,000 + ($1,440/.6) $.18N = $10,800 + $1,440 = $12,240 N = $12,240/$.18 N = 68,000 units

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