2. Cost Behavior Cost Volume Profit Analysis Chapter M3

3. Cost Behavior Refers to the manner in which a cost changes as a related activity changes – Activity Bases – Relevant range

4. Cost Classification Variable Costs Costs that vary in proportion to changes in the level of activity Such as Direct Materials Direct Labor Units Produced DM per unit Total DM Costs 5,000 units$10$50,000 10,000$10$100,000 15,000$10$150,000

5. Cost Classification Fixed Costs Costs that remain the same in total dollar amounts as the level of activity changes. salaries # of Bottles Total Salary Salary per Bottle 50,000$75,000$1.50 100,000$75,000$0.75 150,000$75,000$0.50

6. Cost Classification Mixed Costs – Has characteristics of both a variable and a fixed cost. – Could behave as a fixed cost for part of the relevant range and then variable cost

7. High-Low Method Cost estimation techniques Steps – Find the highest and lowest level of production – Find the difference in total cost from highest to lowest level of production – Find the difference in total units from highest to lowest level of production – Variable cost per unit Difference in Total cost Difference in Total units – Find fixed cost by solving this equation – Total cost = Fixed cost plus Variable cost

8. Example 1 MonthProductionTotal Cost June1,000$45,550 July1,500$52,000 Aug2,100$61,500 Sept1,800$57,500 Oct750$41,250 High: Aug 2,100 units Low: Oct 750 units Diff 1,350 High: Aug $61,500 Oct $41,250 Diff 20,250

9. Variable cost = Diff in TC Diff in units =$20,250 1,350 = $15 per unit Total cost = FC + VC $61,500 = FC + ($15 *2,100 units) $61,500 = FC + 31,500 FC = $30,000

10. Example 2 MonthProductionTotal Cost June2,500$45,000 July2,000$40,000 Aug1,500$35.000 Sept3,000$50,000 Oct1,800$38,000

11. Example 2 High Sept 3,000 $50,000 Low Aug 1,500 $35,000 Diff 1,500 15,000 Variable cost per unit $15,000/1,500 = $10 per unit Total cost = FC + VC $50,000 = FC + (3,000 units * $10) FC = $20,000

12. Cost-Volume-Profit Relationship Is the systematic examination of the relationships among selling prices, sales, and production volume, costs, expenses and profits Provides management with useful information for decision making

13. Contribution Margin Concept Contribution Margin = Sales – Variable Costs Contribution margin ratio Sales – VC Sales Unit Contribution margin Sales per unit - VC per unit

14. Example 3 The company has sales of $1,000,000, variable costs of $800,000. Compute the contribution margin and the contribution margin ratio CM = Sales – VC = $1,000,000 - $800,000 =$200,000 CM ratio = Sales – VC/Sales = 200,000/1000000 = 20%

15. Example 4 The company has sales of $800,000, variable costs of $600,000. Compute the contribution margin and contribution margin ratio CM = sales – VC = $800 - $600 = $200 CM ratio = CM/Sales = 200/800 = 25%

16. Cost Volume Profit Analysis To determine the units of sales necessary to achieve the break even point in operations To determine the units of sales necessary to achieve a target or desired profit

17. Break-Even Point Is the level of operations at which a business’ revenues and expired costs are exactly equal No income or loss BEP = Fixed Costs Unit Contribution Margin

18. Break Even Point Example 5: Suppose that selling price is $35, variable cost is $15 and fixed costs are $90,000. What is break even point? BEP = fixed costs Unit contribution margin (Sales – VC) = $90,000 $35 - $15 = 4,500 units

19. Break even point Check Sales = FC + VC ($35 * 4,500 units) = $90,000 + ($25 * 4,500) $157,500 = $90,000 + $67,500

20. Example 6 Suppose that selling price is $45, variable cost is $30 and fixed costs are $60,000. What is break even point? BEP = Fixed cost Unit CM = $60,000 $45-30 = 4,000 units

21. Graphical Fixed Costs 0 Costs Units Variable costs Total Cost

22. Graphical – Break even point $ Units 0 Total costs Sales Break even point Sales = TC Profit Loss

23. Effect of Changes on BEP Changes in fixed costs – Increase in fixed costs Increases BEP – Decrease in fixed cost Decrease BEP Changes in Variable cost – Increase in variable cost Increases BEP – Decreases in variable cost Decreases BEP Changes in Selling Price – Increase in SP Decrease BEP – Decrease in SP Increase in BEP

24. Desired Profit Firms would like to earn a profit and not just to break even BEP = FC + Desired Profit Unit CM

25. Example 5: Suppose that selling price is $45, variable cost is $30, and fixed costs are $60,000. The company wants a desired profit of $45,000. What is BEP? BEP = FC +  Unit CM = $60,000 + $45,000 = $105,000 = 7,000 $45- $30 $15

26. Example 5: Check Sales – ( FC + VC) = Desired profit ($45 * 7,000) – {$60,000 – ($30 *7,000) = $315,000 – (60,000 + 210,000) = $45,000

27. Example 6: Suppose that selling price is $25, variable cost is $15 and fixed costs are $90,000. The company wants a desired profit of $10,000. What is break even point? BEP = FC + Desired Profit Unit CM = $90,000 + $10,000 $10 = 10,000 units

28. Sales Mix Consideration More than one product is sold at varying selling prices Products often have different unit variable costs Products have different contribution margin Sales volume necessary must a mix of both products

29. Example 6: Cascade Co produces two products Yuk and Gunk. Yuk has a selling price of $90, variable cost of $70 and is 80% of total sales. Gunk has a selling price of $140, variable cost of $95, and is 20% of total sales. Fixed costs are $200,000. What is the break even point for the sales mix?

30. Example 6: ProductSelling Price Variable Cost CMSales % Sales mix CM Yuk$90$70$2080%$16 Gunk$140$95$4520%$9 $25

31. Example 6: BEP = Fixed Costs = $200,000 Sales mix CM $25 BEP = 8,000 units Of what products: YUK: 8,000 units * 80% = 6,400 units GUK: 8,000 units * 20% = 1,600 units

32. Example 7: ABC Company has two products Y and X. Y has a selling price of $100, variable costs of $60 and is 70% of total sales. X has a selling price of $50, variable cost of $25. Fixed costs are $248,500. What is BEP?

33. Example 7: ProductSelling Price Variable Cost CMSales % Sales mix CM Y$100$60$4070%$28 X$50$25 30%$7.50 $35.50

34. Example 7: BEP = Fixed cost Sales mix CM = $248,500 $35.50 = 7,000 units Y: 7,000 units * 70% = 4,900 units X: 7,000 units * 30% = 2,100 units

35. Margin of Safety Indicates possible decrease in sales that may occur before an operating loss occurs. Ms = S – Sat BEP Sales

36. Margin of Safety If sales are $400,000 and sales at break even are $300,000 what is margin of safety? Ms = Sales – Sales BEP = $400 - $300 Sales $400 = 25%

37. Operating Leverage Relative mix of business variable costs and fixed costs Contribution margin Income from operations High = large fixed costs Low – small fixed costs

38. Remember Get detailed handouts at http://faculty.mdc.edu/mmari Homework assigned in class.