2. Introduction to Cost Behavior and Cost-Volume Relationships

3. Cost Drivers and Cost Behavior Traditional View of Cost Behavior Activity-Based View of Cost Behavior Resource A Cost Driver = Units of ResourceOutput Resource A Cost Driver = Units of ResourceOutput Resource B Cost Driver = Units of ResourceOutput Resource B Cost Driver = Units of ResourceOutput Activity A Cost Driver = Units of Activity Output Activity A Cost Driver = Units of Activity Output Activity B Cost Driver = Units of Activity Output Activity B Cost Driver = Units of Activity Output Resource B Cost Driver = Units of ResourceOutput Resource B Cost Driver = Units of ResourceOutput Resource A Cost Driver = Units of ResourceOutput Resource A Cost Driver = Units of ResourceOutput Product or Service Cost Driver = Units of Final Product or Service Cost Driver = Output of Final Product or Service

4. Cost Drivers and Cost Behavior Cost behavior is how the activities of an organization affect its costs. Cost behavior is how the activities of an organization affect its costs. Any output measure that causes the use of costly resources is a cost driver. Any output measure that causes the use of costly resources is a cost driver.

5. Value Chain Functions, Costs, and Cost Drivers Value Chain Function and Example Costs Example Cost Drivers Research and development Salaries marketing research personnel Number of new product proposals costs of market surveys Salaries of product and process engineers Complexity of proposed products Design of products, services, and processes Salaries of product and process engineers Number of engineering hours Cost of computer-aided design equipment Number of parts per product Cost to develop prototype of product for testing Value Chain Function and Example Costs Example Cost Drivers Research and development Salaries marketing research personnel Number of new product proposals costs of market surveys Salaries of product and process engineers Complexity of proposed products Design of products, services, and processes Salaries of product and process engineers Number of engineering hours Cost of computer-aided design equipment Number of parts per product Cost to develop prototype of product for testing

6. Value Chain Functions, Costs, and Cost Drivers Value Chain Function and Example Costs Example Cost Drivers 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 Value Chain Function and Example Costs Example Cost Drivers 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

7. Value Chain Functions, Costs, and Cost Drivers Value chain function and Example costs Example Cost Drivers 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 Value chain function and Example costs Example Cost Drivers 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

8. Cost Classification and Cost Allocation In order to make meaningful decisions a manager must have cost data for each product, department and function of the business The problem with this is how to accurately define the costs and how to allocate the costs to the various products and departments The management accountant classifies costs into fixed and variable costs or direct and indirect costs These costs are then allocated as accurately as possible to the cost centres that generate them. In this way centres are made aware of their responsibility to control costs

9. Fixed, Variable and Semi- Variable Costs Variable Costs – expenses that alter in the short run to changes in output e.g. raw materials, packaging and components. They are payments for the use of inputs Fixed Costs – expenses that do not alter in the short run in relation to changes in output e.g. rent, insurance and depreciation. These costs are linked to time rather the level of business activity Semi Variable Costs – expenses that vary with output but not in direct proportion e.g. maintenance costs. They often comprise a fixed element and a variable element

10. Direct and Indirect Costs Indirect Costs – costs that cannot be allocated accurately to a cost centre or product e.g. administration costs, management salaries or maintenance costs. Another term for this is overheads Direct Costs – costs that can be directly identified with a product or cost centre. They are mainly variable costs but can include some fixed costs e.g. the rent of a building solely used for one product. They are also referred to as prime costs

11. Total Cost Total Cost – this is the addition of all fixed and variable costs (plus any semi-variable costs) Where fixed costs form a significant part of total costs it is important for a business to maximise sales so that the fixed cost element is spread across as many units as possible The total cost is used by the business to see how much finance is required for each level of output

12. Variable and Fixed Cost Behavior A variable cost changes in direct proportion to changes in the cost-driver level. 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. A fixed cost is not immediately affected by changes in the cost-driver. Think of variable costs on a per-unit basis. Think of variable costs on a per-unit basis. The per-unit variable cost remains unchanged regardless of changes in the cost-driver. The per-unit variable cost remains unchanged regardless of changes in the cost-driver. Think of fixed costs on a total-cost basis. Think of fixed costs on a total-cost basis. Total fixed costs remain unchanged regardless of changes in the cost-driver. Total fixed costs remain unchanged regardless of changes in the cost-driver.

13. 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. 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. Even within the relevant range, a fixed cost remains fixed only over a given period of time. Usually the budget period.

14. Relevant Range....is a band of volume in which a specific relationship exists between cost and volume. Outside the relevant range, the cost either increases or decreases. A fixed cost is fixed only within a given relevant range and a given time span.

15. Fixed Costs and Relevant Range 20 40 60 80 100 20 40 60 80 100 115,000115,000 100,000 100,000 60,000 60,000 Total Cost-Driver Activity in Thousands of Cases per Month Total Monthly Fixed Costs Relevant range 115,000115,000 100,000 100,000 60,000 60,000 20 40 60 80 100 20 40 60 80 100

16. CVP Scenario Per Unit Percentage of Sales Per Unit Percentage of Sales Selling price ¢ 1.50100% Variable cost of each item 1.20 80 Selling price less variable cost ¢.30 20% Monthly fixed expenses: Rent ¢ 3,000 Rent ¢ 3,000 Wages for replenishing and Wages for replenishing and servicing 13,500 servicing 13,500 Other fixed expenses 1,500 Other fixed expenses 1,500 Total fixed expenses per month ¢ 18,000 Per Unit Percentage of Sales Per Unit Percentage of Sales Selling price ¢ 1.50100% Variable cost of each item 1.20 80 Selling price less variable cost ¢.30 20% Monthly fixed expenses: Rent ¢ 3,000 Rent ¢ 3,000 Wages for replenishing and Wages for replenishing and servicing 13,500 servicing 13,500 Other fixed expenses 1,500 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). Cost-volume-profit (CVP) analysis is the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit).

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

18. Break-Even Point Breakeven analysis is also known as cost- volume profit analysis Breakeven analysis is the study of the relationship between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of activity

19. Application Breakeven analysis can be used to determine a company’s breakeven point (BEP) Breakeven point is a level of activity at which the total revenue is equal to the total costs At this level, the company makes no profit

20. Assumption of breakeven point analysis Relevant range The relevant range is the range of an activity over which the fixed cost will remain fixed in total and the variable cost per unit will remain constant Fixed cost Total fixed cost are assumed to be constant in total Variable cost Total variable cost will increase with increasing number of units produced Sales revenue The total revenue will increase with the increasing number of units produced

21. Calculation method  Breakeven point  Target profit  Margin of safety  Changes in components of breakeven analysis

22. Breakeven point Contribution is defined as the excess of sales revenue over the variable costs The total contribution is equal to total fixed cost Contribution Margin Method

23. Formula Breakeven point = Fixed cost Contribution per unit Sales revenue at breakeven point = Breakeven point *selling price

24. Alternative method Sales revenue at breakeven point = Contribution required to breakeven Contribution to sales ratio Contribution per unit Selling price per unit Breakeven point in units Sales revenue at breakeven point Selling price =

25. Example Selling price per unit ¢ 12 Variable cost per unit ¢ 3 Fixed costs ¢ 45000 Required: Compute the breakeven point

26. Solution Breakeven point in units = Fixed costs Contribution per unit Contribution per unit = ¢ 45000 = ¢ 45000 ¢ 12- ¢ 3 ¢ 12- ¢ 3 = 5000 units = 5000 units Sales revenue at breakeven point = ¢ 12 * ¢ 5000 = ¢ 60000

27. Alternative method Contribution to sales ratio ¢9 / ¢12 *100% = 75% Sales revenue at breakeven point = Contribution required to break even = Contribution required to break even Contribution to sales ratio Contribution to sales ratio = ¢ 45000 = ¢ 45000 75% 75% = ¢ 60000 = ¢ 60000 Breakeven point in units = ¢ 60000/ ¢ 12 = 5000 units = 5000 units

28. Contribution Margin Method ¢ 18,000 fixed costs ÷ ¢.30 = 60,000 units (break even) ¢ 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 Per Unit Selling price ¢ 1.50 Variable costs 1.20 Contribution margin ¢.30 Contribution margin ratio Per Unit % Selling price100 Variable costs 80 Contribution margin 20 Contribution margin ratio Per Unit % Selling price100 Variable costs 80 Contribution margin 20

29. Contribution Margin Method ¢ 18,000 fixed costs ÷ 20% (contribution-margin percentage) = ¢ 90,000 of sales to break even ¢ 18,000 fixed costs ÷ 20% (contribution-margin percentage) = ¢ 90,000 of sales to break even 60,000 units × ¢ 1.50 = ¢ 90,000 in sales to break even 60,000 units × ¢ 1.50 = ¢ 90,000 in sales to break even

30. Equation Method Sales – variable expenses – fixed expenses = net income ¢ 1.50N – ¢ 1.20N – ¢ 18,000 = 0 ¢.30N = ¢ 18,000 N = ¢ 18,000 ÷ ¢.30 N = 60,000 Units Sales – variable expenses – fixed 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. Let N = number of units to be sold to break even.

31. Equation Method S –.80S – ¢ 18,000 = 0.20S = ¢ 18,000 S = ¢ 18,000 ÷.20 S = ¢ 90,000 S –.80S – ¢ 18,000 = 0.20S = ¢ 18,000 S = ¢ 18,000 ÷.20 S = ¢ 90,000 Let S = sales in Cedis needed to break even. Let S = sales in Cedis needed to break even. Shortcut formulas: Break-even volume in units = fixed expenses unit contribution margin unit contribution margin Break-even volume in sales = fixed expenses contribution margin ratio contribution margin ratio Shortcut formulas: Break-even volume in units = fixed expenses unit contribution margin unit contribution margin Break-even volume in sales = fixed expenses contribution margin ratio contribution margin ratio

32. Cost-Volume-Profit Graph 18,000 30,000 90,000 120,000 138,000 ¢ ¢ 150,000 0 102030405060708090100 Units (thousands) Cedis 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

33. Target profit

34. Target Net Profit Managers use CVP analysis to determine the total sales, in units and dollars, needed To reach a 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 target net income Target sales – variable expenses – fixed expenses target net income target net income Let’s assume ¢1,440 per month is the minimum acceptable net income. Let’s assume ¢1,440 per month is the minimum acceptable net income.

35. Target sales volume in units = (Fixed expenses + Target net income) ÷ Contribution margin per unit 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$.30 Selling price ¢ 1.50 Variable costs 1.20 Contribution margin per unit$.30 Target sales dollars = sales price X sales volume in units Target sales dollars = ¢ 1.50 X 64,800 units = ¢ 97,200. Target sales dollars = sales price X sales volume in units Target sales dollars = ¢ 1.50 X 64,800 units = ¢ 97,200.

36. Sales volume in dollars = 18,000 + ¢ 1,440 = ¢ 97,200 Sales volume in dollars = 18,000 + ¢ 1,440 = ¢ 97,200.20.20 Sales volume in dollars = 18,000 + ¢ 1,440 = ¢ 97,200 Sales volume in dollars = 18,000 + ¢ 1,440 = ¢ 97,200.20.20 Target Net Profit Target sales volume in dollars = Fixed expenses + target net income contribution margin ratio 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 Contribution margin ratio Per Unit % Selling price100 Variable costs.80 Contribution margin.20

37. Work this out Selling price per unit ¢ 12 Variable cost per unit ¢ 3 Fixed costs ¢ 45000 Target profit ¢ 18000 Required: Compute the sales volume required to achieve the target profit

38. Solution No. of units at target profit Fixed cost + Target profit Contribution per unit 45,000 + 18,000 12 - 3 = 7,000 units Required to sales revenue = 12 *7000 = 84,000

39. Alternative method Required sales revenue Fixed cost + Target profit Contribution to sales ratio 45000 + 18000 75% = 84000 Units sold at target profit = 84000 /12 = 7000 units

40. Operating Leverage Operating leverage: a firm’s ratio of fixed costs to variable costs. Margin of safety = planned unit sales – break-even sales How far can sales fall below the planned level before losses occur? Margin of safety = planned unit sales – break-even sales How far can sales fall below the planned level before losses occur? Highly leveraged firms have high fixed costs and low variable costs. A small change in sales volume = a large change in net income. Highly leveraged firms have high fixed costs and low variable costs. A small change in sales volume = a large change in net income. Low leveraged firms have lower fixed costs and higher variable costs. Changes in sales volume will have a smaller effect on net income. Low leveraged firms have lower fixed costs and higher variable costs. Changes in sales volume will have a smaller effect on net income.

41. Contribution Margin and Gross Margin Sales price – Cost of goods sold = Gross margin Sales price - all variable expenses = Contribution margin Per Unit Per Unit Selling price ¢ 1.50 Variable costs (acquisition cost) 1.20 Contribution margin and gross margin are equal ¢.30 gross margin are equal ¢.30

42. Contribution Margin and Gross Margin Contribution Gross Contribution Gross Margin Margin Margin Margin Per Unit Per Unit Per Unit Per Unit Sales ¢ 1.50 ¢ 1.50 Acquisition cost of unit sold1.20 1.20 Variable commission.12 Total variable expense ¢ 1.32 Contribution margin.18 Gross margin ¢.30 Contribution Gross Contribution Gross Margin Margin Margin Margin Per Unit Per Unit Per Unit Per Unit Sales ¢ 1.50 ¢ 1.50 Acquisition cost of unit sold1.20 1.20 Variable commission.12 Total variable expense ¢ 1.32 Contribution margin.18 Gross margin ¢.30 Suppose the firm had to pay a commission of ¢.12 per unit sold.

43. Nonprofit Application Suppose a city has a ¢ 100,000 lump-sum budget appropriation to conduct a counseling program. Suppose a city has a ¢ 100,000 lump-sum budget appropriation to conduct a counseling program. Variable costs per prescription is ¢ 400 per patient per day. Variable costs per prescription is ¢ 400 per patient per day. Fixed costs are ¢ 60,000 in the relevant range of 50 to 150 patients. Fixed costs are ¢ 60,000 in the relevant range of 50 to 150 patients.

44. If the city spends the entire budget appropriation, how many patients can it serve in a year? If the city spends the entire budget appropriation, how many patients can it serve in a year? ¢ 100,000 = ¢ 400N + ¢ 60,000 ¢ 400N = ¢ 100,000 – ¢ 60,000 N = ¢ 40,000 ÷ ¢ 400 N = 100 patients ¢ 100,000 = ¢ 400N + ¢ 60,000 ¢ 400N = ¢ 100,000 – ¢ 60,000 N = ¢ 40,000 ÷ ¢ 400 N = 100 patients Nonprofit Application

45. If the city cuts the total budget Appropriation by 10%, how many Patients can it serve in a year? If the city cuts the total budget Appropriation by 10%, how many Patients can it serve in a year? ¢ 90,000 = ¢ 400N + ¢ 60,000 ¢ 400N = ¢ 90,000 – ¢ 60,000 N = ¢ 30,000 ÷ ¢ 400 N = 75 patients ¢ 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 Budget after 10% Cut ¢ 100,000 X (1 -.1) = ¢ 90,000

46. Sales Mix Analysis Sales mix is the relative proportions or combinations of quantities of products that comprise total sales. Sales mix is the relative proportions or combinations of quantities of products that comprise total sales.

47. Sales Mix Analysis Padus Company Example Sales in units 300,000 75,000 375,000 Sales @ ¢ 8 and ¢ 5 ¢ 2,400,000 ¢ 375,000 ¢ 2,775,000 Variable expenses @ ¢ 7 and ¢ 3 2,100,000 225,000 2,325,000 @ ¢ 7 and ¢ 3 2,100,000 225,000 2,325,000 Contribution margins @ $1 and $2 ¢ 300,000 ¢ 150,000 ¢ 450,000 @ $1 and $2 ¢ 300,000 ¢ 150,000 ¢ 450,000 Fixed expenses 180,000 Net income ¢ 270,000 Sales in units 300,000 75,000 375,000 Sales @ ¢ 8 and ¢ 5 ¢ 2,400,000 ¢ 375,000 ¢ 2,775,000 Variable expenses @ ¢ 7 and ¢ 3 2,100,000 225,000 2,325,000 @ ¢ 7 and ¢ 3 2,100,000 225,000 2,325,000 Contribution margins @ $1 and $2 ¢ 300,000 ¢ 150,000 ¢ 450,000 @ $1 and $2 ¢ 300,000 ¢ 150,000 ¢ 450,000 Fixed expenses 180,000 Net income ¢ 270,000 Wallets(W) Key Cases (K)Total

48. Sales Mix Analysis Break-even point for a constant sales mix of 4 units of W for every unit of K. sales – variable expenses - fixed expenses = zero net income [ ¢ 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 Break-even point for a constant sales mix of 4 units of W for every unit of K. sales – variable expenses - fixed expenses = zero net income [ ¢ 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 Let K = number of units of K to break even, and 4K = number of units of W to break even. Let K = number of units of K to break even, and 4K = number of units of W to break even.

49. Sales Mix Analysis If the company sells only key cases: break-even point = fixed expenses contribution margin per unit = ¢ 180,000 = ¢ 180,000 ¢ 2 ¢ 2 = 90,000 key cases = 90,000 key cases If the company sells only key cases: break-even point = fixed expenses contribution margin per unit = ¢ 180,000 = ¢ 180,000 ¢ 2 ¢ 2 = 90,000 key cases = 90,000 key cases If the company sells only wallets: break-even point = fixed expenses contribution margin per unit = ¢ 180,000 = ¢ 180,000 ¢ 1 ¢ 1 = 180,000 wallets = 180,000 wallets If the company sells only wallets: break-even point = fixed expenses contribution margin per unit = ¢ 180,000 = ¢ 180,000 ¢ 1 ¢ 1 = 180,000 wallets = 180,000 wallets

50. Sales Mix Analysis Suppose total sales were equal to the budget of 375,000 units. Suppose total sales were equal to the budget of 375,000 units. However, Padus sold only 50,000 key cases And 325,000 wallets. What is net income? However, Padus sold only 50,000 key cases And 325,000 wallets. What is net income?

51. Sales Mix Analysis Padus Company Example Sales in units 325,000 50,000 375,000 Sales @ ¢ 8 and ¢ 5 2,600,000 250,000 2,850,000 Variable expenses @ ¢ 7 and ¢ 3 2,275,000 150,000 2,425,000 @ ¢ 7 and ¢ 3 2,275,000 150,000 2,425,000 Contribution margins @ ¢ 1 and ¢ 2 325,000 100,000 425,000 @ ¢ 1 and ¢ 2 325,000 100,000 425,000 Fixed expenses 180,000 Net income 245,000 Sales in units 325,000 50,000 375,000 Sales @ ¢ 8 and ¢ 5 2,600,000 250,000 2,850,000 Variable expenses @ ¢ 7 and ¢ 3 2,275,000 150,000 2,425,000 @ ¢ 7 and ¢ 3 2,275,000 150,000 2,425,000 Contribution margins @ ¢ 1 and ¢ 2 325,000 100,000 425,000 @ ¢ 1 and ¢ 2 325,000 100,000 425,000 Fixed expenses 180,000 Net income 245,000 Wallets(W) Key Cases (K)Total

52. Impact of Income Taxes Suppose that a company earns ¢ 480 before taxes and pays income tax at a rate of 40%. Suppose that a company earns ¢ 480 before taxes and pays income tax at a rate of 40%. What is the after-tax income?

53. Impact of Income Taxes Target income before taxes = Target after-tax net income 1 – tax rate 1 – tax rate Target income before taxes = ¢ 288 = ¢ 480 1 – 0.40 1 – 0.40 Suppose the target net income after taxes was ¢ 288.

54. Impact of Income Taxes Target sales – Variable expenses – Fixed expenses = Target after-tax net income ÷ (1 – tax rate) Target sales – Variable expenses – Fixed expenses = Target after-tax net income ÷ (1 – tax rate) ¢.50N – ¢.40N – ¢ 6,000 = ¢ 288 ÷ (1 – 0.40) ¢.10N = ¢ 6,000 + ( ¢ 288/.6) ¢.06N = ¢ 3,600 + ¢ 288 = ¢ 3,888 N = ¢ 3,888/$.06 N = 64,800 units ¢.50N – ¢.40N – ¢ 6,000 = ¢ 288 ÷ (1 – 0.40) ¢.10N = ¢ 6,000 + ( ¢ 288/.6) ¢.06N = ¢ 3,600 + ¢ 288 = ¢ 3,888 N = ¢ 3,888/$.06 N = 64,800 units

55. Impact of Income Taxes Suppose target net income after taxes was ¢ 480 ¢.50N – ¢.40N – ¢ 6,000 = ¢ 480 ÷ (1 – 0.40) ¢.10N = ¢ 6,000 + ( ¢ 480/.6) ¢.06N = ¢ 3,600 + $ ¢ = ¢ 4080 N = ¢ 4,080 ÷ ¢.06 N = 68,000 units ¢.50N – ¢.40N – ¢ 6,000 = ¢ 480 ÷ (1 – 0.40) ¢.10N = ¢ 6,000 + ( ¢ 480/.6) ¢.06N = ¢ 3,600 + $ ¢ = ¢ 4080 N = ¢ 4,080 ÷ ¢.06 N = 68,000 units

56. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 55 55 Margin of safety

57. 56 Margin of safety Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss. This can be expressed as a number of units or a percentage of sales

58. 57 Formula Margin of safety% = Margin of safety Budget sales level *100% Margin of safety = Budget sales level – breakeven sales level

59. 58 Sales revenue Total Cost/Revenue $ Sales (units) Total cost Profit BEP Margin of safety

60. 59 Example The breakeven sales level is at 5000 units. The company sets the target profit at $18000 and the budget sales level at 7000 units Required: Calculate the margin of safety in units and express it as a percentage of the budgeted sales revenue

61. 60 Margin of safety = Budget sales level – breakeven sales level = 7000 units – 5000 units = 2000 units Margin of safety% = Margin of safety Budget sales level = 2000 7000 = 28.6% *100 % The margin of safety indicates that the actual sales can fall by 2000 units or 28.6% from the budgeted level before losses are incurred. *100 %

62. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 61 61 Changes in components of breakeven point

63. 62 Example Selling price per unit$12 Variable price per unit$3 Fixed costs$45000 Current profit$18000

64. 63 If the selling prices is raised from $12 to $13, the minimum volume of sales required to maintain the current profit will be: Fixed cost + Target profit Contribution to sales ratio = $45000 + $18000 $13 - $3 = 6300 units

65. 64 If the fixed cost fall by $5000 but the variable costs rise to $4 per unit, the minimum volume of sales required to maintain the current profit will be: Fixed cost + Target profit Contribution to sales ratio = $40000 + $18000 $12 - $4 = 7,250 units

66. **More Costing At a production level of 5,400 units, a project has total costs of $112,500. At a production level of 5,400 units, a project has total costs of $112,500. The variable cost per unit is $9.62. Assume the firm can increase production by 1,000 units without increasing its fixed costs. What will the total costs be if 5,900 units are produced? What will the total costs be if 5,900 units are produced? Production Level1 5,400 Total Cost1 112,500 Variable cost per unit 9.62 Production Level2 5,900 Total Cost = [Total Cost1 - (variable cost * PDL1)] + (PDL2 * Variable cost)] 117,310 117,310

67. ** More Break-even The Coffee Express has computed its fixed costs to be $0.46 for every cup of coffee it sells given annual sales of 332,440 cups. The sales price is $1.89 per cup while the variable cost per cup is $0.81. How many cups of coffee must it sell to break-even on a cash basis? How many cups of coffee must it sell to break-even on a cash basis? Fixed Cost 0.46Sales332,440 Sale Price 1.89 Variable Cost 0.81 Profit Margin 0.62 Qcash Break-even Fixed Cost * Sales Sale price - Variable Cost 141,595 141,595

68. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 67 67 Limitation of breakeven point

69. 68 Limitations of breakeven analysis Breakeven analysis assumes that fixed cost, variable costs and sales revenue behave in linear manner. However, some overhead costs may be stepped in nature. The straight sales revenue line and total cost line tent to curve beyond certain level of production

70. 69 It is assumed that all production is sold. The breakeven chart does not take the changes in stock level into account Breakeven analysis can provide information for small and relatively simple companies that produce same product. It is not useful for the companies producing multiple products