1. Chapter 11 Cost Behavior and Cost-Volume-Profit Analysis

2. Cost Behavior Refers to the manner in which a cost changes as a related activity changes. Can be variable, fixed, or mixed.

3. The Activity Base/Cost Driver A measure of what causes the incurrence of a variable cost Units produced Miles driven Labor hours Machine hours

4. Variable Costs Total Variable Cost Graph Total Costs $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 102030 0 Unit Variable Cost Graph $20 $15 $10 $5 0 Cost per Unit 102030 5,000 $ 50,000 $10 10,000 100,000 10 15,000 150,000 10 20,000 200,000 10 25,000 250,000 10 30,000 300,000 10 Units Total Cost Produced Cost per Unit Units Produced (000)

5. Fixed Costs Total Fixed Cost Graph Total Costs 0 Unit Fixed Cost Graph Cost per Unit 50,000 $75,000 $1.500 100,000 75,000.750 150,000 75,000.500 200,000 75,000.375 250,000 75,000.300 300,000 75,000.250 Units Total Cost Produced Cost per Unit $150,000 $125,000 $100,000 $75,000 $50,000 $25,000 100200300 $1.50 $1.25 $1.00 $.75 $.50 $.25 100200300 0 Units Produced (000)

6. Examples Advertising and Research and Development Examples Advertising and Research and Development Examples Depreciation on Equipment and Real Estate Taxes Examples Depreciation on Equipment and Real Estate Taxes Types of Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be significantly reduced in the short term. Committed Long-term, cannot be significantly reduced in the short term.

7. Quick Check Which of the following statements about cost behavior are true? 1.Fixed costs per unit vary with the level of activity. 2.Variable costs per unit are constant within the relevant range. 3.Total fixed costs are constant within the relevant range. 4.Total variable costs are constant within the relevant range. Which of the following statements about cost behavior are true? 1.Fixed costs per unit vary with the level of activity. 2.Variable costs per unit are constant within the relevant range. 3.Total fixed costs are constant within the relevant range. 4.Total variable costs are constant within the relevant range.

8. Problem: Fixed or Variable Hamburger buns in McDonald’s restaurant Advertising by a dental office Apples processed and canned by Del Monte Shipping apples from Del Monte plant to customers Insurance on a Bausch and Lomb factory producing contact lenses

9. Problem: Continued Insurance on IBM’s corporate headquarters Salary of supervisor overseeing production of circuit boards at HP Commissions paid to Encyclopedia Brit salespeople Depreciation of factory lunchroom facilities at GE plant Steering wheels installed in BMWs

10. Cost Behavior Patterns Example Bicycles by the Sea incurs variable costs of $52 for each of its bicycles. Bicycles by the Sea also incurs $94,500 in fixed costs per year

11. Total Costs and Unit Costs Example What is the unit cost when Bicycles assembles 1,000 bicycles in a year?

12. Use Unit Costs Cautiously Assume that Bicycles management uses a unit cost of $146.50 Management is budgeting costs for different levels of production. What is their budgeted cost for an estimated production of 600 bicycles? 600 × $146.50 = $87,900?

13. Use Unit Costs Cautiously What is their budgeted cost for an estimated production of 3,500 bicycles? 3,500 × $146.50 = $512,750?

14. Fixed Charge Variable Cost per Mile Activity (Miles Driven) Total Cost X Y A mixed cost has both fixed and variable components. Consider the example of renting a car. Mixed Costs Total mixed cost

15. Fixed Charge Variable Cost per Mile Activity (Miles Driven) Total Cost X Y Mixed Costs Total mixed cost

16. Mixed Costs Example If your fixed daily rental charge is $40, your variable cost is $0.20 per mile, and your activity level is 100 miles, what is the amount of your rental cost? Y = a + bX Y = $40 + ($0.20 × 100) Y = $60

17. The High-Low Method Cost and Activity Data for Six Months 1.Estimate the fixed and variable components of the maintenance costs as a function of the maintenance hours using the high-low method. 2.Determine the cost formula. 3.What would maintenance costs be if 600 maintenance hours are worked?

18. The Contribution Format Used primarily for external reporting. Used primarily by management.

19. Micro Wave Corporation Contribution Format Income Statement for June

20. Pop Quiz Tasty Bagel is a snack shop in a strip mall. The average selling price of a bagel is $1.49 and the average variable expense per bagel is $0.36. The average fixed expense per month is $1,300. 2,100 bagels are sold each month on average. What is the CM Ratio for Tasty Bagel? a. 1.319 b. 0.758 c. 0.242 d. 4.139

21. Practice… (a) (b) (c) (d) (e) (f) Per Unit Var. Cost Total Operating Selling Per Units CM Fixed Income Price Unit Sold Costs $30 120,000 $720,000 $640,000 $10 $6 100,000 $320,000 $9 80,000 $160,000 $120,000

22. Contribution Margin Method to Determine Break-even The contribution margin method is a variation of the equation method. Fixed expenses Unit contribution margin = Break-even point in units sold

23. Pop Quiz Tasty Bagel is a snack shop in a strip mall. The average selling price of a bagel is $1.49 and the average variable expense per bagel is $0.36. The average fixed expense per month is $1,300. 2,100 bagels are sold each month on average. What is the break-even sales in units? a. 872 bagels b. 3,611 bagels c. 1,200 bagels d. 1,150 bagels

24. CVP Graph Fixed expenses Units Dollars Total ExpensesTotal Sales

25. Units Dollars CVP Graph Break-even point Profit Area Loss Area

26. Break-even Reduction Micro is currently selling 500 ovens per month. Break-even units are 400 per month under the current cost structure. What would be the break-even units if fixed costs decrease to $70,000? What would be the break-even units if variable costs were reduced to $250? What would be the break-even units if selling price was increased to $513.33?

27. Sensitivity Analysis – Fixed Costs Micro Wave Co. is currently selling 500 ovens per month The sales manager believes that an increase of $10,000 in the monthly advertising budget would increase sales of ovens to 540 per month Should the increase in advertising be made?

28. Change in Variable Costs and Sales Volume Micro Wave management is contemplating the use of higher-quality components, which would increase variable costs by $15 per oven. However, the sales manager predicts that the overall higher quality would increase sales to 600 ovens per month. Should the higher quality components be used?

29. Change in Fixed Cost, Sales Price, and Sales Volume To increase sales, the sales manager would like to cut the selling price by $40 per oven and increase the advertising budget by $30,000 per month. The sales manager believes that if these two steps are taken, unit sales will increase by 60% to 800 ovens per month. Should the changes be made?

30. Target Operating Profit - CM Approach Original contribution margin formula: Target operating profit modification: Units Sold to Earn Target Profit = Fixed Expenses +Target Op. Profit Contribution Margin per Unit Break Even Point in Units = Fixed Expenses Contribution Margin per Unit

31. Pop Quiz Tasty Bagel is a snack shop in a strip mall. The average selling price of a bagel is $1.49 and the average variable expense per bagel is $0.36. The average fixed expense per month is $1,300. How many bagels would have to be sold to attain target profits of $2,500 per month? a. 3,363 bagels b. 2,212 bagels c. 1,150 bagels d. 4,200 bagels

32. The Margin of Safety Excess of actual sales over the break-even volume of sales. The amount by which sales can drop before losses begin to be incurred. Margin of safety = Total sales - Break-even sales Let’s calculate the margin of safety for Micro

33. Pop Quiz Tasty Bagel is a snack shop in a strip mall. The average selling price of a bagel is $1.49 and the average variable expense per bagel is $0.36. The average fixed expense per month is $1,300. 2,100 bagels are sold each month on average. What is the margin of safety? a. 3,250 bagels b. 950 bagels c. 1,150 bagels d. 2,100 bagels

34. Cost Structure and Profitability AlphaBetaGamma Amount% % % Sales$800,000100%$800,000100%$800,000100% Variable Expenses 400,000 50% 300,00037.5% 200,000 25% Contribution Margin 400,000 50% 500,000 62.5% 600,000 75% Fixed Expenses 300,000 400,000 500,000 Op. Income $ 100,000

35. Effect on Profit of 10% Increase in Sales Revenue Increase in Sales Revenue Contribution Margin Ratio Increase in Op.Income Alpha$80,000 X 50% = $40,000 +40% Beta$80,000 X 62.5% = $50,000 +50% Gamma$80,000 X 75% = $60,000 +60%

36. Definition of Operating Leverage  The relative mix of a firm’s fixed and variable costs determines its operating leverage.  At a given level of sales: Operating leverage = Contribution Margin factor Operating Income  Operating leverage is greatest in firm’s that have a high proportion of fixed costs in relation to variable costs.  Let’s calculate the operating leverage for each firm.

37. Application of Operating Leverage  At a given level of sales, the operating leverage is a measure of how a given percentage change in sales will affect operating profits.  In fact, the operating profit will increase by the operating leverage times the percentage change in sales.  For a 10% increase in sales, Firm Alpha’s operating income increased 40% (4 times 10%).  For a 10% increase in sales, Firm Beta’s operating income increased 50% (5 times 10%).  For a 10% increase in sales, Firm Gamma’s operating income increased 60% (6 times 10%).

38. Pop Quiz Tasty Bagel is an snack shop in a strip mall. The average selling price of a bagel is $1.49 and the average variable expense per bagel is $0.36. The average fixed expense per month is $1,300. 2,100 bagels are sold each month on average. What is the operating leverage? a. 2.21 b. 0.45 c. 0.34 d. 2.92

39. Pop Quiz At Tasty Bagel the average selling price of a bagel is $1.49, the average variable expense per bagel is $0.36, and the average fixed expense per month is $1,300. 2,100 bagels are sold each month on average. If sales increase by 20%, by how much should operating income increase? a. 30.0% b. 20.0% c. 22.1% d. 44.2%

40. Break-even Analysis (in Units) with Multiple Products Curl Company provides us with the following information: Fixed cost is $120,000. What is the break-even point in units? What are the sales of Surfboards and Sailboards at the break-even point?

41. Mark Corporation produces two models of calculators. The Business model sells for $60, and the Math model sells for $40. The variable expenses are given below: BusinessMath Model Variable production costs per unit $15$16 Variable selling and administrative expenses per unit $9$6 The fixed expenses are $75,000 per month. The expected monthly sales of each model are: Business, 1,000 units; Math, 500 units. The break-even point for the expected sales mix is (round to nearest whole unit): A)833 of each B)1,667 Business and 833 Math C)1,667 of each D)833 Business and 1,667 Math POP QUIZ

42. Assumptions Underlying CVP Analysis Selling price is constant throughout the entire relevant range Costs are linear over the relevant range (costs can be divided into variable and fixed) In multi-product companies, the sales mix is constant In manufacturing firms, inventories do not change (units produced = units sold)