Introduction To Cost Behavior and Cost-Volume Relationships (Horngrenima14e - ch02)

Introduction to Management Accounting
Chapter 2
Introduction to Cost Behavior and Cost-Volume Relationships
2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 2 - 1
Learning Objective 1
Cost Drivers and Cost Behavior

Activity-Based View of Cost Behavior
Resource A Cost Driver = Units of Resource Output Resource B Cost Driver = Units of Resource Output
Traditional View of Cost Behavior

Resource A Cost Driver = Units of Resource Output Resource B Cost Driver = Units of Resource Output
Activity A Cost Driver = Units of Activity Output
Activity B Cost Driver = Units of Activity Output
Product or Service Cost Driver = Units of Final Product or Service
Product or Service Cost Driver = Output of Final Product or Service
Cost Drivers and Cost Behavior

Any output measure that causes the use of costly resources is a cost driver. Cost behavior is how the activities of an organization affect its costs.
Value Chain Functions, Costs, and Cost Drivers

Value Chain Function and Example Costs Example Cost Drivers Number of new product proposals Complexity of proposed products
Research and development

Salaries marketing research personnel costs of market surveys Salaries of product and process engineers Design of products, services, and processes Salaries of product and process engineers Cost of computer-aided design equipment Cost to develop prototype of product for testing Number of engineering hours Number of parts per product

Value Chain Function and Example Costs Production Labor wages Supervisory salaries Maintenance wages Depreciation of plant and machinery supplies Energy cost Marketing Cost of advertisements Salaries of marketing personnel, travel costs, entertainment costs Example Cost Drivers Labor hours Number of people supervised Number of mechanic hours Number of machine hours Kilowatt hours
Number of advertisements Sales dollars
Value chain function and Example costs Distribution Wages of shipping personnel Transportation costs including depreciation of vehicles and fuel
Customer service Salaries of service personnel products Costs of supplies, travel
Example Cost Drivers

Labor hours Weight of items delivered
Hours spent servicing
Number of service calls
Variable and Fixed Cost Behavior

A fixed cost is not immediately affected by changes in the cost-driver. Think of fixed costs on a total-cost basis.
A variable cost changes in direct proportion to 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.
Total fixed costs remain unchanged regardless of changes in the cost-driver.
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.
Fixed Costs and Relevant Range

$115,000 100,000 60,000 20 $115,000 100,000 60,000 20 40 60 80 Total Cost-Driver Activity in Thousands of Cases per Month 100 40 60 80 100
Total Monthly Fixed Costs
Relevant range
CVP Scenario
Cost-volume-profit (CVP) analysis is the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit). Per Unit $1.50 1.20 $ .30 Percentage of Sales 100% 80 20%
Selling price Variable cost of each item Selling price less variable cost Monthly fixed expenses: Rent Wages for replenishing and servicing Other fixed expenses Total fixed expenses per month
$3,000 13,500 1,500 $ 18,000
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)
Contribution Margin Method

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
$18,000 fixed costs $.30 = 60,000 units (break even)
Contribution Margin Method
60,000 units $1.50 = $90,000 in sales to break even
$18,000 fixed costs 20% (contribution-margin percentage) = $90,000 of sales to break even
Equation Method
Let N = number of units to be sold to break even.
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
Equation Method
Let S = sales in dollars needed to break even. S .80S $18,000 = 0 .20S = $18,000 S = $18,000 .20 S = $90,000 Shortcut formulas: Break-even volume in units = fixed expenses unit contribution margin Break-even volume in sales = fixed expenses contribution margin ratio
Cost-Volume-Profit Graph
$150,000 138,000 120,000 Dollars Net Income Area

D
A Net Income
Sales
90,000
60,000 30,000 18,000 0
B
Total Expenses
Net Loss Area
Break-Even Point 60,000 units or $90,000
Variable Expenses
Fixed Expenses 10 20 30 40 50 60 70 80 90 100
Units (thousands)
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.
Target Net Profit

Target sales volume in units = (Fixed expenses + Target net income) Contribution margin per unit Selling price $1.50 Variable costs 1.20 Contribution margin per unit $ .30 ($18,000 + $1,440) $.30 = 64,800 units Target sales dollars = sales price X sales volume in units Target sales dollars = $1.50 X 64,800 units = $97,200.
Target Net Profit

Contribution margin ratio Per Unit % Selling price 100 Variable costs .80 Contribution margin .20 Target sales volume in dollars = Fixed expenses + target net income contribution margin ratio Sales volume in dollars = 18,000 + $1,440 = $97,200 .20
Operating Leverage
Operating leverage: a firms 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.
Low leveraged firms have lower fixed costs and higher variable costs. Changes in sales volume will have a smaller effect on net income. Margin of safety = planned unit sales break-even sales How far can sales fall below the planned level before losses occur?
Contribution Margin and Gross Margin

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

Suppose the firm had to pay a commission of $.12 per unit sold. Contribution Margin Per Unit $1.50 1.20 .12 $1.32 .18 $.30 Gross Margin Per Unit $1.50 1.20
Sales Acquisition cost of unit sold Variable commission Total variable expense Contribution margin Gross margin
Nonprofit Application
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. Fixed costs are $60,000 in the relevant range of 50 to 150 patients.
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
If the city cuts the total budget Appropriation by 10%, how many Patients can it serve in a year?
Budget after 10% Cut $100,000 X (1 - .1) = $90,000

$90,000 = $400N + $60,000 $400N = $90,000 $60,000 N = $30,000 $400 N = 75 patients
Sales Mix Analysis
Sales mix is the relative proportions or combinations of quantities of products that comprise total sales.
Sales Mix Analysis

Ramos Company Example
Wallets (W)
Sales in units Sales @ $8 and $5 Variable expenses @ $7 and $3 Contribution margins @ $1 and $2 Fixed expenses Net income 300,000 $2,400,000 2,100,000 $ 300,000
Key Cases (K)

75,000 $375,000 225,000 $150,000
Total 375,000 $2,775,000 2,325,000 $ 450,000 180,000 $ 270,000
Sales Mix Analysis

Let K = number of units of K to break even, and 4K = number of units of W to break even. 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
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
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?
Sales Mix Analysis

Ramos Company Example
Wallets (W)
Sales in units Sales @ $8 and $5 Variable expenses @ $7 and $3 Contribution margins @ $1 and $2 Fixed expenses Net income
Key Cases (K)
Total 375,000 $2,850,000 2,425,000
325,000 50,000 $2,600,000 $250,000 2,275,000 150,000
$ 325,000 $100,000
$ 425,000 180,000 $ 245,000
Impact of Income Taxes
Suppose that a company earns $480 before taxes and pays income tax at a rate of 40%.
What is the after-tax income?

Target income before taxes = Target after-tax net income 1 tax rate Suppose the target net income after taxes was $288. Target income before taxes = $ 288 = $480 1 0.40

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
Suppose target net income after taxes was $480
$.50N $.40N $6,000 = $480 (1 0.40) $.10N = $6,000 + ($480/.6) $.06N = $3,600 + $480 = $4080 N = $4,080 $.06 N = 68,000 units
The End
End of Chapter 2

Introduction To Cost Behavior and Cost-Volume Relationships (Horngrenima14e - ch02)

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Introduction To Cost Behavior and Cost-Volume Relationships (Horngrenima14e - ch02)

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Introduction to Management Accounting

Introduction to Cost Behavior and Cost-Volume Relationships

Cost Drivers and Cost Behavior

Traditional View of Cost Behavior

Activity A Cost Driver = Units of Activity Output

Activity B Cost Driver = Units of Activity Output

Product or Service Cost Driver = Units of Final Product or Service

Product or Service Cost Driver = Output of Final Product or Service

Cost Drivers and Cost Behavior

Value Chain Functions, Costs, and Cost Drivers

Research and development

Value Chain Functions, Costs, and Cost Drivers

Number of advertisements Sales dollars

Value Chain Functions, Costs, and Cost Drivers

Example Cost Drivers

Hours spent servicing

Number of service calls

Variable and Fixed Cost Behavior

Total fixed costs remain unchanged regardless of changes in the cost-driver.

Fixed Costs and Relevant Range

Total Monthly Fixed Costs

$3,000 13,500 1,500 $ 18,000

Contribution Margin Method

$18,000 fixed costs $.30 = 60,000 units (break even)

Contribution Margin Method

60,000 units $1.50 = $90,000 in sales to break even

Let N = number of units to be sold to break even.

$150,000 138,000 120,000 Dollars Net Income Area

Net Loss Area

Break-Even Point 60,000 units or $90,000

Fixed Expenses 10 20 30 40 50 60 70 80 90 100

Target Net Profit

Target sales variable expenses fixed expenses target net income

$1,440 per month is the minimum acceptable net income.

Target Net Profit

Target Net Profit

Contribution Margin and Gross Margin

Sales price - all variable expenses = Contribution margin

Per Unit $1.50 1.20

Contribution Margin and Gross Margin

Budget after 10% Cut $100,000 X (1 - .1) = $90,000

Sales Mix Analysis

Sales Mix Analysis

Key Cases (K)

Total 375,000 $2,775,000 2,325,000 $ 450,000 180,000 $ 270,000

Sales Mix Analysis

Sales Mix Analysis

Sales Mix Analysis

Sales Mix Analysis

Key Cases (K)

Total 375,000 $2,850,000 2,425,000

325,000 50,000 $2,600,000 $250,000 2,275,000 150,000

$ 425,000 180,000 $ 245,000

Impact of Income Taxes

What is the after-tax income?

Impact of Income Taxes

Impact of Income Taxes

Impact of Income Taxes

Suppose target net income after taxes was $480

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