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CHAPTER 2: COST BEHAVIOR AND COST-VOLUME-PROFIT ANALYSIS

Pham Thi Ngoc Bich UEH

INTRODUCTION
Today we will focus on gaining an understanding of how . . .

Costs Volume, and Profits

Interact

Dr. Fred Barbee

ACCT 202 - UAA - Fall 2004

LECTURE OUTLINE

Important of Cost behavior in Business Activity cost behavior model Separating mixed costs Managerial judgment Cost-Volume-Profit (CVP)analysis Contribution margin and its measures Break-event analysis Applying CVP analysis

Computing income from sales and costs Computing sales for target income Computing margin of safety Using sensitivity analysis Computing multiple-product break-event

Assumptions in CVP analysis

IMPORTANT OF COST BEHAVIOR IN BUSINESS


Understanding

cost behavior help managers

to:

Predict future conditions (planning); and Explain, evaluate, and act on past results (control)

IMPORTANT OF COST BEHAVIOR IN BUSINESS


Setting Sales Prices Entering new markets Introducing new products Buying/Replacing Equipment Make-or-Buy decisions

ACTIVITY COST BEHAVIOUR MODEL


Inputs: Materials Energy
Activities Activity Output

Labour
Capital

Cost Behaviour

Changes in Input Cost

Changes in Output

COST BEHAVIOR
Cost

behavior is a general term for describing whether a cost changes when the level of output changes. Cost behavior patterns:

Fixed costs
Variable costs Mixed costs (Semi-variable costs)

Step costs (Step-fixed costs)

FIXED AND VARIABLE COSTS


Fixed

costs

Remains unchanged in total within a relevant range as the level of output varies
As activity increases, total fixed costs do not change, but unit fixed cost declines

Variable

costs

Change in total in direct proportion to a change in output

As activity increases, total variable costs increase, but unit variable cost do not change
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Notes: The relevant range is the limit of output level within which a specific relationship between costs and the cost driver is valid.

FIXED COSTS

& RELEVANT RANGE

Example: Office space is available at a rental rate of $30,000 per year in increments of 1,000 square feet. As the business grows more space is rented, increasing the total cost.
Cotinue

VARIABLE COST

FIXED AND VARIABLE COSTS: EXAMPLES


Numbers of units Cost per Unit Total costs

1 10
100 200

$30 $30
$30 $30

$30 $300
$3,000 $6,000

Numbers of units 1 10 100 200

Monthly cost $9,000 $9,000 $9,000 $9,000

Cost per unit $9,000 $900 $90 $45

FIXED COST

FIXED AND VARIABLE COSTS


$

Volume

Volume

MIXED COSTS (SEMI-VARIABLE COSTS)


Mixed cost includes both fixed and variable cost components (compensation for sales representatives) The formula for mixed costs is:

Total cost = total fixed cost + total variable cost Y = a + bX


Where Y = total cost a = fixed cost component (the intercept on the vertical axis) b = variable cost per unit of activity (the slope of the line) X = the level of activity

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MIXED-COSTS
Linearity Assumption $ Total Costs

Fixed Costs

Variable Costs

Volume

Total cost = Fixed cost + Total variable cost

STEP-FIXED COSTS (STEP COSTS)


A step cost displays a constant level of cost for a range of output and then jumps to a higher level of cost at some point, where it remains for a similar range of output. The width of step defines the range of output for which a particular amount of the resource applies. Many so-called fixed costs may be, in reality, step costs.

STEP-FIXED COSTS (STEP COSTS)

Step Costs are constant within a range of activity.

$
But different between ranges of activity Volume

SEPARATING MIXED COSTS

Why we need to separate mixed costs into fixed and variable components?
Accounting records typically show the total costs and the associated amount of output of a mixed cost item. E.g. the total cost of maintenance and the number of maintenance hours provided during a given period of time.

Methods for Separating Mixed Costs

The High-Low Method

The Scatterplot Method


The Method of Least Squares

SEPARATING MIXED COSTS


A scatter plot can be useful in allowing us to plot the data points to visualise the relationship between cost and the level of output The high-low method involves taking the two observations with the highest and lowest level of output to calculate the cost function Regression analysis is a statistical technique that uses all observations to determine the cost function

Total Costs

VC Per Unit (Slope)

Fixed Cost (Intercept)

Level of Output

THE SCATTERGRAPH METHOD


Y Total Cost in 1,000s of Dollars 20 Plot the data points on a graph (total cost vs. output).

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* * * *

* ** * **
X

0 1 2 3 4 Activity, 1,000s of Units Produced

QUICK-AND-DIRTY METHOD
Draw a line through the data points with about an equal numbers of points above and below the line. Y 20

Total Cost in 1,000s of Dollars

10

* * * * Intercept is the estimated


fixed cost = $10,000

* ** * **
X

0 1 2 3 4 Activity, 1,000s of Units Produced

QUICK-AND-DIRTY METHOD
The slope is the estimated variable cost per unit. Slope = Change in cost Change in units Y

Total Cost in 1,000s of Dollars

20

10

* * * * Horizontal
distance is the change in activity.

* ** * **
Vertical distance is the change in cost.

0 1 2 3 4 Activity, 1,000s of Units Produced

ADVANTAGES
One

of the principal advantages of this method is that it lets us see the data.

Brentline Hospital Patient Data

Month

January February March April May June July

Activity Level: Patient Days 5,600 7,100 5,000 6,500 7,300 8,000 6,200
Textbook Example

Maintenance Cost Incurred $7,900 8,500 7,400 8,200 9,100 9,800 7,800

Brentline Hospital Patient Data


12000

10000

Maintenance Cost

8000

6000

4000

2000

y = 0.7589x + 3430.9
0 0 2000 4000 6000 8000 10000 Patient-Days

HIGH-LOW METHOD
A

non-statistical method whereby we examine two points out of a set of data . . .


The

high point (the point with highest output level); and low point (the point with lowest output level)

The

HIGH-LOW METHOD
Using

these two points, we determine the equation for that line . . .


The
The

intercept; and
Slope parameters

4 STEPS IN HIGH-LOW METHOD


Step Step

1: Find the high point and low point for a given data set 2: Calculate the variable rate (V) or slope
V
V

Change in cost / Change in output

= (High cost - Low cost) / (High output - Low output)

Step

3: Calculate the fixed cost using the variable rate and either the high point or low point the cost formula

Form

Brentline Hospital Patient Data

Month

January February March April May June July

Activity Level: Patient Days 5,600 7,100 5,000 6,500 7,300 8,000 6,200
Textbook Example

Maintenance Cost Incurred $7,900 8,500 7,400 8,200 9,100 9,800 7,800

Change in Cost V = -----------------Change in Activity

$2,400 V = -----------3,000
= $0.80 Per Unit

Total Cost (TC) = FC + VC FC = TC - VC

FC = $9,800 - (8,000 x $0.80) = $3,400

FC = $7,400 - (5,000 x $0.80) = $3,400

TC = $3,400 + $0.80X

SOME IMPORTANT CONSIDERATIONS


We

have used historical cost to arrive at the cost equation. we have to be careful in how we use the formula. forget the relevant range.

Therefore,

Never

STRENGTHS OF HIGH-LOW METHOD


Simple Easy

to use

to understand

WEAKNESSES OF HIGH-LOW
Only

two data points are used in the analysis. be problematic if either (or both) high or low are extreme (i.e., Outliers).

Can

Other

months may not yield the same formula.

WEAKNESSES OF HIGH-LOW
Other

months may not yield the same formula.

FC = $8,500 - (7,100 x $0.80) = $2,820

REGRESSION ANALYSIS (LEAST SQUARE ANALYSIS) READ MORE IN TEXTBOOK


A

statistical technique used to separate mixed costs into fixed and variable components.

All

observations are used to fit a regression line which represents the average of all data points.

Method

Fixed Cost

Variable Cost

High-Low

$3,400

$0.80

Scattergraph

$3,300

$0.79

Regression

$3,431

$0.76

COST BEHAVIOR AND MANAGERIAL JUDGMENT


Some Tips

Use past experience Try to confirm results with operating personnel Use common sense to confirm statistical studies

COST BEHAVIOR AND MANAGERIAL ETHICS


Ethical judgment
Make sure to have the best information possible when making decisions Not let personal factors affect the use of cost information

COST VOLUME PROFIT (CVP) ANALYSIS


A technique used to determine the effects of changes in an organisations sales volume on its costs, revenue and profit Can be used in profit-seeking and not-for profit organisations

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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INCOME STATEMENTS . . .
Traditional Contribution Format

Sales COGS Gross Margin Operating Exp Net Income

$xxx (xx) $xxx (xx) $xxx

Sales Variable Costs Cont. Margin Fixed Costs Net Income

$xxx (xx) $xxx (xx) $xxx

CONTRIBUTION MARGIN AND ITS MEASURES

Contribution margin (or variable costing) statement

A reporting format where costs are reported by cost behaviour and a contribution margin is calculated

Total contribution margin


The difference between the sales revenue and the variable costs The amount available to cover fixed costs and then contribute to profits

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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CONTRIBUTION MARGIN AND ITS MEASURES

Unit contribution margin

The difference between the sales price per unit and variable cost per unit

Contribution margin ratio


The unit contribution margin divided by the unit sales price The proportion of each sales dollar available to cover fixed costs and earn a profit

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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CONTRIBUTION MARGIN METHOD


The contribution margin method is a variation of the equation method.

Break-even point in units sold

Fixed expenses Unit contribution margin

Break-even point in total sales dollars

Fixed expenses CM ratio

THE BREAK-EVEN POINT


The volume of sales where the total revenues and expenses are equal, and the operation breaks even Can be calculated for an entire organisation or individual projects or activities

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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THE CONTRIBUTION APPROACH


For each additional unit Wind sells, $200 more in contribution margin will help to cover fixed expenses and profit.

Total Sales (500 bikes) $ 250,000 Less: variable expenses 150,000 Contribution margin $ 100,000 Less: fixed expenses 80,000 Net income $ 20,000

Per Unit $ 500 300 $ 200

Perc 1

THE CONTRIBUTION APPROACH


Each month Wind must generate at least $80,000 in total CM to break even.

Sales (500 bikes) Less: variable expenses Contribution margin Less: fixed expenses Net income

Total $250,000 150,000 $100,000 80,000 $ 20,000

Per Unit $ 500 300 $ 200

Perc 1

THE CONTRIBUTION APPROACH


If Wind sells 400 units in a month, it will be operating at the break-even point.
WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Sales (400 bikes) $ 200,000 $ Less: variable expenses 120,000 Contribution margin 80,000 $ Less: fixed expenses 80,000 Net income $ 0

Unit 500 300 200

THE CONTRIBUTION APPROACH


If Wind sells one additional unit (401 bikes), net income will increase by $200.
WIND BICYCLE CO. Contribution Income Statement For the Month of June Total Per Unit Sales (401 bikes) $ 200,500 $ 500 Less: variable expenses 120,300 300 Contribution margin 80,200 $ 200 Less: fixed expenses 80,000 Net income $ 200

COST VOLUME PROFIT (CVP) GRAPH


Shows how costs, revenue and profits change as sales volume changes Five steps

Draw the fixed expense line Draw the total expense line Draw the total revenue line Break-even pointwhere the total revenue and total expense lines intersect

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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PROFIT VOLUME (PV) GRAPH


Shows the total amount of profit or loss at different sales volumes The graph intercept the vertical axis at the amount equal to the fixed costs The break-even point is the point at which the line crosses the horizontal axis

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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CVP GRAPH
450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 100 200 300 400 500 600 700 800

Total Expenses

Fixed expenses

Units

CVP GRAPH
450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 100 200 300 400 500 600 700 800

Total Sales

Units

CVP GRAPH
450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 100 200 300 400 500 600 700 800

Break-even point

Units

TARGET NET PROFIT


A desired profit level determined by management Can be used within the break-even formula

Target sales volume =

Fixed expenses + target profit Unit contribution margin

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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CVP ANALYSIS AND MANAGEMENT


DECISION MAKING

Common applications include


Safety margin Changes in fixed expenses Changes in the unit contribution margin Multiple changes in key variables Operating leverage

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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SAFETY MARGIN
Difference between the budgeted sales revenue and the break-even sales revenue Gives a feel for how close projected operations are to the break-even point

Safety margin in dollars = Budgeted sales Break-even sales

Safety margin in units = Budgeted sales units Break-even units


Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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CHANGES IN FIXED EXPENSES

When estimates of fixed costs are revised, the break-even point will change

Percentage change in fixed expenses will lead to similar increase in the break-even point (in units or dollars)

Different fixed costs may apply to different levels of sales/production volume

More than one break-even point

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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CHANGES IN THE UNIT CONTRIBUTION MARGIN

Change in unit variable expenses

Changes the unit contribution margin A new break-even point An increase in unit variable expenses will increase the break-even point

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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CHANGES IN THE UNIT CONTRIBUTION MARGIN

Change in sales price

Changes the unit contribution margin A new break-even point An increase in unit price will lower the break-even point

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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OPERATING LEVERAGE
Operating leverage is the use of fixed costs to multiple the impact of sales changes on income. Degree of operating leverage (DOL) for a given level of sales

DOL= Contribution margin / Operating income Percentage change in operating income = DOL x percentage change in sales

MULTIPLE CHANGES IN KEY VARIABLES

May involve

Increasing unit prices Undertaking an advertising campaign Hiring a new storage facility
Focuses on the difference in the total contribution margin, fixed expenses and profits under the two alternatives

An incremental approach

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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CVP ANALYSIS WITH MULTIPLE PRODUCTS

Sales mix

The relative proportions of each type of product (units) sold by the organisation
The unit contribution margins of a package in according with sales mix

Package unit contribution margin

Fixed expenses Break - even package = Package unit contribution margin

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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INCLUDING INCOME TAXES


Sales volume required to earn target after - tax profit target net profit after tax Fixed expenses + (1 - t) = Unit contribution margin

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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CVP ANALYSIS AND LONG-TERM DECISIONS


CVP analysis is usually regarded a short-term or tactical decision tool Classification of costs as variable or fixed is usually based on cost behaviour over the short-term The financial impact of long-term decisions best analysed using capital budgeting techniques

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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TREATING CVP ANALYSIS WITH CAUTION


CVP analysis is merely a simplified model The usefulness of CVP analysis may be greater in less complex smaller firms, or stand-alone projects For larger firms, CVP analysis can be valuable as a decision tool for the planning stages of new projects and ventures

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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SENSITIVITY ANALYSIS AND CVP ANALYSIS

Sensitivity analysis

An approach which examines how an outcome may change due to variations in the predicted data or underlying assumptions

Can be run using spreadsheet software, such as Excel

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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SENSITIVITY ANALYSIS AND CVP ANALYSIS

Goal seeking approaches

Allows the analyst to specify the outcome, so that software can specify the necessary inputs
The analyst specifies changes in assumptions to examine the effect of these changes on the output

What-if analysis

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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ASSUMPTIONS UNDERLYING CVP ANALYSIS

Linear cost and revenue functions

Prices and costs known with certainty


Production equal to sales Constant sales mix

Copyright 2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

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