Tutorial Chapter 12 Cost Behaviour and Measurement of Costs

Copyright © 2014 Pearson Education 2-1
Ch 2 – Horngren et al 2014
Tutorial Chapter 12
Introduction to Cost Behavior

and Cost-Volume-Profit
Relationships
Presented by
Dr Noor Ajian Mohd Lair

Senior Lecturer
Mechaincal Engineering Program
Faculty of Engineering
Universiti Malaysia Sabah
Office No 43, 2nd floor

Ext: 3422 2-2
Copyright © 2014 Pearson Education
email: nrajian72@gmail.com
Fixed Costs and Relevant Range
Example 1
Suppose that total monthly fixed costs are $100,000

for a General Electric lightbulb plant as long as
production is between 40,000 and 85,000 cases of
lightbulbs per month. However, if production falls
below 40,000 cases, changes in production
processes will slash fixed costs to $60,000 per
month. On the other hand, if operations rise above
85,000 cases, rentals of additional facilities will
boost fixed costs to $115,000 per month. Exhibit
2-6 graphs
these assumptions about cost behavior. The top
figure shows a refined analysis that reflects all the
complexities described previously.

Example 1
The bottom figure shows a simplified analysis that

focuses only on the cost in the relevant range,
ignoring the issue of cost behavior outside the
relevant range. Within the relevant range
highlighted in yellow, the refined and simplified
analyses coincide. However, the refined
description at the top of Exhibit 2-6 explicitly
shows the rental costs at the levels of activity
outside the relevant range. The simplified
description at the bottom of the exhibit shows only
the rental costs for the relevant range, and uses a
dashed line outside the relevant range to remind
the user that the graphed cost is outside the limits
of Copyright
the relevant range.
© 2014 Pearson Education 2-5
Example 2: Cost-Volume-Profit
(CVP) (or Break even analysis)
Amy Winston, the manager of food services for

one of Boeing’s plants, is trying to decide
whether to rent a line of snack vending
machines. Although individual snack items
have various acquisition costs and selling
prices, Winston has decided that an average
selling price of $1.50 per unit and an average
acquisition cost of $1.20 per unit will suffice
for purposes of this analysis. She predicts the
revenue and expense relationships.

Example 2: CVP
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 Percentage of

Sales
Selling price $1.50 100%
Variable cost of each item 1.20 80
Selling price less variable cost $ .30 20%
Monthly fixed expenses:

Rent $3,000
Wages for replenishing and
servicing 13,500
Other fixed expenses 1,500
Total fixed expenses per month $18,000

Cost-Volume-Profit Graph
$150,000 A
Net Income
138,000 Sales C
120,000 Net Income Area
Dollars
D
90,000 Variable
Total Break-Even Point Expenses
60,000 Expenses 60,000 units
Net Loss
30,000 or $90,000
Area
18,000 B
Fixed Expenses
0 10 20 30 40 50 60 70 80 90 100
Units (thousands)
Break even where: total expenses = total sales (revenue)

Therefore, no loss and net income is zero
Example
Break-Even Point: Contribution
Margin Method
Contribution margin Contribution margin ratio

Per Unit Per Unit %
Selling price $1.50 Selling price 100
Variable costs 1.20 Variable costs 80
Contribution margin$ .30 Contribution margin 20
$18,000 fixed costs ÷ $.30 =

60,000 units (break even)
Break-Even Point: Contribution
Margin Method
60,000 units × $1.50 (Sales Price) = $90,000

in sales to break even
$18,000 fixed costs

÷ 20% (contribution-margin percentage)
= $90,000 of sales to break even
Copyright © 2014 Pearson Education 2 - 10

Example
Break-Even Point:
Equation Method
Let N = number of units

to be sold to break even.
Variable Fixed
Sales – Expenses – Expenses = net income
$1.50N – $1.20N – $18,000 = 0
$.30N = $18,000
N = $18,000 ÷ $.30
N = 60,000 Units
Break-Even Point: 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 = fixed expenses = $18,000 = 60,000
volume in units unit contribution margin .30
Break-even = fixed expenses = $18,000 = $90,000

volume in sales contribution margin ratio .2

Learning
Objective 6 Example
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
Example
Target Net Profit
Winston considers $1,440 per month the

minimum acceptable net income. How many
units will she have to sell to justify the
adoption of the vending machine plan? How
does the number of units “translate” into
dollar sales?

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
Example
Nonprofit Application
Suppose a city has a $100,000
lump-sum budget appropriation
to conduct a counseling program.
Variable costs per prescription

are $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?. 2 - 17
If the city spends the entire budget

appropriation, how many patients
can it serve in a year?
Variable + Fixed
Sales = expenses + expenses
$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
Variable + Fixed
Sales = expenses + expenses
$90,000 = $400N + $60,000
$400N = $90,000 – $60,000
N = $30,000 ÷ $400
N = 75 patients
Example
Contribution Margin and Gross Margin
(Revisit) Amy Winston, the manager of food

services for one of Boeing’s plants, is trying to
decide whether to rent a line of snack vending
machines. Although individual snack items
have various acquisition costs and selling
prices, Winston has decided that an average
selling price of $1.50 per unit and an average
acquisition cost of $1.20 per unit will suffice
for purposes of this analysis. She predicts the
revenue and expense relationships.

Example
Sales price – Cost of goods sold = Gross margin
Sales price - all variable expenses =

Contribution margin
Per Unit
Selling price $1.50
Variable costs (acquisition cost) 1.20
Contribution margin and
gross margin are equal $ .30
The contribution margin and the gross margin are identical

because the cost of goods sold is the only variable cost
However, Suppose the firm paid a commission

of $.12 per unit sold.
Contribution Gross
Margin Margin
Per Unit Per Unit
Sales $1.50 $1.50
Acquisition cost of unit sold 1.20 1.20
Variable commission .12
Total variable expense $1.32
Contribution margin .18
Gross margin $.30
In this case the contribution and gross margin are not identical.
Ch 3 – Horngren et al 2014
Tutorial: Chapter 12 (Cont)

Examples of Committed
and Discretionary Fixed Costs
Marietta Corporation is experiencing financial difficulties. Sales
for its major products are down, and Marietta’s management is
considering cutting back on costs temporarily. Marietta’s
management must determine which of the above fixed costs it can
reduce or eliminate and how much money each would save.
Fixed Costs Planned
Amounts
Advertising and promotion $ 50,000
Depreciation 400,000
Employee training 100,000
Management salaries 800,000
Mortgage payment 250,000
Property taxes 600,000
Research and development 1,500,000
Total Copyright © 2014 Pearson Education$3,700,000 2 - 24
Examples of Committed
and Discretionary Fixed Costs
Fixed Costs Planned Amounts
Committed
Depreciation $ 400,000
Mortgage payment 250,000
Property taxes 600,000
Total committed $1,250,000
Discretionary (potential savings)

Advertising and promotion $ 50,000
Employee training 100,000
Management salaries 800,000
Research and development 1,500,000
Total discretionary $2,450,000
Total committed and discretionary $3,700,000
Can Marietta reduce or eliminate any of the fixed costs?
The answer depends on Marietta’s long-run outlook.
Marietta could reduce costs but also greatly reduce
its ability to compete in the future if it cuts fixed
costs carelessly. Suppose rearranging these costs by
categories of committed and discretionary costs
yields the above analysis.
Eliminating all discretionary fixed costs would save
Marietta $2,450,000 per year. However, Marietta
might be unwise to cut all discretionary costs
completely. This could severely impair the company’s
long-run prospects and its future competitive
position. Distinguishing committed and discretionary
fixed costs would be the company’s first step in
identifying where costs could be reduced.
Example: Choice of Cost Drivers:
Activity Analysis
Northwestern Computers makes two

products: Mozart-Plus and Powerdrive
In the past, most of the support costs

were twice as much as labor costs.
Northwest has upgraded the production

function, which has increased support
costs and reduced labor cost.

Northwestern has just finished upgrading the
production process. Now the company uses
computer-controlled assembly equipment, which has
increased the costs of support activities, such as
engineering and maintenance, and has reduced labor
cost. Its cost function has now changed; specifically,
labor cost is now only 5% of the total costs at
Northwestern. An activity analysis has shown that
the number of components added to products (a
measure of product complexity), not labor cost, is
the primary cost driver for support costs.

Choice of Cost Drivers: Activity
Analysis
Using the old cost driver, labor cost, the

prediction of support costs would be:
Mozart-Plus Powerdrive
Labor cost $ 8.50 $130.00
Support cost:
2 × Direct labor
cost $17.00 $260.00

Choice of Cost Drivers: Activity
Analysis
Using the more appropriate cost driver,
the number of components added to products,
companies can predict support costs more accurately.
Mozart-Plus Powerdrive
Support cost at $20
per component
$20 × 5 components $100.00
$20 × 9 components $180.00
Difference in predicted
support cost $ 83.00 $ 80.00
higher lower
Managers will make better decisions with this more

accurate information.

Learning
Objective 4 Methods of Measuring Cost Functions
Examples covers as followed:

Account analysis
High-low analysis
Least-squares regression analysis

Example: Parkview Medical Center
The facilities maintenance department at the

Parkview Medical Center analyzes cost for a
recent month. The following table shows
costs recorded in a month with 3,700 patient-
days:
Monthly cost Amount

Supervisor’s salary and benefits $ 3,800
Hourly workers’ wages and benefits 14,674
Equipment depreciation and rentals 5,873
Equipment repairs 5,604
Cleaning supplies 7,472
Total maintenance costs $37,423

Example:
Account Analysis
The simplest method of account analysis selects a plausible
cost driver and classifies each account as a variable or fixed cost.
For this case, the most plausible and reliable cost driver is
the number of patient-day serviced per month.
Parkview Medical Center

Monthly cost Amount Fixed Variable
Supervisor’s salary and benefits $ 3,800 $3,800

Hourly workers’ wages and benefits 14,674 $14,674
Equipment depreciation and rentals 5,873 5,873
Equipment repairs 5,604 5,604
Cleaning supplies 7,472 7,472
Total maintenance costs $37,423 $9,673 $27,750

Account Analysis Example
3,700 patient-days
Fixed cost per month = $9,673
Variable cost per patient-day

= $27,750 ÷ 3,700
= $7.50 per patient-day
Y = $9,673 + ($7.50 × patient-days)

Example:High-Low Method
The following table shows the monthly data collected
for the Parkview Medical Center on facitlities
maintenance department costs and the number of
patient-days serviced over the past year.
Month FMD Cost(Y) Num of Patient-Days (X)

January $37,000 3,700
February 23,000 1,600
March 37,000 4,100
April 47,000 4,900
May 33,000 3,300
June 39,000 4,400
July 32,000 3,500
August 33,000 4,000
Sept 17,000 1,200
October 18,000 1,300
Novermber 22,000 1,800
December 20,000 1,600

Example:
High-Low Method
Plot historical data points on a graph.
Focus on the highest- and lowest-activity points.
High month: April

Maintenance cost: $47,000
Number of patient-days: 4,900
Low month: September

Maintenance cost: $17,000
Number of patient-days: 1,200

High-Low Method Example
The point at which the line intersects the Y axis is

the intercept, F, or estimate of Fixed Costs, and the
slope of the line measures the variable cost.
What is the variable cost (V)?

Using algebra to solve for variable and fixed costs.
Variable costs = Change in costs

change in activity
V = ($47,000 – $17,000) ÷ (4,900 – 1,200)

= $30,000 ÷ 3,700 = $8.1081

What is the fixed cost (F)?
F = Total mixed cost – total variable cost

At X (high): F = $47,000 - ($8.1081× 4,900 patient-days)
= $47,000 – $39,730
= $7,270 a month
At X (low): F = $17,000 = ($8.1081× 1,200 patient-days)

= $17,000 – $9,730
= $7,270 a month
Cost function measured by high-low method:

Y = $7,270 per month + ($8.1081 × patient-days)

Example:
Least-Squares Regression Method
Y = $9,329 + ($6.951 × patient-days)

Coefficient of Determination
One measure of reliability,

or goodness of fit, is the
coefficient of determination,
R² (or R-squared).
The coefficient of determination

measures how much of the
fluctuation of a cost is explained
by changes in the cost driver.

The End

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America.

Example
Sales Mix Analysis
Ramos Company Example
Wallets Key Cases
(W) (K) Total
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
Contribution margins
@ $1 and $2 $ 300,000 $150,000 $ 450,000
Fixed expenses 180,000
Net income $ 270,000

Example: CVP – Port William Gift
Shop
The budgeted income statement of Port William Gift Shop
follows:
Net revenue $800,000
Less Expenses, including $400,000 of fixed expense 880,000
Net Loss $(80,000)
The manager believes that an additional outlay of

$200,000 for advertising will increase sales but is
wondering how much sales will have to increase in order
to achieve 1) breakeven or 2) a $40,000 profit.
1. At what sales volume in dollar will the shop break even
after spending $200,000 on advertiting?
2. What sales volume in dollars will result in a net profit of
$40,000 after spending the $200,000 on advertising? 2 - 45
Example: CVP – Port William Gift
Shop
Solution:
1. Note that all data are in dollars. The variable
costs are $880,000-$400,000 and the variable-
cost ratio is $480,000/800,000 = 0.60.
Therefore, the contribution-margin ratio is 0.40.
Let S = break even sales in dollars. Then
Sales – variable cost – fixed cost = net profit
S - 0.60S – ($400,000 + 200,000) = 0
S = $1,500,000
2. Required sales = (fixed costs + target net
profit)/(Contribution-margin ratio)
Required sales = (600,000+40,000)/0.40
= $1,600,000
Example: 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 – fixed = zero net income
expense expenses
[$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
30,000K + 120,000W = 150,000 total units (K + W).

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

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?

Ramos Company Example

Wallets Key Cases
(W) (K) Total
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
Contribution margins
@ $1 and $2 $ 325,000 $100,000 $ 425,000
Fixed expenses 180,000
Net income $ 245,000

Learning
Objective 9 Example
Impact of Income Taxes
Income taxes do not affect the break-even point.

There is no income tax at a level of zero income.
Income taxes affect the calculation of the volume

required to achieve a specified after-tax target
profit.
Suppose that a company earns $1,440 before

Taxes and pays income tax at a rate of 40%.

Suppose the target net income after taxes was $864
Target income before taxes = Target after-tax net income

1 – tax rate
Target income before taxes = $ 864 = $1,440

1 – 0.40

Target sales - Variable expenses - Fixed expenses

= Target after-tax net income ÷ (1 – tax rate)
$1.50N - $1.20N - $18,000 = $864 ÷ (1 – 0.40)

$.30N = $18,000 + ($864/.6)
$.18N = $10,800 + $864 = $11,664
N = $11,664/$.18
N = 64,800 units

Suppose target net income after taxes was $1,440
$1.50N - $1.20N - $18,000 = $1,440 ÷ (1 – 0.40)

$.30N = $18,000 + ($1,440/.6)
$.18N = $10,800 + $1,440 = $12,240
N = $12,240/$.18
N = 68,000 units

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Copyright © 2014 Pearson Education 2-1

Introduction to Cost Behavior

Dr Noor Ajian Mohd Lair

Office No 43, 2nd floor

Suppose that total monthly fixed costs are $100,000

Copyright © 2014 Pearson Education 2-4

The bottom figure shows a simplified analysis that

Amy Winston, the manager of food services for

Copyright © 2014 Pearson Education 2-6

Cost-volume-profit (CVP) analysis is the study of the

Per Unit Percentage of

Monthly fixed expenses:

Copyright © 2014 Pearson Education 2-7

Break even where: total expenses = total sales (revenue)

Contribution margin Contribution margin ratio

$18,000 fixed costs ÷ $.30 =

60,000 units × $1.50 (Sales Price) = $90,000

$18,000 fixed costs

Copyright © 2014 Pearson Education 2 - 10

Let N = number of units

Break-even = fixed expenses = $18,000 = $90,000

Copyright © 2014 Pearson Education 2 - 12

Winston considers $1,440 per month the

Copyright © 2014 Pearson Education 2 - 14

Target sales volume in units =

Selling price $1.50

($18,000 + $1,440) ÷ $.30 = 64,800 units

Target sales dollars = sales price X sales volume in units

Copyright © 2014 Pearson Education 2 - 15

Contribution margin ratio

Target sales volume in dollars =

Variable costs per prescription

Fixed costs are $60,000 in the

If the city spends the entire budget appropriation,

If the city spends the entire budget

Copyright © 2014 Pearson Education 2 - 18

If the city cuts the total budget appropriation by

Budget after 10% Cut

(Revisit) Amy Winston, the manager of food

Copyright © 2014 Pearson Education 2 - 20

Sales price – Cost of goods sold = Gross margin

Sales price - all variable expenses =

The contribution margin and the gross margin are identical

However, Suppose the firm paid a commission

Tutorial: Chapter 12 (Cont)

Copyright © 2014 Pearson Education 2 - 23

Discretionary (potential savings)

Northwestern Computers makes two

In the past, most of the support costs

Northwest has upgraded the production

Copyright © 2014 Pearson Education 2 - 27

Copyright © 2014 Pearson Education 2 - 28

Using the old cost driver, labor cost, the

Copyright © 2014 Pearson Education 2 - 29

Managers will make better decisions with this more

Copyright © 2014 Pearson Education 2 - 30

Examples covers as followed:

Copyright © 2014 Pearson Education 2 - 31

The facilities maintenance department at the

Monthly cost Amount

Copyright © 2014 Pearson Education 2 - 32

Parkview Medical Center

Supervisor’s salary and benefits $ 3,800 $3,800