Lecture 6

Paolo Perego

Management Accounting
IBA 2005-2006
 Program

• Previous session about role of accounting

information in decision-making process and
pricing
• This session covers mid-term planning topics
• Chapter 7: Cost behavior and cost estimation
• Chapter 8: Cost-Volume-Profit analysis
 Introduction

Cost Cost Cost

estimation behavior prediction

Process of Relationship Using knowledge

Chapter 7

determining between of cost behavior to

cost behavior, cost and forecast level of cost
often focusing activity at a particular
on historical activity. Focus
data on the future.
 Variable and fixed cost functions
Total variable cost Unit variable cost
$ $
Slope
b
1
b
Chapter 7

volume volume

Total fixed cost Unit fixed cost

$ $
Intercept

volume volume
 Step variable and step fixed costs
• A step function is a cost function in which the cost is
constant over various ranges of the level of activity,
but the cost increases by discrete amounts as the level
of activity changes from one range to the next.
Chapter 7

e.g. Supervisor’s salary e.g. Depreciation expense

Total cost remains Total cost doesn’t change for a wide

constant within a narrow range of range of activity, and then jumps to a
activity new higher cost for the next higher
range of activity
 Time span and relevant range
• Whether a cost is variable or fixed with respect to a particular
activity depends on the time span
• More costs are variable with longer time spans

• Variable and fixed cost behavior patterns are valid for linear cost
functions only within the given relevant range
• Costs may behave nonlinearly outside the relevant range
Chapter 7

$ Curvilinear
Cost Function

Linear Semi-variable
Cost Function
Slope
Y = a + bX
Relevant range
Intercept
Volume
 Committed, Discretionary and Engineering
costs

• Committed costs: long-term costs, they cannot

be reduced in the short term
– e.g. depreciation on buildings and equipment
• Discretionary costs: they may be altered in the
short term by current managerial decisions.
Chapter 7

– e.g. advertising and Research & Development

• Engineered costs: they bear a physical
relationship with activity measure
– e.g. direct materials
 Current trend
• A trend toward higher portion of fixed costs in
companies’ cost structures because of increased
automation due to advanced manufacturing
systems
• Managers are more “locked-in” with fewer
decision alternatives
Chapter 7

• Planning becomes more crucial because fixed

costs are difficult to change with current
operating decisions
• In labor-intensive (manual) production, current
trend shows increased reliance on temporary
labor force
– The behavior of wage and salary costs can differ across
countries, depending on labor regulations, labor
contracts, and custom
 International comparison

US Companies Japanese companies

Variabl Variabl
Cost category Mixed Fixed Mixed Fixed
e e
Production
86% 6% 8% 52% 5% 43%
labor

Setup labor 60 25 15 44 6 50
Chapter 7

Materials-
48 34 18 23 16 61
handling labor
Quality-
34 36 30 13 12 75
control labor

Energy 26 45 29 42 31 27

Depreciation 1 6 93 0 0 100

Building
1 7 92 0 0 100
occupancy
 Cost estimation methods

• Qualitative methods:
– Account-classification method: analysis of historical
documents
– Conference method estimates cost functions on the
basis of analysis and opinions about cost and their
Chapter 7

drivers from various organizational departments. It

encourages interdepartmental cooperation

• Quantitative methods:
– Visual-fit method
– High-low method
– Least-squares method: regression analysis
 Steps in quantitative methods

1. Choose the dependent variable (i.e. the cost to

be predicted)
2. Identify the independent variables (i.e. the cost
drivers):
• Reliability
Chapter 7

• Causality (i.e. economic plausibility)

3. Collect data
4. Plot data
5. Estimate the cost function
6. Evaluate the cost driver(s) of the estimated
cost function
 High-low method (1)
• Choose the highest and lowest value of the cost driver
and their respective costs within the relevant range
• Determine semi-variable cost function (y = a + bX) using
algebra

• Example about energy costs:

Chapter 7

High capacity December: 55,000 machine hours

Cost of electricity: $80,450
Low capacity September: 30,000 machine hours
Cost of electricity: $64,200

• What is theDifference
variablebetween
rate? the costs corresponding
to the highest and lowest level of
Slope
activity
coefficient =
b Difference between the highest and
lowest level of activity
 High-low method (2)
• Variable cost estimate:
($80,450 – $64,200) ÷ (55,000 – 30,000)
$16,250 ÷ 25,000 = $0.65

• What is the fixed cost? a = Y - bX

$80,450 = Fixed cost + (55,000 x $0.65)
Chapter 7

Fixed cost = $80,450 – $35,750 = $44,700

$64,200 = Fixed cost + (30,000 x $0.65)

Fixed cost = $64,200 – $19,500 = $44,700

Y = a + bX
Y = $44,700 + ($0.65 × machine-hours)
 Visual fit method

Total variable cost = Total cost – Total

fixed cost
Total variable cost = $16,000 – $10,000 =
$6,000
Unit variable cost = $6,000 ÷ 3,000 units =
$2
1,000’s of Dollars

Estimated fixed cost =

Chapter 7

Total Cost in

$10,000 * *
20 *
* *
*
* *
* *
Vertical distance
10 is approximately
$16,000

1 2 3 4
Activity, 1,000’s of Units
Produced
 Least-squares regression

• A method used to analyze mixed costs if a

scatterplot reveals an approximately linear
relationship between the X and Y variables
– This method uses all of the data points to estimate
the fixed and variable cost components of a mixed
cost. Regression analysis usually measures cost
Chapter 7

behavior more reliably than other cost measurement

methods.
– The goal of this method is to fit a straight line to the
data that minimizes the sum of the squared errors

• Statistics courses and computer courses deal

with detailed regression computations using
computer spreadsheet software
– For this course: only introductory concepts
in Appendix using Excel
 Scatterplot

This scatterplot locates pairs of Scatterplot of Advertising Expenditures (X) and Sales (Y)
observations of advertising 140

expenditures on the x-axis and sales 120

on the y-axis. We notice that: 100

Sales
80

60

Larger (smaller) values of sales tend 40

to be associated with larger (smaller) 20

Chapter 7

values of advertising 0
0 10 20 30 40 50
Advertising

• The scatter of points tends to be distributed around a positively

sloped straight line
• The pairs of values of advertising expenditures and sales are not
located exactly on a straight line
• The scatter plot reveals a more or less strong tendency rather
than a precise linear relationship
• The line represents the nature of the relationship on average
 Model building

The inexact nature of Data

the relationship
between advertising In regression
and sales suggests that analysis,
analysis the
Statistical systematic component
a statistical model
model is the overall linear
might be useful in
Chapter 7

analyzing the relationship, and the

relationship. random component is
the variation around
Systematic the line.
A statistical model
component
separates the
+
systematic
Random
component of a
errors
relationship from the
random component.
component
 Simple linear regression (1)

The population simple linear regression model:

Y = β0 + β1 X + ε
Nonrandom or Random
Systematic Component
Component

where
Chapter 7

• Y is the dependent variable, the variable we wish to explain or

predict
• X is the independent variable, also called the predictor variable
• ε is the error term, the only random component in the model, and
thus, the only source of randomness in Y.

β 0 is the intercept of the systematic component of the regression

relationship.
= β 0 + β1X
E[Y X ]component.
β 1 is the slope of the systematic

The conditional mean of Y:

 Simple linear regression (2)

Regression Plot The simple linear regression

Y
model gives an exact linear
relationship between the
expected or average value
E[Y]=β 0 + β 1 X of Y, the dependent variable,
and X, the independent or
Yi predictor variable:
Chapter 7

Error: ε i
{ } β = Slope
1
E[Yi] = β0 + β1 Xi
}
1
Actual observed values of Y
differ from the expected
β 0 = Intercept value by an unexplained or
random error:

X Yi = E[Yi] + εi
Xi
= β0 + β1 Xi + εi
 Assumptions of linear regression

• The relationship between Assumptions of the Simple

X and Y is a straight-line Y Linear Regression Model
relationship.
• The values of the
independent variable X
are assumed fixed (not
Chapter 7

random); the only E[Y]=β 0 + β 1 X

randomness in the values

of Y comes from the error
term εi.
• The errors εi are normally Identical normal
distributed with mean 0 distributions of
errors, all
and variance σ2. The centered on the
regression line.
errors are uncorrelated
(not related) in successive X
observations. That is: ε
~ N(0, σ2)
 Estimates of regression line

Estimation of a simple linear regression relationship involves

finding estimated or predicted values of the intercept and
slope of the linear regression line.

The estimated regression equation:

Y = b0 + b 1 X + e
Chapter 7

where b0 estimates the intercept of the population regression

line β0 ;
b1 estimates the slope of the population regression line β1 ;
and e stands for the observed errors - the residuals from
fitting the estimated regression line b0 + b1X to a set of n
points.
 Fitting a regression line

Y Y

Data
Three errors
Chapter 7

from the least

X squares X
Y regression line

Three
errors Errors from
from a X the least
X
fitted line squares
regression
line are
minimized
 Least-squares regression: Example

JEFFERSON COUNTY AIRPORT

     
     
    Airport
Month Flights Costs
January 1.200 20.000
February 1.000 19.000
Chapter 7

March 900 18.000

April 1.400 19.000
May 800 17.000
June 1.100 20.000
July 1.500 21.000
August 900 17.000
Septemb
er 1.200 21.000
October 1.000 19.000
Novembe
r 1.400 24.000
Decembe
r 1.100 18.000
 Least-squares estimators

Least − squares regression estimators (p. 279) :

(∑ Y )(∑ X 2 ) − (∑ X )(∑ XY )
a =
n(∑ X 2 ) − (∑ X )(∑ X )

n(∑ XY ) − (∑ X )(∑ Y )
Chapter 7

b =
n(∑ X 2 ) − (∑ X )(∑ X )
 Least-squares regression
2. Least-squares regression:
(a) Tabulation of data:
Dependent Independent
Variable Variable
(cost in (flights in
thousands) hundreds)
Month Y X X2 XY
January 20 12 144 240
February 19 10 100 190
March 18 9 81 162
April 19 14 196 266
Chapter 7

May 17 8 64 136
June 20 11 121 220
July 21 15 225 315
August 17 9 81 153
September 21 12 144 252
October 19 10 100 190
November 24 14 196 336
December 18 11 121 198
Total 233 135 1.573 2.658
Correct! Correct! Correct!Correct!
a = INTERCEPT(cellsY, cellsX)
(b) Calculation of parameters:
a= 11,796 «- Correct!
b= 0,677 «- Correct!
b = SLOPE(cellsY, cellsX)
(c) Fixed- and variable-cost components:
Monthly fixed cost = $ 11.796 «- Correct!
Variable cost = $ 677 per hundred flights
 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 (variation) of a cost is
explained by changes in the cost driver
Chapter 7

• Values of R² nearer to 1 means higher

explanatory power
 Coefficient of determination
Y

.
}
Y

Y'
Unexplained Deviation
{ Total Deviation

Y
Explained Deviation
{
Chapter 7

X
X

(∑ Y − Y ' ) 2
Unexplained deviation

R2 = 1− _
(∑ Y − Y ) 2 Total deviation
 Example
2 1 2
R =1- Σ(Y-Y )
2
Σ(Y-Ÿ)

Where Y denotes the observed value of the dependent

variable (cost) at a particular activity level
1
Y denotes the predicted value of the dependent
variable (cost) based on the regression line,
at a particular activity level
Ÿ denotes the mean (average) observation of the
dependent variable (cost)
Tabulation of data: Predicted Cost
Chapter 7

(in thousands)
Based on
Regression
Month Y X Line Y' [(Y-Y')2]† [(Y-Ÿ)2]†
January 20 12 19,920 0,006 0,340
February 19 10 18,566 0,188 0,174
March 18 9 17,889 0,012 2,007
April 19 14 21,274 5,171 0,174
May 17 8 17,212 0,045 5,840
June 20 11 19,243 0,573 0,340
July 21 15 21,951 0,904 2,507
August 17 9 17,889 0,790 5,840
September 21 12 19,920 1,166 2,507
October 19 10 18,566 0,188 0,174
November 24 14 21,274 7,431 21,007
December 18 11 19,243 1,545 2,007
Total 233 135 18,019 42,917
†
Rounded
R² = RSQ(cellsY, cellsX)
Calculation of R2: 0,58 «- Correct!
 Multiple regression

Multiple regression includes two or more

independent variables:

Total cost = a + b1X1 + b2X2 + … + bnXn

Chapter 7

Terms in the equation have the same

meaning as in simple regression with
only one independent variable.
 Data collection and adjustment issues

• Missing data
• Unreliable data
• Extreme values of observations (outliers)
• Mismatched time periods
Chapter 7

– e.g. monthly cost data vs daily production activity data

• Trade-offs in choosing time periods

– Lagged effects
– Non-stationary relationships

• Allocated and discretionary costs

• Inflation
 Effect of learning on cost behavior

• A systematic relationship between the

amount of experience in performing a task
and the time required to carry out the task
• The average time per task declines by a
constant percentage each time the quantity of
Chapter 7

tasks doubles

• Example: BerryCo. makes products requiring labor that

follows an 80 percent learning rate. If the first unit of
such a product requires 10 hours, what is the average
time for 16 units of this product?
• An 80 percent learning rate means that the average
time required to make two units is 80 percent of the
time for one unit, and that the average time for four
units is 80 percent of the time for two units, etc.
 Effect of learning on cost behavior

Average
Number Labor Time Cumulative
of Units (X) per Unit Labor time (Y)
1 1 × 10 = 10 (a) 1 × 10 = 10
2 .80 × 10 = 8 2 × 8 = 16
4 .80 × 8 = 6.4 4 × 6.4 = 25.6
Chapter 7

8 .80 × 6.4 = 5.12 8 × 5.12 = 40.96

16 .80 × 5.12 = 4.096 16 × 4.096 = 65.536

The graphic presentation of the learning

phenomenon is called the learning curve.

Yx = aX b Yx = cumulative average time per unit

X = cumulative number of units produced
ln(%learning ) a = time required to produce first unit
b=
ln 2 b = rate of learning
 Effect of learning on cost behavior

Hours per unit, TN

120
100
TN = (100)(N log.90/log2)
80
60
Chapter 7

40 90% curve
20
80% curve
0
0 100 200 300 400
Cumulative units,
N
Refer to the lecture note
in Blackboard for more
details!
 Examples of learning curve effects
Cumulativ Learnin
Improving e g Time
Example Parameter Paramete
Curve
Frame
Slope
r (%)
1. Model-T Ford Units 1910-
Price 86
production produced 1926
2. Aircraft Direct labor- Units 1925-
80
assembly hours per unit produced 1957
Production
Chapter 7

4. Steel worker labor- Units 1920-

79
production hours per unit produced 1955
produced
5. Integrated Average price Units 1964-
72
circuits per unit produced 1972
Average
6. Hand-held Units 1975-
factory selling 74
calculator produced 1978
price
7. Disk memory Average price Number 1975-
76
drives per bit of bits 1978
Transplan
8. Heart 1-year death ts 1985-
79
transplants rates complete 1988
d
 Break-even point

The break-even point is the point in the volume of

activity where the organization’s revenues and
expenses are equal.
Consider the following information developed by the accountant at
Curl, Inc.:
Chapter 8

Total Per Unit Percent

Sales (500 surf boards) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

For each additional surf board sold, Curl generates $200 in

contribution margin.
 Contribution-Margin Approach

Fixed expenses Break-even point

Unit contribution margin
= (in units)
Chapter 8

Total Per Unit Percent

Sales (500 surf boards) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

$80,000 ÷ $200 = 400 surf boards

 Contribution-Margin Approach

Here is the proof!

Total Per Unit Percent

Chapter 8

Sales (400 surf boards) $ 200,000 $ 500 100%

Less: variable expenses 120,000 300 60%
Contribution margin $ 80,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ -
 Contribution Margin Ratio

Calculate the break-even point in sales dollars

rather than units by using the contribution
margin ratio.
Chapter 8

Contribution margin
Sales = CM Ratio

Fixed expenses Break-even point

CM Ratio = (in sales dollars)
 Contribution Margin Ratio

Total Per Unit Percent

Sales (400 surf boards) $ 200,000 $ 500 100%
Less: variable expenses 120,000 300 60%
Contribution margin $ 80,000 $ 200 40%
Less: fixed expenses 80,000
Chapter 8

Net income $ -

$80,000 ÷ 40% = $200,000

 Equation Approach

Sales revenue – Variable expenses – Fixed expenses = Profit

Unit Sales Unit Sales

Chapter 8

sales × volume variable × volume

price in units expense in units

($500 × X) – ($300 × X) – $80,000 = $0

($200X) – $80,000 = $0

X = 400 surf boards

 Graphing Cost-Volume-Profit Relationships

Viewing CVP relationships in a graph gives managers a

perspective that can be obtained in no other way.
Consider the following information for Curl, Inc.:
Chapter 8
 Cost-Volume-Profit Graph

Total sales
Break-even
point r e a
f it a
o
Sales in Dollars

Pr
Chapter 8

Total expenses

r e a Fixed expenses
a
oss
L
 Target Profit

We can determine the number of surfboards

that Curl must sell to earn a profit of $100,000
using the contribution margin approach.
Chapter 8

Fixed expenses + Target profit Units sold to earn

=
Unit contribution margin the target profit

$80,000 + $100,000
$200 = 900 surf boards
 Equation Approach

Sales revenue – Variable expenses – Fixed expenses = Profit

($500 × X) – ($300 × X) – $80,000 = $100,000

Chapter 8

($200X) = $180,000

X = 900 surf boards

 Applying CVP Analysis

Safety Margin
• The difference between budgeted sales revenue and
break-even sales revenue.
• The amount by which sales can drop before losses
begin to be incurred.
Chapter 8

Curl, Inc. has a break-even point of $200,000. If actual sales are

$250,000, the safety margin is $50,000 or 100 surf boards.
 Changes in Fixed Costs

• Curl is currently selling 500 surf boards per month.

• The owner believes that an increase of $10,000 in the
monthly advertising budget, would increase board sales
to 540 units.

• Should we authorize the requested increase in the

Chapter 8

advertising budget?

540 units × $500 per unit = $270,000

$80,000 + $10,000 advertising = $90,000

 Changes in unit contribution margin

Because of increases in cost of raw materials, Curl’s

variable cost per unit has increased from $300 to
$310 per surf board. With no change in selling
price per unit, what will be the new break-even
point?
Chapter 8

($500 × X) – ($310 × X) – $80,000 = $0

X = 422 units (rounded)

 Predicting Profit Given Expected Volume

Fixed expenses
Given: Unit contribution margin Find: {required sales volume}
Target net profit
Chapter 8

Fixed expenses
Given: Unit contribution margin
Find: {expected profit}
Expected sales volume
 Predicting Profit Given Expected Volume

In the coming year, Curl’s owner expects to sell

525 surfboards. The unit contribution margin
is expected to be $190, and fixed costs are
expected to increase to $90,000.
Chapter 8

Total contribution - Fixed cost = Profit

($190 × 525) – $90,000 = X

X = $99,750 – $90,000
X = $9,750 profit
 CVP Analysis with Multiple Products

For a company with more than one product, sales mix is the
relative combination in which a company’s products are sold.
Chapter 8
 CVP Analysis with Multiple Products
Weighted-average unit contribution margin
Chapter 8

Break-even Fixed expenses

point = Weighted-average unit contribution margin

$170,000
= $331.25

= 514 combined unit sales

(321 surfboards + 193 sailboards)
 Assumptions Underlying CVP

• Selling price is constant throughout the

entire relevant range.
• Costs are linear over the relevant range.
• In multi-product companies, the sales mix
is constant.
Chapter 8

• In manufacturing firms, inventories do not

change (units produced = units sold).
 CVP under AC vs VC (1)

• Variable Costing (VC):

Income = sales x (price – variable costs) – fixed overhead
costs
• Absorption Costing (AC):
Income = sales x (price – full costs) + (actual production –
Chapter 8

normal production) x fixed overhead rate

Example manufacturing company:

• Normal production: 10,000 units/year
• Variable manufacturing cost: €7/unit
• Fixed manufacturing costs: €80,000/year
• Fixed manufacturing costs per unit: €8 (=€80,000/10,000)
• Standard manufacturing cost per unit: €15 (=€7 + €8)
• Sales price: €20/unit
• Assumptions: No period costs and No beginning inventory
 CVP under AC vs VC (2)

VC: level of sales determines the break-even

Sales x (p - var. cost) - Fixed costs = 0
Sales x (€20 - €7) - €80,000 = 0
Sales = 6,154 units

AC: both levels of sales and production determine the break-

Chapter 8

even
Sales x (p - st. cost) + (Prod. - 10,000) x €8 = 0
Sales x (€20 - €15) + (Prod. - 10,000) x €8 = S 0
Sales x €5 + Prod. x €8 = €80,000 16,000

6,154
Break-even line:
Sales = 0 Prod. = 10,000
6,154 10,000 P
Prod. = 0 Sales = 16,000
 Measuring Operating Leverage
• The cost structure of an organization is the relative
proportion of its fixed and variable costs.
• Operating leverage is
– the extent to which an organization uses fixed costs in
its cost structure.
– greatest in companies that have a high proportion of
fixed costs in relation to variable costs.
Chapter 8

Operating leverage = Contribution margin

factor Net income
$100,000 = 5
$20,000

Percent increase in sales 10%

Operating leverage factor × 5
Percent increase in profits 50%
 Lecture notes of CVP

• Revenue-dependent target profit:

FC
BEP =
[(1 − α ) price − var. cost ]
α = target revenue (%)
Chapter 8

• Target profit including taxes:

FC TNI
BEPT = +
( price − var. cost ) (1 − T )(price − var.cost)
TNI = target net income
T = tax rate