3-1 Chapter 3 Chapter 3 Fundamentals of Cost Fundamentals of Cost Analysis Analysis for Decision for Decision Making Making
3-1 Chapter 3 Fundamentals of Cost Analysis for Decision Making.
Dec 30, 2015
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3-1
Chapter 3Chapter 3
Fundamentals of Cost Fundamentals of Cost AnalysisAnalysisfor Decision for Decision
MakingMaking
3-2
Learning ObjectivesLearning Objectives1. Use cost-volume-profit (CVP) analysis
to analyze decisions.
2. Understand the effect of cost structure on decisions.3. Use differential analysis to analyze decisions.4. Understand how to apply differential analysis
to pricing decisions.
5. Understand several approaches for establishing prices based on costs for long-run pricing decisions.
6. Understand how to apply differential analysis to production decisions.
7. Understand the theory of constraints (Appendix).
3-3
L.O. 1 Use cost-volume-profit (CVP) analysis to analyze decisions.
Cost-Volume-Profit Cost-Volume-Profit AnalysisAnalysis
What isC V P?
Cost
Volume
Profit
CVP studies the relations among revenue, cost, and volume and their effect on profit.
3-4The Profit The Profit EquationEquation
Operating profit equals total revenue less total costs.
It’s the income statement written horizontally.
Operating profit
Total revenues
Total costs
Operating profit
Total revenues
Total costs
TR
TC
The Income Statement
The Profit Equation
3-5Profit Equation Profit Equation ContinuedContinued
TR
PX
VX FTC
TR
Price Units of output produced and soldP X
TC Variable costs per unit
Units of output
Fixed costsX FV
3-6Profit Equation Profit Equation ContinuedContinued
TR TC
PX
VX F
P FV X[ ]
3-7
U-Develop; an ExampleU-Develop; an ExampleIncome StatementMonth of March
200X
Operating profit
$1,380
Total Per Unit
Less Variable cost of goods sold
3,600 0.30
Sales $7,200 $0.60
U-Develop
Developed 12,000 prints in March
2,880Contribution margin 0.24
Less Fixed costs
1,500
720Less Variable selling cost
0.06
3-8
Profit Equation ExampleProfit Equation Example
P V FX
$.30 + $.06
$1,380
$2,880
$1,500
$1,380
U-Develop
$1,380
$.60 $.36
$1,500
12,000 units
[ ]
3-9Contribution Contribution MarginMargin
The difference between total revenue and total variable costs.
The difference between sales price and variable costs per unit.
CM unit
CM unitP V
Total contribution margin
Unit contribution margin
P V XX
P V X
3-10Contribution Margin Contribution Margin ExampleExample
CVP studies the relations among revenue, cost, and volume and their effect on profit.
U-Develop
$.30 + $.06
$.60
$.36
12,000 units
CM
CM P V X
CM $2,880
$.60 $.36
CM unit
$.24
CM unit
CM unit P V
Total CM
CM Unit
3-11Contribution Margin Contribution Margin ContinuedContinued
U-Develop
$.24
CM unit
?
For every $1.00 in sales, U-Develop has $.24 available to first cover fixed costs and then to increase profits.
Why do I care?
3-12Target Volume in Target Volume in UnitsUnits
Unit contribution margin
Target Volume (Units)
Fixed costs
Target profit
Target Profit
F
P VX
P V FX[ ]
3-13Target Volume Units Target Volume Units ExampleExample
U-Develop Target
Profit of $1,800
CM unit
XF
$.24
X $1,800$1,500
X 13,750 units
3-14
Total contribution margin as a percent of total sales revenue.
Contribution margin per unit as a percent of sales price per unit.
Contribution Margin RatioContribution Margin Ratio
Contribution margin as a percentage of sales revenue.
Contribution Margin Ratio
Total contribution margin ratio
Unit contribution margin ratio
P X
P V X
P V
P
CMR unit
3-15
CMR ExampleCMR ExampleU-Develop
CMR $2,880$7,200
.40
CMR unit$.24
$.60
.40
$.60
$.36
12,000
.60 12,000
CMRP V X
P X
3-16
=Fixed costs
+ Target profit
Contribution margin ratio
Target volume sales dollars
TR
Target Volume in Sales Target Volume in Sales DollarsDollars
FTR
+
CMR=
3-17Target Sales Dollars Target Sales Dollars ExampleExample
U-Develop
TR .4
0
$1,800
$1,500
TR
$8,250
13,750 x $.60 = $8,250
FTR
+
CMR=
3-18
Break-EvenBreak-Even
Use the target volume formulas to find the break-even point.
Set target profit to zero ( = 0)
Break-even volume (units)
=Fixed costs
CMunit
The sales volume level at which profits equal zero. Total revenues = Total
costs
= 0
FX
+
CM unit
=
3-19
Break-Even Units ExampleBreak-Even Units Example
U-Develop
X 6,250 prints
X
$.24
01,500
FX
CM unit
3-20Break-Even in Sales Break-Even in Sales DollarsDollarsThe total sales dollars at which profits equal zero. =
0 Total revenues = Total costs
FTR
0
CMR
TR
F
CMR
3-21Break-Even Sales Dollars Break-Even Sales Dollars ExampleExample
U-Develop
TR.40
$1500
TR
$3,750
6,250 prints X $.60 = $3,750
FTR
CMR
3-22
CVP SummaryCVP SummarySummary of Target Volume and Break-Even Formulas
Target VolumeTarget volume (units)
=Fixed costs
+ Target profit
Unit contribution margin
Target volume sales dollars
=Fixed costs
+Target profit
Contribution margin ratio
3-23
CVP Summary ContinuedCVP Summary Continued
Break even
Break-even volume (units) =
Fixed costs
Unit contribution margin
Break-even volume (sales dollars)
=Fixed costs
Contribution margin ratio
Summary of Target Volume and Break-Even Formulas
3-24Graphic Graphic PresentationPresentation
Total r
evenue
Total
cost
$3,750
6,250 prints
U-Develop Break-Even
3-25
The proportion of fixed and variable costs to total costs.
The extent to which the cost structure is made up of fixed costs.
CVP and the Effect of Different Cost CVP and the Effect of Different Cost StructuresStructures
L.O. 2 Understand the effect of cost structure on decisions.
Contribution margin
Net income
Operating leverage
Cost structure
The higher the organization’s operating leverage, the higher the break-even point.
3-26
Contribution margin per unit
$0.25 $0.75
Comparison of Cost Structures
Lo-Lev Company Hi-Lev Company
Amount Percentage
Amount Percentage
Sales $1,000,000 100% $1,000,000 100%
Comparison of Cost Comparison of Cost StructuresStructures
Variable Costs $750,000 75% $250,000 25%
Contribution margin
$250,000 25% $750,000 75%
Fixed costs $50,000 5% $550,000 55%
Operating profit $200,000 20% $200,000 20%
Break-even point 200,000 units 733,334 units
Degree of Operating Leverage
1.25 3.75
(1,000,000 units) (1,000,000 units)
3-27Operating Leverage Operating Leverage ExampleExample
Suppose Lo-Lev & Hi-Lev both increase sales 10% or $100,000.
Lo-Lev Hi-Lev
Sales
CMR
Increase in Profit
Prior NI
NI with sales increase of 10%
$100,000.25
$25,000
$200,000
$225,000
$100,000.75
$75,000
$200,000
$275,000
Why do I care?
3-28Operating Leverage Operating Leverage ContinuedContinued
Lo-Lev Hi-Lev
Percent Increase in salesDegree of Operating LeveragePercent increase in NIPrior NI
Percent increase in NI
NI with sales increase of 10%
10%
1.25
12.5%
$200,00012.5%
$225,000
10%
1.75
17.5%
$200,00017.5%
$275,000
3-29
Margin of SafetyMargin of SafetyThe excess of projected or actual sales volume over break-even volume.
The excess of projected or actual sales revenue over break-even revenue.Suppose U-Develop sells 8,000 prints
8,000 6,250 1,750 prints
$4,800
$3,750
$1,050
1750 x $.60 = $1,050
or
3-30
Extending CVP: TaxesExtending CVP: TaxesProfit of $3,000
But this means taxes.
Target VolumeCM unit
F 1 - t
.85X$1,500 $3,000
$.24
X 20,956 units
What if U-Develop is in the 15% tax bracket and wants profit after taxes of $3,000?
3-31
CVP and Taxes ContinuedCVP and Taxes ContinuedCheck it out
VC 20,956
$.36
7,544
CM $5,030
FC 1,500
NIBT $3,530
20,956
$.60
$12,574
Sales
Taxes 5303,530 15%
Net Income $3,000
3-32
Extending CVP: Multiple Extending CVP: Multiple ProductsProducts
U-Develop does prints and enlargements?
What if:
Prints
Enlargements
Selling price
$.60 $1.00
Variable cost .36 .56
Contribution margin
$. 24
$. 44
Total Fixed Costs
$1,820
3-33
Product MixProduct MixFor every 9 prints sold U-Develop sells 1 enlargement.
Weighted Average Contribution Margin
9/10 $.24
$ .261/10 $.44
Breakeven
$1,820
$.26
7,000
6,300 prints
9/10
700 enlargements
1/10
3-34
The process of estimating revenues and costs of alternative actions available to decision makers and of comparing these estimates to the status quo.
The period of time over which capacity will be unchanged, usually one year.
Differential Differential AnalysisAnalysis L.O. 3 Use differential analysis to analyze
decisions.
Short Run
Differential Analysis
3-35
Differential CostsDifferential Costs
Costs that change in response to an alternative course of action.
Differential costs differdiffer between actions.
3-36
Sunk CostsSunk Costs
Costs incurred in the past that cannot be changed by present or future decisions.
A sunk cost is NOT relevant.
3-37
Differential Analysis and Pricing Differential Analysis and Pricing DecisionsDecisions
L.O. 4 Understand how to apply differential analysis to pricing decisions.
Fixed costs
Variable costs
Must be covered in the long run.
Must always be covered.
Cost ($)
Activity level
Costs ($)
Activity level
3-38Full Cost and Pricing Full Cost and Pricing DecisionsDecisionsFull cost of manufacturing and selling a product.
and
Share of organization’s fixed costs.
Necessary to manufacture and sell the product.
Ultimately full costs must be recovered.
Variable costs
Fixed costs
3-39
Fixed costs
Variable costs
Must be covered in the long run.
Must always be covered.
Short-run Pricing Decisions
Long-run Pricing Decisions
Short-run vs Long-runShort-run vs Long-run
3-40
Short-run vs Long-run Pricing Short-run vs Long-run Pricing DecisionsDecisions
Short-run Pricing Decision
Long-run Pricing Decision
1Year
Pricing a one-time special order.
Pricing a new product.
0
Shorter than one year
Longer than one year
How much material is required?
Do I need a new plant?
3-41
Short-run Pricing Decisions: Special Short-run Pricing Decisions: Special OrdersOrders
An order that will not affect other sales and is usually a one-time occurrence.
Special order
Value of Option 1
Accept Special Order?
Is Option 1 >
Option 2?
Status Quo: Reject special offer
Alternative: Accept special offer
Value of Option 2
Option 1
Option 2
3-42Special Order Special Order ExampleExample
Analysis of Special Order U-DevelopStatus Quo: Alternative:
Reject Special Order
Accept Special Order
Difference
Comparison of Totals
Alternative Presentation: Differential Analysis
Differential operating profit (before taxes)
$100
Differential sales, 500 at 40¢
$200
Less differential costs, 500 at 20¢
100
Variable costs (1,000) (1,100) (100)
Fixed costs (1,200) (1,200)
Operating profit $300
$400
$100
Sales revenue $2,500
$2,700
$200
Total contribution 1,500
1,600
100 0
3-43Long-run Pricing Long-run Pricing DecisionsDecisionsL.O. 5 Understand several approaches for establishing
prices based on costs for long-run pricing decisions.
Life-cycle product costing and pricing
Target costing for Target pricing
In the long run an organization must cover variable and fixed costs.
3-44
Concerned with covering costs in all categories of the life cycle.
Life-cycle Product Costing and Life-cycle Product Costing and PricingPricing
The time from initial research and development to the time that support to the customer ends.
Product life-cycle
Life-cycle Costing
R&DDesign
Manufacturing Marketin
gDistribution
&
Customer Servic
e (Disposal)
Take Back
Cradle GraveT
o
3-45
The price based on customers’ perceived value for the product and the price that competitors charge.
Target price
Target Costing from Target Target Costing from Target PricingPricing
The maximum amount of cost allowed.
What would a customer pay?
How much profit do I need?
Can I make it at this cost?
Desired profit
Target cost
3-46
Decision to add or drop a product line or close a business unit.
Decision to make goods or services internally or purchase them externally.
Differential Analysis for Production Differential Analysis for Production DecisionsDecisions
L.O. 6 Understand how to apply differential analysis to production decisions.
Make or buy?
Add or drop a segment?
Product Mix
Decision on what products or services to offer.
3-47Make or Buy Make or Buy ExampleExample
Decision to make goods or services internally or externally.
Make or buy?
Per Unit
100,000 prints
Direct materials $0.05 $5,000
Direct labor 0.12 12,000
Variable manufacturing overhead 0.03 3,000
Fixed manufacturing overhead 4,000
Common costs allocated to this product line 10,000
$34,000
Cost directly traceable
100,000 prints
3-48Make or Buy Make or Buy ContinuedContinued
Make or Buy Analysis, U-DevelopStatus Quo: Alternative
:Process Prints
Outsource Processing
Difference100,000
prints
Common costs 10,000 b 10,000 b 0
Direct costs
a 100,000 units purchased at $.25 = $25,000.
b These common costs remain unchanged for these volumes. Because they do not change, they could be omitted from the analysis.
Labor 12,000 0 12,000 lower
Fixed overhead 4,000 0 4,000 lower
5,000 $25,000 a 20,000Direct materials higher
Variable overhead 3,000 0 3,000 lower
Total costs $34,000
$35,000
$1,000 higher
Differential costs increase by $1,000, so reject alternative to buy.
3-49Make or Buy Make or Buy ContinuedContinuedMake or Buy Analysis, U-
DevelopStatus Quo: Alternative:
Process Prints
Outsource Processing
Difference
Common costs 10,000 b 10,000 b 0
Direct costs
c Total variable costs reduced by half because volume was reduced by half.d 50,000 units purchased at $.25 =$12,500.
Labor 6,000 0 6,000 lower
Fixed overhead 4,000 0 4,000 lower
2,500 c $12,500 d 10,000
Direct materials higher
Variable overhead 1,500 0 1,500 lower
Total costs $24,000
$22,500
$1,500 lower
50,000 prints
Differential costs decrease by $1,500, so accept alternative to buy.
b These common costs remain unchanged for these volumes. Because they do not change, they could be omitted from the analysis.
3-50Opportunity Costs of Opportunity Costs of MakingMaking
Make-or-Buy Analysis with Opportunity Cost of U-Develop
Status Quo Alternative
Process Prints
Outsource Processing
Difference
Differential costs decrease by $1,000 so accept the alternative.
Opportunity cost of using facilities to make covers 2,000 0 2,000 Lower a
Total cost of 100,000 prints
$34,000
$35,000
1,000 Higher a
Total costs, including opportunity costs
$36,000
$35,000
1,000 Lower a
a These indicate whether the alternative is higher or lower than the status quo.
3-51Add or Drop Add or Drop ExampleExample
Decision to add or drop a product line or close a business unit.
Add or drop a segment?
Fourth Quarter Product Line Income Statement, U-Develop
Less fixed costs:
Total Prints Cameras
Frames
Sales revenue $80,000
$10,000
$50,000 $20,000
Cost of sales (all variables)
53,000 _ 8,000
30,000 15,000
Contribution margin $27,000
$2,000
$20,000 $5,000
Rent 4,000 1,000
2,000 1,000
Salaries 5,000 1,000
2,500 1,500
Marketing and administrative
_3,000 __500 _1,500 _1,000
Operating profit (loss) $15,000
$(500) $14,000 $1,500
3-52
Add or Drop ContinuedAdd or Drop ContinuedDifferential Analysis U-DevelopStatus Quo: Alternative:
Keep Prints
Drop Prints
Difference
Profits decrease $750 so keep prints.
Less fixed costs:
Sales revenue $80,000
$70,000
$10,000
decrease
Cost of sales (all variables)
53,000 45,000 _8,000 decrease
Contribution margin $27,000
$25,000
$2,000 decrease
Salaries 5,000 4,000 1,000 decrease
Marketing and administrative
_3,000 _2,750 __250 decrease
Operating profit (loss) $15,000
$14,250
$750 decrease
Rent 4,000 4,000 0
3-53
Product Choice DecisionsProduct Choice Decisions
Activities, resources, or policies that limit the attainment of an objective.
Constraints
Contribution margin per unit of a particular input with limited availability.
Contribution margin per unit of scarce resource
3-54
Product Choice Decisions Product Choice Decisions ExampleExample
Revenue and Cost Information, U-Develop
Metal Frames
Wood Frames
Less variable costs per unit
Fixed manufacturing costs: $3,000 per month
Fixed marketing and administrative costs: $1,500 per month
Price $50 $80
Labor 8 24
Material 8 22
Overhead 4 4
Contribution margin per unit
$30 $30
3-55
Product Choice Decisions Product Choice Decisions ExampleExample
Revenue and Cost Information, U-Develop
Contribution margin $30 $30
Machine hours required .5 1
Per Unit
Metal Frames
Wood Frames
Contribution margin per machine hour
$60 $30
Metal Frames have a higher contribution margin per machine hour.
3-56
Product Choice Decisions Product Choice Decisions ExampleExample
Suppose U-Develop has 200 machine hours per month available.
Selling metal frames results in higher profits than selling wooden frames.
Capacity 400 200
Contribution margin per unit $30 $30
Total contribution margin $12,000
$6,000
Metal Frames
Wood Frames
Less fixed manufacturing costs
3,000 3,000
Less fixed M&A costs 1,500 1,500
Operating profit $7,500 $1,500
3-57
Theory of ConstraintsTheory of ConstraintsL.O. 7 Understand the theory of constraints (Appendix).
Focuses on revenue and cost management when faced with bottlenecks.
Theory of Constraints
Bottleneck
Operation where the work required limits production.
The bottleneck is a constraining resource.
3-58
Chapter 3
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