Introduction to Cost Behavior and Cost-Volume Relationships.

Introduction to Introduction to Cost Behavior and Cost Behavior and

Cost-Volume Cost-Volume RelationshipsRelationships

Introduction to Introduction to Cost Behavior and Cost Behavior and

Cost-Volume Cost-Volume RelationshipsRelationships

Cost Drivers and Cost Cost Drivers and Cost BehaviorBehavior

Traditional View of Cost Traditional View of Cost BehaviorBehavior

Activity-Based View of Cost Activity-Based View of Cost BehaviorBehavior

Resource AResource ACost Driver = Cost Driver =

Units of Units of ResourceResourceOutputOutput



Resource BResource BCost Driver = Cost Driver =




Activity AActivity ACost Driver = Cost Driver =

Units of Units of Activity OutputActivity Output

Activity AActivity ACost Driver = Cost Driver =


Activity BActivity BCost Driver = Cost Driver =


Activity BActivity BCost Driver = Cost Driver =










Product or ServiceProduct or ServiceCost Driver = Units of FinalCost Driver = Units of Final

Product or ServiceProduct or Service

Product or ServiceProduct or ServiceCost Driver = Output of FinalCost Driver = Output of Final

Product or ServiceProduct or Service

Cost Drivers and Cost Behavior Cost Drivers and Cost Behavior

Cost behavior is how the activities Cost behavior is how the activities of an organization affect its costs.of an organization affect its costs.Cost behavior is how the activities Cost behavior is how the activities of an organization affect its costs.of an organization affect its costs.

Any output measure that causesAny output measure that causesthe use of costly resourcesthe use of costly resources

is a cost driver.is a cost driver.

Any output measure that causesAny output measure that causesthe use of costly resourcesthe use of costly resources

is a cost driver.is a cost driver.

Value Chain Functions, Costs, and Cost Value Chain Functions, Costs, and Cost

DriversDriversValue Chain Function and Example CostsValue Chain Function and Example Costs Example Cost Example Cost DriversDrivers

Research and development

•Salaries marketing research personnel Number of new product proposals

costs of market surveys

•Salaries of product and process engineers Complexity of proposed products

Design of products, services, and processes

•Salaries of product and process engineers Number of engineering hours

•Cost of computer-aided design equipment Number of parts per product

•Cost to develop prototype of product

for testing

Value Chain Function and Example CostsValue Chain Function and Example Costs Example Cost Example Cost DriversDrivers

Research and development

•Salaries marketing research personnel Number of new product proposals

costs of market surveys

•Salaries of product and process engineers Complexity of proposed products

Design of products, services, and processes

•Salaries of product and process engineers Number of engineering hours

•Cost of computer-aided design equipment Number of parts per product

•Cost to develop prototype of product

for testing


DriversDriversValue Chain Function and Example CostsValue Chain Function and Example Costs Example Cost Example Cost DriversDriversProduction•Labor wages Labor hours •Supervisory salaries Number of people supervised•Maintenance wages Number of mechanic hours•Depreciation of plant and machinery Number of machine hours suppliesEnergy cost Kilowatt hours

Marketing•Cost of advertisements Number of advertisements•Salaries of marketing personnel, Sales dollars travel costs, entertainment costs

Value Chain Function and Example CostsValue Chain Function and Example Costs Example Cost Example Cost DriversDriversProduction•Labor wages Labor hours •Supervisory salaries Number of people supervised•Maintenance wages Number of mechanic hours•Depreciation of plant and machinery Number of machine hours suppliesEnergy cost Kilowatt hours

Marketing•Cost of advertisements Number of advertisements•Salaries of marketing personnel, Sales dollars travel costs, entertainment costs


DriversDrivers

Value chain function and Example costsValue chain function and Example costs Example Example Cost DriversCost Drivers Distribution•Wages of shipping personnel Labor hours•Transportation costs including Weight of items delivered depreciation of vehicles and fuel

Customer service•Salaries of service personnel Hours spent servicing products•Costs of supplies, travel Number of service calls

Value chain function and Example costsValue chain function and Example costs Example Example Cost DriversCost Drivers Distribution•Wages of shipping personnel Labor hours•Transportation costs including Weight of items delivered depreciation of vehicles and fuel

Customer service•Salaries of service personnel Hours spent servicing products•Costs of supplies, travel Number of service calls

Cost Classification and Cost Cost Classification and Cost AllocationAllocationIn order to make meaningful decisions a manager In order to make meaningful decisions a manager

must have cost data for each product, department must have cost data for each product, department and function of the businessand function of the businessThe problem with this is how to accuratelyThe problem with this is how to accurately definedefine the costs and how tothe costs and how to allocateallocate the costs the costs to the various products and departmentsto the various products and departments

The management accountant classifies costs The management accountant classifies costs into into fixedfixed and and variablevariable costs or costs or directdirect and and indirectindirect costs costs

These costs are then allocated as These costs are then allocated as accurately as possible to the cost accurately as possible to the cost centres that generate them. In this way centres that generate them. In this way centres are made aware of their centres are made aware of their responsibility to control costsresponsibility to control costs

Fixed, Variable and Fixed, Variable and Semi- Variable CostsSemi- Variable Costs

Variable CostsVariable Costs – expenses that alter in the – expenses that alter in the short run to changes in output e.g. raw short run to changes in output e.g. raw materials, packaging and components. They materials, packaging and components. They are payments for the use of inputsare payments for the use of inputsFixed CostsFixed Costs – expenses that do not alter in the – expenses that do not alter in the short run in relation to changes in output e.g. rent, short run in relation to changes in output e.g. rent, insurance and depreciation. These costs are linked insurance and depreciation. These costs are linked to time rather the level of business activityto time rather the level of business activity

Semi Variable CostsSemi Variable Costs – expenses that vary with – expenses that vary with output but not in direct proportion e.g. output but not in direct proportion e.g. maintenance costs. They often comprise a fixed maintenance costs. They often comprise a fixed element and a variable elementelement and a variable element

Direct and Indirect CostsDirect and Indirect Costs

Indirect CostsIndirect Costs – costs that cannot be allocated – costs that cannot be allocated accurately to a cost centre or product e.g. accurately to a cost centre or product e.g. administration costs, management salaries or administration costs, management salaries or maintenance costs. Another term for this ismaintenance costs. Another term for this is overheadsoverheadsDirect CostsDirect Costs – costs that can be directly – costs that can be directly identified with a product or cost centre. They are identified with a product or cost centre. They are mainly variable costs but can include some fixed mainly variable costs but can include some fixed costs e.g. the rent of a building solely used for costs e.g. the rent of a building solely used for one product. They are also referred to asone product. They are also referred to as prime prime costscosts

Total CostTotal Cost

Total CostTotal Cost – this is the addition of all fixed and variable costs (plus – this is the addition of all fixed and variable costs (plus any semi-variable costs)any semi-variable costs)

Where fixed costs form a significant part of total Where fixed costs form a significant part of total costs it is important for a business to maximise sales costs it is important for a business to maximise sales so that the fixed cost element is spread across as so that the fixed cost element is spread across as many units as possiblemany units as possibleThe total cost is used by the business to see how The total cost is used by the business to see how much finance is required for each level of outputmuch finance is required for each level of output

Variable and Fixed Cost Variable and Fixed Cost

BehaviorBehaviorA A variable costvariable cost

changes in direct changes in direct proportion to changes proportion to changes in the cost-driver level.in the cost-driver level.

A A variable costvariable cost changes in direct changes in direct

proportion to changes proportion to changes in the cost-driver level.in the cost-driver level.

A A fixed costfixed cost is is not immediately not immediately

affected by changes affected by changes in the cost-driver.in the cost-driver.

A A fixed costfixed cost is is not immediately not immediately

affected by changes affected by changes in the cost-driver.in the cost-driver.

Think of variable Think of variable costs on a per-unit basis.costs on a per-unit basis.

Think of variable Think of variable costs on a per-unit basis.costs on a per-unit basis.

The per-unit variable The per-unit variable cost remains unchanged cost remains unchanged regardless of changes in regardless of changes in

the cost-driver.the cost-driver.

The per-unit variable The per-unit variable cost remains unchanged cost remains unchanged regardless of changes in regardless of changes in

the cost-driver.the cost-driver.

Think of fixed costs Think of fixed costs on a total-cost basis.on a total-cost basis.Think of fixed costs Think of fixed costs on a total-cost basis.on a total-cost basis.

Total fixed costs remain Total fixed costs remain unchanged regardless of unchanged regardless of

changes in the cost-driver.changes in the cost-driver.

Total fixed costs remain Total fixed costs remain unchanged regardless of unchanged regardless of

changes in the cost-driver.changes in the cost-driver.

Relevant RangeRelevant Range

The relevant range is the limitThe relevant range is the limitof cost-driver activity level within which aof cost-driver activity level within which a

specific relationship between costsspecific relationship between costsand the cost driver is valid.and the cost driver is valid.

The relevant range is the limitThe relevant range is the limitof cost-driver activity level within which aof cost-driver activity level within which a

specific relationship between costsspecific relationship between costsand the cost driver is valid.and the cost driver is valid.

Even within the relevant range, a fixed Even within the relevant range, a fixed cost remains fixed only over a given cost remains fixed only over a given

period of time. Usually the budget period.period of time. Usually the budget period.

Even within the relevant range, a fixed Even within the relevant range, a fixed cost remains fixed only over a given cost remains fixed only over a given

period of time. Usually the budget period.period of time. Usually the budget period.

Relevant RangeRelevant Range

....is a band of volume in which a ....is a band of volume in which a specific relationship exists between cost specific relationship exists between cost and volume.and volume.

Outside the relevant range, the cost Outside the relevant range, the cost either increases or decreases.either increases or decreases.

A fixed cost is fixed only within a given A fixed cost is fixed only within a given relevant range and a given time span.relevant range and a given time span.

Fixed Costs and Relevant RangeFixed Costs and Relevant Range

20 40 60 80 10020 40 60 80 100 20 40 60 80 10020 40 60 80 100

115,000115,000115,000115,000 100,000100,000 100,000100,000

60,00060,000 60,00060,000

Total Cost-Driver Activity in Thousands Total Cost-Driver Activity in Thousands of Cases per Monthof Cases per Month

Tota

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Fix

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Tota

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Fix

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C

osts

Costs

Relevant rangeRelevant range115,000115,000115,000115,000 100,000100,000 100,000100,000

60,00060,000 60,00060,000

20 40 60 80 10020 40 60 80 100

CVP ScenarioCVP Scenario

Per Unit Percentage of Per Unit Percentage of Sales Sales Selling priceSelling price ¢¢1.501.50 100%100%Variable cost of each itemVariable cost of each item 1.20 1.20 8080Selling price less variable costSelling price less variable cost ¢¢.30.30 20%20%

Monthly fixed expenses:Monthly fixed expenses: RentRent ¢ ¢ 3,0003,000 Wages for replenishing andWages for replenishing and servicingservicing 13,500 13,500 Other fixed expenses Other fixed expenses 1,5001,500Total fixed expenses per month Total fixed expenses per month ¢ ¢ 18,00018,000

Per Unit Percentage of Per Unit Percentage of Sales Sales Selling priceSelling price ¢¢1.501.50 100%100%Variable cost of each itemVariable cost of each item 1.20 1.20 8080Selling price less variable costSelling price less variable cost ¢¢.30.30 20%20%

Monthly fixed expenses:Monthly fixed expenses: RentRent ¢ ¢ 3,0003,000 Wages for replenishing andWages for replenishing and servicingservicing 13,500 13,500 Other fixed expenses Other fixed expenses 1,5001,500Total fixed expenses per month Total fixed expenses per month ¢ ¢ 18,00018,000

Cost-volume-profit (CVP) analysis is the study of the effects of output Cost-volume-profit (CVP) analysis is the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit).volume on revenue (sales), expenses (costs), and net income (net profit).Cost-volume-profit (CVP) analysis is the study of the effects of output Cost-volume-profit (CVP) analysis is the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit).volume on revenue (sales), expenses (costs), and net income (net profit).

Break-Even PointBreak-Even Point

The break-even point is the level of sales at which The break-even point is the level of sales at which

revenue equals expenses and net income is zero.revenue equals expenses and net income is zero.The break-even point is the level of sales at which The break-even point is the level of sales at which

revenue equals expenses and net income is zero.revenue equals expenses and net income is zero.

Sales Sales - Variable expenses- Variable expenses- Fixed expenses- Fixed expensesZero net income (break-even point)Zero net income (break-even point)

Sales Sales - Variable expenses- Variable expenses- Fixed expenses- Fixed expensesZero net income (break-even point)Zero net income (break-even point)

Break-Even PointBreak-Even Point

Breakeven analysis is also known as cost-volume Breakeven analysis is also known as cost-volume profit analysisprofit analysis

Breakeven analysis is the study of the relationship Breakeven analysis is the study of the relationship between selling prices, sales volumes, fixed costs, between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of variable costs and profits at various levels of activityactivity

ApplicationApplication

Breakeven analysis can be used to Breakeven analysis can be used to determine a company’s breakeven point determine a company’s breakeven point (BEP)(BEP)

Breakeven point is a level of activity at Breakeven point is a level of activity at which the which the total revenue is equal to the total total revenue is equal to the total costscosts

At this level, the company At this level, the company makes no profitmakes no profit

Assumption of breakeven point Assumption of breakeven point analysisanalysis

Relevant rangeRelevant rangeThe relevant range is the range of an activity over The relevant range is the range of an activity over which the fixed cost will remain fixed in total and the which the fixed cost will remain fixed in total and the variable cost per unit will remain constantvariable cost per unit will remain constant

Fixed costFixed costTotal fixed cost are assumed to be constant in totalTotal fixed cost are assumed to be constant in total

Variable costVariable costTotal variable cost will increase with increasing number Total variable cost will increase with increasing number of units producedof units produced

Sales revenueSales revenueThe total revenue will increase with the increasing The total revenue will increase with the increasing number of units producednumber of units produced

Calculation methodCalculation method

Breakeven pointBreakeven point

Target profitTarget profit

Margin of safetyMargin of safety

Changes in components of Changes in components of breakeven analysisbreakeven analysis

Breakeven pointBreakeven point

Contribution is defined as the excess of Contribution is defined as the excess of sales revenue over the variable costssales revenue over the variable costs

The total contribution is equal to total The total contribution is equal to total fixed cost fixed cost

Contribution Margin MethodContribution Margin Method

FormulaFormula

Breakeven Breakeven point point

==Fixed Fixed costcostContribution per Contribution per

unitunit

Sales revenue at breakeven pointSales revenue at breakeven point

== Breakeven point *selling price Breakeven point *selling price

Alternative methodAlternative method

Sales revenue at breakeven point Sales revenue at breakeven point

== Contribution required to Contribution required to breakevenbreakevenContribution to sales ratioContribution to sales ratio

Contribution per unitContribution per unitSelling price per unitSelling price per unit

Breakeven point in Breakeven point in unitsunitsSales revenue at breakeven Sales revenue at breakeven

pointpointSelling priceSelling price==

ExampleExample

Selling price per unitSelling price per unit ¢¢1212Variable cost per unitVariable cost per unit ¢ ¢ 33Fixed costsFixed costs ¢¢4500045000

Required:Required:Compute the breakeven point Compute the breakeven point

SolutionSolution

Breakeven point in units = Breakeven point in units = Fixed costs Fixed costs Contribution per unitContribution per unit

= = ¢¢4500045000 ¢¢12-12- ¢ ¢33

= 5000 units= 5000 units

Sales revenue at breakeven point = Sales revenue at breakeven point = ¢¢12 * 12 * ¢¢5000 = 5000 = ¢ ¢ 6000060000


Contribution to sales ratio ¢9 / ¢12 Contribution to sales ratio ¢9 / ¢12 *100% = 75%*100% = 75%

Sales revenue at breakeven pointSales revenue at breakeven point

= Contribution required to break = Contribution required to break eveneven

Contribution to sales ratioContribution to sales ratio

= = ¢ ¢ 4500045000

75%75%

= = ¢ ¢ 6000060000

Breakeven point in units = Breakeven point in units = ¢¢60000/60000/ ¢ ¢12 12

= 5000 units= 5000 units


¢ ¢ 18,000 fixed costs ÷ 18,000 fixed costs ÷ ¢¢.30.30= 60,000 units (break even)= 60,000 units (break even)¢ ¢ 18,000 fixed costs ÷ 18,000 fixed costs ÷ ¢¢.30.30

= 60,000 units (break even)= 60,000 units (break even)

Contribution marginContribution margin Per UnitPer Unit

Selling priceSelling price ¢ ¢ 1.50 1.50 Variable costsVariable costs 1.20 1.20 Contribution marginContribution margin ¢ ¢ .30 .30

Contribution marginContribution margin Per UnitPer Unit

Selling priceSelling price ¢ ¢ 1.50 1.50 Variable costsVariable costs 1.20 1.20 Contribution marginContribution margin ¢ ¢ .30 .30

Contribution margin ratioContribution margin ratioPer UnitPer Unit % %

Selling priceSelling price 100 100 Variable costsVariable costs 80 80 Contribution marginContribution margin 20 20


Selling priceSelling price 100 100 Variable costsVariable costs 80 80 Contribution marginContribution margin 20 20


¢ ¢ 18,000 fixed costs18,000 fixed costs÷ 20% (contribution-margin percentage)÷ 20% (contribution-margin percentage)

= = ¢ ¢ 90,000 of sales to break even90,000 of sales to break even

¢ ¢ 18,000 fixed costs18,000 fixed costs÷ 20% (contribution-margin percentage)÷ 20% (contribution-margin percentage)

= = ¢ ¢ 90,000 of sales to break even90,000 of sales to break even

60,000 units × 60,000 units × ¢ ¢ 1.50 = 1.50 = ¢ ¢ 90,00090,000in sales to break evenin sales to break even

60,000 units × 60,000 units × ¢ ¢ 1.50 = 1.50 = ¢ ¢ 90,00090,000in sales to break evenin sales to break even

Equation MethodEquation Method

Sales – variable expenses – fixed expenses = net incomeSales – variable expenses – fixed expenses = net income¢ ¢ 1.50N – 1.50N – ¢¢1.20N – 1.20N – ¢¢18,000 = 018,000 = 0

¢¢.30N = .30N = ¢ ¢ 18,00018,000N = N = ¢ ¢ 18,000 ÷ 18,000 ÷ ¢¢.30.30

N = 60,000 UnitsN = 60,000 Units

Sales – variable expenses – fixed expenses = net incomeSales – variable expenses – fixed expenses = net income¢ ¢ 1.50N – 1.50N – ¢¢1.20N – 1.20N – ¢¢18,000 = 018,000 = 0

¢¢.30N = .30N = ¢ ¢ 18,00018,000N = N = ¢ ¢ 18,000 ÷ 18,000 ÷ ¢¢.30.30

N = 60,000 UnitsN = 60,000 Units

Let N = number of unitsLet N = number of unitsto be sold to break even.to be sold to break even.Let N = number of unitsLet N = number of unitsto be sold to break even.to be sold to break even.

Equation MethodEquation Method

S – .80S – S – .80S – ¢¢18,000 = 018,000 = 0.20S = .20S = ¢ ¢ 18,00018,000

S = S = ¢ ¢ 18,000 ÷ .2018,000 ÷ .20S = S = ¢ ¢ 90,00090,000

S – .80S – S – .80S – ¢¢18,000 = 018,000 = 0.20S = .20S = ¢ ¢ 18,00018,000

S = S = ¢ ¢ 18,000 ÷ .2018,000 ÷ .20S = S = ¢ ¢ 90,00090,000

Let S = sales in CedisLet S = sales in Cedisneeded to break even.needed to break even.Let S = sales in CedisLet S = sales in Cedisneeded to break even.needed to break even.

Shortcut formulas:Shortcut formulas:Break-even volume in units = Break-even volume in units = fixed expensesfixed expenses unit contribution marginunit contribution margin

Break-even volume in sales = Break-even volume in sales = fixed expensesfixed expenses contribution margin ratio contribution margin ratio

Shortcut formulas:Shortcut formulas:Break-even volume in units = Break-even volume in units = fixed expensesfixed expenses unit contribution marginunit contribution margin

Break-even volume in sales = Break-even volume in sales = fixed expensesfixed expenses contribution margin ratio contribution margin ratio

Cost-Volume-Profit Graph

18,000

30,000

90,000

120,000

138,000

¢¢ 150,000

0 10 20 30 40 50 60 70 80 90 100

Units (thousands)

Ced

is

60,000 Total

Expenses

Sales

Net Income Area

Break-Even Point 60,000

units or ¢¢ 90,000

Net Loss Area

A

C

D

B

Fixed Expenses

Variable Expense

s

Net Income

Target profitTarget profit

Target Net ProfitTarget Net Profit

Managers use CVP analysis Managers use CVP analysis to determine the total sales, to determine the total sales, in units and dollars, needed in units and dollars, needed To reach a target net profit.To reach a target net profit.

Managers use CVP analysis Managers use CVP analysis to determine the total sales, to determine the total sales, in units and dollars, needed in units and dollars, needed To reach a target net profit.To reach a target net profit.

Target sales Target sales – – variable expenses variable expenses

– – fixed expenses fixed expenses target net incometarget net income

Target sales Target sales – – variable expenses variable expenses

– – fixed expenses fixed expenses target net incometarget net income

Let’s assume ¢1,440 per month Let’s assume ¢1,440 per month is the minimumis the minimum

acceptable net income.acceptable net income.

Let’s assume ¢1,440 per month Let’s assume ¢1,440 per month is the minimumis the minimum

acceptable net income.acceptable net income.

Target sales volume in units =Target sales volume in units =(Fixed expenses + Target net income)(Fixed expenses + Target net income)

÷ Contribution margin per unit÷ Contribution margin per unit

Target sales volume in units =Target sales volume in units =(Fixed expenses + Target net income)(Fixed expenses + Target net income)

÷ Contribution margin per unit÷ Contribution margin per unit

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


Selling priceSelling price ¢ ¢ 1.50 1.50 Variable costsVariable costs 1.20 1.20 Contribution margin per unitContribution margin per unit $ .30 $ .30

Selling priceSelling price ¢ ¢ 1.50 1.50 Variable costsVariable costs 1.20 1.20 Contribution margin per unitContribution margin per unit $ .30 $ .30

Target sales dollars = sales price X sales volume in unitsTarget sales dollars = sales price X sales volume in unitsTarget sales dollars = Target sales dollars = ¢ ¢ 1.50 X 64,800 units = 1.50 X 64,800 units = ¢ ¢ 97,200.97,200.Target sales dollars = sales price X sales volume in unitsTarget sales dollars = sales price X sales volume in unitsTarget sales dollars = Target sales dollars = ¢ ¢ 1.50 X 64,800 units = 1.50 X 64,800 units = ¢ ¢ 97,200.97,200.

Sales volume in dollars = Sales volume in dollars = 18,000 + 18,000 + ¢ ¢ 1,4401,440 = = ¢ ¢ 97,200 97,200 .20.20

Sales volume in dollars = Sales volume in dollars = 18,000 + 18,000 + ¢ ¢ 1,4401,440 = = ¢ ¢ 97,200 97,200 .20.20


Target sales volume in dollars = Target sales volume in dollars = Fixed expenses + target net incomeFixed expenses + target net incomecontribution margin ratiocontribution margin ratio

Target sales volume in dollars = Target sales volume in dollars = Fixed expenses + target net incomeFixed expenses + target net incomecontribution margin ratiocontribution margin ratio


Selling priceSelling price 100 100 Variable costsVariable costs .80 .80 Contribution marginContribution margin .20 .20


Selling priceSelling price 100 100 Variable costsVariable costs .80 .80 Contribution marginContribution margin .20 .20

Work this outWork this out

Selling price per unitSelling price per unit ¢¢1212

Variable cost per unitVariable cost per unit ¢¢33

Fixed costsFixed costs ¢¢4500045000

Target profitTarget profit ¢¢1800018000

Required:Required:Compute the sales volume required to

achieve the target profit

SolutionSolution

No. of units at target profit Fixed cost + Target profit

Contribution per unit45,000 + 18,00012 - 3

= 7,000 units

Required to sales revenue = 12 *7000 = 84,000


Required sales revenue

Fixed cost + Target profitContribution to sales ratio45000 + 18000

75%

= 84000

Units sold at target profit = 84000 /12 = 7000 units

Operating LeverageOperating Leverage

Operating leverage: a firm’s ratio of fixed costs to variable costs. Operating leverage: a firm’s ratio of fixed costs to variable costs. Operating leverage: a firm’s ratio of fixed costs to variable costs. Operating leverage: a firm’s ratio of fixed costs to variable costs.

Margin of safety = planned unit sales – break-even sales Margin of safety = planned unit sales – break-even sales How far can sales fall below the planned level before losses occur?How far can sales fall below the planned level before losses occur?

Margin of safety = planned unit sales – break-even sales Margin of safety = planned unit sales – break-even sales How far can sales fall below the planned level before losses occur?How far can sales fall below the planned level before losses occur?

Highly leveraged firms have high fixed costs and low 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.A small change in sales volume = a large change in net income.

Highly leveraged firms have high fixed costs and low 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.A small change in sales volume = a large change in net income.

Low leveraged firms have lower fixed costs and higher variable costs. Low leveraged firms have lower fixed costs and higher variable costs. Changes in sales volume will have a smaller effect on net income.Changes in sales volume will have a smaller effect on net income.

Low leveraged firms have lower fixed costs and higher variable costs. Low leveraged firms have lower fixed costs and higher variable costs. Changes in sales volume will have a smaller effect on net income.Changes in sales volume will have a smaller effect on net income.

Contribution MarginContribution Marginand Gross Marginand Gross Margin

Sales price – Cost of goods sold = Gross marginSales price – Cost of goods sold = Gross marginSales price – Cost of goods sold = Gross marginSales price – Cost of goods sold = Gross margin

Sales price - all variable expenses = Contribution marginSales price - all variable expenses = Contribution marginSales price - all variable expenses = Contribution marginSales price - all variable expenses = Contribution margin

Per UnitPer UnitSelling priceSelling price ¢ ¢ 1.501.50Variable costs (acquisition cost)Variable costs (acquisition cost) 1.20 1.20Contribution margin and Contribution margin and gross margin are equalgross margin are equal ¢¢ .30 .30

Contribution Margin and Gross Contribution Margin and Gross

MarginMargin

Contribution Gross Contribution Gross Margin MarginMargin Margin Per UnitPer Unit Per Unit Per Unit

SalesSales ¢ ¢ 1.501.50 ¢ ¢ 1.50 1.50 Acquisition cost of unit soldAcquisition cost of unit sold 1.201.20 1.20 1.20 Variable commissionVariable commission .12 .12Total variable expense Total variable expense ¢ ¢ 1.321.32Contribution marginContribution margin .18 .18 Gross marginGross margin ¢¢.30 .30

Contribution Gross Contribution Gross Margin MarginMargin Margin Per UnitPer Unit Per Unit Per Unit

SalesSales ¢ ¢ 1.501.50 ¢ ¢ 1.50 1.50 Acquisition cost of unit soldAcquisition cost of unit sold 1.201.20 1.20 1.20 Variable commissionVariable commission .12 .12Total variable expense Total variable expense ¢ ¢ 1.321.32Contribution marginContribution margin .18 .18 Gross marginGross margin ¢¢.30 .30

Suppose the firm had to pay a commission of Suppose the firm had to pay a commission of ¢¢.12.12 per unit sold. per unit sold.Suppose the firm had to pay a commission of Suppose the firm had to pay a commission of ¢¢.12.12 per unit sold. per unit sold.

Nonprofit ApplicationNonprofit Application

Suppose a city has a Suppose a city has a ¢ ¢ 100,000100,000lump-sum budget appropriationlump-sum budget appropriation

to conduct a counseling program.to conduct a counseling program.

Suppose a city has a Suppose a city has a ¢ ¢ 100,000100,000lump-sum budget appropriationlump-sum budget appropriation

to conduct a counseling program.to conduct a counseling program.

Variable costs per prescriptionVariable costs per prescriptionis is ¢ ¢ 400 per patient per day.400 per patient per day.

Variable costs per prescriptionVariable costs per prescriptionis is ¢ ¢ 400 per patient per day.400 per patient per day.

Fixed costs are Fixed costs are ¢ ¢ 60,000 in the60,000 in therelevant range of 50 to 150 patients.relevant range of 50 to 150 patients.

Fixed costs are Fixed costs are ¢ ¢ 60,000 in the60,000 in therelevant range of 50 to 150 patients.relevant range of 50 to 150 patients.

If the city spends the entire budgetIf the city spends the entire budgetappropriation, how many patientsappropriation, how many patients

can it serve in a year?can it serve in a year?

If the city spends the entire budgetIf the city spends the entire budgetappropriation, how many patientsappropriation, how many patients

can it serve in a year?can it serve in a year?

¢ ¢ 100,000 = 100,000 = ¢ ¢ 400N + 400N + ¢ ¢ 60,00060,000¢ ¢ 400N = 400N = ¢ ¢ 100,000 – 100,000 – ¢¢60,00060,000

N = N = ¢ ¢ 40,000 ÷ 40,000 ÷ ¢ ¢ 400400N = 100 patientsN = 100 patients

¢ ¢ 100,000 = 100,000 = ¢ ¢ 400N + 400N + ¢ ¢ 60,00060,000¢ ¢ 400N = 400N = ¢ ¢ 100,000 – 100,000 – ¢¢60,00060,000




If the city cuts the total budgetIf the city cuts the total budgetAppropriation by 10%, how many Appropriation by 10%, how many

Patients can it serve in a year?Patients can it serve in a year?

If the city cuts the total budgetIf the city cuts the total budgetAppropriation by 10%, how many Appropriation by 10%, how many

Patients can it serve in a year?Patients can it serve in a year?

¢ ¢ 90,000 = 90,000 = ¢ ¢ 400N + 400N + ¢ ¢ 60,00060,000¢ ¢ 400N = 400N = ¢ ¢ 90,000 – 90,000 – ¢¢60,00060,000


¢ ¢ 90,000 = 90,000 = ¢ ¢ 400N + 400N + ¢ ¢ 60,00060,000¢ ¢ 400N = 400N = ¢ ¢ 90,000 – 90,000 – ¢¢60,00060,000


Budget after 10% CutBudget after 10% Cut¢ ¢ 100,000 X (1 - .1) = 100,000 X (1 - .1) = ¢ ¢ 90,00090,000

Budget after 10% CutBudget after 10% Cut¢ ¢ 100,000 X (1 - .1) = 100,000 X (1 - .1) = ¢ ¢ 90,00090,000

Sales Mix AnalysisSales Mix Analysis

Sales mix is the relative proportions orSales mix is the relative proportions orcombinations of quantities of productscombinations of quantities of products

that comprise total sales.that comprise total sales.

Sales mix is the relative proportions orSales mix is the relative proportions orcombinations of quantities of productscombinations of quantities of products

that comprise total sales.that comprise total sales.


Padus Company ExamplePadus Company Example

Sales in unitsSales in units 300,000 300,000 75,000 75,000 375,000 375,000Sales @ Sales @ ¢ ¢ 8 and 8 and ¢ ¢ 55 ¢ ¢ 2,400,0002,400,000 ¢ ¢ 375,000375,000 ¢ ¢ 2,775,0002,775,000Variable expensesVariable expenses @ @ ¢ ¢ 7 and 7 and ¢ ¢ 33 2,100,000 2,100,000 225,000 225,000 2,325,000 2,325,000 Contribution marginsContribution margins @ $1 and $2@ $1 and $2 ¢ ¢ 300,000 300,000 ¢ ¢ 150,000150,000 ¢ ¢ 450,000 450,000Fixed expensesFixed expenses 180,000 180,000 Net incomeNet income ¢ ¢ 270,000 270,000

Sales in unitsSales in units 300,000 300,000 75,000 75,000 375,000 375,000Sales @ Sales @ ¢ ¢ 8 and 8 and ¢ ¢ 55 ¢ ¢ 2,400,0002,400,000 ¢ ¢ 375,000375,000 ¢ ¢ 2,775,0002,775,000Variable expensesVariable expenses @ @ ¢ ¢ 7 and 7 and ¢ ¢ 33 2,100,000 2,100,000 225,000 225,000 2,325,000 2,325,000 Contribution marginsContribution margins @ $1 and $2@ $1 and $2 ¢ ¢ 300,000 300,000 ¢ ¢ 150,000150,000 ¢ ¢ 450,000 450,000Fixed expensesFixed expenses 180,000 180,000 Net incomeNet income ¢ ¢ 270,000 270,000

WalletsWallets(W)(W)

Key CasesKey Cases(K)(K) TotalTotal


Break-even point for a constant sales mix Break-even point for a constant sales mix of 4 units of W for every unit of K.of 4 units of W for every unit of K.

sales – variable expenses - fixed expenses = zero net incomesales – variable expenses - fixed expenses = zero net income[[¢ ¢ 8(4K) + 8(4K) + ¢ ¢ 5(K)] – [5(K)] – [¢ ¢ 7(4K) + 7(4K) + ¢ ¢ 3(K)] – 3(K)] – ¢¢180,000 = 0 180,000 = 0

32K + 5K - 28K - 3K - 180,000 = 032K + 5K - 28K - 3K - 180,000 = 06K = 180,000 6K = 180,000

K = 30,000K = 30,000W = 4K = 120,000 W = 4K = 120,000

Break-even point for a constant sales mix Break-even point for a constant sales mix of 4 units of W for every unit of K.of 4 units of W for every unit of K.

sales – variable expenses - fixed expenses = zero net incomesales – variable expenses - fixed expenses = zero net income[[¢ ¢ 8(4K) + 8(4K) + ¢ ¢ 5(K)] – [5(K)] – [¢ ¢ 7(4K) + 7(4K) + ¢ ¢ 3(K)] – 3(K)] – ¢¢180,000 = 0 180,000 = 0

32K + 5K - 28K - 3K - 180,000 = 032K + 5K - 28K - 3K - 180,000 = 06K = 180,000 6K = 180,000

K = 30,000K = 30,000W = 4K = 120,000 W = 4K = 120,000

Let K = number of units of K to break even, andLet K = number of units of K to break even, and4K = number of units of W to break even.4K = number of units of W to break even.

Let K = number of units of K to break even, andLet K = number of units of K to break even, and4K = number of units of W to break even.4K = number of units of W to break even.


If the company sells only key cases:If the company sells only key cases:break-even point = break-even point = fixed expensesfixed expenses

contribution margin per unitcontribution margin per unit = = ¢ ¢ 180,000180,000

¢ ¢ 22 = 90,000 key cases = 90,000 key cases

If the company sells only key cases:If the company sells only key cases:break-even point = break-even point = fixed expensesfixed expenses


¢ ¢ 22 = 90,000 key cases = 90,000 key cases

If the company sells only wallets:If the company sells only wallets:break-even point = break-even point = fixed expensesfixed expenses


¢ ¢ 11 = 180,000 wallets = 180,000 wallets

If the company sells only wallets:If the company sells only wallets:break-even point = break-even point = fixed expensesfixed expenses


¢ ¢ 11 = 180,000 wallets = 180,000 wallets


Suppose total sales Suppose total sales were equal to the were equal to the

budget of 375,000 units.budget of 375,000 units.

Suppose total sales Suppose total sales were equal to the were equal to the

budget of 375,000 units.budget of 375,000 units.

However, Padus sold However, Padus sold only 50,000 key casesonly 50,000 key casesAnd 325,000 wallets.And 325,000 wallets.What is net income?What is net income?

However, Padus sold However, Padus sold only 50,000 key casesonly 50,000 key casesAnd 325,000 wallets.And 325,000 wallets.What is net income?What is net income?


Padus Company ExamplePadus Company Example

Sales in unitsSales in units 325,000 50,000 325,000 50,000 375,000 375,000 Sales @ Sales @ ¢ ¢ 8 and 8 and ¢ ¢ 55 2,600,000 2,600,000 250,000 250,000 2,850,000 2,850,000 Variable expensesVariable expenses @ @ ¢ ¢ 7 and 7 and ¢ ¢ 33 2,275,000 2,275,000 150,000150,000 2,425,000 2,425,000 Contribution marginsContribution margins @ @ ¢ ¢ 1 and 1 and ¢ ¢ 22 325,000 325,000 100,000 100,000 425,000 425,000 Fixed expensesFixed expenses 180,000 180,000 Net incomeNet income 245,000 245,000

Sales in unitsSales in units 325,000 50,000 325,000 50,000 375,000 375,000 Sales @ Sales @ ¢ ¢ 8 and 8 and ¢ ¢ 55 2,600,000 2,600,000 250,000 250,000 2,850,000 2,850,000 Variable expensesVariable expenses @ @ ¢ ¢ 7 and 7 and ¢ ¢ 33 2,275,000 2,275,000 150,000150,000 2,425,000 2,425,000 Contribution marginsContribution margins @ @ ¢ ¢ 1 and 1 and ¢ ¢ 22 325,000 325,000 100,000 100,000 425,000 425,000 Fixed expensesFixed expenses 180,000 180,000 Net incomeNet income 245,000 245,000

WalletsWallets(W)(W)

Key CasesKey Cases(K)(K) TotalTotal

Impact of Income TaxesImpact of Income Taxes

Suppose that a company earnsSuppose that a company earns¢ ¢ 480 before taxes and pays480 before taxes and paysincome tax at a rate of 40%.income tax at a rate of 40%.

Suppose that a company earnsSuppose that a company earns¢ ¢ 480 before taxes and pays480 before taxes and paysincome tax at a rate of 40%.income tax at a rate of 40%.

What is the after-tax income?What is the after-tax income?What is the after-tax income?What is the after-tax income?


Target income before taxes = Target income before taxes = Target after-tax net incomeTarget after-tax net income 1 – tax rate1 – tax rate

Target income before taxes = Target income before taxes = ¢¢ 288 288 = = ¢ ¢ 480 480 1 – 0.40 1 – 0.40

Suppose the target net incomeSuppose the target net incomeafter taxes was after taxes was ¢ ¢ 288.288.


Target sales – Variable expenses – Fixed expensesTarget sales – Variable expenses – Fixed expenses= Target after-tax net income ÷ (1 – tax rate)= Target after-tax net income ÷ (1 – tax rate)

Target sales – Variable expenses – Fixed expensesTarget sales – Variable expenses – Fixed expenses= Target after-tax net income ÷ (1 – tax rate)= Target after-tax net income ÷ (1 – tax rate)

¢¢.50N – .50N – ¢¢.40N – .40N – ¢¢6,000 = 6,000 = ¢ ¢ 288 ÷ (1 – 0.40)288 ÷ (1 – 0.40)¢¢.10N = .10N = ¢ ¢ 6,000 + (6,000 + (¢ ¢ 288/.6)288/.6)

¢¢.06N = .06N = ¢ ¢ 3,600 + 3,600 + ¢ ¢ 288 = 288 = ¢ ¢ 3,888 3,888 N = N = ¢ ¢ 3,888/$.06 3,888/$.06 N = 64,800 unitsN = 64,800 units

¢¢.50N – .50N – ¢¢.40N – .40N – ¢¢6,000 = 6,000 = ¢ ¢ 288 ÷ (1 – 0.40)288 ÷ (1 – 0.40)¢¢.10N = .10N = ¢ ¢ 6,000 + (6,000 + (¢ ¢ 288/.6)288/.6)

¢¢.06N = .06N = ¢ ¢ 3,600 + 3,600 + ¢ ¢ 288 = 288 = ¢ ¢ 3,888 3,888 N = N = ¢ ¢ 3,888/$.06 3,888/$.06 N = 64,800 unitsN = 64,800 units


Suppose target net income after taxes was Suppose target net income after taxes was ¢ ¢ 480480Suppose target net income after taxes was Suppose target net income after taxes was ¢ ¢ 480480

¢¢.50N – .50N – ¢¢.40N – .40N – ¢¢6,000 = 6,000 = ¢ ¢ 480 ÷ (1 – 0.40)480 ÷ (1 – 0.40)¢¢.10N = .10N = ¢ ¢ 6,000 + (6,000 + (¢ ¢ 480/.6) 480/.6)

¢¢.06N = .06N = ¢ ¢ 3,600 + $3,600 + $ ¢ ¢ = = ¢ ¢ 40804080N = N = ¢ ¢ 4,080 ÷ 4,080 ÷ ¢¢.06 .06 N = 68,000 unitsN = 68,000 units

¢¢.50N – .50N – ¢¢.40N – .40N – ¢¢6,000 = 6,000 = ¢ ¢ 480 ÷ (1 – 0.40)480 ÷ (1 – 0.40)¢¢.10N = .10N = ¢ ¢ 6,000 + (6,000 + (¢ ¢ 480/.6) 480/.6)

¢¢.06N = .06N = ¢ ¢ 3,600 + $3,600 + $ ¢ ¢ = = ¢ ¢ 40804080N = N = ¢ ¢ 4,080 ÷ 4,080 ÷ ¢¢.06 .06 N = 68,000 unitsN = 68,000 units

©2005 Prentice Hall Business Publishing, ©2005 Prentice Hall Business Publishing, Introduction to Management AccountingIntroduction to Management Accounting 13/e,13/e, Horngren/Sundem/Stratton Horngren/Sundem/Stratton 2 - 2 - 555555


56


Margin of safety is a measure of Margin of safety is a measure of amount by which the sales may amount by which the sales may decrease before a company suffers decrease before a company suffers a loss. a loss.

This can be expressed as a number This can be expressed as a number of units or a percentage of salesof units or a percentage of sales

57

FormulaFormula

Margin of safety%= Margin of safety Budget sales level

*100%

Margin of safety= Budget sales level – breakeven sales level

58

Sales revenueTotal Cost/Revenue $

Sales (units)

Total costProfit

BEP

Margin of safety

59

Example Example

The breakeven sales level is at 5000 The breakeven sales level is at 5000 units. The company sets the target units. The company sets the target profit at $18000 and the budget sales profit at $18000 and the budget sales level at 7000 unitslevel at 7000 units

Required:Required:Calculate the margin of safety in units Calculate the margin of safety in units and express it as a percentage of the and express it as a percentage of the budgeted sales revenuebudgeted sales revenue

60

Margin of safety= Budget sales level – breakeven sales level= 7000 units – 5000 units= 2000 units

Margin of safety%= Margin of safety Budget sales level= 2000 7000= 28.6%

*100 %

*100 %

The margin of safety indicates that the actual sales can fall by2000 units or 28.6% from the budgeted level before losses areincurred.

*100 %


Changes in Changes in

components of components of

breakeven pointbreakeven point

62

ExampleExample

Selling price per unitSelling price per unit $12$12

Variable price per unitVariable price per unit $3$3

Fixed costsFixed costs $45000$45000

Current profitCurrent profit $18000$18000

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If the selling prices is raised from $12 to $13, If the selling prices is raised from $12 to $13, the minimum volume of sales required to the minimum volume of sales required to maintain the current profit will be:maintain the current profit will be:

Fixed cost + Target profit

Contribution to sales ratio

=$45000 + $18000

$13 - $3

= 6300 units

64

If the fixed cost fall by $5000 but the If the fixed cost fall by $5000 but the variable costs rise to $4 per unit, the variable costs rise to $4 per unit, the minimum volume of sales required to minimum volume of sales required to maintain the current profit will be:maintain the current profit will be:

Fixed cost + Target profit

Contribution to sales ratio

=

$40000 + $18000

$12 - $4

= 7,250 units

**More Costing**More Costing

At a production level of 5,400 units, a project has total costs of $112,500.At a production level of 5,400 units, a project has total costs of $112,500.

The variable cost The variable cost per unit is $9.62. Assume the firm can increase per unit is $9.62. Assume the firm can increase production by 1,000 units without increasing production by 1,000 units without increasing its fixed costs.its fixed costs.

What will the total costs be if 5,900 units are producedWhat will the total costs be if 5,900 units are produced? ?

Production Level1Production Level1 5,4005,400Total Cost1Total Cost1 112,500112,500Variable cost per unitVariable cost per unit 9.629.62Production Level2Production Level2 5,9005,900

Total Cost =Total Cost = [Total Cost1 - (variable cost * PDL1)] + (PDL2 * Variable cost)][Total Cost1 - (variable cost * PDL1)] + (PDL2 * Variable cost)]

117,310 117,310

** More Break-even** More Break-even

The Coffee Express has computed its fixed costs to be $0.46 forThe Coffee Express has computed its fixed costs to be $0.46 for

every cup of coffee it sells every cup of coffee it sells given annual sales of 332,440 cups. given annual sales of 332,440 cups.

The sales price is $1.89 per cup while the variable cost per The sales price is $1.89 per cup while the variable cost per cup cup is $0.81.is $0.81.

How many cups of coffee must it sell to break-even on a cash How many cups of coffee must it sell to break-even on a cash basisbasis? ?

Fixed CostFixed Cost 0.460.46SalesSales 332,440332,440Sale PriceSale Price 1.891.89Variable CostVariable Cost 0.810.81

Profit MarginProfit Margin 0.620.62

Qcash Break-Qcash Break-eveneven Fixed Cost * SalesFixed Cost * Sales

Sale price - Variable CostSale price - Variable Cost

141,595 141,595


Limitation of Limitation of

breakeven pointbreakeven point

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Limitations of breakeven Limitations of breakeven analysisanalysis

Breakeven analysis assumes that Breakeven analysis assumes that fixed cost, variable costs and sales fixed cost, variable costs and sales revenue behave in linear manner. revenue behave in linear manner. However, some overhead costs may However, some overhead costs may be stepped in nature. The straight be stepped in nature. The straight sales revenue line and total cost line sales revenue line and total cost line tent to curve beyond certain level of tent to curve beyond certain level of productionproduction

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It is assumed that all production is sold. It is assumed that all production is sold. The breakeven chart does not take the The breakeven chart does not take the changes in stock level into accountchanges in stock level into account

Breakeven analysis can provide Breakeven analysis can provide information for small and relatively information for small and relatively simple companies that produce same simple companies that produce same product. It is not useful for the product. It is not useful for the companies producing multiple products companies producing multiple products

Introduction to Cost Behavior and Cost-Volume Relationships.

Documents

maintenance costs

cost behavior cost behavior

cost centres

cost data

indirect coststhese

cost allocationin order

units of finalproduct

units of resourceoutputproduct