Cost Behavior

Cost Volume Profit Analysis

Chapter M3

Cost Behavior

Refers to the manner in which a cost changes as a related activity changes– Activity Bases– Relevant range

Cost Classification

Variable Costs•Costs that vary in proportion to changes in the level of activity•Such as

•Direct Materials•Direct Labor

Units Produced

DM per unit

Total DM Costs

5,000 units $10 $50,000

10,000 $10 $100,000

15,000 $10 $150,000

Cost Classification

Fixed Costs•Costs that remain the same in total dollar amounts as the level of activity changes.•salaries

# of Bottles

Total Salary

Salary per Bottle

50,000 $75,000 $1.50

100,000 $75,000 $0.75

150,000 $75,000 $0.50

Cost Classification

Mixed Costs– Has characteristics of both a variable and a fixed

cost.– Could behave as a fixed cost for part of the relevant

range and then variable cost

High-Low Method

Cost estimation techniques

Steps– Find the highest and

lowest level of production– Find the difference in total

cost from highest to lowest level of production

– Find the difference in total units from highest to lowest level of production

– Variable cost per unit Difference in Total cost

Difference in Total units

– Find fixed cost by solving this equation

– Total cost = Fixed cost plus Variable cost

Example 1

Month Production Total Cost

June 1,000 $45,550

July 1,500 $52,000

Aug 2,100 $61,500

Sept 1,800 $57,500

Oct 750 $41,250

High: Aug 2,100 unitsLow: Oct 750 unitsDiff 1,350

High: Aug $61,500 Oct $41,250 Diff 20,250

Variable cost = Diff in TC Diff in units =$20,250 1,350 = $15 per unit Total cost = FC + VC $61,500 = FC + ($15 *2,100 units) $61,500 = FC + 31,500 FC = $30,000

Example 2

Month Production Total Cost

June 2,500 $45,000

July 2,000 $40,000

Aug 1,500 $35.000

Sept 3,000 $50,000

Oct 1,800 $38,000

Example 2

High Sept 3,000 $50,000 Low Aug 1,500 $35,000 Diff 1,500 15,000 Variable cost per unit $15,000/1,500 = $10 per unit Total cost = FC + VC $50,000 = FC + (3,000 units * $10) FC = $20,000

Cost-Volume-Profit Relationship

Is the systematic examination of the relationships among selling prices, sales, and production volume, costs, expenses and profits

Provides management with useful information for decision making

Contribution Margin Concept

Contribution Margin =

Sales – Variable Costs Contribution margin ratio

Sales – VC

Sales Unit Contribution margin

Sales per unit

- VC per unit

Example 3

The company has sales of $1,000,000, variable costs of $800,000. Compute the contribution margin and the contribution margin ratio

CM = Sales – VC = $1,000,000 - $800,000

=$200,000 CM ratio = Sales – VC/Sales = 200,000/1000000

= 20%

Example 4

The company has sales of $800,000, variable costs of $600,000. Compute the contribution margin and contribution margin ratio

CM = sales – VC = $800 - $600 = $200 CM ratio = CM/Sales = 200/800 = 25%

Cost Volume Profit Analysis

To determine the units of sales necessary to achieve the break even point in operations

To determine the units of sales necessary to achieve a target or desired profit

Break-Even Point

Is the level of operations at which a business’ revenues and expired costs are exactly equal

No income or loss BEP = Fixed Costs

Unit Contribution Margin

Break Even Point

Example 5: Suppose that selling price is $35, variable cost is $15 and fixed costs are $90,000. What is break even point?

BEP = fixed costs Unit contribution margin (Sales – VC) = $90,000 $35 - $15 = 4,500 units

Break even point

Check Sales = FC + VC ($35 * 4,500 units) = $90,000 + ($25 * 4,500) $157,500 = $90,000 + $67,500

Example 6

Suppose that selling price is $45, variable cost is $30 and fixed costs are $60,000. What is break even point?

BEP = Fixed cost Unit CM = $60,000 $45-30 = 4,000 units

Graphical

Fixed Costs

0

Costs

Units

Variable costsTotal Cost

Graphical – Break even point

$

Units0

Total costs

Sales

Break even pointSales = TC

Profit

Loss

Effect of Changes on BEP

Changes in fixed costs– Increase in fixed costs

Increases BEP

– Decrease in fixed cost Decrease BEP

Changes in Variable cost– Increase in variable cost

Increases BEP

– Decreases in variable cost Decreases BEP

Changes in Selling Price– Increase in SP

Decrease BEP

– Decrease in SP Increase in BEP

Desired Profit

Firms would like to earn a profit and not just to break even

BEP = FC + Desired Profit

Unit CM

Example 5:

Suppose that selling price is $45, variable cost is $30, and fixed costs are $60,000. The company wants a desired profit of $45,000. What is BEP?

BEP = FC + Unit CM = $60,000 + $45,000 = $105,000 = 7,000 $45- $30 $15

Example 5:

Check Sales – ( FC + VC) = Desired profit ($45 * 7,000) – {$60,000 – ($30 *7,000) = $315,000 – (60,000 + 210,000) = $45,000

Example 6:

Suppose that selling price is $25, variable cost is $15 and fixed costs are $90,000. The company wants a desired profit of $10,000. What is break even point?

BEP = FC + Desired Profit

Unit CM

= $90,000 + $10,000

$10

= 10,000 units

Sales Mix Consideration

More than one product is sold at varying selling prices

Products often have different unit variable costs

Products have different contribution margin

Sales volume necessary must a mix of both products

Example 6:

Cascade Co produces two products Yuk and Gunk. Yuk has a selling price of $90, variable cost of $70 and is 80% of total sales. Gunk has a selling price of $140, variable cost of $95, and is 20% of total sales. Fixed costs are $200,000. What is the break even point for the sales mix?

Example 6:

Product Selling Price

Variable Cost

CM Sales

%

Sales mix CM

Yuk $90 $70 $20 80% $16

Gunk $140 $95 $45 20% $9

$25

Example 6:

BEP = Fixed Costs = $200,000 Sales mix CM $25BEP = 8,000 units

Of what products:

YUK: 8,000 units * 80% = 6,400 unitsGUK: 8,000 units * 20% = 1,600 units

Example 7:

ABC Company has two products Y and X. Y has a selling price of $100, variable costs of $60 and is 70% of total sales. X has a selling price of $50, variable cost of $25. Fixed costs are $248,500. What is BEP?

Example 7:

Product Selling Price

Variable Cost

CM Sales

%

Sales mix CM

Y $100 $60 $40 70% $28

X $50 $25 $25 30% $7.50

$35.50

Example 7:

BEP = Fixed cost

Sales mix CM

= $248,500

$35.50

= 7,000 units

Y: 7,000 units * 70% = 4,900 units

X: 7,000 units * 30% = 2,100 units

Margin of Safety

Indicates possible decrease in sales that may occur before an operating loss occurs.

Ms = S – Sat BEP

Sales

Margin of Safety

If sales are $400,000 and sales at break even are $300,000 what is margin of safety?

Ms = Sales – Sales BEP = $400 - $300

Sales $400

= 25%

Operating Leverage

Relative mix of business variable costs and fixed costs

Contribution margin

Income from operations High = large fixed costs Low – small fixed costs

Remember

Get detailed handouts at http://faculty.mdc.edu/mmari Homework assigned in class.