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Cost Behavior

What is cost behavior?

It is how costs are related to, and affected

by, the activities of an organization.

Cost Drivers

What are cost drivers?

Output measures of resources and

activities are called cost drivers.

Cost Drivers

Production Example

Example costs:

Labor wages

Supervisory salaries

Maintenance wages

Depreciation

Energy

Example cost drivers:

Labor hours

No. of people supervised

No. of mechanic hours

No. of machine hours

Kilowatt hours

Cost Drivers

How well the accountant does at identifying

the most appropriate cost drivers determines

how well managers understand cost behavior

and how well costs are controlled.

Learning Objective 2

Show how changes in cost-driver

activity levels affect variable

and fixed costs.

Comparison of Variable and Fixed Costs

A variable cost is a cost that changes in direct

proportion to changes in the cost driver.

A fixed cost is not immediately affected

by changes in the cost driver.

Rules of Thumb

Think of fixed costs as a total.

Total fixed costs remain unchanged

regardless of changes in cost-driver activity.

Rules of Thumb

Think of variable costs on a per-unit basis.

The per-unit variable cost remains

unchanged regardless of changes

in the cost-driver activity.

Relevant Range

- This rule of thumb holds true only within reasonable limits.
- The relevant range is the limit of cost-driver activity within which a specific relationship between costs and the cost driver is valid.

Relevant Range

$16,000 –

$12,000 –

$8,000 –

$4,000

–

–

–

Fixed Costs

Relevant Range

0 500 1,000 1,500 2,000 2,500

Volume in Units

Cost-Volume-ProfitAnalysis (CVP)

What is cost-volume-profit analysis?

It is the study of the effects of output

volume on revenue (sales), expenses

(costs), and net income (net profit).

CVP Scenario

Per UnitPercentage

Selling price $5 100

Variable cost 4 80

Difference $1 20

Total monthly fixed expenses = $8,000

Rent $2,000

Labor $5,500

Other $ 500

Break-Even (BE) Point

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

Margin of Safety

- The margin of safety shows how far sales can fall below the planned level before losses occur.

Planned unit sales

–

Break-even unit sales

=

Margin of safety

Break-Even Point Techniques

- There are two basic techniques for computing break-even point:
- Contribution margin
- Equation

Contribution MarginTechnique – to find BE in Units

Per Unit

Selling price $5

Variable cost 4

Contribution margin $1

$8,000 ÷ $1 = 8,000 units

i.e. Fixed Cost ÷ Contribution per unit

Contribution MarginTechnique - to find BE in $

8,000 units × $5.00 = $40,000

i.e. BE point in units x Selling price per unit

OR

$8,000 ÷ 20% = $40,000

i.e. Fixed Cost ÷ Contribution to Sales ratio

Equation Technique

Net income equals zero at the break-even point.

Sales

Variable expenses

–

Fixed expenses

–

Zero net income (break-even point)

=

Equation Technique – to find BE in Units

Let N = number of units to be sold to break even

$5N – $4N – $8,000 = 0

$1N = $8,000

N = $8,000 ÷ $1

N = 8,000 Units

Equation Technique- to find BE in $

Let S = sales in dollars needed to break even

S – 0.80S – $8,000 = 0

.20S = $8,000

S = $8,000 ÷ .20

S = $40,000

Cost-Volume-Profit Graph

Break even sales point

8,000 units or $40,000

Sales revenue line

Total expense line

Fixed expense line

Calculate sales volume in total

dollars and total units to reach

a target profit.

Learning Objective 5Target Net Profit

Managers can also use CVP

analysis to determine the

total sales, in units and

dollars, needed to

reach a target

net profit.

Target Net Profit

Contribution Margin Technique

Target sales volume in units =

Fixed expenses + Target net income

Contribution margin per unit

Target Net Profit

Equation Technique

Target sales

– Variable expenses

– Fixed expenses

= Target net income

Operating Leverage

- The ratio of fixed to variable costs is called operating leverage.
- In high leveraged companies, small changes in sales volume result in large changes in net income.
- Companies with less leverage are not affected as much by changes in sales volume.

Contribution Margin and Gross Margin

Gross margin (which is also called gross profit)

is the excess of sales over the cost of goods sold.

Contribution margin is the excess of sales over

all variable costs.

Effects of Sales Mixon Income

- Sales mix is the combination of products that a business sells.

Effects of Sales Mixon Income

Avisha’s Dresses Example

Selling price: $90

Less variable cost: 32

Equals contribution margin per dress: $58

Fixed costs = $96,000

Effects of Sales Mixon Income

- Assume that Avisha is considering selling blouses.
- This will not require any additional fixed costs.
- She expects to sell 2 blouses at $30 each for every dress she sells.
- The variable cost per blouse is $19.
- What is the new breakeven point?

Effects of Sales Mixon Income

Contribution margin per blouse: $30 – $19 = $11

What is the contribution margin of the mix?

$58 + (2 × $11) =

$58 + $22 = $80

Effects of Sales Mixon Income

$96,000 fixed costs ÷ $80 = 1,200 packages

1,200 × 2 = 2,400 blouses

1,200 × 1 = 1,200 dresses

Total units = 3,600

Effects of Sales Mixon Income

What is the breakeven in dollars?

2,400 blouses × $30 = $ 72,000

1,200 dresses × $90 = 108,000

$180,000

Effects of Sales Mixon Income

What is the weighted-average budgeted

contribution margin?

+

Blouses: 2 × $11

Dresses: 1 × $58

=

$80 ÷ 3 = $26.67

Effects of Sales Mixon Income

The break even point for the two products is:

$96,000 ÷ $26.667 = 3,600 units

3,600 × 1/3 = 1,200 dresses

3,600 × 2/3 = 2,400 blouses

Effects of Sales Mixon Income

Sales mix can be stated in sales dollars:

DressesBlouses

Sales price $90 $60

Variable costs 32 38

Contribution margin $58 $22

Contribution margin ratio 64.4% 36.6%

Effects of Sales Mixon Income

Assume the sales mix in dollars is 60% dresses

and 40% blouses.

Weighted contribution would be:

64.4% × 60% = 38.64% dresses

36.6% × 40% = 14.64% blouses

53.28%

Effects of Sales Mixon Income

Break even sales dollars is $96,000 ÷ 53.28%

= $180,000 (rounding)

$180,000 × 60% = $108,000 dress sales

$180,000 × 40% = $ 72,000 blouse sales

Target Net Income and Income Taxes

- Management of Avisha’s Dresses would like to earn an after-tax income of $35,721.
- The tax rate is 30%.
- What is the target operating income?
- Target operating income = Target net income ÷ (1 – tax rate)
- TOI = $35,721 ÷ (1 – 0.30)
- TOI = $51,030

Target Net Income and Income Taxes

- How many units must she sell?
- Revenues – Variable costs – Fixed costs = Target net income ÷ (1 – tax rate)
- $90Q – $32Q – $96,000 = $35,721 ÷ 0.70
- $58Q = $51,030 + $96,000
- Q = $147,030 ÷ $58
- Q = 2,535 dresses

Target Net Income and Income Taxes

Revenues (2,535 × $90) $228,150

Variable costs (2,535 × $32) 81,120

Contribution margin: $147,030

Fixed costs: 96,000

Operating income: $ 51,030

Income taxes: ($51,030 × .30) 15,309

Net income $ 35,721

THE END

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