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# Cost Behavior

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1. Cost Behavior Cost behavior is the manner in which a cost changes as a related activity changes. Understanding the behavior of a cost depends on: Identifying the activities that cause the cost to change, called activity bases (or activity drivers). Specifying the range of activity over which the changes in the cost are of interest. This range of activity is called the relevant range. LO 1

2. Variable Costs Variable costsare costs that vary in proportion to changes in the level of activity. LO 1

3. LO 1 Variable Costs Jason Sound Jason Sound Inc. produces stereo systems. The parts for the stereo systems are purchased from suppliers for \$10 per unit (a variable cost) and are assembled by Jason Sound Inc. For Model JS-12, the direct materials costs for the relevant range of 5,000 to 30,000 units of production are shown on the next slide.

4. LO 1 Variable Costs Jason Sound

5. As shown in the previous slides, the variable costs have the following characteristics: Cost per unit remains the same regardless of changes in the activity base. Total cost changes in proportion to changes in the activity base. LO 1 Variable Costs

6. LO 1 Variable Costs \$300,000 \$250,000 \$200,000 \$150,000 \$100,000 \$50,000 \$20 \$15 \$10 \$5 Cost per Unit Total Direct Materials Cost 0 10 20 30 Units Produced (000) 0 10 20 30 Units Produced (000) Number of Units of Model JS-12 Produced Direct Materials Cost per Unit Total Direct Materials Cost 5,000 units \$10 \$ 50,000 10,000 10 l00,000 15,000 10 150,000 20,000 10 200,000 25,000 10 250,000 30,000 10 300,000 Note: Fixed per unit; variable in total

7. Fixed Costs Fixed costs are costs that remain the same in total dollar amount as the activity base changes. LO 1

8. LO 1 Milton Fixed Costs Minton Inc. manufactures, bottles, and distributes perfume. The production supervisor is Jane Sovissi. She is paid \$75,000 per year. The plant produces from 50,000 to 300,000 bottles of perfume.

9. LO 1 Milton Fixed Costs The more units produced, the lower the fixed cost per unit.

10. Fixed costs have the following characteristics: Cost per unitchanges inversely to changes in the activity base. Total costremains the same regardless of changes in the activity base. LO 1 Fixed Costs

11. LO 1 Milton Fixed Costs \$1.50 \$1.25 \$1.00 \$.75 \$.50 \$.25 \$150,000 \$125,000 \$100,000 \$75,000 \$50,000 \$25,000 Total Salary Salary per Unit 100 200 300 0 0 100 200 300 Units Produced (000) Units Produced (000) Salary per Bottle of Perfume Produced Total Salary for Jane Sovissi Number of Bottles of Perfume Produced 50,000 bottles \$75,000 \$1.500 100,000 75,000 0.750 150,000 75,000 0.500 200,000 75,000 0.375

12. Mixed Costs Mixed costs have characteristics of both a variable and a fixed cost. Mixed costs are sometimes called semivariable or semifixed costs. Over one range of activity, the total mixed cost may remain the same. Over another range of activity, the mixed cost may change in proportion to changes in the level of activity. LO 1

13. LO 1 Mixed Costs Simpson Inc. manufactures sails, using rented equipment. The rental charges are \$15,000 per year, plus \$1 for each machine hour used over 10,000 hours.

14. LO 1 Mixed Costs The rental charges for various hours used within the relevant range of 8,000 hours to 40,000 hours are as follows:

15. LO 1 Mixed Costs

16. The high-low method is a cost estimation method that may be used to separate mixed costs into their fixed and variable components. LO 1 Mixed Costs

17. kason LO 1 Mixed Costs The Equipment Maintenance Department of Kason Inc. incurred the following costs during the past five months:

18. kason LO 1 Mixed Costs The number of units produced is the activity base, and the relevant range is the units produced between June and October. The next series of slides for Kason Inc. illustrate how the high-low method is used to determine the fixed and variable costs.

19. kason Difference in Total Cost Variable Cost per Unit = Difference in Production LO 1 Mixed Costs Production Total (Units) Cost Actual costs incurred June 1,000 \$45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 First, select the highest and lowest levels of activity.

20. kason \$20,250 Difference in Total Cost Variable Cost per Unit = Difference in Production LO 1 Mixed Costs Production Total (Units) Cost Next, fill in the formula for difference in total cost. June 1,000 \$45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 \$61,500 41,250 \$20,250

21. kason Difference in Total cost \$20,250 Variable Cost per Unit = Difference in Production LO 1 Mixed Costs Production Total (Units) Cost Then, fill in the formula for difference in production. June 1,000 \$45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 2,100 750 1,350 1,350

22. kason LO 1 Mixed Costs Production Total (Units) Cost June 1,000 \$45,550 July 1,500 52,000 August 2,100 61,500 September 1,800 57,500 October 750 41,250 Variable cost per unit is \$15 \$20,250 =\$15 Variable Cost per Unit = 1,350

23. kason LO 1 Mixed Costs The fixed cost is estimated by subtracting the total variable costs from the total costs for the units produced as shown below: Fixed Cost = Total Costs – (Variable Cost per Unit x Units Produced)

24. kason LO 1 Mixed Costs The fixed cost is the same at the highest and the lowest levels of production as shown below for Kason Inc. Highest Level Fixed Cost = Total Costs – (Variable Cost per Unit x Units Produced) Fixed Cost = \$61,500 – (\$15 x 2,100 units) Fixed Cost = \$61,500 – \$31,500 Fixed Cost =\$30,000

25. kason LO 1 Mixed Costs The fixed cost is the same at the highest and the lowest levels of production as shown below for Kason Inc. Lowest Level Fixed Cost = Total Costs – (Variable Cost per Unit x Units Produced) Fixed Cost = \$41,250 – (\$15 x 750 units) Fixed Cost = \$41,250 – \$11,250 Fixed Cost =\$30,000

26. kason LO 1 Mixed Costs With fixed costs and variable costs estimated at \$30,000 plus \$15 per unit, a formula is in place to estimate production at any level. If the company is expected to produce 2,000 units in November, the estimated total cost would be calculated as follows: Total Cost = (\$15 x Units Produced) + \$30,000 Total Cost = (\$15 x 2,000) + \$30,000 Total Cost = \$30,000 + \$30,000 Total Cost =\$60,000

27. EE 19-1

28. Summary of Cost Behavior Concepts Per-unit variable costs remain the same regardless of activity level. Total variable costs increase and decrease proportionately with activity level. LO 1 Total Variable Costs Total Costs Total Units Produced Unit Variable Costs Per-Unit Cost Total Units Produced

29. Per-unit fixed costs decrease as activity level increases. Total fixed costs remain the same regardless of activity level. LO 1 Summary of Cost Behavior Concepts Total Fixed Costs Total Costs Total Units Produced Unit Fixed Costs Per-Unit Cost Total Units Produced

30. Some examples of variable, fixed, and mixed costs for the activity base units produced are as follows: LO 1 Summary of Cost Behavior Concepts

31. One method of reporting variable and fixed costs is called variable costing or direct costing. Under variable costing, only the variable manufacturing costs are included in the product cost. The fixed factory overhead is treated as an expense of the period in which it is incurred. LO 1 Summary of Cost Behavior Concepts

32. Learning Objective 2 Compute the contribution margin, the contribution margin ratio, and the unit contribution margin.

33. Cost-Volume-Profit Relationships Cost-volume-profit analysis is the examination of the relationships among selling prices, sales and production volume, costs, expenses, and profits. LO 2

34. Some of the ways cost-volume-profit analysis may be used include: Analyzing the effects of changes in selling prices on profits Analyzing the effects of changes in costs on profits LO 2 Cost-Volume-Profit Relationships (continued)

35. LO 2 Cost-Volume-Profit Relationships • Analyzing the effects of changes in volume on profits • Setting selling prices • Selecting the mix of products to sell • Choosing among marketing strategies

36. Contribution Margin Contribution margin is the excess of sales over variable costs, as shown in the formula below. LO 2 Contribution Margin = Sales – Variable Costs

37. Contribution Margin Lambert LO 2 Assume the following data for Lambert, Inc.:

38. Lambert LO 2 Contribution Margin

39. The contribution margin ratio, sometimes called the profit-volume ratio,indicates the percentage of each sales dollar available to cover fixed costs and to provide income from operations. It is computed as follows: Contribution Margin Sales Contribution Margin Ratio = LO 2 Contribution Margin Ratio

40. Lambert Contribution Margin Sales Contribution Margin Ratio= \$400,000 \$1,000,000 Contribution Margin Ratio = LO 2 Contribution Margin Ratio The contribution margin ratio is 40% for Lambert Inc., computed as follows: Contribution Margin Ratio =40%

41. Lambert Contribution Margin Ratio = Sales – Variable Costs Sales \$1,000,000 – \$600,000 \$1,000,000 Contribution Margin Ratio = 40% Contribution Margin Ratio = LO 2 Contribution Margin Ratio 100% 60% 40% 30% 10%

42. Unit Contribution Margin The unit contribution margin is useful for analyzing the profit potential of proposed decisions. The unit contribution margin is computed as follows: Unit Contribution Margin Sales Price per Unit Variable Cost per Unit = – LO 2

43. The unit contribution margin is most useful when the increase or decrease in sales volume is measured in sales units (quantities). The change in income from operations can be determined using the following formula: Unit Contribution Margin Change in Income from Operations Change in Sales Units x = LO 2 Unit Contribution Margin

44. Lambert Unit Contribution Margin Change in Income from Operations Change in Sales Units x = Change in Income from Operations 15,000 units x \$8=\$120,000 = LO 2 Unit Contribution Margin Lambert Inc.’s sales could be increased by 15,000 units, from 50,000 to 65,000 units. Lambert’s income from operations would increase by \$120,000 (15,000 x \$8), as shown below.

45. Lambert LO 2 Unit Contribution Margin Lambert Inc.’s contribution margin income statement, shown below, confirms that income increased to \$220,000 when 65,000 units are sold.

46. Review LO 2 Sales (50,000 units) \$1,000,000 Variable costs 600,000 Contribution margin \$ 400,000 Fixed costs 300,000 Income from operations \$ 100,000 100% 60% 40% 30% 10% \$20 12 \$ 8 Unit contribution margin analyses can provide useful information for managers.

47. Sales (50,000 units) \$1,000,000 Variable costs 600,000 Contribution margin \$ 400,000 Fixed costs 300,000 Income from operations \$ 100,000 100% 60% 40% 30% 10% \$20 12 \$ 8 LO 2 Review The contribution margin can be expressed in three ways: 1. Total contribution margin in dollars. 2. Contribution margin ratio (percentage). 3. Unit contribution margin (dollars per unit).

48. EE 19-2

49. Learning Objective 3 Determine the break-even point and sales necessary to achieve a target profit.

50. Break-Even Point The break-even point is the level of operations at which a company’s revenues and expenses are equal. LO 3