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Cost Behavior and Cost-Volume-Profit Analysis

Cost Behavior and Cost-Volume-Profit Analysis. Chapter 11. Learning Objectives. After studying this chapter, you should be able to: Classify costs as variable costs, fixed costs, or mixed costs. Compute the contribution margin, the contribution margin ratio, and the unit contribution margin.

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Cost Behavior and Cost-Volume-Profit Analysis

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  1. Cost Behavior and Cost-Volume-Profit Analysis Chapter 11

  2. Learning Objectives After studying this chapter, you should be able to: • Classify costs as variable costs, fixed costs, or mixed costs. • Compute the contribution margin, the contribution margin ratio, and the unit contribution margin. • Determine the break-even point and sales necessary to achieve a target profit. • Using a cost-volume-profit chart and a profit-volume chart, determine the break-even point and sales necessary to achieve a target profit. • Compute the break-even point for a company selling more than one product, the operating leverage, and the margin of safety.

  3. Learning Objective 1 Classify costs as variable costs, fixed costs, or mixed costs

  4. Cost Behavior • Refers to the manner in which a cost changes as a related activity changes. Can be variable, fixed, or mixed. • Two factors to consider: • Activity bases – activities that causes a cost to change (e.g., food service costs change with the number of hospital patients) • Relevant range – changes in cost are of interest

  5. Cost Behavior: Variable Costs • Costs that vary in proportion to changes in the activity level.

  6. Cost Behavior: Variable Costs Exhibit 1: Variable Cost Graphs

  7. Cost Behavior: Fixed Costs • Costs that remain the same in total over the relevant range of activity, but changes per unit with the level of activity.

  8. Cost Behavior: Fixed Costs Exhibit 2: Fixed Cost Graphs

  9. Cost Behavior: Mixed Costs • Mixed costs share characteristics of both a variable and a fixed cost: fixed over a range, then increasing based on activity. Exhibit 3: Mixed Cost

  10. Total maintenance cost at highest and lowest levels of production. Total maintenance costs during the last five months. High-Low Method

  11. High-Low Method

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

  13. $ Sales Total Costs units Cost-Volume-Profit Analysis • 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: • Setting selling prices • Selecting product mix • Choosing marketing strategies • Analyzing the effects of changes in cost on profit

  14. Contribution Margin • Contribution margin – identifies revenues available to cover fixed costs and to provide income from operations. Contribution Margin = Sales – Variable Costs

  15. Contribution Margin Income Statement Exhibit 4: Contribution Margin Income Statement

  16. Contribution Margin Ratio • Contribution margin ratio is expressed as a percentage of each sales dollar available to cover fixed costs and to provide income from operations. • It is sometimes referred to as the profit-volume ratio. • Measures the effect of an increase/decrease in sales volume on income from operations. Sales – Variable Costs Sales Contribution Margin Ratio =

  17. Contribution Margin Ratio Sales $ 1,000,000 CM Ratio = Variable Costs 600,000 Contribution Margin 400,000 = 40% Sales = $1 $1,000,000 – $600,000 $1,000,000 Variable costs = ¢60 Contribution margin = ¢40 or 40% of every dollar in sales An $80,000 increase in sales volume would increase income from operations by $32,000 ($80,000 × 40%).

  18. Contribution Margin Ratio • 60% of $80,000 increase in sales will go to variable costs and the remaining 40% will go to contribution margin. • The increase in contribution margin will flow to income from operations as fixed costs do not change with increase in sales.

  19. Unit Contribution Margin • Useful when an increase/decrease in sales volume is measured in units (not dollars). Unit Contribution Margin = Sales Price per Unit – Variable Cost per Unit

  20. Unit Contribution Margin • If sales increases by 15,000 units, from 50,000 units to 65,000 units: Sales Price/Unit $20 Unit Variable Cost 12 Unit Contribution Margin $ 8

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

  22. Break-Even Point • Level of operations where revenues and costs are the same. • Useful in business planning, especially when increasing or decreasing operations.

  23. Fixed Costs = $90,000 Selling price per unit Variable cost per unit $25 $15 Contribution Margin per unit $10 Break-Even Point Fixed Costs UCM $90,000 $10 = 9,000 units = Break-Even Sales (Units) =

  24. Break-Even Point $90,000/$10 = 9,000 units needed to break even

  25. Effect of Changes in Fixed Costs There is a direct relationship between total fixed costs and break-even units.

  26. Effect of Changes in Fixed Costs How would a $100,000 increase in fixed costs affect the break-even sales units? Now: $600,000/$20 UCM = 30,000 break-even Proposed: $700,000/$20 UCM = 35,000 break-even

  27. Effect of Changes in Unit Variable Costs There is a direct relationship between unit variable costs and break-even units.

  28. Effect of Changes in Unit Variable Costs How would an extra 2% commission (increase in variable cost per unit) affect the break-even sales units? Now: $840,000/$105 UCM = 8,000 break-even Proposed: $840,000/$100 UCM = 8,400 break-even

  29. Effect of Changes in Unit Selling Price There is an inverse relationship between unit selling price and break-even units.

  30. Effect of Changes in Unit Selling Price How would a $10 price increase affect the break-even sales units? Now: $600,000/$20 UCM = 30,000 break-even Proposed: $600,000/$30 UCM = 20,000 break-even

  31. Target Profit • To find units needed to attain a certain target profit, add the target profit to the fixed costs in the break-even formula. Fixed Costs + Target Profit UCM Break-Even Sales (Units) =

  32. Fixed Costs = $200,000 Target Profit = $100,000 Selling price Per unit Variable Cost Per unit $75 $45 Contribution Margin per unit $30 Calculating Sales (units) Fixed Costs + Target Profit UCM $200,000 + $100,000 $30 = 10,000 units =

  33. Verification of Units Required to Achieve Target Profit Target Profit

  34. Learning Objective 4 Using a cost-volume-profit chart and a profit-volume chart, determine the break-even point and sales necessary to achieve a target profit

  35. Cost-Volume-Profit (CVP) Chart • Cost-volume-profit charts assist management in understanding relationships among costs, sales, and operating profit or loss. • We’ll construct a CVP chart assuming: • $50 selling price • $30 unit variable cost • $20 unit contribution margin • $100,000 in fixed costs

  36. Cost-Volume-Profit (CVP) Chart Exhibit 5: Cost-Volume-Profit Chart

  37. Cost-Volume-Profit (CVP) Chart Exhibit 6: Revised Cost-Volume-Profit Chart When fixed costs decrease by $20,000, break-even decreases to 4,000 units ($200,000).

  38. Profit-Volume Chart • Focuses on profits. • Plots the difference between total sales and total costs. • We’ll construct a profit-volume chart assuming: • $50 selling price • $30 unit variable cost • $20 unit contribution margin • $100,000 in fixed costs Maximum loss is $100,000 in fixed costs (if no sales). Assume maximum profit is $100,000 (based on 10,000 maximum sales).

  39. Profit-Volume Chart Exhibit 7: Profit-Volume Chart

  40. Learning Objective 5 Calculate the break-even point for a business selling more than one product, the operating leverage, and margin of safety

  41. Sales Mix Considerations • Most businesses sell more than one product, and each product contributes differently to overall profit. • Sales mix is the relative distribution of sales among the various products sold. • The sales volume necessary to break even when more than one product is sold depends on the sales mix.

  42. Sales Mix Assume Burr Company sold 8,000 units of Product A and 2,000 units of Product B last year.

  43. Sales Mix • Combining individual unit information to represent one single product – Product E. • Assuming fixed costs are $200,000, 8,000 units of Product E are needed to break even ($200,000/$25). But how many of Products A and B does that mean?

  44. Sales Mix • Product A: 8,000 × 80% = 6,400 units • Product B: 8,000 × 20% = 1,600 units Break-even point

  45. Operating Leverage • The relative mix of variable and fixed costs is measured by operating leverage. • Companies with high fixed costs (capital intensive) have high operating leverage. • Companies with low fixed costs (labor intensive) have low operating leverage. • Managers use operating leverage to measure how changes in sales affect changes in income from operations.

  46. Operating Leverage High Operating Leverage Low Operating Leverage Increase in operating income 50% 20% Increase in sales Increase in sales 10% 10% Operating Leverage = 5 Operating Leverage = 2

  47. Margin of Safety • Margin of safety measures how much sales revenue can drop before an operating loss occurs. • Assume current sales are $250,000 and break-even sales are $200,000. The margin of safety is 20%: (250,000-200,000)/250,000. • Sales would have to drop by more than 20% before an operating loss would result. Sales – Sales at Break-Even Point Sales

  48. End of Chapter 11

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