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Introduction to Cost Behavior and Cost-Volume Relationships

Introduction to Cost Behavior and Cost-Volume Relationships. Chapter 2. Boeing - knowing your costs and the volume needed to cover those costs, the case of the 747X. Learning Objective 1. Explain how cost drivers affect cost behavior. Cost Behavior. It is how the activities of an

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Introduction to Cost Behavior and Cost-Volume Relationships

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  1. Introduction to Cost Behavior and Cost-Volume Relationships Chapter 2

  2. Boeing- knowing your costs and the volume needed to cover those costs, the case of the 747X

  3. Learning Objective 1 • Explain how cost drivers affect cost behavior.

  4. Cost Behavior It is how the activities of an organization affect its costs.

  5. Cost Drivers Any output measure that causes the use of costly resources is a cost driver.

  6. Value Chain Function and Example Costs Example Cost Drivers Research and development · Salaries of marketing research Number of new product proposals personnel, costs of of market surveys Production · Labor wages Labor hours Marketing · Cost of advertisements Number of advertisements Distribution · Wages of shipping personnel Labor hours Customer service · Salaries of service personnel Hours spent servicing products Examples of Value Chain Functions, Costs, and Cost Drivers

  7. Learning Objective 2 • Show how changes incost-driver activity levels affect variable and fixed costs.

  8. ComparingVariable and Fixed Costs A variable cost changes in direct proportion to changes in the cost-driver level. A fixed cost is not immediately affected by changes in the cost-driver level.

  9. Rules of Thumb Think of fixed costs as a total. Total fixed costs remain unchanged regardless of changes in cost-driver activity.

  10. 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.

  11. Relevant Range Relevant Range The relevant range specifies the limits of cost-driver activity within which a specific relationship between a cost and its cost driver will be valid.

  12. Relevant range Relevant Range $115,000 100,000 Fixed Costs 60,000 0 20 40 60 80 100 Volume in Thousands of Units

  13. Learning Objective 3 • Calculate break-even sales volume in total dollars and total units.

  14. 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).

  15. Per Unit Percentage of Sales Selling price $.50 100% Variable cost of each item .40 80 Selling price less variable cost $.10 20% Monthly fixed expenses: Rent $1,000 Wages 4,500 Other 500 Total fixed expenses $6,000 CVP Scenario

  16. Break-Even Point – Contribution-Margin and Equation Methods The break-even point is the level of sales at which revenue equals expenses and net income is zero.

  17. Break-Even Point – Contribution-Margin and Equation Methods Basic Methods Contribution margin Equation

  18. Contribution MarginMethod Per Unit Selling price $.50 Variable costs .40 Contribution margin $.10 $6,000 fixed costs ÷ $.10 = 60,000 units (break even)

  19. Contribution MarginMethod 60,000 units × $.50 = $30,000 of sales to break even) Or $6,000 fixed costs ÷ 20% (contribution-margin percentage) = $30,000 of sales to break even

  20. – Variable expenses – Fixed expenses = Zero net income (break-even point) Equation Method Net income equals zero at the break-even point. Sales

  21. Equation Method Let N = number of units to be sold to break even. $.50N – $.40N – $6,000 = 0 $.10N = $6,000 N = $6,000 ÷ $.10 N = 60,000 Units

  22. Equation Method Let S = sales in dollars needed to break even. S – .80S – $6,000 = 0 .20S = $6,000 S = $6,000 ÷ .20 S = $30,000

  23. Learning Objective 4 • Create a cost-volume-profit graph and understand the assumptions behind it.

  24. Sales revenue line Total expense line Fixed expense line Cost-Volume-Profit Graph Break-even sales point 60,000 units or $30,000 $60000 $50000 $40000 Dollars $30000 $20000 $10000 0 0 10 20 30 40 50 60 70 80 90 100 Units (thousands)

  25. Expenses can be classified into variable and fixed categories. 1 The behavior of revenues and expenses is linear over the relevant range. 2 Expect no changes in efficiency and productivity. 3 Assumptions

  26. The difference in inventory level at the beginning and at the end of a period is insignificant. 5 Assumptions Sales mix remains constant. 4 Let’s do the handout

  27. Learning Objective 5 • Calculate sales volume in total dollars and total units to reach a target profit.

  28. Target Net Profit Managers can also use CVP analysis to determine the total sales, in units and dollars, needed to reach a target net profit.

  29. Target Net Profit $480 per month is the minimum acceptable net income. Target sales – Variable expenses – Fixed expenses = Target net income S – 0.80S – $6,000 = $480 .20S = $6,480 S = $6,480 ÷ .20 S = $32,400

  30. Target Net Profit Target sales volume in units = (Fixed expenses + Target net income) ÷ Contribution margin per unit ($6,000 + 480) ÷ $.10 = 64,800 units

  31. Multiple Changes in Key Factors Two approaches: Construct and solve equations Incremental approach

  32. CVP Analysis and Computer-Based Spreadsheets The use of spreadsheets simplifies the examination of multiple changes in key factors in a CVP model. Use of these models is a cost-benefit issue.

  33. Additional Uses of Cost-Volume Analysis Best cost structure Operating leverage Margin of safety

  34. Learning Objective 6 • Differentiate between contribution margin and gross margin.

  35. Contribution Marginand Gross Margin Gross margin = Sales price – Cost of goods sold Contribution margin = Sales price – All variable expenses

  36. Contribution Marginand Gross Margin Per Unit Selling price $.50 Variable costs (acquisition cost) .40 Contribution margin and gross margin are equal $.10 Suppose that the firm had to pay a commission of 4¢ per unit sold.

  37. Contribution Marginand Gross Margin What are the margins? Per UnitPer Unit Selling price $.50 $.50 Acquisition cost .40 .40 Commission .04 Contribution margin$.06 Gross margin$.10

  38. Nonprofit Application Suppose a city has a $100,000 lump-sum budget appropriation to conduct a counseling program. Variable costs per prescription is $400 per patient per day. Fixed costs are $60,000 in the relevant range of 50 to 150 patients.

  39. Nonprofit Application If the city spends the entire budget appropriation, how many patients can it serve in a year? $100,000 = $400N + $60,000 $400N = $100,000 – $60,000 N = $40,000 ÷ $400 N = 100 patients

  40. Learning Objective 8 • Compute cost-volume-profit relationships on an after-tax basis.

  41. Impact of Income Taxes Suppose that a company earns $480 before taxes and pays income tax at a rate of 40%. What is the after-tax income? $480 – (40% × $480) = $288

  42. Impact of Income Taxes Target income before taxes = Target after-tax net income ÷ (1 – tax rate) $480 = $288 ÷ (1 – 0.40) Suppose the target net income after taxes was $288.

  43. Impact of Income Taxes What is the equation? Target sales – Variable expenses – Fixed expenses = Target after-tax net income ÷ (1 – tax rate) $.50N – $.40N – $6,000 = $288 ÷ (1 – 0.40) $.10N = $6,000 + $480 N = $6,480 ÷ $.10 N = 64,800 units Let’s do 2-43 & 2-44

  44. End of Chapter 2

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