Cost Behavior and Cost-Volume-Profit Analysis

1. 4 Cost Behavior and Cost-Volume-Profit Analysis

2. 0 4-1 Objective 1 Classify costs by their behavior as variable costs, fixed costs, or mixed costs.

3. 0 4-1 Jason Inc.’s Waterloo Plant Jason Inc. produces stereo sound systems under the brand name of J-Sound. The parts for the J-Sound stereos are purchased from outside suppliers for $10 per unit (a variable cost) and assembled in Jason Inc.’s Waterloo plant.

4. 0 4-1 Variable Cost Graphs (Cont’d) Total Variable Cost Graph $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 Total Direct Materials Cost 0 10 20 30 Total Units (Model JS-12) Produced (thousands) 9

5. 0 4-1 Variable Cost Graphs Unit Variable Cost Graph $20 $15 $10 $5 Direct Materials Cost per Unit 0 10 20 30 Total Units (Model JS-12) Produced (thousands) 10 (Concluded)

6. 0 4-1 Unit Cost Compared to Total Cost $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $20 $15 $10 $5 Cost per Unit Total Costs 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 11

7. 0 4-1 Minton Inc.’s Los Angeles Plant The production supervisor for Minton Inc.’s Los Angeles plant is Jane Sovissi. She is paid $75,000 per year. The plant produces from 50,000 to 300,000 bottles of La Fleur Perfume.

8. 0 4-1 Fixed Versus Variable Cost of Jane Sovissi’s Salary Salary per Bottle of Perfume Produced Number of Bottles of Perfume Produced Total Salary for Jane Sovissi 50,000 bottles $75,000 $1.500 100,000 75,000 0.750 150,000 75,000 0.500 200,000 75,000 0.375 250,000 75,000 0.300 300,000 75,000 0.250 14

9. 0 4-1 $150,000 $125,000 $100,000 $75,000 $50,000 $25,000 $1.50 $1.25 $1.00 $.75 $.50 $.25 Total Costs Unit Cost 100 200 300 0 0 100 200 300 Bottles Produced (000) Units Produced (000) Salary per Bottle of Perfume Produced Number of Bottles of Perfume Produced Total Salary for Jane Sovissi 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 15

10. 0 4-1 Simpson Inc. Example 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.

11. 0 4-1 Mixed Cost Graph for Simpson Inc.’s Equipment Rental Charges $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 Mixed costs are usually separated into their fixed and variable components for management analysis. Total Costs 0 10 20 30 40 Total Machine Hours (000) 18

12. 0 4-1 High-Low Method The high-low method is a simple cost estimate technique that may be used for separating mixed costs into their fixed and variable components.

13. Example Exercise 4-1 0 4-1 The manufacturing cost of Alex Industries for the first three months of the year are provided below: Total Cost Production January $80,000 1,000 units February $125,000 2,500 March $100,000 1,800 Using the high-low method, determine the (a) variable cost per unit, and (b) the total fixed cost. 27

14. Follow My Example 4-1 $125,000 – $80,000 (2,500 – 1,000) • $30 per unit = 0 4-1 b. $50,000 = $125,000 – ($30 x 2,500) or $80,000 – ($30 x 1,000) 28 For Practice: PE4-1A, PE4-1B

15. Unit costs remain the same per unit regardless of activity. Total costs increase and decrease proportionately with activity level. 0 4-1 Summary of Cost Behavior Concepts Total Variable Costs Total Costs Total Units Produced Unit Variable Costs Per Unit Cost 29 Total Units Produced

16. Total costs increase and decrease with activity level. Unit costs remain the same regardless of activity. 0 4-1 Summary of Cost Behavior Concepts Total Fixed Costs Total Costs Total Units Produced Unit Fixed Costs Per Unit Cost 30 Total Units Produced

17. 0 4-2 Objective 2 Compute the contribution margin, the contribution margin ratio, and the unit contribution margin, and explain how they may be useful to managers.

18. 0 4-2 Cost-Volume-Profit Relationships Cost-volume-profitanalysis is the systematic examination of the relationships among selling prices, sales and production volume, costs, expenses, and profits.

19. 0 4-2 Thecontribution margin is the excess of sales revenues over variable costs. It contributes first toward covering fixed costs, then contributes to profit.

20. 4 0 4-2 Contribution Margin Income Statement Sales (50,000 units) $1,000,000 Variable costs 600,000 Contribution margin $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 34

21. Contribution Margin Ratio = Sales – Variable Costs Sales $1,000,000 – $600,000 $1,000,000 Contribution Margin Ratio = 40% Contribution Margin Ratio = 0 4-2 Contribution Margin Ratio 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% 35

22. 0 4-2 Unit Contribution Margin The unit contribution margin is also useful for analyzing the profit potential of proposed projects. The unit contribution margin is the sales price lessthe variable cost per unit.

23. 65,000 units 0 4-2 Using Contribution Margin per Unit as a Shortcut 50,000 units $1,300,000 780,000 $ 520,000 300,000 Sales ($20) $1,000,000 Variable costs ($12) 600,000 Contribution margin ($8) $ 400,000 Fixed costs 300,000 Income from operations $ 100,000 $220,000 The increase in income from operations of $120,000 could have been determined quickly by multiplying the increase in unit sales (15,000) by the contribution margin per unit ($8). 37

24. 0 4-2 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. 38

25. 0 4-2 Review 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 The contribution margin can be expressed three ways: 1. Total contribution margin in dollars. 2. Contribution margin ratio (percentage). 3. Unit contribution margin (dollars per unit). 39

26. Example Exercise 4-2 0 4-2 Molly Company sells 20,000 units at $12 per unit. Variable costs are $9 per unit, and fixed costs are $25,000. Determine the (a) contrib-ution margin ratio, (b) unit contribution margin, and (c) income from operations. 40

27. Follow My Example 4-2 0 4-2 a. 25% = ($12 – $9)/$12 or ($240,000 – $180,000)/$240,000 • $3 per unit = $12 – $9 • Sales $240,000 (20,000 x $12) • Variable costs 180,000 (20,000 x $9) • Contribution margin $ 60,000 [20,000 x $12 –$9)] • Fixed costs 25,000 • Income from operations $ 35,000 41 For Practice: PE4-2A, PE4-2B

28. 0 4-3 Objective 3 Using the unit contribution margin, determine the break-even point and the volume necessary to achieve a target profit.

29. 0 4-3 Break-Even Point The break-even point is the level of operations at which a business’s revenues and expired costs are exactly equal.

30. Unit selling price $25 Unit variable cost 15 Unit contribution margin $10 0 4-3 Barker Corporation’s fixed costs are estimated to be $90,000. The unit contribution margin is calculated as follows: 44

31. Fixed Costs Unit Contribution Margin Break-Even Sales (units) = $90,000 $10 Break-Even Sales (units) = 9,000 units Break-Even Sales (units) = 0 4-3 The break-even point is calculated using the following equation: 45

32. Sales ($25 x 9,000) $225,000 Variable costs ($15 x 9,000) 135,000 Contribution margin $ 90,000 Fixed costs 90,000 Income from operations $ 0 0 4-3 Proof of the Preceding Computation Income from operations is zero when 9,000 units are sold—hence, break-even is 9,000 units. 46

33. 0 4-3 Effect of Changes in Fixed Costs Fixed Costs Break- Even Then If Fixed Costs Break- Even Then If 47

34. 0 4-3 Bishop Co. is evaluating a proposal to budget an additional $100,000 for advertising. Fixed costs before the additional advertising are estimated at $600,000, and the unit contribution margin is $20.

35. Fixed Costs Unit Contribution Margin Break-Even in Sales (units) = 30,000 units 35,000 units $600,000 $20 $700,000 $20 = = Break-Even in Sales (units) = Break-Even in Sales (units) = 0 4-3 Without additional advertising: With additional advertising: 49

36. 0 4-3 Effect of Changes in Unit Variable Costs Unit Variable Cost Break- Even Then If Break- Even Unit Variable Costs Then If 50

37. Unit selling price $250 Unit variable cost 145 Unit contribution margin $105 0 4-3 Park Co. is evaluating a proposal to pay an additional 2% commission on sales to its salespeople (a variable cost) as an incentive to increase sales. Fixed costs are estimated at $840,000. The unit contribution margin before the additional 2% commission is determined as follows: 51

38. Fixed Costs Unit Contribution Margin Break-Even in Sales (units) = 8,000 units 8,400 units $840,000 $105 = = Break-Even in Sales (units) = $840,000 $100 Break-Even in Sales (units) = $250 – [$145 + ($250 x 2%)] = $100 0 4-3 Without additional 2% commission: With additional 2% commission: 52

39. 0 4-3 Effect of Changes in the Unit Selling Price Unit Selling Price Break- Even Then If Unit Selling Price Break- Even Then If 53

40. Current Proposed Unit selling price $50 $60 Unit variable cost 30 30 Unit contribution margin $20 $30 0 4-3 Graham Co. is evaluating a proposal to increase the unit selling price of a product from $50 to $60. The following data have been gathered: Total fixed costs $600,000 $600,000 54

41. Fixed Costs Unit Contribution Margin Break-Even in Sales (units) = 30,000 units 20,000 units $600,000 $20 $600,000 $30 = = Break-Even in Sales (units) = Break-Even in Sales (units) = 0 4-3 Without price increase: With price increase: 55

42. Variable cost per unit Unit sales price 0 4-3 Summary of Effects of Changes on Break-Even Point Effect of Change Direction of on Break-Even Change Sales (Units) Type of Change Increase Fixed cost Increase Decrease Decrease Increase Increase Decrease Decrease Increase Decrease Increase Decrease 56

43. Example Exercise 4-3 Follow My Example 4-3 0 4-3 Nicholas Enterprises sells a product for $60 per unit. The variable cost is $35 per unit, while fixed costs are $80,000. Determine the (a) break-even point in sales units, and (b) break-even point if the selling price were increased to $67 per unit. a. 3,200 units = $80,000/($60 – $35) b. 2,500 units = $80,000/($67 – $35) 57 For Practice: PE4-3A, PE4-3B

44. Fixed Costs + Target Profit Unit Contribution Margin Sales (units) = 0 4-3 Target Profit The sales volume required to earn a target profit is determined by modifying the break-even equation. 58

45. Unit selling price $75 Unit variable cost 45 Unit contribution margin $30 Fixed Costs + Target Profit Unit Contribution Margin Sales (units) = 0 4-3 Units Required for Target Profit Fixed costs are estimated at $200,000, and the desired profit is $100,000. Unit contribution margin is $30. $100,000 $200,000 $30 Sales (units) = 10,000 units 59

46. 0 4-3 Sales (10,000 units x $75) $750,000 Variable costs (10,000 x $45) 450,000 Contribution margin (10,000 x $30) $300,000 Fixed costs 200,000 Income from operations $100,000 Proof that sales of 10,000 units will provide a profit of $100,000. 60

47. Example Exercise 4-4 Follow My Example 4-4 0 4-3 The Forest Company sells a product for $140 per unit. The variable cost is $60 per unit, and fixed costs are $240,000. Determine the (a) break-even point in sales units, and (b) break-even point in sales units if the company desires a target profit of $50,000. a. 3,000 units = $240,000/($140 – $60) b. 3,625 units = ($240,000 + $50,000)/($140 – $60) 61 For Practice: PE4-4A, PE4-4B

48. 0 4-4 Objective 4 Using a cost-volume-profit chart and a profit-volume chart, determine the break-even point and the volume necessary to achieve a target profit.

49. 0 4-4 Cost-Volume-Profit (Break-Even) Chart A cost-volume-profitchart, sometimes called a break-even chart, may assist management in understanding relationships among costs, sales, and operating profit or loss.

50. 0 4-4 The cost-volume-profit chart in Exhibit 5 (Slides 65-73) is based on the following data: Unit selling price $ 50 Unit variable cost 30 Unit contribution margin $ 20 Total fixed costs $100,000