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Cost Volume analysis

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Cost

behavior

Build model of

expected relationship

between cost and

activity

Cost

estimation

Use historical data to

test model and to

determine parameters

Cost

prediction

Use estimated

parameters to forecast

costs at a particular

activity level.

Product costs: Costs related to getting a product or service

ready for sale.

Appear above the line for gross margin in income statements

These costs can be inventoried

They flow through the inventory account in the balance sheet

Sometime called Inventoriable costs.

marketing and administration

Appear below the line for gross margin

These costs are expensed in the period they are incurred.

These costs do not flow through inventory accounts

Period Costs

Product Costs

The gross margin income statement mingles

Relevant & non relevant costs

Variable and fixed costs

Direct and indirect costs

Service Firms

Products are not tangible or storable

Hotels, restaurants, consulting, airlines, gyms,

universities, museums,

product

Exceptions exist

We can inventory costs of software projects that go

across accounting periods

Merchandising Firms

Examples include Wal Mart, Big Bazaar etc.

These firms

Sell substantively the same product they

purchase.

Carry inventory to make goods available in the

quantities, varieties and delivery schedules

demanded by customers.

Inventory Equation

Need to flow costs via inventory account

Cost of purchase is NOT the cost of goods sold

We can capture flow as:

+

Cost of goods purchased during the period

Cost of ending inventory

Cost of goods sold (COGS) during the period

First In First Out (FIFO)

Last In First Out (LIFO)

Solution

+ Cost of goods purchased +

- Cost of ending inventory

= Cost of goods sold

=

$3,450,200

24,795,740

3,745,600

$24,500,340

Transportation

in, stocking

Manufacturing Firms

Use labor and equipment to transform raw materials

into finished goods

Have work-in-process

Need inventory accounts for all three kinds of

stages in the production process

Much variation in

Nature of production process

Relative amounts of different costs

Conversion

Costs

Prime

Costs

to be made:

Calculation

Procedure

Calculate Raw Materials Used

+ Purchases

- Ending materials inventory

= Raw materials used

$240,000

+ 1,200,000

320,000

= $1,120,000

+

+

+

=

3

Result

Materials used

Labor cost

Manufacturing overhead

Ending WIP inventory

Cost of goods manufactured

+

+

+

=

$50,000

1,120,000

845,000

760,500

100,000

2,675,500

Beginning FG inventory

+ COGM

- Ending FG inventory

= Cost of goods sold

$375,000

+ 2,675,500

294,500

= $2,765,000

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.

Think of variable

costs on a per-unit basis.

on a total-cost basis.

cost remains unchanged

regardless of changes in

the cost-driver.

unchanged regardless of

changes in the cost-driver.

Direct material consumed.

Direct Labour

Direct Expenses/overheads

Selling commission based on number of units sold

Salary of factory manager

Factory Rent

Depreciation on machinery

Office & administrative costs

Selling & distribution costs if fixed

Those fixed costs which

cannot be reduced without

curtailing the organisations

operations substantially

Those fixed costs which

can be reduced in difficult

times

Relevant Range

The relevant range is the limit

of cost-driver activity level within which a

specific relationship between costs

and the cost driver is valid.

cost remains fixed only over a given

period of time Usually the budget period.

$115,000

100,000

60,000

20

40

60

Relevant range

80

100

80

100

$115,000

100,000

60,000

20

40

60

Total Cost-Driver Activity in Thousands

of Cases per Month

Linear-cost Behavior

Costs are assumed to be fixed or variable

the relevant range of activity

within

Step costs change abruptly at intervals

of activity because the resources and

their costs come in indivisible chunks.

Mixed costs contain elements of both

fixed- and variable-cost behavior.

over a range of cost-driver activity.

proportionately with cost-driver activity.

Parkview Medical Center

Predicted costs = fixed + variable costs (patient-days)

Predicted costs = $10,000 + $5(4,000)

Predicted costs = $30,000

Cost Functions

Planning and controlling the activities

of an organization require accurate

and useful estimates of future

fixed and variable costs.

Cost Functions

Understanding relationships between costs

and their cost drivers allows managers to...

Make better operating, marketing,

And production decisions

Plan and evaluate actions

Determine appropriate costs for

short-run and long-run decisions.

Cost Functions

The first step in estimating or predicting

costs is measuring cost behavior as a

function of appropriate cost drivers.

measures to estimate future costs at

expected levels of cost-driver activity.

Let:

Y = Total cost

F = Fixed cost

V = Variable cost per unit

X = Cost-driver activity in number of units

The mixed-cost function is called a linear-cost function.

Mixed-cost function:

Y = F + VX

Y = $10,000 + $5.00X

Functions

1. Account analysis

2. High-low analysis

3. Visual-fit analysis

4. Least-squares regression analysis

Account Analysis

The simplest method of account analysis selects a plausible

cost driver and classifies each account as a variable or fixed cost.

Parkview Medical Center

Monthly cost

Amount

Fixed

Hourly workers wages and benefits

Equipment depreciation and rentals

Equipment repairs

Cleaning supplies

Total maintenance costs

$ 3,800

14,674

5,873

5,604

7,472

$37,423

$3,800

Variable

$14,674

5,873

$9,673

5,604

7,472

$27,750

3,700 patient-days

Variable cost per patient-day

= $27,750 3,700

= $7.50 per patient-day

Y = $9,673 + ($7.50 patient-days)

High-Low Method

Plot historical data points on a graph.

Focus on the highest- and lowest-activity points.

Maintenance cost: $47,000

Number of patient-days: 4,900

Low month: September

Maintenance cost: $17,000

Number of patient-days: 1,200

The point at which the line intersects the Y axis is the intercept,

F, or estimate of Fixed Costs, and the slope of the line

measures the variable cost.

What is the variable cost (V)?

Using algebra to solve for variable and fixed costs.

change in activity

V = ($47,000 $17,000) (4,900 1,200)

= $30,000 3,700 = $8.1081

What is the fixed cost (F)?

F = Total mixed cost total variable cost

At X (high) F = $47,000 - ($8.1081 4,900 patient days)

= $47,000 $39,730

= $7,270 a month

At X (low) F = $17,000 = ($8.1081 1,200 patient days)

= $17,000 $9,730

= $7,270 a month

Cost function measured by high-low method:

Y = $7,270 per month + ($8.1081 patient-days)

Visual-Fit Method

In the visual-fit method, the cost analyst

visually fits a straight line through a plot

of all of the available data, not just

between the high point and the

low point, making it more reliable

than the high-low method.

Regression analysis measures

a cost function more objectively

by using statistics to fit a cost

function to all the data.

cost behavior more reliably than

other cost measurement methods.

Coefficient of Determination

One measure of reliability,

or goodness of fit, is the

coefficient of determination,

R (or R-squared).

measures how much of the

fluctuation of a cost is explained

by changes in the cost driver.

Example

Presented below is the production data for the first six months of the year showing the

mixed costs incurred by Euclid Company.

Month

Cost

Units

January

February

March

April

May

June

$7,500

13,000

11,500

11,700

13,500

11,850

4,000

7,500

9,000

11,500

12,000

6,000

What shall be cost function?

Example

The Reynolds Company used regression analysis to predict the annual cost of utilities.

The results were as follows:

Utilities Cost

Explained by Direct Labor Hours

Constant

Standard error of Y estimate

R - squared

No. of observations

Degrees of freedom

$7,650

$245.20

0.8650

30

28

X coefficient(s)

8.437

Cost Hierarchy

variability

Allows us to consider multiple activities

Unit-level costs

Batch-level costs

Product-level costs

Facility-level costs

Allows us to compute a more accurate estimate of

costs

Can extend concept to other levels

Customer level costs, channel level costs,

However,

Difficult to assign many costs to hierarchy categories

Need finer data on operations

estimation

CVP Scenario

Cost-volume-profit (CVP) analysis is the study of the effects of output

volume on revenue (sales), expenses (costs), and net income (net profit).

Selling price

Variable cost of each item

Selling price less variable cost

Monthly fixed expenses:

Rent

Depreciation

Other fixed expenses

Total fixed expenses per month

Per Unit

$3.00

2.10

$ .90

$10,000

20,000

15,000

$ 45,000

Percentage of Sales

100%

70

30%

CVP Assumptions

1. The behaviour of costs and revenues have been reliably determined

and is linear over the relevant range

2. All costs may be divided into fixed and variable elements.

3. Fixed cost remain constant over the relevant volume range of the

break-even analysis.

4. Variable costs are proportional to volume.

5. Selling prices to be unchanged.

6. Prices of cost factors are to be unchanged.

7. Efficiency and productivity remain unchanged.

8. The analysis either covers a single product or it assumes that a given

sales-mix will be maintained as total volume changes.

9. Revenue and costs are being compared on a common activity base.

10. Changes in beginning and ending inventory levels are insignificant in

amount.

Break-Even Point

revenue equals expenses and net income is zero.

Sales

- Variable expenses

- Fixed expenses

Zero net income (break-even point)

Contribution margin

Per Unit

Selling price

$3.00

Variable costs

2.10

Contribution margin $ .90

Per Unit

%

Selling price

100

Variable costs

70

Contribution margin 30

= 50,000 units (break even)

in sales to break even

30% (contribution-margin percentage)

= $150,000 of sales to break even

Equation Method

to be sold to break even.

$3.00N $2.10N $45,000 = 0

$.90N = $45,000

N = $45,000 $.90

N = 50,000 Units

Equation Method

Let S = sales in dollars

needed to break even.

S .70S $45,000 = 0

.30S = $45,000

S = $45,000 .30

S = $150,000

Shortcut formulas:

Break-even volume in units = fixed expenses

unit contribution margin

Break-even volume in sales = fixed expenses

contribution margin ratio

Managers use CVP analysis

to determine the total sales,

in units and dollars, needed

To reach a target net profit.

Target sales

variable expenses

fixed expenses

target net income

is the minimum

acceptable net income.

Target sales volume in units =

(Fixed expenses + Target net income)

Contribution margin per unit

Selling price

$3.00

Variable costs

2.10

Contribution margin per unit $ .90

($45,000 + $9,000) $.90 = 60,000 units

Target sales dollars = sales price X sales volume in units

Target sales dollars = $3.00 X 60,000 units = $180,000.

Contribution margin ratio

Per Unit

%

Selling price

100

Variable costs

70

Contribution margin 30

Target sales volume in dollars = Fixed expenses + target net income

contribution margin ratio

Sales volume in dollars = 45,000 + $9,000 = $180,000

.30

Margin of Safety

The excess of actual sales revenue over the break even sales revenue.

Safety Ratio.

Higher the Margin of Safety Ratio, better it is.

Example

A company had incurred fixed expenses of Rs.4,50,000 with sales of

Rs.15,00,000 and earned a profit of Rs.3,00,000 during the first half

of the year. In the Second half, it suffered a loss of Rs.1,50,000.

Compute:

i.

The profit volume ratio, break even point and margin of safety

for the first half.

ii.

Sales of second half assuming that the selling price per

unit, variable cost per unit and fixed expenses remained

unchanged.

iii. The margin of safety and breakeven point for the whole year.

Operating Leverage

Operating leverage: a firms ratio of fixed costs to variable costs.

Highly leveraged firms have high fixed costs and low variable costs.

A small change in sales volume = a large change in net income.

Low leveraged firms have lower fixed costs and higher variable costs.

Changes in sales volume will have a smaller effect on net income.

Margin of safety = planned unit sales break-even sales

How far can sales fall below the planned level before losses occur?

combinations of quantities of products

that comprise total sales.

Ramos Company Example

Sales in units

Sales @ $8 and $5

Variable expenses

@ $7 and $3

Contribution margins

@ $1 and $2

Fixed expenses

Net income

Wallets

(W)

Key Cases

(K)

300,000

$2,400,000

75,000

$375,000

375,000

$2,775,000

2,100,000

225,000

2,325,000

300,000

$150,000

$ 450,000

180,000

$ 270,000

Total

How much units of Wallets and Key Cases should the company sell to break even?

Let K = number of units of K to break even, and

4K = number of units of W to break even.

Break-even point for a constant sales mix

of 4 units of W for every unit of K.

sales variable expenses - fixed expenses = zero net income

[$8(4K) + $5(K)] [$7(4K) + $3(K)] $180,000 = 0

32K + 5K - 28K - 3K - 180,000 = 0

6K = 180,000

K = 30,000

W = 4K = 120,000

If the company sells only key cases:

break-even point =

fixed expenses

contribution margin per unit

= $180,000

$2

= 90,000 key cases

If the company sells only wallets:

break-even point =

fixed expenses

contribution margin per unit

= $180,000

$1

= 180,000 wallets

budget of 375,000 units.

And 325,000 wallets.

What is net income?

Ramos Company Example

Wallets

(W)

Sales in units

Sales @ $8 and $5

Variable expenses

@ $7 and $3

Contribution margins

@ $1 and $2

Fixed expenses

Net income

Key Cases

(K)

Total

325,000

50,000

$2,600,000 $250,000

375,000

$2,850,000

2,275,000

150,000

2,425,000

$ 325,000 $100,000

$ 425,000

180,000

$ 245,000

Example

The Garware Paints Ltd. presents you the following income statement for the

first quarter

Product

Total

X

Y

Z

Sales

100,000

60,000

40,000

200,000

Variable Costs

80,000

42,000

24,000

146,000

Contribution

20,000

18,000

16,000

54,000

Fixed costs

27,000

Net Income

27,000

P/V ratio

0.27

Break Even sales

100,000

Sales mix percent

0.50

0.30

0.20

1.00

If Rs.40,000 of the sales shown for the product X could be shifted to product Y

and Z equally, how would the net income, P/V ratio and BEP change.

and pays income tax at a rate of 40%.

1 tax rate

after taxes was $288.

$ 288 = $480

1 0.40

= Target after-tax net income (1 tax rate)

$.10N = $6,000 + ($288/.6)

$.06N = $3,600 + $288 = $3,888

N = $3,888/$.06

N = 64,800 units

$.10N = $6,000 + ($480/.6)

$.06N = $3,600 + $480 = $4080

N = $4,080 $.06

N = 68,000 units

Q. State whether P/V ratio will increase or decrease or remain unchanged in the

following situations (Consider all situations independently keeping other things

constant):

An increase in physical sales volume

No Change

An increase in fixed costs

No Change

A decrease in variable cost per unit

Increase.

A decrease in contribution margin per unit

Decrease

An increase in Selling price

Increase

No change

A 10% increase in both variable costs and selling price

No Change

A 10% increase in selling price and 10% decrease in physical sales volume

Increase

A 50% increase in variable cost and 50% decrease in fixed costs

Decrease

Example

S Ltd. furnishes the following data relating to the year 2012:

IInd Half of

Ist Half of the year the year

Sales

45,000

50,000

Total Cost

40,000

43,000

Assuming that there is no change in prices and variable costs per unit and that the fixed

expenses are incurred equally in the two half year periods, calculate for the entire year:

i.

ii.

iii.

iv.

Fixed expenses

Break even sales

Margin of safety ratio

Example

M Ltd. manufactures three products P, Q and R. The unit selling price of these products are

Rs.100, Rs.80 and Rs.50 respectively. The corresponding unit variable costs are Rs.50, Rs.40

and Rs.20. The proportions (quantity wise) in which these products are manufactured and

sold are 20%, 30% and 50% respectively. The total fixed costs are Rs.14,80,000.

Given the above information you are required to work out overall break even quantity and

product wise break up of such quantity.

Example

Two competing companies HERO Ltd. and ZERO Ltd. sell same type of product in the same

market. Their forecasted Profit and Loss A/c for the year ending Mar 2014 are as follows:

HERO

ZERO

Sales

500,000

500,000

400,000

300,000

Fixed costs

50,000

150,000

50,000

50,000

You are required to state which company is likely greater profits in the conditions of:

a. Low demand

b. High Demand.

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