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Cost Behavior and CostVolume Relationships

Steps in Estimating Costs

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 and Period Costs


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.

Period costs: Costs that are not product costs. Related to


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

A Traditional Income Statement

Period Costs
Product Costs

Usefulness for Internal Decisions


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,

Generally, there is no inventory of their final


product
Exceptions exist
We can inventory costs of software projects that go
across accounting periods

Flow of Costs: Service Settings

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 beginning inventory


Cost of goods purchased during the period
Cost of ending inventory
Cost of goods sold (COGS) during the period

Make inventory cost flow assumption


First In First Out (FIFO)
Last In First Out (LIFO)

Solution

Cost of beginning inventory


+ Cost of goods purchased +
- Cost of ending inventory
= Cost of goods sold
=

$3,450,200
24,795,740
3,745,600
$24,500,340

Flow of Costs in Merchandising

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

Cost Terms in Manufacturing

Names for Groups of Costs

Cost Terms in Manufacturing


Conversion
Costs

Prime
Costs

To verify the amounts specified above, THREE calculations need


to be made:

Calculation

Procedure
Calculate Raw Materials Used

Beginning materials inventory


+ Purchases
- Ending materials inventory
= Raw materials used

$240,000
+ 1,200,000
320,000
= $1,120,000

Calculate Cost of Goods Manufactured

+
+
+
=
3

Result

Beginning WIP inventory


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

Calculate Cost of Goods Sold

Beginning FG inventory
+ COGM
- Ending FG inventory
= Cost of goods sold

$375,000
+ 2,675,500
294,500
= $2,765,000

Variable and Fixed Cost Behavior


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.

Think of fixed costs


on a total-cost basis.

The per-unit variable


cost remains unchanged
regardless of changes in
the cost-driver.

Total fixed costs remain


unchanged regardless of
changes in the cost-driver.

Examples of Variable Costs


Direct material consumed.
Direct Labour
Direct Expenses/overheads
Selling commission based on number of units sold

Examples of Fixed Cost


Salary of factory manager
Factory Rent
Depreciation on machinery
Office & administrative costs
Selling & distribution costs if fixed

Committed Fixed Costs:


Those fixed costs which
cannot be reduced without
curtailing the organisations
operations substantially

Discretionary Fixed Costs:


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.

Even within the relevant range, a fixed


cost remains fixed only over a given
period of time Usually the budget period.

Total Monthly Fixed Costs

Fixed Costs and Relevant Range


$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 Cost Behavior Patterns


Step costs change abruptly at intervals
of activity because the resources and
their costs come in indivisible chunks.

Step Cost Behavior Patterns

Mixed-Cost Behavior Patterns


Mixed costs contain elements of both
fixed- and variable-cost behavior.

The fixed-cost element is unchanged


over a range of cost-driver activity.

The variable-cost element varies


proportionately with cost-driver activity.

Mixed-Cost Behavior Patterns


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.

The second step is to use these cost


measures to estimate future costs at
expected levels of cost-driver activity.

Cost Function Equation


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

Methods of Measuring Cost


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

Supervisors salary and benefits


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

Account Analysis Example


3,700 patient-days

Fixed cost per month = $9,673


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.

High month: April


Maintenance cost: $47,000
Number of patient-days: 4,900
Low month: September
Maintenance cost: $17,000
Number of patient-days: 1,200

High-Low Method Example

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.

High-Low Method Example


What is the variable cost (V)?
Using algebra to solve for variable and fixed costs.

Variable costs = Change in costs


change in activity
V = ($47,000 $17,000) (4,900 1,200)
= $30,000 3,700 = $8.1081

High-Low Method Example


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.

Least-Squares Regression Method


Regression analysis measures
a cost function more objectively
by using statistics to fit a cost
function to all the data.

Regression analysis measures


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).

The coefficient of determination


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

Euclid Company uses the high-low method to analyze mixed costs.


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

What shall be the estimated total cost for 1,000 units?

Cost Hierarchy

The cost hierarchy broadens the principle of


variability
Allows us to consider multiple activities

The cost hierarchy recognizes four types of costs

Unit-level costs
Batch-level costs
Product-level costs
Facility-level costs

Why the Cost Hierarchy?


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

Wrong classification of levels introduces errors in cost


estimation

Example: Deluxe Checks

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

The break-even point is the level of sales at which


revenue equals expenses and net income is zero.

Sales
- Variable expenses
- Fixed expenses
Zero net income (break-even point)

Contribution Margin Method


Contribution margin
Per Unit
Selling price
$3.00
Variable costs
2.10
Contribution margin $ .90

Contribution margin ratio


Per Unit
%
Selling price
100
Variable costs
70
Contribution margin 30

$45,000 fixed costs $.90


= 50,000 units (break even)

Contribution Margin Method

50,000 units $3.00 = $150,000


in sales to break even

$45,000 fixed costs


30% (contribution-margin percentage)
= $150,000 of sales to break even

Equation Method

Let N = number of units


to be sold to break even.

Sales variable expenses fixed expenses = net income


$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

Target Net Profit


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

$9,000 per month


is the minimum
acceptable net income.

Target Net Profit


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.

Target Net Profit


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.

Margin of safety divided by actual sales revenue gives the Margin of


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?

Sales Mix Analysis

Sales mix is the relative proportions or


combinations of quantities of products
that comprise total sales.

Sales Mix Analysis


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?

Sales Mix Analysis


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

Sales Mix Analysis


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

Sales Mix Analysis

Suppose total sales were equal to the


budget of 375,000 units.

However, Ramos sold only 50,000 key cases


And 325,000 wallets.
What is net income?

Sales Mix Analysis


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.

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?

Impact of Income Taxes

Target income before taxes = Target after-tax net income


1 tax rate

Suppose the target net income


after taxes was $288.

Target income before taxes =

$ 288 = $480
1 0.40

Impact of Income Taxes

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 + ($288/.6)
$.06N = $3,600 + $288 = $3,888
N = $3,888/$.06
N = 64,800 units

Impact of Income Taxes

Suppose target net income after taxes was $480

$.50N $.40N $6,000 = $480 (1 0.40)


$.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

A decrease in fixed costs


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.

The contribution margin ratio


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

Less: Variable Costs

400,000

300,000

Fixed costs

50,000

150,000

Forecasted net profit

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.