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  • 1. Cost Classifications for Predicting Cost Behavior How a cost will react to changes in the level of business activity. – Total variable costs change when activity changes. – Total fixed costs remain unchanged when activity changes. How a cost will react to changes in the level of business activity. – Total variable costs change when activity changes. – Total fixed costs remain unchanged when activity changes.
  • 2. Total Variable Cost Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked TotalLongDistance TelephoneBill
  • 3. Variable Cost Per Unit Minutes Talked PerMinute TelephoneCharge The cost per long distance minute talked is constant. For example, 10 cents per minute.
  • 4. Total Fixed Cost Your monthly basic telephone bill probably does not change when you make more local calls. Number of Local Calls MonthlyBasic TelephoneBill
  • 5. Fixed Cost Per Unit Number of Local Calls MonthlyBasicTelephone BillperLocalCall The average cost per local call decreases as more local calls are made.
  • 6. Cost Classifications for Predicting Cost Behavior Behavior of Cost (within the relevant range) Cost In Total Per Unit Variable Total variable cost changes Variable cost per unit remains as activity level changes. the same over wide ranges of activity. Fixed Total fixed cost remains Fixed cost per unit goes the same even when the down as activity level goes up. activity level changes.
  • 7. The Activity Base A measure of the event that causes the incurrence of a variable cost – a cost driver A measure of the event that causes the incurrence of a variable cost – a cost driver Units produced Units produced Miles driven Miles driven Labor hours Labor hours Machine hours Machine hours
  • 8. Step-Variable Costs Activity Cost Total cost remains constant within a narrow range of activity. Total cost remains constant within a narrow range of activity.
  • 9. Step-Variable Costs Activity Cost Total cost increases to a new higher cost for the next higher range of activity. Total cost increases to a new higher cost for the next higher range of activity.
  • 10. Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. A straight line closely approximates a curvilinear variable cost line within the relevant range. Activity TotalCost Economist’s Curvilinear Cost Function The Linearity Assumption and the Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost) Exh. 5-4
  • 11. Cost Behavior Merchandisers Cost of Goods Sold Merchandisers Cost of Goods Sold Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Merchandisers and Manufacturers Sales commissions and shipping costs Merchandisers and Manufacturers Sales commissions and shipping costs Service Organizations Supplies and travel Service Organizations Supplies and travel Examples of normally variable costsExamples of normally variable costs Examples of normally fixed costsExamples of normally fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salaries Depreciation, Advertising Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salaries Depreciation, Advertising
  • 12. Examples Advertising and Research and Development Examples Advertising and Research and Development Examples Depreciation on Buildings and Equipment Examples Depreciation on Buildings and Equipment Types of Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be reduced in the short term. Committed Long-term, cannot be reduced in the short term.
  • 13. RentCostin ThousandsofDollars 0 1,000 2,000 3,000 Rented Area (Square Feet) 0 30 60 Fixed Costs and Relevant Range 90 Relevant Range Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Exh. 5-6
  • 14. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) TotalUtilityCost X Y A mixed cost has both fixed and variable components. Consider the example of utility cost. A mixed cost has both fixed and variable components. Consider the example of utility cost. Mixed Costs Total mixed cost
  • 15. Total Per Unit Sales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$ Less: fixed expenses 80,000 Net operating income 20,000$ WIND BICYCLE CO. Contribution Income Statement For the Month of June The Basics of Cost-Volume- Profit (CVP) Analysis Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted.
  • 16. Total Per Unit Sales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$ Less: fixed expenses 80,000 Net operating income 20,000$ WIND BICYCLE CO. Contribution Income Statement For the Month of June The Basics of Cost-Volume- Profit (CVP) Analysis CM goes to cover fixed expenses.CM goes to cover fixed expenses.
  • 17. Total Per Unit Sales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$ Less: fixed expenses 80,000 Net operating income 20,000$ WIND BICYCLE CO. Contribution Income Statement For the Month of June The Basics of Cost-Volume- Profit (CVP) Analysis After covering fixed costs, any remaining CM contributes to income.
  • 18. The Contribution Approach For each additional unit Wind sells, $200 more in contribution margin will help to cover fixed expenses and profit.
  • 19. The Contribution Approach Each month Wind must generate at least $80,000 in total CM to break even.
  • 20. The Contribution Approach If Wind sells 400 units in a month, it will be operating at the break-even point.
  • 21. Total Per Unit Sales (401 bikes) 200,500$ 500$ Less: variable expenses 120,300 300 Contribution margin 80,200 200$ Less: fixed expenses 80,000 Net operating income 200$ WIND BICYCLE CO. Contribution Income Statement For the Month of June The Contribution Approach If Wind sells one more bike (401 bikes), net operating income will increase by $200.
  • 22. CVP Relationships in Graphic Form Viewing CVP relationships in a graph is often helpful. Consider the following information for Wind Co.: Income 300 units Income 400 units Income 500 units Sales 150,000$ 200,000$ 250,000$ Less: variable expenses 90,000 120,000 150,000 Contribution margin 60,000$ 80,000$ 100,000$ Less: fixed expenses 80,000 80,000 80,000 Net operating income (20,000)$ -$ 20,000$
  • 23. - 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 - 100 200 300 400 500 600 700 800 CVP Graph Fixed expenses Units Dollars Total Expenses Total Sales
  • 24. - 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 - 100 200 300 400 500 600 700 800 Units Dollars CVP Graph Break-even point Profit Area Loss Area
  • 25. Contribution Margin Ratio The contribution margin ratio is: For Wind Bicycle Co. the ratio is: $ 80,000 $200,000 = 40% Total CM Total sales CM Ratio =
  • 26. Contribution Margin Ratio Or, in terms of units, the contribution margin ratio is: For Wind Bicycle Co. the ratio is: $200 $500 = 40% Unit CM Unit selling price CM Ratio =
  • 27. Contribution Margin Ratio At Wind, each $1.00 increase in sales revenue results in a total contribution margin increase of 40¢. If sales increase by $50,000, what will be theIf sales increase by $50,000, what will be the increase in total contribution margin?increase in total contribution margin?
  • 28. Contribution Margin Ratio 400 Bikes 500 Bikes Sales 200,000$ 250,000$ Less: variable expenses 120,000 150,000 Contribution margin 80,000 100,000 Less: fixed expenses 80,000 80,000 Net operating income -$ 20,000$ A $50,000 increase in sales revenue
  • 29. Changes in Fixed Costs and Sales Volume Wind is currently selling 500 bikes per month. The company’s sales manager believes that an increase of $10,000 in the monthly advertising budget would increase bike sales to 540 units. Should we authorize the requested increase in the advertising budget?
  • 30. Current Sales (500 bikes) Projected Sales (540 bikes) Sales 250,000$ 270,000$ Less: variable expenses 150,000 162,000 Contribution margin 100,000 108,000 Less: fixed expenses 80,000 90,000 Net operating income 20,000$ 18,000$ Changes in Fixed Costs and Sales Volume Sales increased by $20,000, but net operating income decreased by $2,000.. Sales increased by $20,000, but net operating income decreased by $2,000.. $80,000 + $10,000 advertising = $90,000$80,000 + $10,000 advertising = $90,000
  • 31. Changes in Fixed Costs and Sales Volume The Shortcut SolutionThe Shortcut Solution Increase in CM (40 units X $200) 8,000$ Increase in advertising expenses 10,000 Decrease in net operating income (2,000)$
  • 32. Break-Even Analysis Break-even analysis can be approached in three ways: 1. Graphical analysis. 2. Equation method. 3. Contribution margin method.
  • 33. Equation Method Profits = Sales – (Variable expenses + Fixed expenses) Sales = Variable expenses + Fixed expenses + Profits OR At the break-even point profits equal zero.
  • 34. Break-Even Analysis Here is the information from Wind Bicycle Co.: Total Per Unit Percent Sales (500 bikes) 250,000$ 500$ 100% Less: variable expenses 150,000 300 60% Contribution margin 100,000$ 200$ 40% Less: fixed expenses 80,000 Net operating income 20,000$
  • 35. Equation Method We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 Where: Q = Number of bikes sold $500 = Unit selling price $300 = Unit variable expense $80,000 = Total fixed expense
  • 36. Equation Method We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = $80,000 ÷ $200 per bike Q = 400 bikes
  • 37. Equation Method We can also use the following equation to compute the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + $80,000 + $0 Where: X = Total sales dollars 0.60 = Variable expenses as a % of sales $80,000 = Total fixed expenses
  • 38. Equation Method X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $80,000 ÷ 0.40 X = $200,000 We can also use the following equation to compute the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits
  • 39. Contribution Margin Method The contribution margin method is a variation of the equation method. Fixed expenses Unit contribution margin = Break-even point in units sold Fixed expenses CM ratio = Break-even point in total sales dollars
  • 40. Target Profit Analysis Suppose Wind Co. wants to know how many bikes must be sold to earn a profit of $100,000. We can use our CVP formula to determine the sales volume needed to achieve a target net profit figure.
  • 41. The CVP Equation Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $100,000 $200Q = $180,000 Q = 900 bikes
  • 42. The CVP Equation Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $100,000 $200Q = $180,000 Q = 900 bikes