Introduction to Cost Behavior and Cost-Volume Relationships

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Chapter 2
Introduction to Management Accounting

• Introduction to Cost Behavior and Cost-Volume
  Relationships

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Cost Drivers and Cost Behavior
Learning Objective 1
Traditional View of Cost Behavior
Activity-Based View of Cost Behavior
Resource A Cost Driver Units of
Resource Output
Resource B Cost Driver Units of
Resource Output
Resource B Cost Driver Units of
Resource Output
Resource A Cost Driver Units of
Resource Output
Activity A Cost Driver Units of Activity
Output
Activity B Cost Driver Units of Activity
Output
Product or Service Cost Driver Units of
Final Product or Service
Product or Service Cost Driver Output of
Final Product or Service
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Cost Drivers and Cost Behavior
Cost behavior is how the activities of an
organization affect its costs.
Any output measure that causes the use of costly
resources is a cost driver.
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Value Chain Functions, Costs, and Cost Drivers

• Value Chain Function and Example Costs
  Example Cost Drivers
• Research and development
• Salaries marketing research personnel Number
  of new product proposals
• costs of market surveys
• Salaries of product and process engineers
  Complexity of proposed products
• Design of products, services, and processes
• Salaries of product and process engineers
  Number of engineering hours
• Cost of computer-aided design equipment
  Number of parts per product
• Cost to develop prototype of product
• for testing

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Value Chain Functions, Costs, and Cost Drivers

• Value Chain Function and Example Costs
  Example Cost Drivers
• Production
• Labor wages Labor hours
• Supervisory salaries Number of people
  supervised
• Maintenance wages Number of mechanic
  hours
• Depreciation of plant and machinery
  Number of machine hours
• supplies
• Energy cost Kilowatt hours
• Marketing
• Cost of advertisements
  Number of advertisements
• Salaries of marketing personnel,
  Sales dollars
• travel costs, entertainment costs

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Value Chain Functions, Costs, and Cost Drivers

• Value chain function and Example costs
  Example Cost Drivers
• Distribution
• Wages of shipping personnel Labor
  hours
• Transportation costs including Weight
  of items delivered
• depreciation of vehicles and fuel
• Customer service
• Salaries of service personnel Hours
  spent servicing products
• Costs of supplies, travel Number of
  service calls

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Variable and Fixed Cost Behavior
Learning Objective 2
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.
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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.
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Fixed Costs and Relevant Range
115,000
Total Monthly Fixed Costs
100,000
60,000
20 40 60
80 100
115,000
100,000
60,000
20 40 60
80 100
Total Cost-Driver Activity in Thousands of Cases
per Month
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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).
Per Unit Percentage of Sales
Selling price 1.50 100 Variable
cost of each item 1.20
80 Selling price less variable cost
.30 20 Monthly fixed expenses Rent
3,000 Wages for replenishing and
servicing 13,500 Other fixed expenses
1,500 Total fixed
expenses per month 18,000
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Break-Even Point
Learning Objective 3
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)

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Contribution Margin Method
Contribution margin Per Unit Selling
price 1.50 Variable costs 1.20
Contribution margin .30
Contribution margin ratio Per Unit
Selling price 100 Variable costs .80
Contribution margin .20
18,000 fixed costs .30 60,000 units (break
even)
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Contribution Margin Method
60,000 units 1.50 90,000 in sales to break
even
Or
18,000 fixed costs 20 (contribution-margin
percentage) 90,000 of sales to break even
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Equation Method
Let N number of units to be sold to break even.
Sales variable expenses fixed expenses net
income 1.50N 1.20N 18,000 0 .30N
18,000 N 18,000 .30 N 60,000 Units
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Equation Method
Let S sales in dollars needed to break even.
S .80S 18,000 0 .20S 18,000 S 18,000
.20 S 90,000
Shortcut formulas Break-even volume in units
fixed expenses
unit contribution margin Break-even
volume in sales fixed expenses
contribution margin
ratio
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Cost-Volume-Profit Graph
Learning Objective 4
A
150,000
Net Income
138,000
Sales
C
120,000
Net Income Area
D
Dollars
90,000
Variable Expenses
Total Expenses
Break-Even Point 60,000 units or 90,000
60,000
Net Loss Area
30,000
B
18,000
Fixed Expenses
0
10
20
30
40
50
60
70
80
90
100
Units (thousands)
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Target Net Profit
Learning Objective 5
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
1,440 per month is the minimum acceptable net
income.
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Target Net Profit
Target sales volume in units (Fixed expenses
Target net income) Contribution margin per unit
Selling price 1.50 Variable costs 1.20
Contribution margin per unit .30
(18,000 1,440) .30 64,800 units
Target sales dollars sales price X sales volume
in units Target sales dollars 1.50 X 64,800
units 97,200.
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Target Net Profit
Contribution margin ratio Per Unit
Selling price 100 Variable costs .80
Contribution margin .20
Or
Target sales volume in dollars Fixed expenses
target net income contribution
margin ratio
Sales volume in dollars 18,000 1,440
97,200 .20
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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?
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Contribution Marginand Gross Margin
Learning Objective 6
Sales price Cost of goods sold Gross margin
Sales price - all variable expenses
Contribution margin
Per Unit Selling price 1.50
Variable costs (acquisition cost)
1.20 Contribution margin and gross margin
are equal .30
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Contribution Margin and Gross Margin
Suppose the firm had to pay a commission of .12
per unit sold.
Contribution Gross
Margin Margin
Per Unit Per Unit Sales 1.50 1.
50 Acquisition cost of unit sold 1.20 1.20
Variable commission .12 Total variable
expense 1.32 Contribution margin
.18 Gross margin .30
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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.
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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
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Nonprofit Application
If the city cuts the total budget Appropriation
by 10, how many Patients can it serve in a year?
Budget after 10 Cut 100,000 X (1 - .1)
90,000
90,000 400N 60,000 400N 90,000
60,000 N 30,000 400 N 75 patients
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Sales Mix Analysis
Learning Objective 7
Sales mix is the relative proportions
or combinations of quantities of products that
comprise total sales.
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Sales Mix Analysis
Ramos Company Example
Wallets (W)
Key Cases (K)
Total
Sales in units 300,000 75,000
375,000 Sales _at_ 8 and 5 2,400,000 375,000
2,775,000 Variable expenses _at_ 7 and 3
2,100,000 225,000 2,325,000 Contribution
margins _at_ 1 and 2 300,000 150,000
450,000 Fixed expenses
180,000 Net income 270,000
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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
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Sales Mix Analysis
If the company sells only key cases break-even
point fixed expenses contributio
n margin per unit 180,000
2 90,000 key
cases
If the company sells only wallets break-even
point fixed expenses contributio
n margin per unit 180,000
1 180,000
wallets
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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?
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Sales Mix Analysis
Ramos Company Example
Wallets (W)
Key Cases (K)
Total
Sales in units 325,000 50,000
375,000 Sales _at_ 8 and 5 2,600,000
250,000 2,850,000 Variable expenses _at_ 7
and 3 2,275,000 150,000
2,425,000 Contribution margins _at_ 1 and 2
325,000 100,000 425,000 Fixed
expenses 180,000 Net
income 245,000
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Impact of Income Taxes
Learning Objective 8
Suppose that a company earns 480 before taxes
and pays income tax at a rate of 40.
What is the after-tax income?
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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
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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
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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
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The End
End of Chapter 2