INTRODUCTION TO

1
CHAPTER 2

• INTRODUCTION TO
• COST BEHAVIOR
• AND
• COST-VOLUME
• RELATIONSHIPS

2
COST BEHAVIOR

• One of the main goals of management accounting is
  controlling (and reducing) costs.
• Managers cannot control costs unless they
  understand cost behaviour.
• What is cost behaviour?

3
COST BEHAVIOR

• How costs are related to and affected by the
  activities of an organization.

4
COST DRIVERS

• Output measures of resources and
• activities are called cost drivers.

5
COST DRIVERS

• Production Example
• Example Costs
• Labour wages
• Supervisory salaries
• Maintenance wages
• Depreciation of plant and machinery, supplies
• Energy

• Example Cost Drivers
• Labour hours
• No. of people supervised
• No. of mechanic hours
• No. of machine hours
• Kilowatt hours

6
COMPARISON OF VARIABLE AND FIXED COSTS

• A variable cost is a cost that changes in
  direct proportion to changes in the cost driver.
• A fixed cost is not immediately affected by
  changes in the cost driver.

7
RULES OF THUMB

• 1. Think of fixed costs as a total.
• Total fixed costs remain unchanged regardless of
  changes in cost-driver activity.

8
RULES OF THUMB

• 2. Think of variable costs on a per-unit basis.
  
• The per-unit variable cost remains unchanged
  regardless of changes in the cost-driver activity.

9
RELEVANT RANGE

• This rule of thumb holds true only within
  reasonable limits.

10
RELEVANT RANGE

• The relevant range is the limit of cost-driver
  activity within which a specific relationship
  between costs and the cost driver is valid.

11
Relevant Range
16,000 12,000 8,000 4,000

Fixed Costs
Relevant Range
0 500 1,000 1,500 2,000
2,500
Volume in Units
12
COST-VOLUME-PROFIT ANALYSIS (CVP)

• The study of the effects of output volume on
  revenue (sales), expenses (costs), and net
  income (net profit).

13
CVP SCENARIO

• Snack Vending Machines Example
  Percentage
• Per Unit of Sales
• Selling price
  0.50 100
• Variable cost of each item
  0.40 80
• Selling price less variable cost
  0.10 20
  
  
  
  
  
• Monthly fixed expenses
• Rent 1,000
• Wages for replenishing and servicing
  4,500
• Other fixed expenses
  500
• Total fixed expenses per month
  6,000

14
BREAK-EVEN POINT

• The break-even point is the level of sales at
  which revenue equals expenses and net income is
  zero.

15
MARGIN OF SAFETY

• The margin of safety shows how far sales can
  fall below the planned level before losses
  occur.
• Planned unit sales
• - Break-even unit sales
• Margin of Safety

16
Margin of Safety

• The margin of safety shows how far sales can fall
  below the planned level before losses occur.

Planned unit sales

Break-even unit sales

Margin of safety
17
BREAK-EVEN POINT TECHNIQUES

• There are two basic techniques for computing
  break-even point
• Contribution Margin
• Equation

18
CONTRIBUTION MARGIN TECHNIQUE

• The contribution margin or marginal income is
  the sales price minus the variable cost per unit.

19
CONTRIBUTION MARGIN TECHNIQUE

• BREAK-EVEN SALES VOLUME IN TOTAL UNITS
• Unit sales price 0.50
• Less Unit variable cost 0.40
• Unit contribution margin 0.10
• Fixed costs 6,000
• Divided by Unit contribution margin 0.10
• Break-even sales volume 60,000 Units

20
CONTRIBUTION MARGIN TECHNIQUE

• BREAK-EVEN SALES VOLUME IN TOTAL DOLLARS
• Sales volume in units 60,000
• Times Unit sales price 0.50
• Break-even sales revenue 30,000
• - or -
• The contribution margin of 20 of each sales
  dollar is available for the recovery of fixed
  expenses of 6,000
• 6,000 \ .20 30,000 sales are needed to
  break-even.

21
EQUATION TECHNIQUE

• Net income equals zero at the break-even point.
• Sales
• - Variable expenses
• - Fixed expenses
• Zero net income (break-even point)

22
EQUATION TECHNIQUE

• BREAK-EVEN SALES VOLUME IN TOTAL UNITS
• Let N number of units to be sold to break
  even.
• 0.50N - 0.40N - 6,000 0
• 0.10N 6,000
• N 6,000 / 0.10
• N 60,000 Units

23
EQUATION TECHNIQUE

• BREAK-EVEN SALES VOLUME IN TOTAL DOLLARS
• Sales volume in units 60,000
• Times Unit sales price 0.50
• Break-even sales revenue 30,000
• - or -
• Substitute the variable costs as a percentage of
  sales of
• 80 into the equation as follows

24
EQUATION TECHNIQUE

• BREAK-EVEN SALES VOLUME IN TOTAL DOLLARS
• Let S sales in dollars needed to break even.
• S - 0.80S - 6,000 0
• .20S 6,000
• S 6,000 / .20
• S 30,000

25
COST-VOLUME-PROFIT GRAPH

• 50,000 --
• 40,000 --
• 30,000 --
• 20,000 --
• 10,000 --
• 
  
  
• 0 10 20 30 40
  50 60 70 80 90 100
• Units (In Thousands)

26
COST-VOLUME-PROFIT GRAPH

• 50,000 --
  
  A
• 40,000 --
  Sales
• 30,000 --
• 20,000 --
• 10,000 --
• 
  
  
• 0 10 20 30 40
  50 60 70 80 90 100
• Units (In Thousands)

27
COST-VOLUME-PROFIT GRAPH

• 50,000 --
  
  A
• 40,000 --
  Sales
• 30,000 --
• 20,000 --
• 10,000 -- B
• 6,000 -- Fixed Expenses
• 
  
  
• 0 10 20 30 40
  50 60 70 80 90 100
• Units (In Thousands)

28
COST-VOLUME-PROFIT GRAPH

• 50,000 --
  
  A
• 46,000
  
  C
• 40,000 --
  Sales
• 30,000 -- Variable
• Total Expenses
• 20,000 -- Expenses
• 10,000 -- B
  
  Fixed
• 6,000 -- Expenses
• 
  
  0 10 20 30 40
  50 60 70 80 90 100
• Units (In Thousands)

29
COST-VOLUME-PROFIT GRAPH

• 50,000 --
  
  A Net
• 46,000 Net
  Income Area
  C Income
• 40,000 --
  Sales
• D
• 30,000 -- Variable
• Total Break-Even Point
  Expenses
• 20,000 -- Expenses 60,000 Units
• Net Loss or 30,000
• 10,000 -- B Area
  
  Fixed
• 6,000 Expenses
• 
  
• 0 10 20 30 40
  50 60 70 80 90 100
• Units (In Thousands)

30
SALES MIX

• The sales mix is the relative proportions or
  combinations of quantities of products that
  constitute total sales.

31
CHANGES IN FIXED EXPENSES

• Changes in fixed expenses cause changes in the
  break-even point.

32
CHANGES IN CONTRIBUTION MARGIN PER UNIT

• Changes in variable costs also cause the
  break-even point to shift.

33
Exercise

• Fundamental Assignment Material
• 2-A1 Page 62
• 2-A2
• 2-B2