Cost Behavior

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Cost BehaviorCost Volume Profit Relationships
TOPIC 9
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Cost Behavior Analysis Use
What is cost behavior?
It is how costs are related to, and affected by,
the activities of an organization.
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Cost Behavior Analysis
STUDY OF HOW SPECIFIC COSTS RESPOND TO CHANGES IN
THE LEVEL OF ACTIVITY WITHIN A COMPANY.
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Cost Behavior Use

• Many managerial decisions (e.g., adding or
  dropping a product) require estimates of cash
  flows for each alternative course of action.
• Understanding the cost behavior enables a manager
  to better predict the cash outflow for costs at
  various levels of activity, and thus results in
  better decisions.

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Why Evaluate Cost Behavior?

• Decisions are made about the future and often
  require information about what costs will be
  (choosing among alternatives).
• Actual future costs are not available.
• Predicting costs requires knowing how they behave
  (how and why they increase/decrease)

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Why Evaluate Cost Behavior?

• Basic assumptions needed to estimate costs in a
  linear fashion
• Variable costs and fixed costs are linear within
  a range.

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Variable Costs

• Variable costs vary in total in direct proportion
  to the level of activity
• they are fixed per unit of activity.
• Variable costs can be
• Engineered -- causally related to level of
  activity
• Discretionary -- decided on by management as part
  of the budget

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Total Variable Cost Example

• Your total long distance telephone bill is
  based on how many minutes you talk.

Total Long DistanceTelephone Bill
Minutes Talked
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Variable Cost Per Unit Example

• The cost per minute talked is constant. For
  example, 10 cents per minute.

Per MinuteTelephone Charge
Minutes Talked
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Fixed Costs

• Fixed costs remains the same in total regardless
  of the level of activity
• Unit fixed cost drops as activity level
  increases.
• Fixed costs can be
• Committed -- related to possession of plant and
  equipment and existence of the organization
• Discretionary (or managed)-- decided on by
  management as part of the budget

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Total Fixed Cost Example

• Your monthly basic telephone bill is probably
  fixed and does not change when you make more
  local calls.

Monthly Basic Telephone Bill
Number of Local Calls
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Fixed Cost Per Unit Example

• The fixed cost per local call decreases as more
  local calls are made.

Monthly Basic Telephone Bill per Local Call
Number of Local Calls
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Types of Cost Behavior Patterns
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Relevant Range

• Definition the range over which a relationship
  holds the range over which one has data and is
  interested in outcomes

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The Linearity Assumption and the Relevant Range
EconomistsCurvilinear Cost Function
Total Cost
Activity
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Fixed Costs and Relevant Range

• Example Office space is available at a
  rental rate of 30,000 per year in increments of
  1,000 square feet. As the business grows more
  space is rented, increasing the total cost.

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Fixed Costs and Relevant Range
90
Total cost doesnt change for a wide range of
activity, and then jumps to a new higher cost for
the next higher range of activity.
Relevant Range
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Rent Cost in Thousands of Dollars
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0
0 1,000 2,000
3,000 Rented Area (Square Feet)
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Long Run Versus Short Run Cost Behavior

• In the long run, all costs are variable.
• What does this mean?

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Mixed Costs
A mixed cost has both fixed and
variablecomponents. Consider the example of
utility cost.
Total mixed cost
Total Utility Cost
Variable Cost per KW
Fixed MonthlyUtility Charge
Activity (Kilowatt Hours)
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Mixed Costs
Total mixed cost Y a bX
Total Utility Cost
Variable Cost per KW
Fixed MonthlyUtility Charge
Activity (Kilowatt Hours)
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Analysis of Mixed Costs(Cost Estimation)

• Involves estimating the fixed and the variable
  components of a mixed (or total) cost, i.e.,
  generally estimating a linear cost formula Y a
  bX that can be used to estimate cost at various
  levels of activity.
• Y (the amount of mixed cost) is the dependent
  variable it is affected by the level of
  activity.
• X (level of activity) is the independent
  variable.
• b is the multiplier for X, i.e., variable cost
  per unit.
• a is the fixed cost component of mixed cost.

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Cost Estimation MethodsRegression Analysis
A statistical method used to create an equation
relating independent (or X) variables to
dependent (or Y) variables. Past data is used to
estimate relationships between costs and
activities.
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Cost Estimation MethodsRegression Analysis
The simple cost model is actually a regression
model TC F VX
Caution Before doing the analysis, take time to
determine if a logical relationship between the
variables exists.
This model will only be useful within a relevant
range of activity.
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Cost Estimation MethodsRegression Analysis
Standard error of the estimate is a measure of
how far the actual cost figures deviate from our
estimate of cost.
Each regression model has an R-square (R2)
measure of how good the model is. Range of R2 0
to 1.0
The result of the regression process is a
regression model TC F VX
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Cost Estimation MethodsRegression Analysis

• A set of data can be regressed using several
  techniques
• Manual computations
• SPSS or SAS Statistical Software
• Minitab
• Excel or other spreadsheet

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Simple Regression AnalysisExample (Manual
computations)
Observation Actual Units of
Predicted Number (i) Costs (yi )
Prod. (xi) Costs (yi) 1
6705 1,550
6,719.6 2 5916
1,210 5,905.3 3
7500 1,870
7,486.0 4 6900
1,630 6,911.2
Cost Prediction Eqn TOTAL COST 3,007.34
2.395 X
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AVERAGE VALUE OF y
Therefore
TOTAL VARIATION AROUND
VARIATION NOT EXPLAINED BY REGRESSION EQN.
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THEREFORE WE HAVE EXPLAINED 99.95 OF THE
VARIATION IN THE COST DATA. SO, OUR ESTIMATES
COST FUNCTION FITS THE OBSERVED DATA WELL.
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R2 is the percentage of the variation in total
cost explained by the activity.

Y
yi
y



Average Observed cost







Total Cost
R2 for this relationship is near100 since the
data points arevery close to the regression line.
X

Activity
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Simple Regression AnalysisExample (Excel or
other spreadsheet)
Fasco wants to know its average fixed cost and
variable cost per unit. Using the data to the
right, lets see how to do a regression using
Excel.
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Simple Regression AnalysisExample

• You will need three pieces of information
  from your regression analysis
• Estimated Variable Cost per Unit (line slope)
• Estimated Fixed Costs (line intercept)
• Goodness of fit, or R2

To get these three pieces of information we
will need to use THREE different excel
functions. LINEST, INTERCEPT, RSQ
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Simple Regression Using Excel 2000
First, open the excel file with your data and
click on Insert and Function
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Simple Regression Using Excel 2000
When the function box opens, click on
Statistical, then on LINEST
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Simple Regression Using Excel 2000
By clicking on the buttons to the left, you can
highlight the desired cells directly from the
spreadsheet.
1. Enter the cell range for the cost amounts in
the Known_ys box. 2. Enter the cell range for
the quantity amounts in the Known_xs box.
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Simple Regression Using Excel 2000
The Slope, or estimated variable cost per unit,
is identified here. Click OK to put this value
on your spreadsheet.
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Simple Regression Using Excel 2000
Repeat the procedure using Intercept, to
estimate fixed cost.
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Simple Regression Using Excel 2000
As previously, enter the appropriate cell ranges
in their appropriate places.
The estimated fixed cost is identified here.
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Simple Regression Using Excel 2000
Finally, determine the goodness of fit, or R2,
by using the RSQ function.
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Simple Regression Using Excel 2000
As previously, enter the appropriate cell ranges
in their appropriate places.
The estimated R2 for your estimated cost function
is identified here.
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The Contribution Format
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The Contribution Format
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Cost-Volume-Profit Relationships
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Cost-Volume-Profit (CVP) Analysis

• CVP ANALYSIS THE STUDY OF THE EFFECTS OF
  CHANGES IN COSTS VOLUME ON A COS PROFITS. IT
  IS IMPORTANT FOR
• PROFIT PLANING
• SETTING SELLING PRICES
• DETERMINIG THE BEST PRODUCT MIX
• MAKING MAX USE OF PRODUCTION FACILITIES
• CONTROL OF DEPARTMENTS OPERATIONS

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ASSUMPTIONS OF CVP ANALYSIS

• BEHAVIOR OF BOTH COSTS AND REVENUES IS LINEAR
  THROUGHT THE REVELANT RANGE.
• ALL COSTS CAN BE CLASIFIED AS EITHER VARIABLE OR
  FIXED WITH REASONABLE ACRUACY
• CHANGES IN ACTIVITY ARE THE ONLY FACTORS THAT
  AFFECT COSTS.
• ALL UNITS PRODUCED ARE SOLD. (PROD. VOLUME SALES
  VOLUME)
• WHEN MORE THAN ONE TYPE OF PRODUCT IS SOLD,
  TOTAL SALES WILL BE IN A CONSTANT SALES MIX.

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CVP RELATIONSHIP IS EXPRESSED IN A SINGLE
EQUATION R SALES REVENUE VC FC NI OR NET
INCOME SALES REVENUE- VC - FC
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The Basics of CVP Analysis
Contribution Margin (CM) is the amount remaining
from sales revenue after variable expenses have
been deducted.
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The Contribution Approach

• For each additional unit Fatos sells, 200 more
  in contribution margin will help to cover fixed
  expenses and profit.

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The Contribution Approach

• Each month Fatos must generate at least 80,000
  in total CM to break even.

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CVP Relationships in Graphic Form

• Viewing CVP relationships in a graph is often
  helpful. Consider the following information for
  Fatos Co.

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CVP Graph
Dollars
Units
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CVP Graph
Profit Area
Dollars
Loss Area
Units
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Contribution Margin Ratio

• Contribution margin (CM) Sales - VC
• The contribution margin ratio is
• For Fatos Ball Co. the ratio is

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Contribution Margin Ratio

• Or, in terms of units, the contribution margin
  ratio is
• For Fatos Ball Co. the ratio is

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Contribution Margin Ratio

• At Fatos, 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 the
  increase in total contribution margin?

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Contribution Margin Ratio
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Contribution Margin Ratio
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EXAMPLE ?

• Coffee Klatch is an espresso stand in a
  downtown office building. The average selling
  price of a cup of coffee is 1.49 and the average
  variable expense per cup is 0.36. The average
  fixed expense per month is 1,300. 2,100 cups are
  sold each month on average. What is the CM Ratio
  for Coffee Klatch?

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EXAMPLE?

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Changes in Fixed Costs and Sales Volume

• Fatos is currently selling 500 balls per month.
  The companys sales manager believes that an
  increase of 10,000 in the monthly advertising
  budget would increase ball sales to 540 units.
• Should we authorize the requested increase in the
  advertising budget?

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Changes in Fixed Costs and Sales Volume
Sales increased by 20,000, but net operating
income decreased by 2,000.
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Changes in Fixed Costs and Sales Volume

• The Shortcut Solution

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Break Even Analysis

• Because we can assume a correlation (linear
  relationship) between total costs and output
• FC is constant (in the relevant range)
• VC is constant per unit (again in relevant
  range)
• We can also assume total revenue is constant, or
  a constant price x quantity sold and thus also
  linear
• Therefore, we can chart the break-even point,
  or the point where salestotal costs
• See graph following

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Break Even Analysis
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Break Even Analysis

• Why a break even point? Dont we want to make
  a profit?
• Yes, but establishing the b/e point enables us to
  determine the level of production and sales
  necessary to cover our total costs
• Any sales level below b/e point is a loss
• Any sales level above b/e point generates profit
• Problem with graphicsa visual display, must have
  a computer or good graphics skills. Probably
  more accurate to do using basic algebra.

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Break-Even Analysis

• Break-even analysis can be approached in three
  ways
• Graphical analysis.
• Equation method.
• Contribution margin method.

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Equation Method
Profits Sales (Variable expenses Fixed
expenses)
OR
Sales Variable expenses Fixed expenses
Profits
At the break-even point profits equal zero.
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Break-Even Analysis

• Here is the information from Fatos Ball Co.

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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 balls sold 500 Unit
selling price 300 Unit variable
expense 80,000 Total fixed expense
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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 ball Q 400
balls
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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
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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
0.40X 80,000 X 80,000 0.40
X 200,000
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Contribution Margin Method

• The contribution margin method is a variation of
  the equation method.

Break-even point in total sales dollars
Fixed expenses CM ratio

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Example ?

• Coffee Klatch is an espresso stand in a
  downtown office building. The average selling
  price of a cup of coffee is 1.49 and the average
  variable expense per cup is 0.36. The average
  fixed expense per month is 1,300. 2,100 cups are
  sold each month on average. What is the
  break-even sales in units?

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Example ?
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Example ?

• Coffee Klatch is an espresso stand in a
  downtown office building. The average selling
  price of a cup of coffee is 1.49 and the average
  variable expense per cup is 0.36. The average
  fixed expense per month is 1,300. 2,100 cups are
  sold each month on average. What is the
  break-even sales in dollars?

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Example ?
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Target Profit Analysis

• Suppose Fatos Co. wants to know how many balls
  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.

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The CVP Equation
Sales Variable expenses Fixed expenses
Profits
500Q 300Q 80,000 100,000 200Q
180,000 Q 900 balls
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The Contribution Margin Approach

• We can determine the number of balls that must
  be sold to earn a profit of 100,000 using the
  contribution margin approach.

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Example ?

• Coffee Klatch is an espresso stand in a
  downtown office building. The average selling
  price of a cup of coffee is 1.49 and the average
  variable expense per cup is 0.36. The average
  fixed expense per month is 1,300. How many cups
  of coffee would have to be sold to attain target
  profits of 2,500 per month?

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Example ?

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The Margin of Safety

• Excess of budgeted (or actual) sales over the
  break-even volume of sales. The amount by which
  sales can drop before losses begin to be incurred.

Margin of safety Total sales - Break-even
sales
Lets calculate the margin of safety for Fatos.
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The Margin of Safety

• Fatos has a break-even point of 200,000. If
  actual sales are 250,000, the margin of safety
  is 50,000 or 100 balls.

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The Margin of Safety

• The margin of safety can be expressed as 20 of
  sales.(50,000 250,000)

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Example ?

• Coffee Klatch is an espresso stand in a
  downtown office building. The average selling
  price of a cup of coffee is 1.49 and the average
  variable expense per cup is 0.36. The average
  fixed expense per month is 1,300. 2,100 cups are
  sold each month on average. What is the margin
  of safety?

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Example ?
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End of Topic 9
QUIZ TIME!!!!