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Cost Behavior Analysis: Reviewing The Chapter
Cost Behavior Analysis: Reviewing The Chapter
Objective 2: Identify variable, fixed, and mixed costs, and separate mixed costs into their
variable and fixed components.
2.
3.
Total costs that change in direct proportion to changes in productive output (or any other
measure of volume) are variable costs. Examples include hourly wages and the costs of
direct materials and operating supplies.
a.
b.
The traditional definition of variable cost assumes a linear relationship between costs
and activity levels. However, many variable costs behave in a nonlinear fashion; for
example, an additional hourly rental rate for computer usage may be higher than the
previous hours rental rate. Linear approximation is a method of converting nonlinear
variable costs into linear variable costs. It relies on the concept of relevant range,
which is the range of volume or activity in which a companys actual operations are
likely to occur.
Fixed costs are total costs that remain constant within a relevant range of volume or
activity. Salaries, annual property taxes, and depreciation expense are examples. Fixed costs
change only when volume or activity exceeds the relevant rangefor example, when
additional supervisory personnel must be hired to accommodate increased activity. Fixed
unit costs vary inversely with activity or volume. If more units are produced than
anticipated, the fixed costs are spread over more units, thus decreasing the fixed cost per
unit; if fewer units are produced than anticipated, the fixed costs are spread over fewer
units, thus increasing the fixed cost per unit. (Note, however, that fixed costs are usually
considered as a total rather than on a per unit basis.)
4.
Mixed costs have both fixed and variable cost components. For example, monthly
electricity charges include both a fixed service charge and a per kilowatt-hour charge. For
planning and control purposes, mixed costs must be broken down into their fixed and
variable components. The following four methods are commonly used to do this:
a.
The engineering method (sometimes called a time and motion study) separates costs
into their fixed and variable components by performing a step-by-step analysis of the
tasks, costs, and processes involved in completing an activity or product.
b.
A scatter diagrama chart of plotted points representing past costs and related
measures of volumehelps determine whether a linear relationship exists between a
cost item and the related measure. If the diagram suggests a linear relationship, a cost
line drawn through the points can provide an approximate representation of the
relationship.
c.
The high-low method is a three-step approach to separating a mixed cost into its
variable and fixed components. It calculates the variable cost per activity base, the
total fixed costs, and a formula to estimate the total costs (fixed and variable) within
the relevant range.
d.
Objective 3: Define cost-volume-profit (C-V-P) analysis and discuss how managers use it as a
tool for planning and control.
5.
6.
C-V-P analysis is, however, useful only under certain conditions and only when certain
assumptions hold true. If any of the following are absent, C-V-P analysis can be misleading:
a.
b.
Costs and revenues have a close linear relationship (e.g., when costs rise, revenues rise
proportionately).
c.
Efficiency and productivity hold steady within the relevant range of activity.
d.
Cost and price variables also hold steady during the period being planned.
e.
The sales mix does not change during the period being planned.
f.
Objective 4: Define breakeven point and use contribution margin to determine a companys
breakeven point for multiple products.
7.
The breakeven point is the point at which sales revenues equal the sum of all variable and
fixed costs. A company can earn a profit only by surpassing the breakeven point. The
breakeven point is useful in assessing the likelihood that a new venture will succeed. If the
margin of safety is low, the profitability of the venture is unlikely. The margin of safety is
the number of sales units or the amount of sales dollars by which actual sales can fall below
planned sales without resulting in a loss.
8.
Sales (S), variable costs (VC), and fixed costs (FC) are used to compute the breakeven
point, as follows:
S VC FC = 0
A rough estimate of the breakeven point can also be made by using a scatter, or breakeven,
graph. Although less exact, this method does yield meaningful data. A breakeven graph has
(a) a horizontal axis for units of output, (b) a vertical axis for dollars of revenue, (c) a
horizontal fixed-cost line, (d) a sloping line representing total cost that begins where the
fixed-cost line crosses the vertical axis, and (e) a sloping line representing total revenue that
begins at the origin. At the point at which the total revenue line crosses the total cost line,
revenues equal total costs.
9.
Contribution margin (CM) is the amount that remains after all variable costs have been
subtracted from sales:
S VC = CM
A products contribution margin represents its net contribution to paying off fixed costs and
earning a profit (P):
CM FC = P
Using the contribution margin, the breakeven point (BE) can be expressed as the point at
which contribution margin minus total fixed costs equals zero. Stated another way, the BE is
at the point at which the contribution margin equals total fixed costs.
10. The breakeven point for multiple products can be computed in three steps:
a.
b.
Calculate the weighted-average breakeven point by dividing total fixed costs by the
weighted-average contribution margin.
c.
Calculate the breakeven point for each product by multiplying the weighted-average
breakeven point by each products percentage of the sales mix.
Objective 5: Use C-V-P analysis to project the profitability of products and services.
11.
The primary goal of a business venture is not to break even; it is to generate a profit. A
targeted profit can be factored into the C-V-P analysis to estimate a new ventures
profitability. This approach is excellent for what-if analyses, in which managers select
several scenarios and compute the profit that may be anticipated from each.
12. Managers in a manufacturing business can estimate the profitability of a product by using
the following equation, in which P is the targeted profit, and solving for the number of unit
sales needed to achieve the desired profit:
S VC FC = P
The contribution margin approach is also useful for profit planning. For example, it can be
used to project operating income given a change in one or more of the income statement
components. In contribution income statements, all variable costs related to production,
selling, and administration are subtracted from sales to determine the total contribution
margin; all fixed costs related to those functions are subtracted from the total contribution
margin to determine operating income.
13. C-V-P analysis can also be used to estimate the profitability of a service. In this case,
managers do the following:
a.
Estimate service overhead costs by calculating (1) the variable service overhead cost
per service, (2) the total fixed service overhead costs, (3) the total service overhead
costs for a period, and (4) the total service overhead costs for that period assuming a
certain number of services will be performed.
b.
Determine the breakeven point by using the following formula, in which x = number
of services (e.g., number of tax returns prepared by an accountant):
Sx = VCx + FC
c.
Determine the effect of a change in operating costs (i.e., the effect on profitability if
fixed or variable costs change).
d.
Compute targeted profit for a given number of services by using the following
formula, in which x = targeted sales in units:
Sx = VCx + FC + P