1/11/2018

Cost Analysis for decision making

(chapters 6 and 7)
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ANA MARQUES

Before the new material…

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 Case discussion: Tech Tonic Sports Drink

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Main topics:
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 Activity analysis, cost behavior, and cost

estimation (chapter 6)

 Cost-volume-profit analysis (chapter 7)

How do costs change?

4

Managers want to know how costs and revenues are

affected by changes in the organization’s activity. For
this they performe a cost-volume-profit analysis,
which leads us to the following 3 steps:

Cost Cost Cost

estimation behavior prediction

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Cost behaviour
5

 Costs can be:

 Variable (e.g.: flour)
 Step-variable (e.g.: delivery-truck drivers)
 Fixed (e.g.: depreciation of central factory)
 Step-fixed (e.g.: cost of managers)
 Semi-variable (e.g.: delivery trucks => lease + gas & others)
 Curvilinear (e.g.: utility costs, due to existence of new and
old sections in factory and increased demand during
Summer)

Step-Variable Costs
6

Total cost remains

constant within a
narrow range of
activity.
Cost

Activity

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Step-Fixed Costs
7

 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.

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.

How does this type of fixed cost differ from

a step-variable cost?

Semivariable Cost
8

Slope is A semivariable cost

variable cost is partly fixed and
per unit partly variable.
of activity.
Total Utility Cost

Variable
Utility Charge

Fixed Monthly
Utility Charge
Activity (KwH)

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Curvilinear Cost
9 Curvilinear
Cost Function
Total Cost

A straight-line
closely
approximates a
curvilinear line
Relevant Range within
the relevant range

Activity

Engineered, committed and

discretionary costs
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Engineered
Based on the physical relationship with
the activity measure.
E.g.: Direct Materials

Committed
Long-term, cannot be
reduced in the short term.
E.g.: Depreciation on
buildings and equipment
Discretionary
May be altered in the short
term by current managerial
decisions.
E.g.: Advertising and R&D

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Methods for cost estimation

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 Account-Classification Method

 Visual-Fit Method

 High-Low Method

 Least-Squares Regression Method

Account Classification Method

12

Cost estimates are based on a

review of each account making up
the total cost being analyzed

The cost analyst classifies each cost

item in the ledger as a variable,
fixed, or semi-variable cost.

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MCQ 1
13

 Parker Corporation observed that when 25,000 units

were sold, a particular cost amounted to $75,000, or
$3.00 per unit. When volume increased by 10%, the
cost totaled $82,500 (i.e., $3.00 per unit). The cost
that Parker is studying can best be described as a:
A. variable cost.
B. fixed cost.
C. semivariable cost.
D. discretionary fixed cost.
E. step-fixed cost.

Exercise
14

 Some information about Bavarian Wurst:

o Depreciation schedules revealed that monthly depreciation on
buildings and equipment is $19,000
o Inspection of several invoices from meat packers indicated that meat
costs the company $2.20 per Kg of sausage produced
o Wage records showed that compensation for production employees
costs $1.40 per Kg of sausage produced
o Payroll records showed that supervisiory salaries total $12,000 per
month
o Bills revealed that the company incurs utility costs of $4,000 per
month plus $0.60 per Kg of sausage produced

1. Classify each cost item as variable, fixed or semivariable

2. Write a cost formula to express the production costs

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Question for discussion

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Is direct labor a variable or fixed cost?

Visual-Fit Method
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Estimated fixed cost = $10,000

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* ** *
1,000’s of Dollars
Total Cost in

* *
** Vertical distance
10 * * is total cost,
approximately
$16,000.
0
0 1 2 3 4
Activity, 1,000’s of Units Produced

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The High-Low Method

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OwlCo recorded the following production activity

and maintenance costs for two months:

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100

Using these two levels of activity, compute:

- the variable cost per unit.
- the total fixed cost

The High-Low Method

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Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

 Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit

 Fixed cost = Total cost – Total variable cost

Fixed cost = $9,700 – ($.90 per unit × 9,000 units) = $1,600
Fixed cost = $6,100 – ($.90 per unit × 5,000 units) = $1,600
What does this method assume?

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Least-Squares Regression Method

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Regression is a statistical procedure used

to determine the relationship between variables
such as activity and cost.
Total Cost

The objective of
the regression
method is the
general cost equation:
Y = a + bX
Activity

Cost behavior
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The relation between cost and activity is called

cost behavior.

Cost Cost Cost

estimation behavior prediction

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Effect of Learning on Cost Behavior

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As I make more of these I’ve noticed the same

things it takes me less
time for each one. It must
be the learning curve effect
that the boss was
talking about.
thing. And if you include
all the variable overhead
costs that are also
declining, that must be the
experience curve.

Cost prediction
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Cost Cost Cost

estimation behavior prediction

1. Sales forecast
2. Production forecast, based on (1) and desired
levels of inventory
3. Cost forecast, based on (2), the knowledge of
materials/labor/overhead necessary for each
product and the behavior of those costs

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MCQ2
23

Fixed costs are normally deemed to be:

A
Constant per unit of output;
B
Constant in total when production volume changes;
C
Outside the control of management;
D
Those unaffected by inflation

MCQ3
24

The following data relate to two output levels of a department:

Machine hours 17000 18500

Overheads Rs. 246,500 Rs. 251,750

The amount of fixed overheads is:

A. Rs. 5,250

B. Rs. 59,500

C. Rs. 187,000

D. Rs. 246,500

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MCQ4
25

The following details relate to cost per unit (Rs.) of product R:

Level of Activity
1,000 units 2,000 units

Direct Material 4.00 4.00

Direct Labour 3.00 3.00

Production Overhead 3.50 2.50

Selling Overhead 1.00 0.50

The total fixed and variable cost per unit are

MCQ4
26

Total Fixed Cost (Rs.) Variable cost per unit( Rs.)

A 2,000 1.50

B 2,000 7.00

C 3,000 7.00

D 3,000 8.50

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MCQ5
27

Duradyne has total costs of $18,000 when 2,000

units are produced and $26,000 when 5,200 units
are produced. If 4,000 units were produced and
sold for $8 each in a month, the firm will report:
A. Profit of $ 9,000 B. Loss of $ 4,000
C.
Profit of $ 12,000 D. Zero Profit

MCQ6
28

A company observed a decrease in the cost per unit. All

other things being equal, which of the following is
probably true?

A. The company is studying a variable cost, and total

volume has increased.
B. The company is studying a variable cost, and total
volume has decreased.
C. The company is studying a fixed cost, and total volume
has increased.
D. The company is studying a fixed cost, and total volume
has decreased.

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Suggested Exercises
29

 6-25

 6-32

 6-35

Start of session 6:
30

Case discussion:
Krog’s metal Fab

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Main topics:
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 Activity analysis, cost behavior, and cost

estimation (chapter 6)

 Cost-volume-profit analysis (chapter 7)

Cost-Volume-Profit (CVP) analysis

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 The goal of CVP analysis is to answer:

What happens to firm’s costs as revenues when the

levels of the organization’s activity changes?

Usually this starts by calculating the

break-even point

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The Break-Even Point

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The break-even point is the point in the volume of

activity where the organization’s revenues and
expenses are equal.

Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 100,000
Net income $ -

Two approaches – BEP, in units

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 Equation Approach

Profit =
Sales revenue – Variable expenses – Fixed expenses

 Contribution-Margin Approach

Fixed expenses
= Break-even point
Unit contribution margin

(Sale price – Variable cost) per unit

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Emirates’ data
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 Airlines keep a close eye on break-even load factors

 The Emirates group listed its break-even load

factor as 64.4% in a recent annual report.

Emirates’ data
36

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BEP, in $
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Calculate the break-even point in $ rather than

units by using the contribution margin ratio:

Contribution margin = CM Ratio

Sales

Fixed expense Break-even point

=
CM Ratio (in sales dollars)

Cost-Volume-Profit Graph
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450,000

400,000

350,000
Break-even
300,000
point
250,000
Dollars

200,000

150,000

100,000

50,000

100 200 300 400 500 600 700 800

Units

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Profit-Volume Graph
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Some managers like the profit-volume
graph because it focuses on profits and volume.
100,000

80,000

60,000
Break-even
40,000 point
20,000
Profit

0 `

(20,000) 100 200 300 400 500 600 700

Units
(40,000)

(60,000)

Target Net Profit

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We can determine the units a firms must sell to

earn a profit of X using the contribution margin
approach:

Fixed expenses + Target profit Units sold to earn

=
Unit contribution margin the target profit

Can you think of another method for this same purpose?

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Effect of Income Taxes

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Income taxes affect a company’s CVP

relationships. To earn a particular
after-tax net income, a greater
before-tax income will be required.

Target after-tax net income Before-tax

=
1 - t net income

Problem
42

 Corrigan Enterprises is studying the acquisition of two

electrical component insertion systems for producing
its sole product. Data:
 Model # 6754 : Variable costs are $16 per unit and Annual
fixed costs are $985,600
 Model # 4399: Variable costs are $12.80 per unit and Annual
fixed costs are $1,113,600
 Selling price per unit is $64, and there is a 5% sales
commission

1. How many units does the company have to sell to break even
if model 6754 is selected?
2. Which of the 2 systems would be more profitable if sales and
production are expected to average 46,000units per year?

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Problem
43

3. Assume model 4399 requires the purchase of additional

equipment, which will cost $450,000 and be
depreciated over a 5-year life by straight-line method.
How many units must the firm sell to earn $956,400 of
operating income is this model is chosen?

4. Ignoring the information in (3), at what volume level

will management be indifferent between the acquisition
of model 6754 and model 4399?

Some applications of CVP analysis

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 Safety margin
 Changes in fixed costs
 Changes in the unit contribution margin
 Predicting profit given expected volume
 Interdependent changes in key variables
 Information published in annual reports

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Safety margin
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 This is the difference between budgeted sales

revenue and break-even sales revenue

 Thus, it is the amount by which sales can drop

before losses begin to be incurred

Change in fixed costs

46

Curl is currently selling 500 surfboards per year. The

owner believes that an increase of $10,000 in the annual
advertising budget, would increase sales to 540 units.
Should the company increase the advertising budget?
Current Proposed
Sales Sales
(500 Boards) (540 Boards)
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 income $ 20,000 $ 18,000

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Predicting Profit Given

Expected Volume
In the coming year, Curl’s owner expects to sell
525 surfboards. The unit contribution margin
is expected to be $190, and fixed costs are
expected to increase to $90,000.

Total contribution - Fixed cost = Profit

($190 × 525) – $90,000 = X

X = $99,750 – $90,000
X = $9,750 profit

CVP Analysis with Multiple Products

48

For a company with more than one product,

sales mix is the relative combination in which a
company’s products are sold

Different products have different selling prices,

cost structures, and contribution margins. The
break even point is calculated as:
Fixed expenses
Weighted-average unit contribution margin

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MCQ1
49

Jamal & Co. makes and sells two types of shoes, Plain
and Fancy. Data concerning these products are as
follows:

Sixty percent of the unit sales are Plain, and annual

fixed expenses are $45,000. Assuming that the sales
mix remains constant, the number of units of Plain
that Jamal must sell to break even is:

MCQ1
50

A. 2,000.
B. 3,000.
C. 3,375.
D. 5,000.

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Assumptions Underlying
CVP Analysis
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1. Selling price is constant throughout the entire

relevant range.
2. Costs are linear over the relevant range.
3. In multi-product companies, the sales mix is
constant.
4. In manufacturing firms, inventories do not
change (units produced = units sold).
- How confortable are you with these?
- What do you need to do to take these into consideration in
practice?

Cost structure and Operating leverage

52

 The cost structure of an organization is the relative

proportion of its fixed and variable costs.

 An organization’s cost structure has a significant effect

on the sensitivity of its profit to changes in volume:
 The greater the proportion of fixed costs in a firm’s cost
structure the greater the impact on profit will be from a given %
change in sales revenue

 The extent to which an organization uses fixed costs in

its cost structure is called operating leverage

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Operating leverage
53

 Operating leverage is greatest in companies that

have a high proportion of fixed costs in relation to
variable costs:

Operating leverage Contribution margin

=
factor Operating income

 Multiplying the percentage change in sales revenue

by the operating leverage factor yields the
percentage change in operating income

MCQ2
54

Astair, Inc. reported sales of $8,000,000 for the month and

incurred variable expenses totaling $5,600,000 and fixed
expenses totaling $1,440,000. The company has no
beginning or ending inventories. A total of 80,000 units
were produced and sold last month. What is the company's
degree of operating leverage?

A) 0.12
B) 0.40
C) 2.5
D) 3.3

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Operating leverage
55

 A firm with proportionately high fixed costs

has relatively high operating leverage.

 This results in the firm generating a large %

increase in net income from a relatively small
% in sales revenue…

 On the other hand, a firm with high operating

leverage has a relatively high break-even
point.

MCQ3
56

Which of the following will have no

effect on the break-even point?
A
Increase in variable cost
B.
Increase in selling price
C.
Increase in Sale units
D.
Increase in Fixed cost

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MCQ4
57

A recent income statement of Diva Products reported the

following data:
Sales Revenue ₹ 640,000
Variable Cost ₹ 360,000
Fixed Cost ₹ 164,500
If these data are based on the sale of 40,000 units, the
break-even point would be
A. 6,580 units.
B. 10,300 units
C. 23,500 units
D. 3,76,000 units

MCQ5
58

The CVP analysis of a product shows Sales revenue

of Rs. 200 per unit, Variable cost of Rs. 110 and a
fixed cost of Rs. 30 lakhs. The amount of capital
employed by the firm for the products is Rs. 210
lakhs. If the firm expects 20% after tax return on
capital employed, how many units are to be sold?
Assume the tax rate for the firm is 30%

A
33,333 units
B
60,000 units
C
80,000 units
D
100,000 units

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MCQ6
59

Z plc makes a single product which it sells for Rs. 16

per unit. Fixed costs are Rs.76,800 per month and
the product has a contribution to sales ratio of 40%.
In a period when actual sales were Rs.22,4000, Z
plc’s margin of safety, in units, was

A
2,000
B
6,000
C
8,000
D
12,000

MCQ7
60

Prime Fab sells its single product at a price of Rs.75 per

unit. During the previous year the company's variable
costs were Rs.90,000; Fixed costs were Rs. 45,000 and
profit was Rs. 15,000.
The Head of Marketing made an analysis which showed
that a 15% increase in selling price would reduce number
of units sold by 10%. If this pricing strategy is adopted
by the company, its profit may be expected to
A. Increase by Rs.29,250
B. Increase by Rs.14,250
C. Increase by Rs.17,100
D. Increase by Rs.2,100

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MCQ8
61
A firm reported a contribution margin equal to 45% of
revenues and profit before taxes equal to 20% of
revenues. If fixed costs were Rs.100,000, what were the
firm's revenues?

A
Rs. 400,000
B
Rs. 500,000
C
Rs. 222,222
D
Rs. 153,846

MCQ9
62

Brooklyn sells a single product to wholesalers. The

company's budget for the upcoming year revealed
anticipated unit sales of 31,600, a selling price of
$20, variable cost per unit of $8, and total fixed
costs of $360,000.
If Brooklyn's unit sales are 300 units more than
anticipated, its break-even point will:
A. increase by $12 per unit sold.
B. decrease by $12 per unit sold.
C. increase by $8 per unit sold.
D. Not Change

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MCQ10
63

A firm expects, when sales doubles, profit also

doubles. It means:

A.
The operating leverage is equal to 1
B.
The operating leverage is less than 1
C.
The operating leverage is more than 1

D. Information is inadequate to comment on

operating leverage

MCQ11
64

Rogers Racers makes toy race cars that sell for $12 each
with a variable cost of $5 per car. Annual fixed costs are
$7,000.
If Rogers Racers sells 50 units fewer than break-even, how
much loss would the company recognize on its income
statement?
A. $350
B. $4,200
C. $250
D. $70

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Exercise – Primus Industries

65

1. If the company had dropped the product MV on

1st April 2010, what effect would that action have
had on the operating income of the previous
year?

2. What is Primus’ most profitable product?

Suggested Exercises
66

 7-28

 7-38

 7-42

 7-44

 7-49

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For next session:

67

 Read chapter 14

 Prepare case: Wendy’s Chili

Questions/ Comments?

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