Cost Behavior and Cost-Volume-Profit Analysis

Chapter 11

Cost Behavior

Cost behavior is the manner in which a cost changes as some related activity changes An understanding of cost behavior is necessary to plan and control costs A relevant range is the range over which we are interested in the costs behavior

Cost Behavior

Variable cost

Cost is constant on a per unit basis, but the total cost varies directly with changes in activity

Materials, fuel, etc.

Fixed cost

Cost is constant in total, but varies inversely with changes in activity

Salaries, property taxes, straight-line depreciation, etc.

Cost Behavior

Step cost

Cost which is fixed over small ranges of activity, but varies across wider ranges

Supervision costs, labor costs, etc.

Mixed cost

Cost has both a fixed and a variable component

Utility costs in which you pay a fixed amount to have the service available to you, and a variable charge based on how much you use the utility; rental costs in which you pay a fixed amount per period plus a variable amount based on usage, etc.

Cost Behavior

Mixed costs must be separated into their fixed and variable components in order to predict changes in the cost

High-low method Simple regression Multiple regression

Cost Behavior

High-low method

Compares the points of highest and lowest activities, and their related costs, and calculates the formula for a straight line connecting the two points
Dividing the incremental cost by the incremental units of activity gives the variable cost per unit of activity The variable cost per unit is substituted into the cost formula to determine the fixed cost

Total cost = fixed cost + variable cost per unit * number of units of activity

Cost Behavior
High point $ Low point Difference $ Cost 18,000 12,000 6,000 Units of activity 10,000 6,000 4,000

$6,000 / 4,000 = $1.50 per unit At the low point: $12,000 = Fixed cost + $1.50 per unit * 6,000 units $3,000 = Fixed cost Total cost = $3,000 + $1.50 per unit * number of units

Applications of Cost Behavior Concepts

Contribution margin

Excess of sales over variable costs

Contribution is the incremental amount of each sale that is available to cover fixed costs and provide a profit Knowing the contribution margin allows us to predict changes in net income that will result from a change in sales volume

Applications of Cost Behavior Concepts

Sales Variable costs Contribution margin Fixed costs Net income

Total Percentage Per unit* $ 1,000,000 100% $ 1,000 600,000 60% 600 $ 400,000 40% $ 400 300,000 $ 100,000

* - assume 1,000 units are sold

Applications of Cost Behavior Concepts

Contribution margin percentage

Proportion of each sales dollar that is available to cover fixed costs and provide a profit

If sales increase by $100,000, profit will increase by $40,000 ($100,000 * 40%)

Contribution margin per unit

Dollar amount that each unit contributes toward covering fixed costs and providing a profit

If 50 more units are sold, profit will increase by $20,000 (50 units * $400)

Applications of Cost Behavior Concepts

Breakeven point

Volume of sales needed to earn no profit or no loss Revenues = total costs

Fixed cost + target profit Contribution margin per unit = number of units Fixed cost + target profit Contribution margin percentage = dollars of sales

Applications of Cost Behavior Concepts

The breakeven formulas allow us to play what if games

What happens if

Sales price is increased (or decreased)

Variable costs are replaced by fixed costs

Volume increases Additional amounts spent on advertising will increase sales volume Etc.

Applications of Cost Behavior Concepts

Margin of safety

The excess of current sales volume over the breakeven point

In units

Current unit sales breakeven unit sales

In percentage

(Current sales breakeven sales) / current sales

The sales figures may be in dollars or units

Applications of Cost Behavior Concepts

Operating leverage

Measures the relative mix of fixed and variable costs Contribution margin / operating income Can determine the change in operating income that will result from a change in sales by multiplying the % change in sales by the operating leverage

High operating leverage implies high risk, high reward

Applications of Cost Behavior Concepts

Breakeven calculations in a multi-product environment

Assume the mix of products sold remains constant

Determine the contribution margin for a basket of goods (the normal sales mix)
Calculate the breakeven point as the number of baskets needed to break even

Applications of Cost Behavior Concepts

Product Laptops Printers Scanners Normal Contribution Total sales mix per unit contribution 6 $ 70 $ 420 2 30 60 1 20 20 $ 500

If fixed costs are $800,000, the breakeven point is $800,000 / 500 = 1,600 "baskets" 9,600 laptops 3,200 printers 1,600 scanners