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Cost Behavior and Cost-Volume Relationships
Cost Behavior and Cost-Volume Relationships
Period costs: Costs that are not product costs. Related to marketing and administration
Appear below the line for gross margin These costs are expensed in the period they are incurred. These costs do not flow through inventory accounts
The gross margin income statement mingles Relevant & non relevant costs Variable and fixed costs Direct and indirect costs
Service Firms
Products are not tangible or storable
Hotels, restaurants, consulting, airlines, gyms, universities, museums,
Merchandising Firms
Examples include Wal Mart, Big Bazaar etc. These firms
Sell substantively the same product they purchase. Carry inventory to make goods available in the quantities, varieties and delivery schedules demanded by customers.
Inventory Equation
Need to flow costs via inventory account Cost of purchase is NOT the cost of goods sold We can capture flow as:
+ = Cost of beginning inventory Cost of goods purchased during the period Cost of ending inventory Cost of goods sold (COGS) during the period
Make inventory cost flow assumption First In First Out (FIFO) Last In First Out (LIFO)
Solution
Cost of beginning inventory + Cost of goods purchased + - Cost of ending inventory = Cost of goods sold =
Manufacturing Firms
Use labor and equipment to transform raw materials into finished goods Have work-in-process Need inventory accounts for all three kinds of stages in the production process Much variation in Nature of production process Relative amounts of different costs
Prime Costs
Calculation
Result
Beginning materials inventory + Purchases - Ending materials inventory = Raw materials used
2
Calculate Cost of Goods Manufactured
+ + + =
3
Beginning WIP inventory Materials used Labor cost Manufacturing overhead Ending WIP inventory Cost of goods manufactured
+ + + =
Cost Hierarchy
However,
Difficult to assign many costs to hierarchy categories
Need finer data on operations
Committed Fixed Costs: Those fixed costs which cannot be reduced without curtailing the organisations operations substantially
Discretionary Fixed Costs: Those fixed costs which can be reduced in difficult times
Relevant Range
The relevant range is the limit of cost-driver activity level within which a specific relationship between costs and the cost driver is valid.
Even within the relevant range, a fixed cost remains fixed only over a given period of time Usually the budget period.
Relevant range
CVP Scenario
Cost-volume-profit (CVP) analysis is the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit). Per Unit $3.00 2.10 $ .90 Percentage of Sales 100% 70 30%
Selling price Variable cost of each item Selling price less variable cost Monthly fixed expenses: Rent Depreciation Other fixed expenses Total fixed expenses per month
Break-Even Point
The break-even point is the level of sales at which revenue equals expenses and net income is zero.
Sales - Variable expenses - Fixed expenses Zero net income (break-even point)
$45,000 fixed costs 30% (contribution-margin percentage) = $150,000 of sales to break even
Equation Method
Sales variable expenses fixed expenses = net income $3.00N $2.10N $45,000 = 0 $.90N = $45,000 N = $45,000 $.90 N = 50,000 Units
Equation Method
Let S = sales in dollars needed to break even. S .70S $45,000 = 0 .30S = $45,000 S = $45,000 .30 S = $150,000 Shortcut formulas: Break-even volume in units = fixed expenses unit contribution margin Break-even volume in sales = fixed expenses contribution margin ratio
Margin of Safety
The excess of actual sales revenue over the break even sales revenue.
Margin of safety divided by actual sales revenue gives the Margin of Safety Ratio. Higher the Margin of Safety Ratio, better it is.
Example
A company had incurred fixed expenses of Rs.4,50,000 with sales of Rs.15,00,000 and earned a profit of Rs.3,00,000 during the first half of the year. In the Second half, it suffered a loss of Rs.1,50,000. Compute: i. The profit volume ratio, break even point and margin of safety for the first half. ii. Sales volume of second half assuming that the selling price and fixed expenses remained unchanged. iii. The margin of safety and breakeven point for the whole year.
Operating Leverage
Operating leverage: a firms ratio of fixed costs to variable costs.
Highly leveraged firms have high fixed costs and low variable costs. A small change in sales volume = a large change in net income.
Low leveraged firms have lower fixed costs and higher variable costs. Changes in sales volume will have a smaller effect on net income. Margin of safety = planned unit sales break-even sales How far can sales fall below the planned level before losses occur?
Sales mix is the relative proportions or combinations of quantities of products that comprise total sales.
Wallets (W) Sales in units Sales @ $8 and $5 Variable expenses @ $7 and $3 Contribution margins @ $1 and $2 Fixed expenses Net income 300,000 $2,400,000 2,100,000 $ 300,000
Total
375,000 $2,775,000 2,325,000 $ 450,000 180,000 $ 270,000
How much units of Wallets and Key Cases should the company sell to break even?
However, Ramos sold only 50,000 key cases And 325,000 wallets. What is net income?
$ 325,000 $100,000
Example
The Garware Paints Ltd. presents you the following income statement for the first quarter Product Total X Y Z Sales 100,000 60,000 40,000 200,000 Variable Costs 80,000 42,000 24,000 146,000 Contribution 20,000 18,000 16,000 54,000 Fixed costs 27,000 Net Income 27,000 P/V ratio 0.27 Break Even sales 100,000 Sales mix percent 0.50 0.30 0.20 1.00 If Rs.40,000 of the sales shown for the product X could be shifted to product Y and Z equally, how would the net income, P/V ratio and BEP change.
Suppose that a company earns $480 before taxes and pays income tax at a rate of 40%.
Target income before taxes = Target after-tax net income 1 tax rate
Target sales Variable expenses Fixed expenses = Target after-tax net income (1 tax rate)
$.50N $.40N $6,000 = $288 (1 0.40) $.10N = $6,000 + ($288/.6) $.06N = $3,600 + $288 = $3,888 N = $3,888/$.06 N = 64,800 units
$.50N $.40N $6,000 = $480 (1 0.40) $.10N = $6,000 + ($480/.6) $.06N = $3,600 + $480 = $4080 N = $4,080 $.06 N = 68,000 units
Q. State whether P/V ratio will increase or decrease or remain unchanged in the following situations (Consider all situations independently keeping other things constant): An increase in physical sales volume No Change An increase in fixed costs No Change A decrease in variable cost per unit Increase. A decrease in contribution margin per unit Decrease An increase in Selling price Increase
A decrease in fixed costs No change A 10% increase in both variable costs and selling price No Change A 10% increase in selling price and 10% decrease in physical sales volume Increase A 50% increase in variable cost and 50% decrease in fixed costs Decrease An increase in angle of incidence Increase
Example S Ltd. furnishes the following data relating to the year 2012:
IInd Half of Ist Half of the year the year Sales 45,000 50,000 Total Cost 40,000 43,000
Assuming that there is no change in prices and variable costs per unit and that the fixed expenses are incurred equally in the two half year periods, calculate for the entire year: i. ii. iii. iv. The profit volume ratio Fixed expenses Break even sales Margin of safety ratio
Example M Ltd. manufactures three products P, Q and R. The unit selling price of these products are Rs.100, Rs.80 and Rs.50 respectively. The corresponding unit variable costs are Rs.50, Rs.40 and Rs.20. The proportions (quantity wise) in which these products are manufactured and sold are 20%, 30% and 50% respectively. The total fixed costs are Rs.14,80,000.
Given the above information you are required to work out overall break even quantity and product wise break up of such quantity.
Example Two competing companies HERO Ltd. and ZERO Ltd. sell same type of product in the same market. Their forecasted Profit and Loss A/c for the year ending Mar 2011 are as follows:
HERO
Sales Less: Variable Costs Fixed costs 500,000 400,000 50,000
ZERO
500,000 300,000 150,000
50,000
50,000
You are required to state which company is likely greater profits in the conditions of: a. Low demand b. High Demand.
Example A Japanese soft drink is planning to establish a subsidiary company in India to produce mineral water. Based on the estimated annual sales of 40,000 bottles of mineral water, cost studies produced the following estimates for Indian Subsidiary:
Percent of total annual Total Annual Costs cost which is variable 210,000 100% 150,000 80% 92,000 60% 40,000 35%
The Indian production will be sold by the manufacturer's representatives who will receive a commission of 8% of the sale price. i. What should be the selling price per bottle to earn a net profit of 10% on sales. ii. What will be the break even point in units and in Rupee sales at the above computed selling price.
Example Suppose a Holiday Inn Hotel has annual fixed costs applicable to its rooms of $1.2 million for its 300-room hotel, average daily room rents of $50, and average variable costs of $10 for each room rented. It operates 365 days per year. What is the amount of net income on rooms that will be generated if the hotel is half full throughout the entire year? What is the break even point in number of room days? What is the percentage of occupancy needed to break even? Ans: $990,000, 30,000 room days 27.4%
Example General Hospital has total variable costs of 90% of total revenues and fixed costs of $5 million per year. There are 50,000 patient-days estimated for next year. What is the average daily revenue per patient necessary to breakeven? Ans: $1,000 average daily revenue per patient necessary to breakeven
Example Berea Company currently sells 19,000 units. Total fixed costs are $84,000, and the contribution margin per unit is $6.00. Bereas tax rate is 40%. What is the margin of safety in units? Ans: 5,000 units
Eaxmple Muy Mal Company, a producer of salsa, has the following information: Income tax rate Selling price per unit Variable cost per unit Total fixed costs 30% $5.00 $3.00 $90,000.00
How many number of units must be sold to obtain a targeted after-tax income of $14,000? Ans: 55,000 units
Example Bonnie and Clyde started the BC Restaurant in 20X0. They rented a building, bought equipment, and hired two employees to work full time at a fixed monthly salary. Utilities and other operating charges remain fairly constant during each month.
During the past two years, the business has grown with average sales increasing 1% a month. This situation pleases both Bonnie and Clyde, but they do not understand how sales can grow by one percent a month while profits are increasing at an even faster pace. They are afraid that one day they will wake up to increasing sales but decreasing profits. Required: Explain why the profits have increased at a faster rate than sales.
Linear-cost Behavior
Costs are assumed to be fixed or variable the relevant range of activity within
Quality levels
Product features
Distribution channels
Capacity Decisions
They are the fixed costs of being able to achieve a desired level of production or to provide a desired level of service while maintaining product or service attributes.
Each planning period, management will determine how much to spend on discretionary items. These costs then become fixed until the next planning period.
Management salaries
Technology Decisions
Choice of technology (e-commerce versus in-store or mail-order sales) positions the organization to meet its current goals and to respond to changes in the environment.
Cost Functions
Planning and controlling the activities of an organization require accurate and useful estimates of future fixed and variable costs.
Cost Functions
Understanding relationships between costs and their cost drivers allows managers to... Make better operating, marketing, And production decisions Plan and evaluate actions Determine appropriate costs for short-run and long-run decisions.
Cost Functions
The first step in estimating or predicting costs is measuring cost behavior as a function of appropriate cost drivers.
The second step is to use these cost measures to estimate future costs at expected levels of cost-driver activity.
A cost functions estimates of costs at actual levels of activity must reliably conform with actually observed costs.
Activity analysis directs management accountants to the appropriate cost drivers for each cost.
1. Engineering analysis 2. Account analysis 3. High-low analysis 4. Visual-fit analysis 5. Least-squares regression analysis
Engineering Analysis
Engineering analysis measures cost behavior according to what costs should be, not by what costs have been.
Engineering analysis entails a systematic review of materials, supplies, labor, support services, and facilities needed for products and services.
Account Analysis
The simplest method of account analysis selects a plausible cost driver and classifies each account as a variable or fixed cost. Parkview Medical Center
Monthly cost Supervisors salary and benefits Hourly workers wages and benefits Equipment depreciation and rentals Equipment repairs Cleaning supplies Total maintenance costs Amount $ 3,800 14,674 5,873 5,604 7,472 $37,423 Fixed $3,800 $14,674 Variable
5,873
5,604 7,472 $27,750
$9,673
High-Low Method
Plot historical data points on a graph. Focus on the highest- and lowest-activity points.
High month: April Maintenance cost: $47,000 Number of patient-days: 4,900 Low month: September Maintenance cost: $17,000 Number of patient-days: 1,200
The point at which the line intersects the Y axis is the intercept, F, or estimate of Fixed Costs, and the slope of the line measures the variable cost.
Variable costs = Change in costs change in activity V = ($47,000 $17,000) (4,900 1,200) = $30,000 3,700 = $8.1081
Visual-Fit Method
In the visual-fit method, the cost analyst visually fits a straight line through a plot of all of the available data, not just between the high point and the low point, making it more reliable than the high-low method.
Regression analysis measures cost behavior more reliably than other cost measurement methods.
Coefficient of Determination
One measure of reliability, or goodness of fit, is the coefficient of determination, R (or R-squared).
The coefficient of determination measures how much of the fluctuation of a cost is explained by changes in the cost driver.
Example Presented below is the production data for the first six months of the year showing the mixed costs incurred by Euclid Company. Month January February March April May June Cost $7,500 13,000 11,500 11,700 13,500 11,850 Units 4,000 7,500 9,000 11,500 12,000 6,000
Euclid Company uses the high-low method to analyze mixed costs. What shall be cost function?
Example The Reynolds Company used regression analysis to predict the annual cost of utilities. The results were as follows: Utilities Cost Explained by Direct Labor Hours Constant Standard error of Y estimate R - squared No. of observations Degrees of freedom X coefficient(s) Standard error of coefficient(s) What shall be the estimated total cost for 1,000 units? $7,650 $245.20 0.8650 30 28 8.437 0.917
Example: The cost of the maintenance department at Forest Manufacturing has always been charged to the production departments based upon number of employees. Recently, an activity analysis of possible cost drivers was performed which indicated that the square feet of space may also be a predictor of costs to be assigned to each department. Given the following data, compare the different amounts of maintenance department cost that would be allocated to each of the production departments if the cost driver used is (a) number of employees, and (b) the square feet of space. Dept. X 300 15,000 Dept. Y Dept. Z 250 50 25,000 10,000
Example Two manufacturing companies which have the following operating details decided to merge:
Company 1 Capacity Utiliation (%) Sales (Rs. Lakhs) Variable Costs (Rs.Lakhs) Fixed Costs
Assuming that the proposal is implemented, calculate: i. ii. iii. iv.
Break even sales for the merged plant and the capacity utilization at that stage. Profitability of the merged plant at 80% capacity utilization. Sales turnover of the merged plant to earn a profit of Rs.75 Lakh When the merged plant is working at a capacity to earn a profit of Rs.75 lakhs, what percentage increase in selling price is required to sustain an increase of 5% in fixed overheads.
Example ABC Ltd. has installed capacity of 1,20,000 units per annum. The cost structure of the product manufactured is as under: Variable Cost: Materials Labour Overheads
Fixed overheads Rs.168750 per annum Semi variable overheads Rs.48,000 at 60% capacity and Rs.60,000 at 80% capacity. The capacity utilization for next year is estimated at 60% for first two months , 70% for next six months and 80% for rest of the year. Company is planning to have a profit of 25% on sales. Compute the selling price per unit and break even point in units at the computed selling price.
Example: XYZ School has a total of 150 students. The school plans a picnic to places like Zoo, Planetarium etc. A private bus operator has come forward to lease out the bus(es). Each bus will have 50 seats for students besides 2 seats reserved for teachers. There will be two teachers per bus and each teacher will be paid an allowance of Rs.50. The following are other cost estimates: Cost per Student Rs.5 Rs.10 Rs.3 Rs.2
Rent per bus is Rs.650. Special permit of Rs.50 per bus is also required to be paid. Block entrance fees at planetarium is Rs.250. Prizes to students for games Rs.250. School charges Rs.45 per student. Compute the break even point.
Example 6000 pen drives of 2GB to be sold in a perfectly competitive market to earn Rs.1,06,000 of profit, whereas in monopoly only 1200 units are required to be sold to earn the same profit. The fixed costs for the period are Rs.74,000. The contribution per unit in monopoly market is as high as three fourth of it variable costs. Determine the target selling price per unit under each market condition.
Example Paints Ltd. manufactures 2,00,000 tins of paints annually at normal capacity. It incurs the following manufacturing cost per unit: Direct material Direct Labour Variable overhead Fixed overhead Rs.7.80 Rs.2.10 Rs.2.50 Rs.4.00
Each unit is sold for Rs.21 with an additional variable selling overhead incurred at Rs.0.60 per unit. During the next quarter only 10,000 units can be produced and sold. Management plans to shut down the plant estimating that the fixed manufacturing costs can be reduced to Rs.74,000 for the quarter. When the plant is operating, the fixed overheads are incurred at uniform rate through out the year. Additional costs plant shut down for the quarter are estimated at Rs.14,000. You are required to advise whether it is more economical to shut down the plant during the quarter rather than operate the plant.
Example Entertain U Ltd hires an air conditioned theatre to stage plays on weekend evenings. One play is staged per evening. The following are the seating arrangements: VIP Rows First 3 rows of 10 seats per row, priced at Rs 320 per seat. Middle Level The next 18 rows of 20 seats per row, priced at Rs 220 per seat. Last Level 6 rows of 30 seats per row, priced at Rs 120 per seat. For each evening, a drama troupe has to be hired at Rs 71,000, rent has to be paid to theatre at Rs 14,000 per evening and air conditioning and other stage arrangement charges work out to Rs 7,400 per evening. Every time a play is staged, the drama troupes friends and guests occupy the first row of the VIP class, free of charge by virtue of passes granted to these guests. The troupe ensures that 50% of the remaining seats in the VIP class and 50% of the seats of the other two classes are sold to outsiders in advance and the money is passed on to Entertain U. The troupe also finds for every evening, a sponsor who puts up his advertisement banner near the stage and pays Entertain U a sum of Rs 9,000 per evening. Entertain U supplies snacks during the interval, free of charge to all guests in the hall, including the VIP free guests. The snacks cost Entertain U Rs 20 per person. Entertain U sells the remaining tickets and observes that for every one seat demanded from the last level, there are 3 seats demanded from middle level and 1 seat demanded from the VIP level. You may assume that in case any level is filled, the visitor buys the next higher or lower level, subject to availability. You are required to calculate the number of seats that Entertain U has to sell in order to break-even and give the category wise total seat occupancy at BEP.
Industry-Company relationship