2 - 1 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 2 Introduction to Cost Behavior

2 - 1©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

Chapter 2

Introduction to Cost Behavior

and Cost-Volume Relationships

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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

Learning Objective 1

Explain how cost drivers

affect cost behavior.

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Cost Behavior

It is how costs are related to, and affectedby, the activities of an organization.

What is cost behavior?

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Cost Drivers

Output measures of resources and

activities are called cost drivers.

What are cost drivers?

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Production Example

Example costs:Labor wagesSupervisory salariesMaintenance wagesDepreciation Energy

Example cost drivers:Labor hoursNo. of people supervisedNo. of mechanic hoursNo. of machine hoursKilowatt hours

Cost Drivers

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Cost Drivers

How well the accountant does at identifying

the most appropriate cost drivers determines

how well managers understand cost behavior

and how well costs are controlled.

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Show how changes in cost-driver

activity levels affect variable

and fixed costs.

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Comparison of Variable and Fixed Costs

A variable cost is a cost that changes in directproportion to changes in the cost driver.

A fixed cost is not immediately affectedby changes in the cost driver.

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Rules of Thumb

Total fixed costs remain unchangedregardless of changes in cost-driver activity.

Think of fixed costs as a total.

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Rules of Thumb

The per-unit variable cost remainsunchanged regardless of changesin the cost-driver activity.

Think of variable costs on a per-unit basis.

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Relevant Range

This rule of thumb holds true only within reasonable limits.

The relevant range is the limit of cost-driver activity within which a specific relationship between costs and the cost driver is valid.

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Fix

ed

Cos

ts

Volume in Units

$16,000 –

$12,000 –

$8,000 –

$4,000

0 500 1,000 1,500 2,000 2,500

– – –

Relevant Range

Relevant Range

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Calculate break-even sales

volume in total dollars

and total units.

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Cost-Volume-ProfitAnalysis (CVP)

It is the study of the effects of outputvolume on revenue (sales), expenses(costs), and net income (net profit).

What is cost-volume-profit analysis?

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Per Unit PercentageSelling price $5 100Variable cost 4 80Difference $1 20

CVP Scenario

Total monthly fixed expenses = $8,000Rent $2,000Labor $5,500Other $ 500

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Break-Even (BE) Point

The break-even point is the level of sales at which revenue equals expenses and net income is zero.

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Margin of Safety

The margin of safety shows how far sales can fall below the planned level before losses occur.

Planned unit sales –

Break-even unit sales=

Margin of safety

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Break-Even Point Techniques

There are two basic techniques for computing break-even point:

1 Contribution margin2 Equation

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Contribution MarginTechnique – to find BE in Units

Per UnitSelling price $5Variable cost 4Contribution margin $1

$8,000 ÷ $1 = 8,000 units

i.e. Fixed Cost ÷ Contribution per unit

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Contribution MarginTechnique - to find BE in $

8,000 units × $5.00 = $40,000

$8,000 ÷ 20% = $40,000

i.e. BE point in units x Selling price per unit

i.e. Fixed Cost ÷ Contribution to Sales ratio

OR

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Equation Technique

Net income equals zero at the break-even point.

Sales

Variable expenses

Fixed expenses

Zero net income (break-even point)=

–

–

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Equation Technique – to find BE in Units

$5N – $4N – $8,000 = 0$1N = $8,000N = $8,000 ÷ $1N = 8,000 Units

Let N = number of units to be sold to break even

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Equation Technique- to find BE in $

S – 0.80S – $8,000 = 0.20S = $8,000S = $8,000 ÷ .20S = $40,000

Let S = sales in dollars needed to break even

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Create a cost-volume-profit

graph and understand the

assumptions behind it.

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Cost-Volume-Profit Graph

$0

$10,000

$20,000

$30,000

$40,000

$50,000

0 2 4 6 8 10 12

Units (thousands)

Dol

lars

Break even sales point8,000 units or $40,000

Sales re

venue line

Total expense line

Fixed expense line

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Calculate sales volume in total

dollars and total units to reach

a target profit.

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Target Net Profit

Managers can also use CVPanalysis to determine thetotal sales, in units anddollars, needed toreach a targetnet profit.

Managers can also use CVPanalysis to determine thetotal sales, in units anddollars, needed toreach a targetnet profit.

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Target Net Profit

Contribution Margin Technique

Target sales volume in units =Fixed expenses + Target net incomeContribution margin per unit

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Target Net Profit

Equation Technique

Target sales– Variable expenses– Fixed expenses= Target net income

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Operating Leverage

The ratio of fixed to variable costs is called operating leverage.

In high leveraged companies, small changes in sales volume result in large changes in net income.

Companies with less leverage are not affected as much by changes in sales volume.

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Calculate contribution

margin and gross margin.

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Contribution Margin and Gross Margin

Gross margin (which is also called gross profit)is the excess of sales over the cost of goods sold.

Contribution margin is the excess of sales overall variable costs.

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Explain the effects of sales

mix on profits.

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Effects of Sales Mixon Income

Sales mix is the combination of products that a business sells.

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Avisha’s Dresses Example

Selling price: $90Less variable cost: 32Equals contribution margin per dress: $58

Fixed costs = $96,000

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Assume that Avisha is considering selling blouses.

This will not require any additional fixed costs.

She expects to sell 2 blouses at $30 each for every dress she sells.

The variable cost per blouse is $19. What is the new breakeven point?

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$58 + (2 × $11) = $58 + $22 = $80

Contribution margin per blouse: $30 – $19 = $11

What is the contribution margin of the mix?

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$96,000 fixed costs ÷ $80 = 1,200 packages

1,200 × 2 = 2,400 blouses1,200 × 1 = 1,200 dressesTotal units = 3,600

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What is the breakeven in dollars?

2,400 blouses× $30 = $ 72,0001,200 dresses × $90 = 108,000

$180,000

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What is the weighted-average budgeted contribution margin?

Dresses: 1 × $58 + Blouses: 2 × $11

= $80 ÷ 3 = $26.67

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The break even point for the two products is:$96,000 ÷ $26.667 = 3,600 units

3,600 × 1/3 = 1,200 dresses3,600 × 2/3 = 2,400 blouses

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Sales mix can be stated in sales dollars: Dresses

BlousesSales price $90 $60Variable costs 32 38Contribution margin $58 $22Contribution margin ratio 64.4% 36.6%

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Assume the sales mix in dollars is 60% dressesand 40% blouses.

Weighted contribution would be:64.4% × 60% = 38.64% dresses36.6% × 40% = 14.64% blouses

53.28%

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Break even sales dollars is $96,000 ÷ 53.28%= $180,000 (rounding)

$180,000 × 60% = $108,000 dress sales$180,000 × 40% = $ 72,000 blouse sales

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Compute cost-volume-profit

relationships on an after-tax

basis.

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Target Net Income and Income Taxes

Management of Avisha’s Dresses would like to earn an after-tax income of $35,721.

The tax rate is 30%. What is the target operating income? Target operating income

= Target net income ÷ (1 – tax rate) TOI = $35,721 ÷ (1 – 0.30) TOI = $51,030

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How many units must she sell? Revenues – Variable costs – Fixed costs

= Target net income ÷ (1 – tax rate) $90Q – $32Q – $96,000 = $35,721 ÷ 0.70 $58Q = $51,030 + $96,000 Q = $147,030 ÷ $58 Q = 2,535 dresses

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Revenues (2,535 × $90) $228,150Variable costs (2,535 × $32) 81,120Contribution margin: $147,030Fixed costs: 96,000Operating income: $ 51,030Income taxes: ($51,030 × .30) 15,309Net income $ 35,721

THE END

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2 - 1 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 2 Introduction to Cost Behavior