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1
Cost Drivers and Cost Behavior
CHAPTER 5
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in
part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use.
PowerPoint Presentation by
LuAnn BeanProfessor of AccountingFlorida Institute of Technology
Managerial Accounting 11E
Maher/Stickney/Weil
2
1Distinguish between variable and fixed costs and between short run and long run, and define the relevant range.
LEARNING OBJECTIVE
3
VARIABLE COSTS: Definition
Are costs that change in total as the level of activity changes.
LO 1
4
What are fixed costs?
Fixed costs do not changein total with changes in activity levels.
LO 1
5
SHORT RUN, LONG RUN
In the short run, a firm has only the capacity of the existing plant. Management can change production only in the long run.
LO 1
6
RELEVANT RANGE: Definition
Is the range of activity over which the firm expects a set of cost behaviors to be consistent.
LO 1
7
LO 1
EXHIBIT 5.1
Estimates of variable and fixed costs apply only if level of
activity lies within
relevant range.
8
EXAMPLE
Exotic Eats, a profitable restaurant located in the financial district and featuring Far Eastern dishes, opens from 11am – 2pm Monday through Friday. The maximum capacity of the restaurant is 210 and the daily average is 200 customers.
Management wants to know the effect of doubling the capacity.
LO 1
Continued
9
EXOTIC EATS: Operating Profits
Revenues $1,000Less Variable costs $ 400
Less Fixed costs 350 750
Operating Profits $ 250
LO 1
Continued
10
LO 1
EXHIBIT 5.2
When analysis ignores
capacity limitations, projections
are unrealistic.
11
LO 1
EXHIBIT 5.3
When capacity limitations
(relevant range) are considered, a more realistic profit picture
emerges.
12
EXOTIC EATS: Profit Projections
Revenues $ 1,000 $ 2,000 $ 2,000Less Variable costs 400 800 800
Contribution margin $ 600 $ 1,200 $ 1,200
Less Fixed costs 350 350 550
Operating Profits $ 250 $ 850 $ 650
LO 1
Current capacity
Incorrect capacity
New capacity
Click the button to skip Exercise 8
13
EXERCISE 8
Press “Enter” or click left mouse button for answer.
True or False: “My variable costs are $2 per unit. If I want to increase production from
100,000 units to 150,000 units, my total costs should go up by only $100,000.”
LO 1
FALSE. This reasoning does not consider relevant range and fixed costs.
14
2 Identify capacity costs, committed costs, and discretionary costs.
LEARNING OBJECTIVE
15
FIXED COSTS
Fixed (capacity) costs are divided between ¯Committed costs
¯Capacity costs that will continue to exist even if operations are temporarily reduced
¯Discretionary (programmed or managed) costs¯Need not be incurred in the short run to operate the
business
LO 2
16
3 Describe the nature of the various cost behavior patterns.
LEARNING OBJECTIVE
17
VARIABLE and FIXED COSTS: A Reminder
Variable costs change with the volume of activity.
Fixed costs remain constant over the relevant range of activity.
LO 3
18
CURVILINEAR VARIABLE COSTS: Definition
Are costs that vary with the volume of activity but not in
constant proportion.
LO 3
19
What is an example of a curvilinear cost?
Costs become curvilinear when volume discounts are offered.
LO 3
20
LO 3
EXHIBIT 5.5
Volume discounts.
21
What is the significance of learning
curves?
Learning curves illustrate how costs that are initially high for a new process, decrease over time with experience.
LO 3
22
LO 3
EXHIBIT 5.6 A
Production time decreases as
volume increases due to learning from
experience.
23
LO 3
EXHIBIT 5.6 B & C
Total labor time and costwill decrease
with increases in volume. Time
Cost
24
SEMIVARIABLE COSTS: Definition
Are costs that have both fixed and variable components. Also called
Mixed Costs.
LO 3
25
What are examples of semivariable costs?
Two examples of semivariable costs are:
¯Repairs and Maintenance
¯Utility costs
LO 3
26
LO 3
EXHIBIT 5.7
Semifixed costs change because of changes in long-term
assets;semivariable costs do not.
Semivariable
Semifixed
27
SIMPLIFYING COST ANALYSESSome costs do not vary in the short run
over the relevant range (fixed costs). Some vary with volume (variable costs). Others are neither completely fixed or variable.
Decision makers can simplify these variations by treating costs as either fixed or variable.
LO 3
Click the button to skip Exercise 4
28
EXERCISE 4
Press “Enter” or click left mouse button for answer.
The simplifying assumptions on which cost estimations are based include which of the following?
a) Cost behavior depends on one activity variable (except multiple regression).
b) Cost behavior patterns are not linear within the relevant range.
c) Costs are only fixed.
d) All of the above.
LO 3
(a) One activity variable
29
4 Describe how managers use cost behavior patterns.
LEARNING OBJECTIVE
30
EXERCISE 3
Press “Enter” or click left mouse button for answer.
Name three methods of cost estimation.
LO 4
Statistical regression, Account analysis, and Engineering estimation
31
5 Explain how to use historical data to estimate costs.
LEARNING OBJECTIVE
32
ANALYZING HISTORICAL COSTS
Two steps to analyze historical cost data¯Make an estimate of the past relation¯Update for current, future periods
¯Adjust costs for inflation and other changes
LO 5
33
TOTAL COST EQUATIONLO 5
Total costs =
Fixed costs + (Variable costs × Activity)
Independent Variables
34
ANALYZING COSTSSteps in analyzing costs are:
¯Review alternative cost drivers (independent variables)
¯Plot the data¯Examine the data and method of
accumulation
LO 5
35
6Describe how analysts estimate cost behavior using regression, account analysis, and engineering methods.
LEARNING OBJECTIVE
36
CHICAGO HOSPITAL 1
The Chicago Hospital operating room suite has 12 operating rooms. Can we estimate the overhead costs that can be directly traced to a particular surgery?
Continued
LO 6R
37
CHICAGO HOSPITAL: Overhead Costs
LO 6
Continued
EXH
IBIT
5.8
R
38
TOTAL OVERHEAD COST ESTIMATE
LO 6
A computer program using least squares fits a straight line to observed data points to minimize the sum of squares of vertical distances between observed points and the regression line. The line will depict the best fit of projected costs.
Total overhead costs (estimated) = Fixed costs + (Variable costs × Activity) =$18,600 + ($908 × Operating room hours)
R
39
The hospital administrator estimates that there will be 600 operating
room hours next month. What will
the total overhead costs be?
LO 6R
$563,400
40
MULTIPLE REGRESSION: Definition
Has more than one independent variable.
LO 6R
41
CHICAGO HOSPITAL 2Our first regression example was simplified
by lumping all overhead costs into one variable. The Chicago Hospital operating room suite is used for different kinds of surgery. By looking at more than just hours and using multiple regression, we can get a better handle of these costs.
Continued
LO 6R
42
CHICAGO HOSPITAL: Multiple Cost Drivers
LO 6
Continued
EXH
IBIT
5.9
Cost Driver Volumes
R
43
TOTAL OVERHEAD COST ESTIMATE 2
LO 6
A computer program using least squares fits a straight line to observed data points to minimize the sum of squares of vertical distances between observed points and the regression line.
Total overhead costs (estimated) = Fixed costs + (Hours + Setup + VIP + # rooms used + Special surgeries) =
$90,592 + ($175 ×Operating Room Hours) + ($257 ×Operating Room Setup Hours) + ($3,839 × VIP patients) + ($2,043 × # operating
rooms used) + ($6,050 × Special surgeries)
R
44
The hospital administrator estimates that there will be 600 operating
room hours, 280 setup hours, 6 VIP patients,8 operating rooms used on average,
and 40 special surgeries. What will
the total overhead costs be?
LO 6R
$548,930
45
CHICAGO HOSPITAL: Profitability Analysis
Chicago Hospital (CH) is considering an offer to become the site for knee and hip replacement surgeries for a flat fee. The administrator believe 3 overhead cost drivers will be affected:
1. Operating hours increase by 100 per month2. Setup hours increase by 40 per month3. Average operating rooms used increase by 1 per
dayContinued
LO 6R
46
CHICAGO HOSPITAL: Cost Projections
LO 6
EXHIBIT 5.10B
R
47
CHICAGO HOSPITAL: Fixed Fee
LO 6
Once the costs associated with becoming a knee and hip replacement center have been estimated and the HMO’s fixed fee offer is received, Chicago Hospital can decide whether the offer will be profitable.
Remember, the estimate has been made on the basis of historical costs which will change with inflation and other changes in cost drivers.
R
48
CHICAGO HOSPITAL: Account Analysis
Step 1: Using account analysis, the Chicago Hospital administrator will classify each overhead cost related to surgery to a cost driver. For example, staff wages for operating room clean up between surgeries will be classified as “Operating room setup.”
Continued
LO 6A
49
CHICAGO HOSPITAL: Account Analysis Step 2
LO 6
EXHIBIT 5.11
Overhead costs are estimated
by:
Cost ÷ Cost driver volume
A
÷
50
CHICAGO HOSPITAL: Engineering Estimation
Engineering method of cost estimation indicates what costs should be. This is a very costly method to put into practice because it requires experts to make the estimates, especially for indirect costs.
LO 6E
51
DATA PROBLEMSRegardless of method used, results will only be
as good as the quality of the data used. Problems include
¯Missing data¯Outliers¯Allocated and discretionary costs¯Inflation¯Mismatched time periods¯Trade-offs in choosing time period
LO 6
52
PRESSURE
Managers often pressure analysts to come up with the “right” answer. An answer that is too low will get pet projects approved. An answer that is too high will be easy to beat for a good review by a supervisor. Falsifying data carries a stiff penalty if caught.
LO 6E!!!
53
United Airlines (UAL) analysts estimated that 70% of costs were variable. Other analysts thought most costs
were fixed. How should UAL respond to extra passengers if 35% of seats on average
are empty?
UAL used a combination of increased numbers of
aircraft (fixed) and filling empty seats
(variable).
LO 6
MANAGERIAL APPLICATION
54
7Explain the costs, benefits, and weaknesses of the various cost estimation methods.
LEARNING OBJECTIVE
55
LO 7
EXHIBIT 5.12
Every method of
cost estimation
has strengths and
weaknesses.
56
COMMON SIMPLIFICATIONSIn general, more sophisticated methods provide
more accurate cost estimates than simpler ones. Methods of simplification are
¯Using only one cost driver¯Assuming cost behavior patterns are linear within the
relevant range¯Assume cost decreases are not “sticky”
LO 7
57
What are sticky costs?
Sticky costs do not decrease when activity decreases. Example: keeping (not firing) workers when activity levels decrease.
LO 7
EXHIBIT 5.13
58
8Identify the derivation of learning curves. (Appendix 5.1).
LEARNING OBJECTIVE
59
DERIVING LEARNING CURVES
¯Mathematically, the learning curve effect can be expressed by the equation: Y=aX b, where
¯Y = average number of labor hours required per unit for X units
¯a = number of labor hours required for the first unit¯X = cumulative number of units produced¯b = index of learning, equal to the log of the learning
rate divided by the log of 2.
LO 8
60
9 Interpret the results of regression analyses. (Appendix 5.2).
LEARNING OBJECTIVE
61
STANDARD ERRORS OF THE COEFFICIENTS
¯The standard errors of the coefficients give an idea of the confidence we can have in the fixed and variable cost coefficients.
¯The smaller the standard error relative to its coefficient, the more precise the estimate.
¯Such computational precision does not necessarily indicate that the estimating procedure is theoretically correct, however.
LO 9
62
T-STATISTIC¯The ratio between an estimated regression coefficient
and its standard error is known as the t-value or t-statistic.
¯If the absolute value of the t-statistic is approximately 2 or larger, we can be relatively confident that the actual coefficient differs from zero.
LO 9
63
R-SQUARED¯The R2 attempts to measure how well the line fits the
data (that is, how closely the data points cluster about the fitted line).
¯If all the data points were on the same straight line, the R2 would be 1.00—a perfect fit. If the data points formed a circle or disk, the R2 would be zero, indicating that no line passing through the center of the circle or disk fits the data better than any other.
LO 9
64
R-SQUARED (CONTINUED)
¯Technically, R2 is a measure of the fraction of the total variance of the dependent variable about its mean that the fitted line explains.
¯An R2 of 1 means that the regression explains all of the variance; an R2 of zero means that it explains none of the variance.
¯R2 is sometimes known as the “coefficient of determination.”
LO 9
65
CAUTIONS WHEN USING REGRESSION
¯Users of regression analysis should be wary of drawing too many inferences from the results unless they are familiar with the following statistical estimation problems:¯Multicollinearity - independent variables are not
independent of each other but are correlated¯Autocorrelation - a linear regression is fit to data where a
nonlinear relation exists¯Heteroscedasticity - the dependent variable from the best-
fitting linear relation is systematically larger in one part of the range of independent variable(s) than in others
LO 9
66
Financial Modeling for Short-Term
Decision-Making
CHAPTER 6
Managerial Accounting 11E
Maher/Stickney/Weil
PowerPoint Presentation by
LuAnn BeanProfessor of AccountingFlorida Institute of Technology
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in
part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use.
67
1Describe the use of financial modeling for profit-planning purposes.
LEARNING OBJECTIVE
68
FINANCIAL MODEL
Financial modeling enables analysts to test the interaction of economic variables in a variety of settings. It requires analysts to develop a set of equations that represents a company’s operating and financial relations.
LO 1
69
BENEFITS: Financial Modeling
Once developed, analysts can use the model to ¯Review potential results before taking action¯Identify a bad project or decision in advance
¯Caveat¯GIGO- garbage in, garbage out¯A model is only as good as the assumptions it uses
LO 1
70
2 Explain how to perform cost-volume-profit (CVP) analysis.
LEARNING OBJECTIVE
71
COST-VOLUME-PROFIT (CVP)
CVP can be used to answer questions such as ¯What effect on profit can GM expect if it builds a
larger SUV?¯How will NBC’s profit change if ratings increase
for its evening news program?¯How many subscribers must a Dish Network
obtain to break even for the year?¯What happens if Verizon reduces fees charged to
customers?
LO 2
72
EXAMPLE: Early Horizons Daycare
Early Horizons Daycare is a daycare center that defines a unit of output as “service provided for 1 child for a month.” Building capacity is 30 children. An accountant developed the following estimates:
LO 2
Continued
Price per child per month $ 600
Variable cost per child per month 200
Fixed costs per month 5,000
EHD
73
CAPACITY and COSTSEarly Horizons Daycare has a capacity of 20
units (relevant range), after which it must hire more staff.¯Variable costs include
¯Snacks and food¯ Supplies ¯A portion of insurance
¯Fixed costs include:¯Rent and utilities¯A portion of insurance¯Minimum staffing
LO 2EHD
74
BREAK-EVEN POINT: Definition
Is the point in the basic CVP model where revenues equal
costs.
Total Revenue = Total Costs
LO 2
75
BREAK-EVEN: Table Format
Using break-even computations:
LO 2
Sales Revenue (12.5 × $600) $ 7,500
Less Variable costs (12.5 × $200) 2,500
Contribution Margin (CM) $ 5,000
Less Fixed costs 5,000
Operating profit $ 0
EHD
76
CONTRIBUTION MARGIN: Definition
Is the excess of revenue over variable costs.
Total Revenue – Variable Costs
LO 2
77
Can we use contribution margin
to compute break-even (BE) volume?
YES!
BE Volume =
Fixed cost / CM per child
LO 2MANAGERS WANT TO KNOW!EHD
78
CONTRIBUTION MARGIN APPROACH
Using the contribution margin approach:
LO 2EHD
Break-even Volume = Fixed Costs / CM per child= $5,000 / $400
= 12.5 children
Click the button to skip equation approach
79
EQUATION APPROACHUsing the equation approach (Operating profit at
break-even = 0):
LO 2EHD
Operating profit 0= Sales revenue - Costs= Sales revenue -Variable costs (VC) – Fixed costs (FC)= (Unit selling price (SP) × Sales volume)
- (VC per unit × Sales volume) - FC($600 - $200) × Sales volume = $5,000
Sales volumeBE = $5,000/$400 = 12.5 children/month
80
Can we graph the relationships in CVP
analysis?
YES!
LO 2MANAGERS WANT TO KNOW!
81
LO 2
EXHIBIT 6.1
By graphing revenues
and costs on same graph,
you can find BE,
profit and loss areas.
Break-even Volume = Fixed Costs / CM
EHD
82
LO 2
EXHIBIT 6.2
Slope of line is
variable cost per
unit.
Break-even Volume = Fixed Costs / CM
EHD
83
Can we calculate a target profit volume?
LO 2MANAGERS WANT TO KNOW!
YES!
Target profit Volume =
(Fixed cost + Target profit) / CM
84
TARGET PROFIT: CM Approach
LO 2
Target profit Volume = (Fixed costs + Target Profit) / CM= ($5,000 + $3,000) / $400
Sales revenue (20 × $600) $ 12,000
Less Variable costs (20 × $200) 4,000Contribution Margin $ 8,000Less Fixed costs 5,000Operating profit $ 3,000
EHD
Continued
# children = 20Click the button to
skip equation approach
85
TARGET PROFIT: Equation Approach
LO 2
Sales revenue – Variable costs - Fixed costs = Operating Profit($600 - $200) × Sales volume - $5,000 = $3,000
$400*Sales volume = $8,000
Sales revenue (20 × $600) $ 12,000Less Variable costs (20 × $200) 4,000Contribution Margin $ 8,000Less Fixed costs 5,000Operating profit $ 3,000
EHD
Continued
Sales volume = 20 childrenClick the button to skip Exercise 10
86
EXERCISE 10
Press “Enter” or click left mouse button for answer.
If companies that are operating below break-even cannot raise prices, what must they do
to break even?
LO 2
A company can either (a) increase the contribution margin by 1) raising the selling
price or 2) reducing variable costs or (b) decrease fixed costs.
87
3 Describe the use of spreadsheets in financial modeling.
LEARNING OBJECTIVE
88
TARGET PROFIT: Reminder
LO 3
Target profit Volume = (Fixed costs + Target Profit) / CM
Sales revenue (20 × $600) $ 12,000
Less Variable costs (20 × $200) 4,000Contribution Margin $ 8,000Less Fixed costs 5,000Operating profit $ 3,000
EHD
Continued
89
Can EHD improve operating profit by
changing cost or selling price?
LO 3MANAGERS WANT TO KNOW!
YES!
First, look at the conditions in the base case.
EHD
90
EARLY HORIZONS DAYCARE: Sensitivity Analysis
AssumptionsPrice/child $ 600 $ 600 $ 600 $ 660VC/child $ 200 $ 200 $ 210 $ 200Monthly FC $5,000 $4,500 $5,000 $5,000Children enrolled 20 20 20 18
Model results: ISSales revenue $ 12,000 $ 12,000 $ 12,000 $ 11,880Less VC 4,000 4,000 4,200 3,600Total CM $8,000 $8,000 $7,800 $8,280
Less FC 5,000 4,500 5,000 5,000Operating profit $3,000 $3,500 $3,000 $3,280
LO 3
Base Cost FC $500 VC $10 Price $60, Vol. 2
Click the button to go directly to solution
EHD
EXH
IBIT
6.3
91
Alternative #1: What will the effect on profit
be if EHD can decrease FC by $500?
LO 3MANAGERS WANT TO KNOW!
Operating profit willincrease by $500.
EHD
92
EARLY HORIZONS DAYCARE: Sensitivity Analysis
AssumptionsPrice/child $ 600 $ 600 $ 600 $ 660VC/child $ 200 $ 200 $ 210 $ 200Monthly FC $5,000 $4,500 $5,000 $5,000Children enrolled 20 20 20 18
Model results: ISSales revenue $ 12,000 $ 12,000 $ 12,000 $ 11,880Less VC 4,000 4,000 4,200 3,600Total CM $8,000 $8,000 $7,800 $8,280
Less FC 5,000 4,500 5,000 5,000Operating profit $3,000 $3,500 $3,000 $3,280
LO 3
Base Cost FC $500 VC $10 Price $60, Vol. 2Alt #1
EHD
EXH
IBIT
6.3
93
LO 3MANAGERS WANT TO KNOW!
Alternative #2: What will the effect on profit
be if EHD can decrease VC by $10?
Operating profit willdecrease by $200.
EHD
94
EARLY HORIZONS DAYCARE: Sensitivity Analysis
AssumptionsPrice/child $ 600 $ 600 $ 600 $ 660VC/child $ 200 $ 200 $ 210 $ 200Monthly FC $5,000 $4,500 $5,000 $5,000Children enrolled 20 20 20 18
Model results: ISSales revenue $ 12,000 $ 12,000 $ 12,000 $ 11,880Less VC 4,000 4,000 4,200 3,600Total CM $8,000 $8,000 $7,800 $8,280
Less FC 5,000 4,500 5,000 5,000Operating profit $3,000 $3,500 $2,800 $3,280
LO 3
Base Cost FC $500 VC $10 Price $60, Vol. 2Alt #1 Alt #2
EHD
EXH
IBIT
6.3
95
LO 3MANAGERS WANT TO KNOW!
Alternative #3: What will the effect on profit be if EHD can increase
price by $60 anddecrease volume by 2?
Operating profit willincrease by $280.
EHD
96
EARLY HORIZONS DAYCARE: Sensitivity Analysis
AssumptionsPrice/child $ 600 $ 600 $ 600 $ 660VC/child $ 200 $ 200 $ 210 $ 200Monthly FC $5,000 $4,500 $5,000 $5,000Children enrolled 20 20 20 18
Model results: ISSales revenue $ 12,000 $ 12,000 $ 12,000 $ 11,880Less VC 4,000 4,000 4,200 3,600Total CM $8,000 $8,000 $7,800 $ 8,280
Less FC 5,000 4,500 5,000 5,000Operating profit $3,000 $3,500 $2,800 $ 3,280
LO 3
Base Cost FC $500 VC $10 Price $60, Vol. 2Alt #1 Alt #2 Alt #3
EHD
EXH
IBIT
6.3
97
LO 3MANAGERS WANT TO KNOW!
Which situation would you choose: base cost
or one of the alternatives?
Alternative #1 is the best choice if EHD can
decrease FC by $500.
EHD
98
EXERCISE 5
Press “Enter” or click left mouse button for answer.
What effect could the following changes have on 1) break-even point, 2) unit CM, and 3)
expected total profit?
LO 3
a) Increase in FC?BE CM Total Profit
No EffectClick the button to skip
parts b & d.
99
EXERCISE 5
Press “Enter” or click left mouse button for answer.
What effect could the following changes have on 1) break-even point, 2) unit CM, and 3)
expected total profit?
LO 3
b) Decrease in wage rates of variable labor costs?
BE CM Total Profit
100
EXERCISE 5
Press “Enter” or click left mouse button for answer.
What effect could the following changes have on 1) break-even point, 2) unit CM, and 3)
expected total profit?
LO 3
d) Increase in production and sales volume?
BE CM Total Profit No Effect No Effect
101
LO 3
EXHIBIT 5.7
Semifixed costs change because of changes in long-term
assets;semivariable costs do not.
Semivariable
Semifixed
REMINDER FROM CH. 5
102
EHD: Expanding Operations
EHD has been at full capacity (20 children). Adding 5 children would require $4,600 in additional fixed costs. In a second step, adding another 5 children would add $2,800 more in fixed costs. Building capacity: 30 children.
LO 3EHD
103
LO 3MANAGERS WANT TO KNOW!
How many children (sales volume) provide
the best operating profit for EHD?
EHD
104
Using the contribution margin approach:
LO 3EHD
Break-even Volume = Fixed Costs / CM per child= $5,000 / $400 = 12.5 children
EHD: Step (Semifixed) Costs
1. Status quo: 0-20 children
2. 1st step: 21-25 children
3. 2nd step: 25-30 children
Break-even Volume = Fixed Costs / CM per child= $9,600 / $400
Break-even Volume = Fixed Costs / CM per child= $12,400 / $400
= 24 children
= 31 children
2. 1st step: 21-25 children
105
Using the contribution margin approach:
LO 3EHD
Break-even Volume = Fixed Costs / CM per child= $5,000 / $400 = 12.5 children
EHD: Step (Semifixed) Costs
1. Status quo: 0-20 children
2. 1st step: 21-25 children
3. 2nd step: 25-30 children
Break-even Volume = Fixed Costs / CM per child= $9,600 / $400
Break-even Volume = Fixed Costs / CM per child= $12,400 / $400
= 24 children
= 31 children
2. 1st step: 21-25 children
106
Using the contribution margin approach:
LO 3EHD
Break-even Volume = Fixed Costs / CM per child= $5,000 / $400 = 12.5 children
EHD: Step (Semifixed) Costs
1. Status quo: 0-20 children
2. 1st step: 21-25 children
3. 2nd step: 25-30 children
Break-even Volume = Fixed Costs / CM per child= $9,600 / $400
Break-even Volume = Fixed Costs / CM per child= $12,400 / $400
= 24 children
= 31 children
107
MARGIN OF SAFETY: Definition
Is the excess of projected (or actual) sales units over Break-
even unit sales level.
Sales units – BE Sales units or
Sales dollars – BE Sales dollars
LO 3
108
MARGIN OF SAFETY: Early Horizons Daycare
LO 3EHD
Sales units – BE Sales units = 20 – 12.5 = 7.5
Or
Sales dollars – BE Sales dollars = $12,000 – $7,500 = $4,500
109
4Identify the effects of cost structure and operating leverage on the sensitivity of profit to changes in volume.
LEARNING OBJECTIVE
110
COST STRUCTURE: Definition
Refers to the proportion of fixed and variable costs to total
costs.
LO 4
111
OPERATING LEVERAGE: Definition
Is the extent to which an organization’s cost structure is
made up of fixed costs.
Note: the higher the fixed costs, the higher the break-even point.
LO 4
112
What is the contribution margin
ratio?
Contribution margin ratio (CMR) is the contribution amount per dollar of sales.
CM / Sales
LO 4
113
EXAMPLE: Variable Co. and Fixed Co.
Consider two companies: Variable Co. (VC) and Fixed Co. (FC), so named because of their cost structures.
LO 4
Continued
EXH
IBIT
6.4
114
LO 4MANAGERS WANT TO KNOW!
If sales increase 10% (to $1,100,000), which company, FC or VC,
would be more profitable?
FC (assuming it is within the relevant range) because its contribution margin, and therefore profit is higher:
75% compared with 25% for VC.
115
5 Explain how to use sales dollars as the measure of volume.
LEARNING OBJECTIVE
116
SALES DOLLARS and VOLUME:A Relationship
LO 5EHD
BE Sales units = FC / CM= $5,000 / $400 = 12.5 children
Or
BE Sales dollars = FC / CMR= $5,000 / ($400 / $600) = $7,500
117
LO 5MANAGERS WANT TO KNOW!
If EHD wants to earn a $2,000 profit, what would target volume
(sales dollars) be?
BE Sales units = (FC + Profit) / CM= $7,000 / $400 = 17.5 children
BE Sales dollars = (FC + Profit) / CMR= $7,000 / ($400 / $600) = $10,500
EHD
118
6 Explain the effect of taxes on financial modeling.
LEARNING OBJECTIVE
119
LO 6MANAGERS WANT TO KNOW!
Can EHD determine what the effect of taxeswill be on its profits?
Yes!
After tax profits = Before tax profits X (1 – tax rate)
EHD
Click the button to skip example
120
By combining the equations for after tax profit with target profit ($1,800), we can calculate the number of children EHD must serve.
LO 6EHD TAXES and TARGET PROFIT
1. After-tax profits; 40% tax rate
2. Target profit in units
After tax profits = Before tax profits X (1 – tax rate)After tax profits / (1 – tax rate) = Before tax profits
$1,800 / (1 – 0.4) = $3,000 = Before tax profits
Volume = (Fixed Costs + Target profit) / CM per child= $8,000 / $400 = 20 children per month
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By combining the equations for after tax profit with target profit ($1,800), we can calculate the number of children EHD must serve.
LO 6EHD TAXES and TARGET PROFIT
1. After-tax profits; 40% tax rate
2. Target profit in units
After-tax profits = Before tax profits × (1 - tax rate)After-tax profits / (1 – tax rate) = Before-tax profits
$1,800 / (1 – 0.4) = $3,000 = Before-tax profits
Volume = (Fixed Costs + Target profit) / CM per child= $8,000 / $400 = 20 children per month
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122
AFTER-TAX PROFIT: Table Format
LO 6
Sales Revenue (20 × $600) $12,500
Less Variable costs (20 × $200) 4,000
Contribution Margin (CM) 5,000
Less Fixed costs 8,000
Profit before taxes 3,000
Income taxes ($3,000 × 0.4) 1,200
Operating profit $ 1,800
EHD
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Three entrepreneurs borrowed money to start a
brewpub. Banks and investors wanted profit
projections and one owner was concerned that the
projections were too high. What analysis will help?
By using CMR in a break-even analysis,
sales could drop by more than 35% before the
brewpub would have a loss.
LO 6
MANAGERIAL APPLICATION
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7Describe the use of financial modeling in a multiple-product setting.
LEARNING OBJECTIVE
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Financial modeling is useful when multiple products with varying contribution margins are sold. Assumptions must be made about sales mix. Remember the rule:GIGO—garbage in, garbage out
LO 7
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SPORTS AUTOS: Three Analyses
With multiple products and variable costs, how does Sports Autos determine how to reach its target profit?
1. Assume weighted-average CM2. Treat each product as separate entity3. Use sales dollars as measure of volume
LO 7SA
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EXAMPLE: Sport Autos
Sport Autos is a car dealership selling two models: Sleek and Powerful. The relevant prices and costs are:
LO 7
Continued
Average monthly fixed costs $100,000Selling price: Sleek $ 20,000Average VC: Sleek $ 15,000
Selling price: Powerful $ 30,000
Average VC: Powerful $ 20,000
SA
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LO 7MANAGERS WANT TO KNOW!
What is the CM for each car?
Sleek = ($20,000-$15,000) = $5,000
Powerful = ($30,000-$20,000)= $10,000
SA
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LO 7MANAGERS WANT TO KNOW!
What is the CM ratio for each car?
Sleek = ($5,000 ÷ $20,000) = 25%
Powerful = ($10,000 ÷ $30,000)= 33%
SA
130
LO 7
Break-even units = Fixed Costs / Weighted Ave. CM= $100,000 / $6,667 = 15 cars
SPORTS AUTOS: Alternatives
2. Treat each car separately
Break-even Sleeks = $40,000 / ($20,000 - $15,000) = 8 carsBreak-even Powerfuls = $60,000 / ($30,000 - $20,000) = 6 cars
SA
1. Assume weighted average CM: Also assume product mix of 2/3 Sleeks; 1/3 Powerfuls (2/3*$5,000 + 1/3*$10,000 = $6,667)
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LO 7
Break-even units = Fixed Costs / Weighted Ave. CM= $100,000 / $6,667 = 15 cars
SPORTS AUTOS: Alternatives
Alt #2. Treat each car separately
Break-even Units = FC / CM per unitBreak-even Sleeks = $40,000 / ($20,000 - $15,000) = 8 cars
Break-even Powerfuls = $60,000 / ($30,000 - $20,000) = 6 cars
SA
Alt #1. Assume weighted average CM: Also assume product mix of 2/3 Sleeks; 1/3 Powerfuls (2/3*$5,000 + 1/3*$10,000 = $6,667)
Continued
132
LO 7
SPORTS AUTOS: Alternatives
Alt #3. Use Sales dollars as measure of volume. Assume 20 Sleeks, 10 Powerfuls sold monthly.
Weighted Ave. CMR = Total CM / Total Sales= (20×$5,000 + 10×$10,000) / (20×$20,000 + 10×$30,000)
= $200,000/ $700,000 = 0.286
Break-even Sales dollars = FC / Weighted Ave. CMR= $100,000 / 0.286
= $350,000
SA
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Financial modeling can help with product decisions when there are constraints on the product mix.
LO 7
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134
SPORTS AUTOS: Product Decisions
Suppose Sports Autos wants to sell inexpensive sports cars and can sell one but not both.
LO 7SA
Continued
Price VC CMSportster Coupe $12,000 $ 7,000 $ 5,000Sportster Convertible 15,000 11,000 4,000
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If Sports Autos can only sell one car, that is either the Sportster Coupe or
Convertible, which should it be?
LO 7
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SUMMARY OF SIMPLIFYING CVP ASSUMPTIONS
¯Can separate total costs into fixed and variable¯Cost and revenue behavior is linear. Implies
the following in the relevant range¯Total fixed costs do not change ¯Variable costs per unit remain constant¯Selling price per unit remains constant
¯Product mix remains constant over relevant range
LO 7
137
8 Explain financial modeling with multiple cost drivers.
LEARNING OBJECTIVE
138
USING ABC FOR EHD
Previously, Early Horizons Daycare used a financial model with only volume (number of children) as the cost driver. What if multiple cost drivers using the cost hierarchy are identified and used?
LO 8EHD
139
Activity Category ExampleCapacity Size limitations Building size: 30 children
Customer Needs Children transported
Product Production needs Field trips
Batch Batch A room of 5 children
Unit Variable costs Child
HIERARCHY OF COSTS: Reminder
LO 8
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COST EQUATIONLO 8E
HD
Total Cost = (Unit-level cost × #children) + (Batch-level cost × # rooms) +(Product-level cost × #field trips) +(Customer-level cost × #children transported) +(Capacity-level costs × #facilities)
Continued
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LO 8MANAGERS WANT TO KNOW!
When we have identified cost drivers
can we conduct sensitivity analysis?
Yes! Let’s consider what happens if the number of children increases to 22or decreases to 15.
EHD
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EHD: ABC and Sensitivity Analysis
Sales $ 12,000 $ 13,200 $ 9,000Unit-level costs 400 440 300Batch-level costs 2,800 3,500 2,100Product-level costs 300 300 300Customer-level costs 800 800 500Facility-level costs 4,700 4,700 4,700Operating profits $ 3,000 $ 3,480 $ 1,100
LO 8
Base Case
Continued
EHD
EXH
IBIT
6.8
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EHD: ABC and Sensitivity Analysis
Sales $ 12,000 $ 13,200 $ 9,000Unit-level costs 400 440 300Batch-level costs 2,800 3,500 2,100Product-level costs 300 300 300Customer-level costs 800 800 500Facility-level costs 4,700 4,700 4,700Operating profits $ 3,000 $ 3,480 $ 1,100
LO 8
Base CaseIncrease to 22
Continued
EHD
EXH
IBIT
6.8
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EHD: ABC and Sensitivity Analysis
Sales $ 12,000 $ 13,200 $ 9,000Unit-level costs 400 440 300Batch-level costs 2,800 3,500 2,100Product-level costs 300 300 300Customer-level costs 800 800 500Facility-level costs 4,700 4,700 4,700Operating profits $ 3,000 $ 3,480 $ 1,100
LO 8
Base CaseIncrease to 22
Decrease to 15
EHD
EXH
IBIT
6.8