1 chapter m5 business decisions using cost behavior © 2007 pearson custom publishing

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CHAPTER M5CHAPTER M5

Business Decisions Business Decisions Using Cost BehaviorUsing Cost Behavior

© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Learning Objective Learning Objective 1:1:

Describe the Describe the differences between differences between a functional income a functional income

statement and a statement and a contribution income contribution income

statement.statement.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Functional Income Functional Income StatementsStatements

All financial income statements are All financial income statements are ffunctional unctional income statements.income statements.

Expenses are grouped together according to Expenses are grouped together according to their function. More specifically, they are their function. More specifically, they are grouped as either grouped as either product costsproduct costs (COGS) or (COGS) or period costsperiod costs (selling and administrative). (selling and administrative).

© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing

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Functional Format Functional Format ReviewReview

A CD Dealer buys and sells compact discs. A CD Dealer buys and sells compact discs. Each CD is purchased at a cost of $6 and Each CD is purchased at a cost of $6 and

sold for $15. sold for $15. Selling expenses last month were $10,000, Selling expenses last month were $10,000,

when 2,000 CDs were sold.when 2,000 CDs were sold. Administrative expenses last month were Administrative expenses last month were

$6,000.$6,000. Make an income statement for last month.Make an income statement for last month.


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The CD DealerFunctional Income Statement

For the Month Ended March 31, 2007

Sales (2,000 @ $15) 30,000$ Cost of goods sold ($6 ea.) 12,000

Gross profit 18,000$ Operating expenses:

Selling expenses 10,000$ Administrative expenses 6,000 16,000

Operating income 2,000$


Functional Income Statement

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Discussion Discussion QuestionsQuestions

Using the functional income statement on the Using the functional income statement on the previous slide, answer these questions:previous slide, answer these questions: How many units must they sell to break even?How many units must they sell to break even? If sales increased by 10%, by what percentage If sales increased by 10%, by what percentage

would income increase?would income increase? If they were to sell 100 more units, how much If they were to sell 100 more units, how much

additional profit would there be?additional profit would there be? These questions are difficult to answer These questions are difficult to answer

without having more information.without having more information.


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Contribution Income Contribution Income StatementStatement

Managers find that the Managers find that the contribution income contribution income statementstatement can be more helpful when making can be more helpful when making certain types of internal decisions.certain types of internal decisions.

For the contribution format, expenses are For the contribution format, expenses are grouped together according to their grouped together according to their cost cost behaviorbehavior.. Variable expenses are reported Variable expenses are reported separately from fixed expenses.separately from fixed expenses.


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Purpose of the Purpose of the Contribution FormatContribution Format

The contribution income statement enables The contribution income statement enables the manager to answer questions like those the manager to answer questions like those just asked about the CD Dealer.just asked about the CD Dealer.

With expenses organized according to cost With expenses organized according to cost behavior, managers find it much easier to behavior, managers find it much easier to see the potential effect of changes they may see the potential effect of changes they may initiate in managing the business. initiate in managing the business.


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Contribution MarginContribution Margin Sales revenue minus variable expenses Sales revenue minus variable expenses

equals the equals the contribution margin.contribution margin. To break even, a company needs to generate To break even, a company needs to generate

a large enough contribution margin to cover a large enough contribution margin to cover all of the fixed expenses.all of the fixed expenses.

To make a profit, a company must generate To make a profit, a company must generate more contribution margin than its fixed more contribution margin than its fixed expenses.expenses.


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Determine per unit Determine per unit amounts for sales, amounts for sales, variable costs, and variable costs, and

the contribution the contribution margin.margin.


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Cost Behavior for CD Cost Behavior for CD DealerDealer

Assume that the expenses for CD Dealer Assume that the expenses for CD Dealer have the following behavior patterns:have the following behavior patterns: Cost of goods sold.......all variableCost of goods sold.......all variable Selling expenses…......$4,000 variable, $6,000 Selling expenses…......$4,000 variable, $6,000

fixedfixed Admin. Expenses...…$2,000 variable, $4,000 Admin. Expenses...…$2,000 variable, $4,000

fixedfixed Compute the per unit revenue and costs for Compute the per unit revenue and costs for

CD Dealer.CD Dealer.


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The CD DealerPer Unit Analysis

For the Month Ended March 31, 2007 Per Unit Total

Sales (2,000 @ $15) 15.00$ 30,000$ Variable Expenses: Cost of goods sold ($6 ea.) 6.00 12,000

Selling expenses 2.00 4,000 Administrative expenses 1.00 2,000

Contribution Margin 6.00$ 12,000$


Cost Behavior for CD Cost Behavior for CD DealerDealer

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Prepare and analyze Prepare and analyze a contribution a contribution

income statement income statement for a merchandising for a merchandising

firm.firm.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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The CD DealerContribution Income Statement


Sales (2,000 @ $15) 30,000$

Variable expenses:Cost of goods sold 12,000 Selling expenses 4,000 Administrative expenses 2,000 18,000

Contribution margin 12,000$ Fixed expenses:

Selling expenses 6,000$ Administrative expenses 4,000 10,000



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The CD Dealer made a $2,000 profit on The CD Dealer made a $2,000 profit on sales of 2,000 units. What profit would he sales of 2,000 units. What profit would he earn on sales of 4,000 units?earn on sales of 4,000 units?

If he does sell 4,000 units, would you expect If he does sell 4,000 units, would you expect the fixed expenses to increase?the fixed expenses to increase?

If he does sell 4,000 units (double the If he does sell 4,000 units (double the current sales), which other numbers on the current sales), which other numbers on the statement would you expect to double?statement would you expect to double?


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The CD DealerContribution Income Statement


Total Per Unit % of Sales

Sales (2,000 units) 30,000$ 15.00$ 100.0%Variable expenses 18,000 9.00 60.0%

Contribution margin 12,000$ 6.00$ 40.0%Fixed expenses: 10,000


The condensed contribution income statement shown The condensed contribution income statement shown above helps to answer the kind of questions posed above helps to answer the kind of questions posed earlier.earlier.


Condensed Contribution Income Statement

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Using the Contribution Using the Contribution MarginMargin

The condensed contribution income The condensed contribution income statement clearly shows two very useful statement clearly shows two very useful pieces of information.pieces of information.

The unit contribution margin (UCM) is a The unit contribution margin (UCM) is a key element in many management key element in many management decisions. For the CD Dealer, the UCM decisions. For the CD Dealer, the UCM equals $6.00. Thus, each additional unit equals $6.00. Thus, each additional unit sold adds $6.00 to the monthly profit.sold adds $6.00 to the monthly profit.


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At the start business on the first day of a At the start business on the first day of a month, is it fair to say that the CD Dealer month, is it fair to say that the CD Dealer has a net loss of $10,000 for the month?has a net loss of $10,000 for the month?

What would be the net loss after the first What would be the net loss after the first CD of the month is sold? What about after CD of the month is sold? What about after the second? After the third?the second? After the third?


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Determine the Determine the contribution margin contribution margin ratio and explain its ratio and explain its

importance as a importance as a management tool.management tool.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Using the Contribution Using the Contribution MarginMargin

The second piece of useful information is The second piece of useful information is the the contribution margin ratiocontribution margin ratio (CMR). (CMR).

For the CD Dealer, the CMR is 40%. This For the CD Dealer, the CMR is 40%. This means that for any dollar increase in means that for any dollar increase in sales, there should be an increase in sales, there should be an increase in income equal to 40% of the dollar increase income equal to 40% of the dollar increase in sales.in sales.


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Describe cost-Describe cost-volume-profit (CVP) volume-profit (CVP) analysis and explain analysis and explain its importance as a its importance as a management tool.management tool.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Cost-Volume-Profit Cost-Volume-Profit AnalysisAnalysis

Cost-volume-profit analysisCost-volume-profit analysis (CVP)(CVP) is the is the analysis of the relationship between cost and analysis of the relationship between cost and volume and the effect of these relationships volume and the effect of these relationships on profit.on profit.

CVP analysis can help determine the future CVP analysis can help determine the future profitability prospects, or lack thereof, for profitability prospects, or lack thereof, for managers, owners, or potential owners of managers, owners, or potential owners of businesses.businesses.


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Break-Even PointBreak-Even Point The most basic analysis in the CVP The most basic analysis in the CVP

toolbox is break-even analysis. The toolbox is break-even analysis. The break-even pointbreak-even point is the sales volume is the sales volume required to generate neither a profit nor a required to generate neither a profit nor a loss.loss.

Using the contribution income statement, Using the contribution income statement, the total contribution margin will equal the the total contribution margin will equal the total fixed expenses at the break-even total fixed expenses at the break-even point.point.


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Break-even Points in Break-even Points in UnitsUnits

Break-even Point (units)Break-even Point (units) = = Total Fixed CostsTotal Fixed CostsUCMUCM

For the CD Dealer =For the CD Dealer = $10,000$10,000 $6.00 $6.00

== 1,667 Units1,667 Units


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Break-even Point in Break-even Point in Sales DollarsSales Dollars

Break-even Point ($) =Break-even Point ($) = Total Fixed CostsTotal Fixed CostsCMRCMR

For the CD Dealer = For the CD Dealer = $10,000$10,000 .40 .40

== $25,000 of Sales$25,000 of Sales


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Predicting Profits Predicting Profits Using CVP AnalysisUsing CVP Analysis

A natural extension of break-even analysis A natural extension of break-even analysis is to calculate the amount of sales volume is to calculate the amount of sales volume needed to earn a certain level of profit.needed to earn a certain level of profit.

In order to earn a desired level of profit, In order to earn a desired level of profit, the total contribution margin must be equal the total contribution margin must be equal to the total fixed costs plus the desired to the total fixed costs plus the desired amount of profit.amount of profit.


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Use CVP analysis to Use CVP analysis to determine the determine the

amount of sales amount of sales required to break required to break even or to earn a even or to earn a targeted profit.targeted profit.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Required Sales in Units Required Sales in Units to to

Meet Target ProfitsMeet Target ProfitsRequired Unit Sales = Required Unit Sales = Fixed Costs + Target ProfitFixed Costs + Target Profit

UCM UCM

For the CD Dealer to earn $5,000 profit:For the CD Dealer to earn $5,000 profit: = = $10,000 + $5,000$10,000 + $5,000

$6.00 $6.00

= 2,500 Units= 2,500 Units


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Required Sales ($) to Required Sales ($) to Meet Target ProfitsMeet Target Profits

Required Sales ($) = Required Sales ($) = Fixed Costs + Target ProfitFixed Costs + Target ProfitCMRCMR

For the CD Dealer to earn $5,000 profit:For the CD Dealer to earn $5,000 profit: = = $10,000 + $5,000$10,000 + $5,000

.40.40

= $37,500 Sales= $37,500 Sales


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CVP GraphingCVP Graphing A CVP graph would be drawn as follows:A CVP graph would be drawn as follows:

The sales revenue line would start at the The sales revenue line would start at the origin and slope upward at a rate equal to the origin and slope upward at a rate equal to the selling price per unit.selling price per unit.

The total cost line would start at the amount of The total cost line would start at the amount of fixed costs, and slope upward at a rate equal fixed costs, and slope upward at a rate equal to the variable cost per unit.to the variable cost per unit.

The break-even point is that volume where The break-even point is that volume where the revenue and cost lines intersect.the revenue and cost lines intersect.


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CVP Graph

sales

30,000$ total cost

25,000$

20,000$

15,000$ fixed cost

10,000$

5,000$

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

Breakeven =1,667 Units

Breakeven = $25,000 Sa les

Current Sales= $30,000

Current Sales= 2,000 Units


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Use CVP to perform Use CVP to perform sensitivity analysis.sensitivity analysis.


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Sensitivity AnalysisSensitivity Analysis

Sensitivity analysisSensitivity analysis is applied to assess the is applied to assess the changes in the CVP analysis when changes changes in the CVP analysis when changes are made in the basic parameters (price, are made in the basic parameters (price, volume, etc.)volume, etc.)

It is also called It is also called what-if what-if analysis. For analysis. For example: “What if we increased our fixed example: “What if we increased our fixed costs by 10%, while lowering our variable costs by 10%, while lowering our variable costs by 20%?”costs by 20%?”


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Change in Selling Change in Selling PricePrice

If the only change is in the selling price, then If the only change is in the selling price, then the contribution margin also changes in the the contribution margin also changes in the same direction by the same amount.same direction by the same amount.

You would expect the break-even point and You would expect the break-even point and target profit volumes to change in the target profit volumes to change in the opposite direction of the change in selling opposite direction of the change in selling price. If the selling price decreases, the price. If the selling price decreases, the break-even point increases.break-even point increases.


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Change in Price Change in Price ExampleExample

Lets assume that the CD Dealer decreases Lets assume that the CD Dealer decreases the price of CDs from $15 to $14. This the price of CDs from $15 to $14. This results in a decrease in the UCM from $6 to results in a decrease in the UCM from $6 to $5, and a decrease in the CMR from 40% to $5, and a decrease in the CMR from 40% to 33.3%.33.3%.

New break-even point in units:New break-even point in units:$10,000 / $5 = 2,000 units$10,000 / $5 = 2,000 units

New breakeven in dollars:New breakeven in dollars:$10,000 / .333 = $30,000$10,000 / .333 = $30,000


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Change in Variable Change in Variable CostCost

If the only change is in the variable cost, the If the only change is in the variable cost, the contribution margin also changes in the contribution margin also changes in the opposite direction by the same amount. opposite direction by the same amount.

You would expect a change in the break-You would expect a change in the break-even point and target profit volumes in the even point and target profit volumes in the same direction as the change in the variable same direction as the change in the variable cost. If the variable cost increases, the cost. If the variable cost increases, the break-even point also increases.break-even point also increases.


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Change in Variable Change in Variable Cost ExampleCost Example

The CD Dealer experiences an increase in The CD Dealer experiences an increase in variable costs from $9 to $11. This results in a variable costs from $9 to $11. This results in a decrease in the UCM from $6 to $4, and a decrease in the UCM from $6 to $4, and a decrease in the CMR from 40% to 26.7%.decrease in the CMR from 40% to 26.7%.


New breakeven in dollars:New breakeven in dollars:$10,000 / 26.7% = $37,500$10,000 / 26.7% = $37,500


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Change in Fixed Change in Fixed CostCost

If the only change is in the fixed cost, then If the only change is in the fixed cost, then there is no change in the contribution there is no change in the contribution margin. margin.

You would expect a change in the break- You would expect a change in the break- even point and target profit volumes in the even point and target profit volumes in the same direction as the change in fixed cost. same direction as the change in fixed cost. If the fixed cost decreases, then the break- If the fixed cost decreases, then the break- even point also decreases.even point also decreases.


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Change in Fixed Cost Change in Fixed Cost ExampleExample

The CD Dealer experiences a decrease in The CD Dealer experiences a decrease in fixed costs from $10,000 to $9,000. This fixed costs from $10,000 to $9,000. This change has no affect on the UCM or CMR.change has no affect on the UCM or CMR.


New breakeven in dollars:New breakeven in dollars:$9,000 / .40 = $22,500$9,000 / .40 = $22,500


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Change in Both Change in Both CostsCosts

If there are changes in both the fixed cost If there are changes in both the fixed cost and the variable cost, then there will be a and the variable cost, then there will be a change in the contribution margin. change in the contribution margin.

There will most likely be a change in the There will most likely be a change in the break-even point and target profit volumes, break-even point and target profit volumes, but the direction of that change depends on but the direction of that change depends on both the direction and relative magnitude of both the direction and relative magnitude of the changes in the variable and fixed costs.the changes in the variable and fixed costs.


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Change in Both Costs Change in Both Costs ExampleExample

The CD Dealer lowers variable selling costs The CD Dealer lowers variable selling costs by $1 per unit while increasing fixed selling by $1 per unit while increasing fixed selling costs by $1,900. The new UCM is $7, the costs by $1,900. The new UCM is $7, the new CMR is 46.7%, and the new fixed cost new CMR is 46.7%, and the new fixed cost is $11,900.is $11,900.

Breakeven in units =Breakeven in units = $11,900 / $7 = 1,700 $11,900 / $7 = 1,700 Breakeven in $ =Breakeven in $ = $11,900 / .467 = $25,500 $11,900 / .467 = $25,500


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Multiple ProductsMultiple Products

What would we do if the CD Dealer started What would we do if the CD Dealer started selling cassette tapes in addition to CDs?selling cassette tapes in addition to CDs?

In a In a multiple productmultiple product situation, we can situation, we can still perform the basic CVP calculations if still perform the basic CVP calculations if we use the total amounts, rather than the we use the total amounts, rather than the per unit amounts.per unit amounts.


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Multiple Products Multiple Products ExampleExample

Assume that the CD Dealer has prepared a Assume that the CD Dealer has prepared a contribution income statement using his contribution income statement using his sales and costs expectations for the sales and costs expectations for the average month in the future.average month in the future.

Included in the sales and costs are the Included in the sales and costs are the amounts related to both the CDs and the amounts related to both the CDs and the tapes. The statement is shown on the next tapes. The statement is shown on the next slide.slide.


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The CD and DVD DealerContribution Income Statement

For the Average Month

Total % of Sales

Sales 40,000$ 100.0%Variable expenses 22,000 55.0%

Contribution margin 18,000$ 45.0%Fixed expenses: 14,000


Notice that the average contribution margin is now 45%, compared to 40% previously. Also, fixed costs have increased from $10,000 to $14,000.


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Can you give examples of why the CD Can you give examples of why the CD Dealer might experience an increase in Dealer might experience an increase in monthly fixed costs when DVDs are added monthly fixed costs when DVDs are added to the inventory?to the inventory?

Since the income statement shows a Since the income statement shows a doubling of profit from $2,000 to $4,000, doubling of profit from $2,000 to $4,000, should the owner add DVDs without should the owner add DVDs without question?question?


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Multiple Product Multiple Product Break-Even PointBreak-Even Point

For the CD and DVD Dealer, the break-For the CD and DVD Dealer, the break-even point can now be calculated as even point can now be calculated as follows:follows:

Fixed costFixed cost = = $14,000$14,000 = = $31,111 $31,111

Avg. CMRAvg. CMR .45 .45


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Multiple Product Multiple Product Target ProfitTarget Profit

Prior to adding DVDs, the CD Dealer Prior to adding DVDs, the CD Dealer earned a monthly profit of $2,000 on sales earned a monthly profit of $2,000 on sales of $30,000. What sales volume is now of $30,000. What sales volume is now required to earn that same $2,000 profit?required to earn that same $2,000 profit?

Fixed + ProfitFixed + Profit = = $16,000$16,000 = $35,556 = $35,556

Avg. CMRAvg. CMR .45 .45


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The addition of DVDs caused the expected The addition of DVDs caused the expected profit to increase, but also caused the break- profit to increase, but also caused the break- even point to increase. Does this indicate a even point to increase. Does this indicate a greater risk of loss for the business?greater risk of loss for the business?

The target profit analysis shows that sales will The target profit analysis shows that sales will have to be $5,556 higher than the current level have to be $5,556 higher than the current level of $30,000 just to earn the same $2,000 of $30,000 just to earn the same $2,000 income that is currently earned. Does that income that is currently earned. Does that sound right? What would you do?sound right? What would you do?


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Simplifying Simplifying AssumptionsAssumptions

The following five assumptions are made The following five assumptions are made when performing CVP analysis as described when performing CVP analysis as described in this chapter:in this chapter:

1. All costs are either fixed or variable.1. All costs are either fixed or variable.

2. Total fixed costs remain fixed throughout the 2. Total fixed costs remain fixed throughout the relevant range.relevant range.

(continued on next slide)(continued on next slide)


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Simplifying Simplifying AssumptionsAssumptions

3. Variable cost per unit remains stable 3. Variable cost per unit remains stable throughout the relevant range.throughout the relevant range.

4. Selling prices remain stable throughout 4. Selling prices remain stable throughout the relevant range.the relevant range.

5. Average contribution margin ratio for 5. Average contribution margin ratio for multiple products remains stable multiple products remains stable throughout the relevant range.throughout the relevant range.


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The End of Chapter The End of Chapter M5M5


1 chapter m5 business decisions using cost behavior © 2007 pearson custom publishing

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