Cost Behavior andCost-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 cost’s 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

Units ofCost activity

High point 18,000$ 10,000 Low point 12,000 6,000 Difference 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

Total Percentage Per unit*Sales 1,000,000$ 100% 1,000$ Variable costs 600,000 60% 600 Contribution margin 400,000$ 40% 400$

Fixed costs 300,000 Net income 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 Normal Contribution Total

Product sales mix per unit contributionLaptops 6 70$ 420$ Printers 2 30 60 Scanners 1 20 20

500$

If fixed costs are $800,000, the breakeven point is

$800,000 / 500 = 1,600 "baskets"

9,600 laptops3,200 printers1,600 scanners