Part III: Tools to Analyze Financial Operations

CHAPTER 7:

COST BEHAVIOR ANDBREAK-EVEN ANALYSIS

Fixed, Variable and Semivariable Costs

Distinguishing between fixed, variable and semivariable costs is important because this

knowledge is a basic working tool in financial management.

Fixed, Variable and Semivariable Costs

Fixed Costs are those costs that do not vary in total when activity

levels (or volume) of operations change.

Examine the examples in the chapter.

Variable Costs are those costs that vary in direct proportion when activity levels (or volume) of

operations change.

Fixed, Variable and Semivariable Costs

Examine the examples in the chapter.

Semivariable Costs vary when the activity levels (or volume) of

operations change, but not in direct proportion

Fixed, Variable and Semivariable Costs

Examine the examples in the chapter.

The most frequent patters of semivariable costs is the step pattern.

Analyze Mixed Costs

The Manager needs to know how to analyze mixed costs because

they occur so often.

Analyze Mixed Costs by Two Simple Methods

Both of these methods are judgmental.

The Predominant Characteristics Method— The manager judges whether the cost is more fixed or more variable.

The Step Method — The manager examines the “steps” in the step pattern of a fixed cost and decides whether the pattern appears to be more fixed or more variable.

Analyze Mixed Costs Through The High-Low Method

Obtain the difference in cost between the high and low levels; divide the amount of change in the activity (or volume).

Cost is examined at its high level and its low level.

Examine the examples in the chapter.

Analyze Mixed Costs by the Scatter Graph Method

The Scatter Graph finds the Mixed Cost’s average rate of variability more accurately.

Use a graph to plot all points of data; cost on vertical axis, volume on horizontal axis of the graph. Fit a regression line to the plotted points. The average fixed cost is found at the point where the regression line intersects with the cost axis.

Examine the examples in the chapter.

Understand Computation Of the Contribution Margin

The Contribution Margin equals Variable Cost deducted from net revenues. The

answer is the Contribution Margin.

(So called because it contributes to fixed costs and profits.)

Examine the examples in the chapter.

Contribution Margin: Example

Amount$1,260,000

(600,822)$ 659,178

RevenueLess Variable CostContribution Margin

Examine Table 7-1 Page 53, which contains Operating Room Fixed andVariable Costs. We can see that the total costs are $,1,217,756. Of thisamount, $600,822 is designated as variable cost and $616,934 is designated as fixed ($529,556 + $87,378 = $616,934). For purposesof our example, assume the Operating Room revenue amounts to $1,260,000. The contribution margin is computed as follows:

Thus $659,178 is available to contribute to fixed costs and to profit. In this example fixed costs are $616,934, so there is an amount left to contribute toward profit

Contribution Margin: Practice

Step 2. Compute the contribution margin:Amount

$3,500,000(1,380,000)$2,120,000(2,070,000

$50,000

RevenueLess Variable CostsContribution MarginLess Fixed CostsOperating Income

Assumptions: Greenside Clinic has revenue totaling $3,500,000.Of this amount, 40 percent is variable cost and 60 percent is fixed cost.

Step 1. Divide costs into variable and fixed. In this case $3,450,000times 40 percent equals $1,380,000 variable cost and $3,450,000Times 60 percent equals $2,070,000fixed cost.

Contribution Margin: Assignment

______________________________________________________________________

RevenueLess Variable CostContribution MarginLess Fixed CostOperating Profit (Loss)

Assumptions: The Mental Health program for the Community Centerhas just completed its fiscal year end. The Program Director determinesThat his program has revenue for the year of $1,210,000. He believes his variable expense amounts to $205,000 and he knows his fixed expense amounts to $1,100,000.

Required: Compute the contribution margin for the Community MentalHealth program.

Computation:$1,210,000 ($205,000)

$1,005,000 ($1,100,000)

($95,000)

Contribution Margin:Assignment

What does the result tell us about the program?

1. The contribution margin of $1,005,000 does not cover the fixed costs of $1,100,000.

2. There is an overall loss in the program of $95,000.

3. The fixed cost is very high, making it imperative thatsufficient revenue levels be achieved.

The Cost-Volume-Profit (CVP) Ratio or Breakeven Point

The Breakeven Point is the point when the contribution margin equals the fixed

costs.

Loss equals a loss;More equals a profit.Thus, Breakeven Point.

Examine the examples in the chapter.

CVP Example

N umber of V is its0 1000 2000 3000 4000 5000

0

100

200

300

400

500

Variable CostLine

Revenu eLine

Fixed CostLine

NetLoss

Ne tOp e ra t in g

In co m e

B re a k ev enPo in t

$

Co st - V olu m e - Profit (C VP ) C ha rt

Revenues (net) $500,000 100%Less: variable cost (350,000) 70%Contribution margin $150,000 30%Less fixed cost (120,000)Operating income $30,000

Compute the Profit-Volume (PV) Ratio

If the contribution margin is expressed as a percentage of net revenues, it is often called the Profit-Volume Ratio

A PV chart needs only 2 lines to show the effect of changes in volume.

See example and explanation in the chapter.

CVP-PV Practice+ 1 0 0

+ 9 0+ 8 0+ 7 0+ 6 0+ 5 0+ 4 0+ 3 0+ 2 0+ 1 0

0- 1 0- 2 0- 3 0- 4 0- 5 0- 6 0- 7 0- 8 0- 9 0

- 1 0 0- 1 1 0- 1 2 0- 1 3 0- 1 4 0- 1 5 0

+ 1 0 0+ 9 0+ 8 0+ 7 0+ 6 0+ 5 0+ 4 0+ 3 0+ 2 0+ 1 0

0- 1 0- 2 0- 3 0- 4 0- 5 0- 6 0- 7 0- 8 0- 9 0

- 1 0 0- 1 1 0- 1 2 0- 1 3 0- 1 4 0- 1 5 0

0 1 0 0 2 0 0 3 0 0 4 0 0 5 0 0 6 0 0 7 0 0R e v e n u e ( i n t h o u s a n d s o f d o l l a r s )

P r o je c t e dR e v e n u e s

F ix e d C o s t sR e c o v e r e d

B r e a k e v e nP o i n t

N e t L o s s( du e to

u n re c o v e r e df ix ed c os ts )

N e tI n c o m e

S a f e t yC u s h io n

( be fo r eb re a k e v e n )

Revenues (net) $500,000 100%Less: variable cost (350,000) 70%Contribution margin $150,000 30%Less fixed cost (120,000)Operating income $30,000

CPV – PV Practice

Amount Percent Per-VisitRevenueLess variable costContribution marginLess fixed costOperating (loss)

______________________________________________________

________________________________________________

=PV or CM Ratio

__________________________________________

Assumptions: The Mental Health program for the Community Centerhas just completed its fiscal year end. The Program Director determinesThat his program has revenue for the year of $1,210,000. He believes his variable expense amounts to $205,000 and he knows his fixed expense amounts to $1,100,000.

$100.0016.94

$83.0690.91$7.85

=PV or CM Ratio

100.00%16.94%83.06%90.91%7.85%

$1,210,000(205,000)

$1,005,000(1,100,000)

$95,000

RevenueLess variable costContribution marginLess fixed costOperating (loss)

Per-VisitPercentAmount

CPV – PV Assignment

Amount Percent Per-VisitRevenueLess variable costContribution marginLess fixed costOperating profit (loss)

______________________________________________________

________________________________________________

=PV or CM Ratio

__________________________________________

Assumptions: Greenside Clinic has revenue totaling $3,500,000.Of this amount, 40 percent is variable cost and 60 percent is fixedcost. The clinic had 35,000 visits.

$100.00-39.43$60.57-59.14$1.43

=PV or CM Ratio

100.00%-39.43%60.57%

-59.14%1.43%

$3,510,000(1,380,000)$2,120,000(2, 070,000)

$50,000

RevenueLess variable costContribution marginLess fixed costOperating profit (loss)

Per-Visit

Understand Further Use of The Contribution Margin

Contribution Margins are also useful in showing measures of

profitability in a simple, easy-to-understand manner.

(For example, see the DRG matrix in Figure 7-8.)