Cost Behavior Analysis

1. Cost Behavior Analysis 23

2. Cost Behavior and Management OBJECTIVE 1: Define cost behavior, and identify variable, fixed, and mixed costs.

3. Figure 1: A Common Variable Cost Behavior Pattern: A Linear Relationship

4. Figure 2: Examples of Variable, Fixed, and Mixed Costs

5. Figure 3: A Common Fixed Cost Behavior Pattern

6. Figure 4: Behavior Patterns of Mixed Costs

7. Figure 5: The Relevant Range and Linear Approximation

8. Cost Behavior and Management • Cost behavior refers to the way costs respond to changes in volume or activity.

9. Cost Behavior and Management • Managers use assumptions about cost behavior in almost every decision they make. • When planning, managers use cost behavior to determine how many units of products or services must be sold to generate a targeted amount of profit and how changes in planned activities will affect operating income.

10. Cost Behavior and Management • Managers use assumptions about cost behavior in almost every decision they make. (cont.) • When performing their duties, managers use cost behavior to determine the impact of their decisions on operating income. • When evaluating and reporting on performance, managers analyze how changes in costs and sales affect profitability.

11. Cost Behavior and Management • The behavior of costs • Total costs that change in direct proportion to changes in productive output (or other volume measures) are called variable costs. • However, on a per unit basis, variable costs remain constant as volume changes. • Operating capacity is the upper limit of an organization’s productive output capability, given its existing resources.

12. Cost Behavior and Management • The behavior of costs (cont.) • There are three common measures of operating capacity: • Theoretical (ideal) capacity • Practical capacity • Normal capacity

13. Cost Behavior and Management • The behavior of costs (cont.) • The traditional definition of variable costs assumes that a linear relationship exists between costs and the measure of capacity chosen. • Many costs vary with operating activity in a nonlinear fashion; this cost behavior can be approximated within the relevant range using linear approximation.

14. Cost Behavior and Management • The behavior of costs (cont.) • Fixed costs are total costs that remain constant within a relevant range of volume or activity. Fixed unit costs vary inversely with changes in activity or volume. • Mixed costs have both variable and fixed cost components. • Many mixed costs vary with operating activity in a nonlinear fashion. • Accountants use linear approximation to allow the inclusion of nonlinear costs in cost behavior analysis.

16. Mixed Costs and the Contribution Margin Income Statement OBJECTIVE 2: Separate mixed costs into their variable and fixed components, and prepare a contribution margin income statement.

17. Figure 6: Scatter Diagram of Machine Hours and Electricity Costs

18. Table 1: Comparison of Income Statements

19. Table 2 Contribution Margin Income Statement

20. Mixed Costs and the Contribution Margin Income Statement • Mixed costs are a combination of variable and fixed cost components. • For cost planning and control purposes, mixed costs must be divided into their variable and fixed components.

21. Mixed Costs and the Contribution Margin Income Statement • Engineering method • Separates costs by performing step-by-step analysis of tasks, costs and processes involved. • Also called a time and motion study.

22. Mixed Costs and the Contribution Margin Income Statement • Scatter diagram method • Used when there is doubt about the behavior pattern of a particular cost. • If the diagram suggests a linear relationship, a cost line can be imposed.

23. Mixed Costs and the Contribution Margin Income Statement • High-low method • Three-step approach to determining variable and fixed components. • Find the variable rate. • Find the total fixed costs. • Express the cost formula to estimate total costs within the relevant range.

24. Mixed Costs and the Contribution Margin Income Statement • High-low method (cont.) • Its disadvantage is that if one or both data points are not representative of the remaining data set, the estimate of variable and fixed costs may not be accurate. • Its advantage is that it can be used when only limited data are available.

25. Mixed Costs and the Contribution Margin Income Statement • Statistical methods, such as regression analysis • Mathematically describe the relationship between costs and activities • Because all data observations are used, the resulting linear equation is more representative of cost behavior than either the high-low or scatter diagram methods.

26. Mixed Costs and the Contribution Margin Income Statement • Contribution margin income statements • A contribution margin income statement is formatted to emphasize cost behavior rather than organizational functions. • Contribution margin (CM) is the amount that remains after all variable costs are subtracted from sales.

28. Cost-Volume-Profit Analysis OBJECTIVE 3: Define cost-volume-profit (C-V-P) analysis and discuss how managers use it as a tool for planning and control.

29. Cost-Volume-Profit Analysis • C-V-P analysis • C-V-P analysis is an examination of the cost behavior patterns that underlie the relationships among cost, volume of output, and profit. • Sales Revenue – Variable Costs – Fixed Costs = Profit

30. Cost-Volume-Profit Analysis • C-V-P analysis (cont.) • Tool for both planning and control. • Can calculate net income when sales volume is known • Can determine the level of sales need to reach a targeted amount of income.

31. Cost-Volume-Profit Analysis • C-V-P analysis (cont.) • Only used under certain conditions and when certain assumptions hold true. • The behavior of variable and fixed costs can be measured accurately. • Costs and revenues have a close linear approximation. • Efficiency and productivity hold steady within the relevant range.

32. Cost-Volume-Profit Analysis • C-V-P analysis (cont.) • Only used under certain conditions and when certain assumptions hold true. (cont.) • Cost and price variables hold steady during the period being planned. • The product sales mix does not change during the period being planned. • Production and sales volume are approximately equal.

34. Breakeven Analysis OBJECTIVE 4: Define breakeven point and use contribution margin to determine a company’s breakeven point for multiple products.

35. Figure 7: Graphic Breakeven Analysis for My Media Place

36. Figure 8: Sales Mix for My Media Place

37. Breakeven Analysis • The breakeven point is the point of zero profit, where S – VC – FC = 0. • The margin of safety is the number of sales units or amount of sales dollars by which actual sales can fall below planned sales without resulting in a loss. • A scatter graph can be used to make a rough estimate of the breakeven point.

38. Breakeven Analysis • Contribution margin equals sales minus total variable costs. • Profit equals contribution margin minus fixed costs. • Contribution margin per unit equals selling price minus variable cost per unit.

39. Breakeven Analysis • Contribution margin equals sales minus total variable costs. (cont.) • Breakeven point in units equals fixed costs divided by the contribution margin per unit. • Breakeven point in sales dollars equals breakeven point in units times the selling price per unit. • When an organization sells more than one product, a sales mix is used to calculate the breakeven point for each product.

41. Using C-V-P Analysis to Plan Future Sales, Costs, and Profits OBJECTIVE 5: Use C-V-P analysis to project the profitability of products and services.

42. Exhibit 1: Comparative Summary of Alternatives at My Media Place

43. Using C-V-P Analysis to Plan Future Sales, Costs, and Profits • C-V-P analysis enables managers to determine how changes in volume, selling price, and costs will affect the profitability of a product. • The following formula is used to determine the number of units that must be sold to produce a certain profit: • Targeted sales in units = (FC + P) ÷ (CM per Unit)

44. Using C-V-P Analysis to Plan Future Sales, Costs, and Profits • A service business can use C-V-P analysis to separate the mixed costs of service overhead into their variable and fixed components, calculate a breakeven point, and determine how changes in cost, volume, or price will affect the profitability of a service.