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Chapter 2 Introduction to Cost Behavior and Cost-Volume Relationship

Chapter 2 Introduction to Cost Behavior and Cost-Volume Relationship. Objective 1 Explain how cost drivers affect cost behavior. Cost Drivers.

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Chapter 2 Introduction to Cost Behavior and Cost-Volume Relationship

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  1. Chapter 2Introduction to Cost Behaviorand Cost-Volume Relationship

  2. Objective 1 Explain how cost drivers affect cost behavior

  3. Cost Drivers are factors or activities that have a direct cause-effect relationship to a cost. For example, production volume has a direct effect on the total cost of raw material used and can be said to "drive" that cost. In addition, volume could be used as a valid "driver" of raw material cost.

  4. In most situations, the cause-effect relationship is less clear, since costs are commonly caused by multiple factors. For example, quality control costs are affected by a variety of factors, such as production volume, quality of material used, skill level of workers, and level of automation. Any of these factors could be chosen as a cost driver if a reasonable amount of confidence exists as to the factor's ability to correlate with cost changes. A major task in specifying cost behavior is to identify the cost drivers-that is to determine the activities that cause costs to be incurred.

  5. This chapter focuses on volume-related cost drivers. Volume-related cost drivers include: • The number of orders processed, • Production volume in a production department, • The hours of labor worked in an assembly department, • Sales in a retail business. Of course, when only one product is being produced the units of production is the most obvious volume related cost driver for production-related costs.

  6. Objective 2 Show how changes in cost- driver activity levels affect variable and fixed costs

  7. Comparison of variable and fixed costs Costs are classified as variable or fixed depending on how much they change as the level of a particular cost driver changes. A variable cost is a cost that changes in direct proportion to changes in the cost driver. A fixed cost is not immediately affected by changes in the cost driver. Variable costs vary in direct proportion to the volume of activity, that is doubling the level of activity will double the total variable costs. Consequently, total variable cost is constant. Figure 2.1 illustrates a variable cost where the variable cost per unit of activity is L.E. 10

  8. A : Total Variable Cost B : Unit Variable Cost Figure 2-1 Variable Costs Total Variable Cost Unit Variable Cost ------------------------------ 5000 4000 ------------------- 3000 L.E 2000 10 1000 -------- 100 200 300 400 500 100 200 300 400 500 Activity level Activity level (Units of output) (Units of output)

  9. Examples ofvariable manufacturing costsinclude direct labor, direct material and power. These costs are assumed to fluctuate directly in proportion to operating activity within a certain range of activity. Examples ofnon-manufacturingvariablecostsinclude sales commissions, which fluctuate with sales value. Suppose for example, a firm pays its sales persons a sales commission. As sales value increases, the commission paid will increase proportionally. If a firm pays a commission of 10 % of sales value. The total commission paid will be as follows:

  10. Note that variable cost (commission paid) varies proportionally with the level of activity (as expressed in sales value) where as the unit variable cost remains unchanged at 10 PT. per L.E. 1 of sales. Fixed costs remain constant over wide ranges of activity for a specified time period. Examples of fixed costs include supervisors salaries, straight-line depreciation, and insurance. Figure 2-2 illustrates fixed cost .

  11. You will see that the total fixed costs are constant for all levels of activity (within relevant range), whereas unit fixed costs decrease proportionally with the level of activity. for example, if the total of the fixed costs L.E. 5000 for a month , the fixed costs per unit will be as follows:

  12. A : Total Fixed Costs B : Unit Fixed Costs Figure 2-2 Fixed Costs Unit Fixed Cost (L.E) Total Fixed Cost (L.E) 100 200 300 400 500 100 200 300 400 500 Activity level Activity level

  13. Note carefully from these examples that the “variable” or “fixed” characteristic of a cost relates to its total amount and not to its per unit amount. The following table summarizes these relationships.

  14. When predicting costs, two rules of thumb are useful : • Think of fixed costs as a total. Total fixed costs remain unchanged regardless of changes in cost-driver activity. • Think of variable costs on a per-unit basis. The per-unit variable cost remains unchanged regardless of changes in cost-driver activity.

  15. Relevant Range is a range of activity over which a variable cost per unit remains constant or a fixed cost remains fixed in total. In other words, a relevant range is a range of activity in which costs behave in accordance with the way they have been define. The relevant range is generally the normal operating range for a company. In addition remember that even within the relevant range a fixed cost remains fixed only over a given period of time-usually the budget period.

  16. Cost – volume-profit Analysis • Cost-volume-profit (CVP) analysis means the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit) • The study of cost-volume-profit relationship is often called break-even analysis, This term is misleading, because finding the break-even point is often just the first step in a planning decision. • To apply CVP analysis, the major simplification-in this chapter- is to classify costs as either variable or fixed with respect to a single measure of the volume of output activity.

  17. Objective 3 Calculate break-even sales volume in total pounds and total units

  18. Break-Even Point – Contribution Margin and Equation Techniques. Break-even point is the level of sales at which revenue equal expenses and net income is zero. Contribution-Margin Technique Contribution margin or marginal income is the sales price minus the variable production, selling and administrative costs per unit.

  19. Break-even point (units) = Break-even point (L.E) = Break-even point (units) X sales price Note: Contribution margin per unit is constant because revenue and variable cost have been defined as remaining constant per unit.

  20. Contribution-margin percentage (or ratio) =Contribution margin per unit Sales price per unit Variable-cost percentage (or ratio) = Variable cost per unit Sales price per unit Note: Contribution-margin percentage + variable-costpercentage = 100 %

  21. Break-even point (L.E) = Using the contribution-margin percentage, you can compute the break-even volume in pounds (L.E.) without determining the break-even point in units. Example: Data needed to compute break- even point and perform CVP analysis are given in the income statement in Exhibit 2-3 for XYZ company.

  22. Exhibit 2-3 XYZ CompanyIncome StatementFor the Year Ended Dec,31,‏1997

  23. Break-even point & contribution margin techniqueContribution margin per unit = L.E. 100 – L.E 40 = L.E. 60 Contribution margin percentage = 60% Break-even point (units) = L.E 300000 L.E 60 = 5000 units Break-even point (pounds) = 5000(units) X L.E 100 (selling price) = L.E. 500,000 Or = L.E. 300000 Fixed costs / 60% Contribution margin percent = L.E. 500,000

  24. The income statement at the break-even point is

  25. Equation Technique Any income statement can be expressed in equation form, as follows : Sales – Variable expenses – Fixed expenses = net income That is, (Unit sales Price X number of units) – (Unit Variable Cost X number of units ) – Fixed costs = net income

  26. At the break-even point net income is zero : Sales – Variable expenses – Fixed expense = 0 Let X = number of unit to be sold to break-even. Then for XYZ company example. L.E. 100 X - L.E 40 X - L.E 300,000 = 0 L.E. 60 X = L.E. 300,000 X = L.E. 300,000  L.E. 6 X = 5000 units Break-even point in pounds (L.E) = 5000 units X unit sales price = 5000 X L.E. 100 = L.E. 500,000

  27. You can also solve the equation for sales pounds without computing the unit break-even point by using the relationship of variable costs and profits as a percentage of sales : Variable-cost percentage = Variable cost per unit (or ratio ) Sales price per unit = L.E. 40 L.E. 100 = 40% or 0.4 Let S = Sales in pounds (L.E.) needed to break-even . Then S - 0.4 S - L.E. 300,000 = 0 0.6 S = L.E.300,000 S = L.E. 300,000  0.6 = L.E. 500,000

  28. General shortcut break-even formulas: Break-even volume= Fixed expenses In units Contribution margin per unit Break-even volume = Fixed expenses In pounds (L.E.) Contribution margin ratio

  29. Objective 4 Construct a cost - volume- profit graph

  30. Break–even chart-Graphical techniques A break- even chart is a graph that depicts the relationship among revenues, variable costs, fixed costs and profits (or losses). The break-even point is located at the point where the total cost and total revenue lines cross. There are two approaches to prepare break- even charts : The traditional approach the contemporary approach The third graphical presentation, the profit-volume graph, is closely related to the break- even chart

  31. Traditional Approach The traditional approach focuses on the relationships among revenues, costs, and profits (Losses). This approach does not show contribution margin. A traditional break – even Chart for XYZ company is prepared in the following manner: 1) Draw the axes. The horizontal axis is the sales volume, and the vertical axis is pounds of cost and revenue. 2) Plot sales volume, select a convenient sales volume (within the relevant range), say, 15,000 units, and plot point A for total sales at that volume : 15,000 X L.E 100 = L.E. 1,500,000. Draw the revenue( i.e. sales) Line from point A to the origin, point 0

  32. 3) Plot fixed expenses. Draw a horizontal Line intersecting the vertical axis at L.E 300,000, point B 4) Plot variable expenses. Determine the variable portion of expenses at a convenient level of activity: 15,000 X L.E. 40 = L.E 600,000 . Add this to the fixed expenses : L.E 600,000 + L.E 300,000 = L.E. 900,000. Plot point C for 15,000 units and L.E. 900,000. Then draw a line between point C and point B. This is the total expenses line. 5) Locate the Break- even point is where the total expenses line crosses the sales line, 5000 units or L.E. 500,000, namely where total sales revenues exactly equal total costs, point D. Exhibit 2-4 is a graph of the cost – volume- profit relationship in our XYZ company example.

  33. Exhibit 2-4Cost – volume-profit Graph Volume in thousands of units

  34. Contemporary Approach – contribution Graph The contribution margin provided by each level of sales volume is not apparent on the preceding traditional break-even chart. Since contribution margin is so important in CVP analysis, another graphic approach can be used. The contemporary graphic approach specifically presents CM in the break – even chart. The preparation of this chart is detailed in the following steps:

  35. Step (1) plot the variable cost firstly: The revenue line is plotted next, and the contribution margin area is indicated. Volume in thousands of units

  36. Step (2) Total cost is graphed by adding a line parallel to the total variable cost Line. The distance between the total cost line and the variable cost line is the amount of fixed cost. The break-even point is located where the revenue and total cost lines intersect.

  37. The contemporary graphic approach allows the following important observations to be made: • Contribution margin is created by the excess of revenues over variable costs. • Total contribution margin is always equal to total fixed cost plus profit or minus loss. • Before profits can be generated, contribution margin must exceed fixed costs.

  38. Profit-Volume (PV) Graph The profit-volume graph reflects the amount of profit or loss associated with each level of sales. The horizontal axis on the PV graph represents sales volume. The vertical axis represents profits and losses. Amounts above the horizontal axis are positive and represent profits; amounts below the horizontal axis are negative and represent losses.

  39. Two points are located on the graph: If sales are zero, the loss will be the amount of the fixed costs. To plot the other point, select any other level of sales volume; say 15,000 units ( in our XYZ example). Determine profit (or loss) for this level, {15,000 units X L.E. 60 (CM)} - L.E. 300,000 (Fixed costs) = L.E.900,000 - L.E. 300,000 = L.E. 600,000 So, the two points are

  40. The last step in preparing the PV graph is to draw a profit line that passes between and extends through the two located points. Using this Line, the amount of profit or loss for any sales volume can be read from the vertical axis. The profit Line is really a contribution margin Line, and the slope of the line is determined by the unit contribution margin. The Line shows that no profit is earned until the contribution margin covers the fixed costs.

  41. The PV graph for XYZ Company is shown below:

  42. With each unit sold, a contribution of L.E 60 is obtained toward the fixed costs, and the break-even point is at 5,000 units when the total contribution (5000 units X L.E. 60 = L.E 300,000) exactly equal the total of the fixed costs. With each additional unit sold beyond 5000 units a surplus of L.E.60 per unit is obtained. If 12,000 units are sold, the profit will be L.E. 420,000(7000 units at L.E. 60 contribution).

  43. Changes in fixed costs Changes in fixed costs causes changes in the break-even point. For example, if fixed costs increase from 300,000 to 360,000 (in our example), what would be the break-even point in units and in pounds? Break-even point = Fixed expenses (in units) Contribution margin per unit = L.E. 360,000 L.E 60 = 6000 units

  44. Break-even point = Fixed expenses (in pounds) Contribution margin ratio = L.E.360,000 0.6 = L.E. 600,000 Note that a one-fifth increase in fixed expenses altered the break-even point by one-fifth: from 5,000 units to 6,000 units, and from L.E 500,000 to L.E 600,000. This type of relationship always exists if every thing else remains constant. The P/V graph is shown below:

  45. Changes in Contribution margin per Unit Changes in variable costs also cause the break – even point to shift. Companies can reduce their break-even points by increasing their contribution margins per unit of product through either increases in sales prices or decreases in unit variable costs, or both. For example, assume that (1) the variable expenses increase from L.E. 40 per unit to L.E. 50. (2) the selling price falls from L.E. 100 to L.E. 80 per unit, and the original variable costs per unit are unchanged, Find the break-even point in units and pounds.

  46. Unit contribution margin = L.E 100 – L.E. 50 = L.E. 50 Contribution margin ratio = L.E. 50 L.E. 100 = 0.5 The original fixed expenses of L.E. 300,000 would be unaffected, but the denominators would change from those previously used. Thus Break-even point = L.E. 300,000 (in units) L.E. 50 = 6000 units Break-even point = L.E. 300,000 ( in pounds) 0.5 = L.E. 600,000

  47. Unit contribution margin = L.E. 80 – L.E. 40 = L.E. 40 Contribution margin ratio = L.E. 40 L.E. 80 = 0.5 Break-even point = L.E. 300,000 = 7500 (in units) L.E. 40 Units Break-even point = L.E. 300,000 = 0.5 (in pounds) L.E. 600,000

  48. The P/V graphs for the above two cases compared with the original case of XYZ company is shown below : Case 1

  49. Objective 5 Calculate sales volume in total units and total pounds to reach a target (a planned) profit.

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