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Chapter 3

Fundamentals of Cost Analysis. Chapter 3. for Decision Making. Use cost-volume-profit (CVP) analysis to analyze decisions. 2. Understand the effect of cost structure on decisions. 3. Use differential analysis to analyze decisions.

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Chapter 3

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  1. Fundamentals of Cost Analysis Chapter 3 for Decision Making

  2. Use cost-volume-profit (CVP) analysis to analyze decisions. 2. Understand the effect of cost structure on decisions. 3. Use differential analysis to analyze decisions. • Understand how to apply differential analysis to pricing decisions. • Understand several approaches for establishing prices based on costs for long-run pricing decisions. • Understand how to apply differential analysis to production decisions. 7. Understand the theory of constraints (Appendix). Learning Objectives

  3. L.O. 1 Use cost-volume-profit (CVP) analysis to analyze decisions. Cost Volume Profit CVP studies the relations among revenue, cost, and volume and their effect on profit. Cost-Volume-Profit Analysis V ? C P What is

  4. The Income Statement Total revenues Total costs Operating profit The Profit Equation Operating profit Total revenues Total costs p TR TC The Profit Equation Operating profit equals total revenue less total costs. It’s the income statement written horizontally.

  5. Units of output produced and sold Price TR P X TR PX Fixed costs Variable costs per unit Units of output TC X F V TC VX F Profit Equation Continued

  6. p TR TC p PX VX F [ ] p P V X F Profit Equation Continued

  7. Developed 12,000 prints in March Total PerUnit Sales $7,200 $0.60 Less Variable cost of goods sold 3,600 0.30 Less Variable selling cost 720 0.06 Contribution margin 2,880 0.24 Less Fixed costs 1,500 Operating profit $1,380 U-Develop; an Example U-Develop Income Statement Month of March 200X

  8. U-Develop p P V X F [ ] $1,380 $.60 $.36 12,000 units $1,500 $.30 + $.06 $1,380 $2,880 $1,500 p $1,380 Profit Equation Example

  9. Total contribution margin P X V X P V X Unit contribution margin CM unit CM unit P V Contribution Margin The difference between total revenue and total variable costs. The difference between sales price and variable costs per unit.

  10. CM P V X Total CM CM $.60 $.36 12,000 units CM $2,880 $.30 + $.06 CM unit CM Unit P V CM unit $.60 $.36 CM unit $.24 Contribution Margin Example CVP studies the relations among revenue, cost, and volume and their effect on profit. U-Develop

  11. CM unit $.24 ? Why do I care? For every $1.00 in sales, U-Develop has $.24 available to first cover fixed costs and then to increase profits. Contribution Margin Continued U-Develop

  12. [ ] Target Profit P V X F Target Volume (Units) Fixed costs Target profit F p X P V Target Volume in Units Unit contribution margin

  13. p F X $1,500 $1,800 X X 13,750 units Target Volume Units Example U-Develop Target Profit of $1,800 CM unit $.24

  14. P V X P X P V P Contribution Margin Ratio Contribution Margin Ratio Contribution margin as a percentage of sales revenue. Total contribution margin ratio Total contribution margin as a percent of total sales revenue. Unit contribution margin ratio Contribution margin per unit as a percent of sales price per unit. CMR unit

  15. P V X $.60 $.36 12,000 CMR P X .60 12,000 $2,880 CMR .40 $7,200 $.24 CMR unit .40 $.60 CMR Example U-Develop

  16. Target volume sales dollars Fixed costs + Target profit = Contribution margin ratio TR F + p TR = CMR Target Volume in Sales Dollars

  17. $1,500 $1,800 F + p TR TR = .40 CMR TR $8,250 Target Sales Dollars Example U-Develop 13,750 x $.60 = $8,250

  18. F + p X = CM unit Fixed costs Break-even volume (units) = CMunit Break-Even The sales volume level at which profits equal zero. Total revenues = Total costs Use the target volume formulas to find the break-even point. Set target profit to zero (p = 0) p = 0

  19. F p X CM unit 1,500 0 X $.24 X 6,250 prints Break-Even Units Example U-Develop

  20. F 0 TR CMR F TR CMR Break-Even in Sales Dollars The total sales dollars at which profits equal zero. p = 0 Total revenues = Total costs

  21. F p TR CMR $1500 TR .40 TR $3,750 Break-Even Sales Dollars Example U-Develop 6,250 prints X $.60 = $3,750

  22. Fixed costs Target profit + Target volume (units) = Unit contribution margin Fixed costs + Target profit Target volume sales dollars = Contribution margin ratio CVP Summary Summary of Target Volume and Break-Even Formulas Target Volume

  23. Fixed costs Break-even volume (units) = Unit contribution margin Fixed costs Break-even volume (sales dollars) = Contribution margin ratio CVP Summary Continued Summary of Target Volume and Break-Even Formulas Break even

  24. Total revenue $3,750 Total cost 6,250 prints Graphic Presentation U-Develop Break-Even

  25. Contribution margin Net income The higher the organization’s operating leverage, the higher the break-even point. CVP and the Effect of Different Cost Structures L.O. 2 Understand the effect of cost structure on decisions. Cost structure Operating leverage The proportion of fixed and variable costs to total costs. The extent to which the cost structure is made up of fixed costs.

  26. Comparison of Cost Structures

  27. Why do I care? Lo-Lev Hi-Lev Sales $100,000 $100,000 CMR .25 .75 Increase in Profit $25,000 $75,000 Prior NI $200,000 $200,000 NI with sales increase of 10% $225,000 $275,000 Operating Leverage Example Suppose Lo-Lev & Hi-Lev both increase sales 10% or $100,000.

  28. Lo-Lev Hi-Lev 10% 10% Percent Increase in sales 1.25 1.75 Degree of Operating Leverage 12.5% 17.5% Percent increase in NI $200,000 $200,000 Prior NI 12.5% 17.5% Percent increase in NI $225,000 $275,000 NI with sales increase of 10% Operating Leverage Continued

  29. The excess of projected or actual sales volume over break-even volume. The excess of projected or actual sales revenue over break-even revenue. 8,000 6,250 1,750 prints $4,800 $3,750 $1,050 Margin of Safety or Suppose U-Develop sells 8,000 prints 1750 x $.60 = $1,050

  30. What if U-Develop is in the 15% tax bracket and wants profit after taxes of $3,000? p F 1 - t CM unit $3,000 $1,500 .85 X $.24 X 20,956 units Extending CVP: Taxes Profit of $3,000 But this means taxes. Target Volume

  31. Sales 20,956 $.60 $12,574 VC 20,956 $.36 7,544 CM $5,030 FC 1,500 NIBT $3,530 Taxes 3,530 15% 530 Net Income $3,000 CVP and Taxes Continued Check it out

  32. Prints Enlargements Selling price $.60 $1.00 .36 .56 Variable cost Contribution margin $. 24 $. 44 Total Fixed Costs $1,820 Extending CVP: Multiple Products What if: U-Develop does prints and enlargements?

  33. 9/10 $.24 1/10 $.44 9/10 6,300 prints $1,820 7,000 1/10 $.26 700 enlargements Product Mix For every 9 prints sold U-Develop sells 1 enlargement. Weighted Average Contribution Margin $ .26 Breakeven

  34. The process of estimating revenues and costs of alternative actions available to decision makers and of comparing these estimates to the status quo. The period of time over which capacity will be unchanged, usually one year. Differential Analysis L.O. 3 Use differential analysis to analyze decisions. Differential Analysis Short Run

  35. Costs that change in response to an alternative course of action. Differential costs differ between actions. Alternative A Alternative B Differential Costs

  36. Costs incurred in the past that cannot be changed by present or future decisions. IT’S GONE TOO BAD SO SAD A sunk cost is NOT relevant. Sunk Costs

  37. Differential Analysis and Pricing Decisions L.O. 4 Understand how to apply differential analysis to pricing decisions. Variable costs Must always be covered. Cost ($) Activity level Fixed costs Must be covered in the long run. Costs ($) Activity level

  38. Full Cost and Pricing Decisions Full cost of manufacturing and selling a product. Variable costs Necessary to manufacture and sell the product. and Fixed costs Share of organization’s fixed costs. Ultimately full costs must be recovered.

  39. Short-run vs Long-run Variable costs Must always be covered. Short-run Pricing Decisions Fixed costs Must be covered in the long run. Long-run Pricing Decisions

  40. Short-run vs Long-run Pricing Decisions Year 0 1 Short-run Pricing Decision Long-run Pricing Decision Shorter than one year Longer than one year Pricing a one-time special order. Pricing a new product. How much material is required? Do I need a new plant?

  41. Option 1 Value of Option 1 Status Quo: Reject special offer Accept Special Order? Is Option 1 > Option 2? Alternative: Accept special offer Value of Option 2 Option 2 Short-run Pricing Decisions: Special Orders Special order An order that will not affect other sales and is usually a one-time occurrence.

  42. Comparison of Totals Reject Special Order Accept Special Order Difference $2,700 $200 Sales revenue $2,500 (1,100) (100) Variable costs (1,000) 1,600 100 Total contribution 1,500 (1,200) 0 Fixed costs (1,200) $400 $100 Operating profit $300 $200 Differential sales, 500 at 40¢ 100 Less differential costs, 500 at 20¢ $100 Differential operating profit (before taxes) Special Order Example Analysis of Special Order U-Develop Status Quo: Alternative: Alternative Presentation: Differential Analysis

  43. Long-run Pricing Decisions L.O. 5 Understand several approaches for establishing prices based on costs for long-run pricing decisions. In the long run an organization must cover variable and fixed costs. Life-cycle product costing and pricing Target costing for Target pricing

  44. Manufacturing Customer Take Back R&D Service (Disposal) Design Marketing & Distribution Cradle Grave To Life-cycle Product Costing and Pricing Product life-cycle The time from initial research and development to the time that support to the customer ends. Life-cycle Costing Concerned with covering costs in all categories of the life cycle.

  45. Desired profit Target cost Target Costing from Target Pricing Target price The price based on customers’ perceived value for the product and the price that competitors charge. What would a customer pay? How much profit do I need? The maximum amount of cost allowed. Can I make it at this cost?

  46. Differential Analysis for Production Decisions L.O. 6 Understand how to apply differential analysis to production decisions. Decision to make goods or services internally or purchase them externally. Make or buy? Decision to add or drop a product line or close a business unit. Add or drop a segment? Decision on what products or services to offer. Product Mix

  47. Per Unit 100,000 prints Direct materials $0.05 $5,000 Direct labor 0.12 12,000 Variable manufacturing overhead 0.03 3,000 Fixed manufacturing overhead 4,000 Common costs allocated to this product line 10,000 Make or Buy Example Make or buy? Decision to make goods or services internally or externally. 100,000 prints Cost directly traceable $34,000

  48. 20,000 higher 5,000 $25,000 a Direct materials Labor 12,000 0 12,000 lower Variable overhead 3,000 0 3,000 lower Fixed overhead 4,000 0 4,000 lower Common costs 10,000 b 10,000 b 0 Total costs $34,000 $35,000 $1,000 higher Make or Buy Continued Make or Buy Analysis, U-Develop Status Quo: Alternative: Process Prints Outsource Processing Difference 100,000 prints Direct costs Differential costs increase by $1,000, so reject alternative to buy. a 100,000 units purchased at $.25 = $25,000. b These common costs remain unchanged for these volumes. Because they do not change, they could be omitted from the analysis.

  49. 10,000 higher 2,500 c $12,500 d Direct materials Labor 6,000 0 6,000 lower Variable overhead 1,500 0 1,500 lower Fixed overhead 4,000 0 4,000 lower Common costs 10,000 b 10,000 b 0 Total costs $24,000 $22,500 $1,500 lower Make or Buy Continued Make or Buy Analysis, U-Develop Status Quo: Alternative: Process Prints Outsource Processing Difference 50,000 prints Direct costs Differential costs decrease by $1,500, so accept alternative to buy. b These common costs remain unchanged for these volumes. Because they do not change, they could be omitted from the analysis. c Total variable costs reduced by half because volume was reduced by half. d 50,000 units purchased at $.25 =$12,500.

  50. Total cost of 100,000 prints $35,000 $34,000 1,000 Higher a Opportunity cost of using facilities to make covers 2,000 0 2,000 Lower a Total costs, including opportunity costs $36,000 $35,000 1,000 Lower a Opportunity Costs of Making Make-or-Buy Analysis with Opportunity Cost of U-Develop Status Quo Alternative Process Prints Outsource Processing Difference Differential costs decrease by $1,000 so accept the alternative. a These indicate whether the alternative is higher or lower than the status quo.

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