Ch 18 Cost Behavior and Cost Volume Profit Analysis

Target profit formula

)Sales (units) = (Fixed Costs + Target Profit) / Unit Contribution Margin

What are two characteristics of Fixed Costs?

1. COST PER UNIT changes INVERSELY to changes in the Activity Base (as more produced, cost per unit drops) 2. TOTAL COST remains the SAME regardless of changes in Activity Base (the salary paid to a worker does not differ with production level)

What are two characteristics of Variable Costs?

1. COST PER UNIT remains the SAME regardless of changes in the Activity Base 2. TOTAL COST CHARGES in proportion to CHANGES in the activity base

What are the three ways margin of safety can be expressed?

1. Dollars of sales 2. Units of sales 3. Percent of current sales

Understanding the behavior of cost depends on what two factors?

1. Identifying activities that cause change in cost (activity bases) 2. Specifying the range of activity over which the changes in the cost are of interest (relevant range)

Exercise Nicolas entertainment sells a product for $60 per unit. The variable cot is $35 per unit, while fixed costs are 80,000. Determine (a) the break-even sales units and (b) break even point if the selling price was $67.

A. Break even sales = Fixed costs / unit contribution margin Break even sales = fixed costs / (selling price - variable cost) break even sales = 80,000 / (60-35) = 3200 units B. Break even sales = fixed costs / unit contribution margin Break even sales = 80,000 / (67-35) = 2500 units

Exercise Molly company sells 20,000 units at $12 per unit. Variable costs are $9 per unit and fixed costs are $25,000. Determine the (a) contribution margin ratio, (b) unit contribution margin and (c) income from operations

A. Contribution Margin Ratio = Contribution Margin / Sales Contribution Margin Ratio = ($12- $9) / $12 =25% or Contribution Margin Ratio = (240,000-180,000) / 240,000 = 25% B. Unit Contribution Margin = Selling Price - Variable Cost Unit Contribution Margin = $12 - $9 = $3 C. Income from Operations Sales----------------------------------------240,000 (20,000 unit x $12) Less Variable Cost----------------------180,000 (20,000 unit x $9) Contribution Margin---------------------60,000 (240,000 - 180,000) Less Fixed Costs-------------------------25,000 (given) Income from Operations----------------35,000

Example: Sales -------------------------------- $ 250,000 Sales at break even point -------$ 200,000 Unit selling price -------------------$ 25 A. What is the margin of safety in dollars? B. What is the margin of safety in units? C. What is the margin of safety in percent of current sales?

A. Margin of safety in dollars = Sales dollars - sales at break even point Margin of safety in dollars = 250,000 - 200,000 = $50,000 B. Margin of safety in units = (sales dollars - sales at break even point) / unit selling price Margin of safety in units = (250,000 - 200,000) / 25 = 2,000 units C. Margin of safety in percent =(sales - sales at break even point) / sales Margin of safety in percent = (250,000 - 200,000) / 250,000 = 20% Therefore sales may decline by $50,000, 2,000 units or by 20% before an operating loss occurs.

Example Exercise The manufacturing costs of Alex Industries for the first three months are as follows: Month--------------Total Cost-------------Production January-------------$80,000---------------1,000 units Feb-------------------125,000---------------2,500 units Mar-------------------100,000--------------1,800 units Using the high-low method determine (a) the variable cost per unit and (b) the fixed cost

A. The variable cost per unit = Difference in the Total Cost / Difference in Production VCPU = (125,000- 80,000) / (2500-1000) = $30 B. The fixed cost = Total cost for the high/low period - (variable cost per unit x units produced in high/low period) TFO = 80,000 - ($30 x 1,000) = $50,000 or TFO = 125,000 - ($30 x 2500) = 50,000

Describe the behavior of (a) total fixed costs and (b) unit fixed costs as the level of activity increases

A. Total fixed costs remain the same B. Unit fixed costs decrease as activity level increases

If fixed costs increase what would be the impact on (a) the contribution margin and (b) income from operations?

A. no impact on contribution margin (contribution margin is only affected by Fixed and Variable costs) B. Income from operations would decrease

How would the following costs be classified if units produced is the activity base? a. Salary of factory supervisor b. Straight line depreciation of plant c. Property rent per month on plant

All are Fixed Costs

How would each of the following costs be classified if units produced is the activity base? a. direct materials cost b. direct labor cost c. electric costs of .35 per hour

All are Variable Costs since units produced is the activity base

If insurance rates are increased, what change will this have on the break even point?

An increase in fixed costs increases the break even point.

Break even Sales (SALES UNITS ) formula

Break Even Sales (units) = Fixed Cost/ Unit Contribution Margin Recall: Unit Contribution Margin = Unit Selling Price - Unit Variable Cost

Break even Sales (SALES DOLLARS)

Break even Sales (DOLLARS) = fixed costs / Unit contribution Ratio -or- Break even Sales (dollars) = fixed costs / (unit contribution margin/unit selling price)

Example Baker Corporation has fixed costs of $90,000. Unit selling price is $25 and unit variable cost is $15. What is the break even point (units)? Report it on an income from operations statement

Break even Sales (UNITS) = $90,000 fixed cost / ($25 unit selling price - $15 unit variable cost) Break even Sales (units) = 90,000 / (25-15) = 9,000 units Sales (9,000 x $25)----------------------------------- $ 225,000 Less Variable Cost (9,000 x 15) -------------------$ 135,000 Contribution Margin (225,000- 135,000) --------$ 90,000 Less Fixed Cost (given)------------------------------$ 90,000 Income from Operations ----------------------------$ 0

Example Baker Corporation has fixed costs of $90,000. Unit selling price is $25 and unit variable cost is $15. What is the break even point (dollars)?

Break even Sales (dollars) = fixed costs / unit contribution ratio Unit contribution ratio= unit contribution margin / selling price Unit contribution margin = selling price - variable cost Break even Sales (dollars) = 90,000 / ((25-15) /25) =90,000 / 40% = $225,000

Example Forest Company sells a product for $140 per unit. The variable cot is $60 per unit, and fixed costs are $240,000. Determine the (a) break even point in sales units and (b) break even point in sales units if the company desires a target profit of 50,000.

Break even point (sales units) = Fixed costs / Unit contribution margin Break even point = (240,000) / (140-60) = 3000 units Break even point with target profit = (fixed costs + target profit) / unit contribution margin break even point = (240,000 + 50,000) / (140 - 60) = 3625 units

Example Bishop co. is evaluating a budget proposal to increase advertising expenses by $100,000 (adjusts fixed cost) Unit Selling Prices will remain at $90 Unit Variable cost will remain at $70 Fixed Costs will increase from $600,000 to 700,000 What is the old and the proposed break even point?

Break even point = Fixed Costs / Unit contribution Margin Break even point = 600,000 / (90-70) = 600,000 / 20 =30,000 units Break even point = Fixed costs/ unit contribution margin Break even point = 700,000 / (90-70) = 700,000 /20 = 35,000 units

Example Park Co is evaluating a proposal to pay an addition 2% commission to sales people as an incentive to increase sales Unit selling price will remain at $250 Unit variable cost will increase from $145 to 150 Fixed costs will remain at $840,000 What is the old and proposed break even point?

Break even point = Fixed costs / unit contribution margin Break even point = 840,000 / (250-145) = 840,000 / 105 = 8000 units Break even point = fixed costs / unit contribution margin Break even point = 840,000 / (250 - 150) = 840,000 /100 = 8400 units

Example Graham co. is considering a proposal to increase their selling price by $10 Unit selling price will increase from $50 to 60 Unit variable cost will remain $30 Fixed costs will remain $600,000 What is the old and proposed break even point?

Break even point = Fixed costs/ unit contribution margin Break even point = 600,000 / (50-30) = 600,000 / 20 =30,000 units Break even point = fixed costs / unit contribution margin Break even point = 600,000 / (60-30) =600,000 /30 = 20,000 units

Example Lambert inc. adds $80,000 in sales and has a 40% contribution margin ratio. How much is their change in operations?

Change in Income from Operations = Change in Sales DOLLARS x Contribution Margin Ratio CIO = $80,000 x 40% = $32,000

How is change in income from operations calculated with Unit contribution Margin?

Change in Income from Operations = Change in Sales Units x Unit Contribution Margin

Exercise Lambert Inc sales could be increased by 15,000 units how much would their income from operations increase if their selling price is $20 per unit and variable cost per unit is $12?

Change in Income from Operations = Change in sales unit (quantity) x Unit Contribution Margin CIO= 15,000 new units sold x ($20 - $12) CIO= 15,000 x $8 = $120,000

what are three things that change the break even point?

Changes in Variable costs changes in Fixed costs changes in Selling Cost per unit

Contribution Margin formula

Contribution Margin = Sales - Variable Costs

Contribution Margin Ratio formula

Contribution Margin Ratio = Contribution Margin / Sales Useful in changes with sales dollars

Fixed Cost (def)

Costs that remain the same in total dollar amount regardless of the activity base

Variable Cost (def)

Costs that vary in proportion according to changes in the activity base Example: For a manufacturing production company, when the activity base is units produced- the variable costs would be the direct materials and direct labor costs because it is dependent on the amount of production on how much is needed.

If the unit cost of direct materials is decreased, what affect will this have on the break even point?

Decrease in variable cost decreases break even point

In applying the high-low method of cost estimation, how is the total fixed cost estimated?

Fixed Cost = TC - (VCPU x Q)

Fixed Cost Formula

Fixed Cost= Total Costs for High or Low period - (Variable Cost per Unit x Units Produced in High or Low period)

How do changes in fixed costs adjust the break even point?

Increase in Fixed Costs ----- Increase Break Even Point Decrease in Fixed Costs----- Decrease Break Even Point

How do changes in Variable costs adjust the break even point?

Increase in Fixed Costs -----Increase in Break even point Decrease in Fixed Costs ----- Decrease in break even point

How do changes in the unit selling price adjust the break even point?

Increases in the unit selling price --------Decreases break even point Decreases in the unit selling price ------- Increase break even point *due to change in the contribution margin

Margin of safety (def)

Indicates a possible decrease in sales that may occur before an operating loss results

Example Fixed Costs $200,000 Target Profit $100,000 Unit Selling Price $75 Unit Variable cost $45 Unit Contribution Margin $30 What would be the necessary units to achieve the target profit? How would the income statement look?

Less Variable Cost (45 x 10,000 units) -------------450,000 Contribution Margin (30 x 10,000 units) -------------300,000 Less Fixed Costs (given) -------------------------------- 200,000 Income from Operations -------------------------------- 100,000

Example The Rachel Company has sales of $400,000 and the break even point in sales dollars is $300,000. Determine the company's margin of safety in sales dollars and percent of sales.

Margin of safety in sales dollars = Sales - Break even point Margin of safety in sales dollars = 400,000 -300,000 = 100,000 Margin of safety in percent of sales = (sales - break even point) / sales Margin of safety in percent of sales = (400,000 - 300,000) / 400,000 = 25% Therefore sales may decline by 25% or $100,000 before an operating loss occurs.

In cost analysis how are mixed costs treated?

Mixed costs are separated into their fixed and variable cost components.

What is the order of the income statement? (SLVCCMLFCIO)

Sales Less variable costs = Contribution Margin (Can also be divided by sales for ratio) Less Fixed Cost =Income from Operations

Unit Contribution Margin (def)

Sales Price per unit less variable cost per unit useful in analyzing profit potential of proposed decisions in changes of unit sales (quantities)

Contribution Margin (def)

Sales less variable costs and variable selling and administration expenses (Provides insight into the profit potential of a company

High-Low method

Technique that uses the highest and lowest total costs as a basis for estimating the variable cost per unit and the fixed cost component of a mixed cost

Variable Costing (def)

The concept that considers the cost of products manufactured to be composed only of those manufacturing costs that increase or decrease as the volume of production rises or falls (direct materials, direct labor and variable factory overhead) AKA Direct Costing

Break Even Point

The level of operations at which a company's revenues match expenses. There is neither a profit or loss at the break even point.

Cost behavior (def)

The manner in which a cost changes in relation to its activity base

Cost-Volume Profit analysis (def)

The systematic examination of the relationships among the selling prices, volume of sales and production, costs, expenses and profits

Why is the High-Low method used?

The total fixed cost does not change with production changes. Thus the difference in the High cost and the Low cost is the change in the total variable costs. Dividing this difference in total cost by the difference in total production gives the Variable Cost per unit

Total Cost Formula estimate for different level of production

Total Cost = (Variable Cost per Unit x Units Produced) + Fixed Costs

Describe how total variable costs and unit variable costs behave with changes in the level of activity

Total Variable Cost vary with changes in activity when unit variable cost remain the same

True or False Variable costs as a percentage of sales are equal to 100% minus the contribution margin ratio

True. Example : If the contribution margin is 40%, the variable cost would be 60%

Unit Contribution Margin formula

Unit contribution formula = Sales per unit - Variable cost per unit

What is the use of a cost-volume profit analysis

Used for managerial decision making to analyze the effects of changes in selling prices on profits, changes in costs on profits, changes in volume on profits, setting of selling price, selecting the product mix and choosing marketing strategy

Variable Cost Per Unit Formula

Variable Cost per Unit = Difference in Total Cost / Difference in Production

Summarize the cost behavior concepts of fixed and variable costs

Variable costs increase/ decrease with changes in activity levels but the per unit amount remains the same regardless of those changes Fixed costs remain the same with changes in activity levels but the per unit amount increase/decrease with those changes

What are the three types of costs?

Variable, Fixed and Mixed Costs

Mixed Cost (def)

costs that have characteristics of a variable and a fixed cost AKA semi-variable or semi-fixed costs

Contribution Margin Ratio (def)

expression of Contribution Margin as percentage Indicates the percentage of each sales dollar available to cover fixed costs and provide income from operations Most useful when using a change in income from operations due to increased sales dollars

Target Profit (def)

the targeted profit determined by modifying the break even sales equation the sales required can be determined.