Chapter 6

Relevant costs and revenues

1. Differ across alternatives 2. Are future costs Relevant costs are often called differential costs, incremental costs, avoidable costs. Costs that will not change regardless of the alternative selected are irrelevant and should be ignored.

High-Low Method

1. Find the high point of activity level and the low point of activity level for a given set of data 2. Using the high and low points, calculate the variable cost per unit of activity Variable rate = (Change in cost between high and low point/change in output between high and low point) Total variable costs can be calculated for different activity levels Total variable costs = variable rate * output 3. Calculate the fixed costs using total cost at either the high point or the low point Fixed costs = total mixed cost at high point - (variable rate * high point) Fixed costs = total mixed cost at low point - (variable rate * low point) 4. Create the cost formula using the variable rate from Step 2 and fixed costs from step 3: Total cost = (variable rate *output) + total fixed cost

Separating Mixed in Variable and Fixed Cost

1. High-low Method 2. The scatter graph method 3. The method of least squares (regression)

Steps in Managerial Decision Making

1. Identify the decision problem. 2. Determine the decision alternatives. 3. Evaluate the costs and benefits of the alternatives. 4. Make the decision. 5. Review the results of the decision making process.

Special Orders

Are outside the scope of normal sales. If the incremental revenue exceeds the incremental costs of filling the special order, it will increase short-term profitability. If the special order does not exceed the operating capacity. When calculate only include the variable costs not the fixed costs. If the company is already at capacity the company would then need to eliminate a current sale to accept the special order. Therefore, you need to replace the REVENUE of the sale that is being displaced - otherwise your profitability will decrease ****Opportunity cost is the lost regular CM Consider qualitative factors: excess capacity, original customer finds out

BE Points in Units - Weighted Average CM

CM per unit is based on the weighted average of all products CM ratio is also based on the weighted average of all products Everything must be done in Total first - and then split by product line (Contribution margin unit of A * Sales % mix for A) +(Contribution margin unit of B * Sales % mix for B) _____________________________________________________ Break-even total = fixed costs/WACM # of units of A = BE units * sales % mix for A # of units of B = BE units * sales % mix for B

Product Mix

Constrained resource is a resource that is unable to meet the need placed on it. It could be anything that is needed to operating the business such as cash, employees, machines, or facilities. When any of the constrained resources are not enough to meet the demand, managers must decide what products and customers should be given priority. In the long run, managers can manage constrained resources by eliminating non-value added activities. In the short run managers can maximize profit by prioritizing products or customers based on the amount of contribution margin generated by the most constrained resource, called the bottleneck

Opportunity Costs

Costs that are forgone (lost) benefits of choosing one alternative over another. Opportunity costs occur when resources are limited or when capacity constraints are reached and should be incorporated into the incremental analysis

Cost Behavior

Describes how a cost behaves or changes as the amount of output (activity) changes

Fixed Costs

Fixed manufacturing Fixed selling and administrative In total, are constant within the relevant range as activity output changes factory rent changes as activity level changes

Keep Versus Drop

Focus on that segment margin, the amount of profit being generated by the segment after variable costs and direct fixed costs have been deducted. Common fixed costs would be incurred even if the segment is eliminated and are not relevant to the decision Also consider how elimination would affect other segments or product lines and whether alternative uses for the resources currently devoted to the business segment exist.

Mixed Costs

Have both fixed and a variable component ease payment of $1000 per month plus $10 per machine hour used Total mixed cost = fixed + Variable cost

Relevant Range

Is the range over which the cost relationships are expected to be valid for the normal operations of the firm

Margin of Safety

Measures the potential effect of a change in sales on profits: Margin of Safety = Planned sales - BE sales

Assumption of Multiple Product CVP

Sales Mix remains the sam

Operating leverage

The potential effect of he risk that sales will fall short of planned levels, as influenced by the relative proportion of fixed to variable manufacturing costs, can be measured by operating leverage, which is the ratio of the contribution margin to profit Operating Leverage = Contribution margin/profit A higher value for operating leverage indications a higher risk in the sense that a given change in sales will have a relatively greater impact on profits. When sales volume is strong a high level of operating leverage is desirable, but when sales begin to fall, a lower level of operating leverage is preferable

Contribution Margin Ratio

The proportion of each sales dollar that must be used to cover fixed costs and provide for profit. CMR = Total CM/Total Revenue CMR = Contribution margin per unit/selling price per unit CMR = 1 - Variable cost ratio

Make versus buy (outsource)

The relevant costs of making a product or providing a service internally include all the variable costs plus any incremental fixed costs The opportunity costs of making something internally include alternative uses for the internal resources Many qualitative considerations including quality, reliability, and environmental concerns are also important in make-or-buy decisions

The break even point

This is where total revenue equals total cost, the point of zero profit OI=Sales-Total VE - Total FE OI=(Price*Units Sold)-(Variable Cost Per Unit*Units Sold) - Total FE Total Revenue - Total Variable Cost - Total Fixed Cost = 0 Total Revenue = Total Variable cost + Total fixed cost Units BE = (Fixed Cost/CM per unit) BE = (Fixed Cost/Selling price per unit - variable cost per unit) Selling unit (x) = variable cost (x) + fixed cost BE Sales = selling price per unit * unit sales at break-even BE Sales = (Fixed Cost/Contribution Margin Ratio)

Irrelevant Costs and Revenues

Those that will not impact a particular decision or differ between alternatives. Two types of costs do not change depending on the alternative selected and should therefore be ignored. 1. Sunk costs - costs that have already been incurred and are not relevant to future decisions 2. Costs that are the same regardless of the alternative the manager chooses

Desired Profit Formula

Total Revenue = Total Variable Cost + Total FC + Desired Profit

Variable Costs

Variable Manufacturing Variable Selling and administrative In total, vary in direct proportion to changes in activity output direct materials direct labor remains constant per unit of activity Total Variable Cost = cost per unit * units of activity

Sell or Process Further

Whether to sell a product as is or continue to refine it so that it can be sold for a higher price We can analyze the decision by comparing the incremental costs and benefits of this decision. A product should be processed further if the incremental benefits are greater than the incremental costs of processing further

Cost formula

Y = vx + f Y = total cost v = variable cost per unit or the slope of the line on the graph x = volume or number of units f = fixed costs or the intercept on a graph of the line A major goal of cost behavior analysis is to develop cost functions so costs can be estimated at various levels of activity.

Margin of Safety Ratio

a percentage of sales. Is useful measure for comparing the risk of two alternative products or for assessing the risk in any given product. The product with a relatively low margin of safety ratio is the riskier of the two products and therefore usually requires more of management's attention. Margin of Safety Ratio = Margin of safety/planned sales

Contribution margin income statement

classifies costs by behavior through variable and fixed costs Sales -VE ___________________ Contribution Margin -FE ____________________ Income before taxes

Contribution Margin

equals sales less all variable expenses. It is the amount left after variable expenses are covered, the amount that contributes to covering fixed expenses and operating income.

Variable Cost Ratio

is the proportion of each sales dollars that must be used to cover variable costs VCR = Variable Costs/Sales Revenue