Chapter 23 Cost Behavior Analysis Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University
Learning Objectives 1. Define cost behavior and explain how managers use this concept in the management cycle. 2. Identify variable, fixed, and mixed costs, and separate mixed costs into their variable and fixed components. 3. Define cost-volume-profit (C-V-P) analysis and discuss how managers use it as a tool for planning and control. Copyright © Houghton Mifflin Company. All rights reserved. 23– 2
Learning Objectives (cont’d) 4. Define breakeven point and use contribution margin to determine a company’s breakeven point for multiple products. 5. Use C-V-P analysis to project profitability of products and services. Copyright © Houghton Mifflin Company. All rights reserved. 23– 3
Cost Behavior and the Management Cycle • Objective 1 – Define cost behavior and explain how managers use this concept in the management cycle Copyright © Houghton Mifflin Company. All rights reserved. 23– 4
Cost Behavior and the Management Cycle • Cost behavior – The way costs respond to changes in volume or activity – Is a factor in almost every decision managers make – Used to analyze alternative courses of action • Select the course that will – Generate income for owners – Maintain liquidity for creditors Copyright © Houghton Mifflin Company. All rights reserved. 23– 5
The Use of Cost Behavior in the Management Cycle 23– 6
Planning • Managers use cost behavior to determine – Number of units or services that must be sold to generate targeted amount of profit – How changes in planned operating, investing, and financing activities will affect operating income Copyright © Houghton Mifflin Company. All rights reserved. 23– 7
Planning (cont’d) • Manufacturing companies – Decide how to adjust output to meet changing sales demand • Service Organizations – Determine the optimal mix of services offered – Decide whether to charge by the service provided or a flat monthly fee Copyright © Houghton Mifflin Company. All rights reserved. 23– 8
Executing • Managers determine how decisions about current operating, investing, and financing activities affect operating income – Must understand anticipate cost behavior • Manufacturing companies – Understand the changes that will result in income from a decision to buy new, more productive manufacturing equipment Copyright © Houghton Mifflin Company. All rights reserved. 23– 9
Reviewing and Reporting • Variable costing income statements – Used to analyze how changes in cost and sales affect the profitability of • Product lines • Sales territories • Customers • Departments • Other segments Copyright © Houghton Mifflin Company. All rights reserved. 23– 10
Reviewing and Reporting (cont’d) • Other reports based on cost behavior – Used to decide whether to • Eliminate a product line • Accept a special order • Outsource services Copyright © Houghton Mifflin Company. All rights reserved. 23– 11
Discussion Q. What is cost behavior? A. Cost behavior is the way costs respond to changes in volume or activity Copyright © Houghton Mifflin Company. All rights reserved. 23– 12
The Behavior of Costs • Objective 2 – Identify variable, fixed, and mixed costs, and separate mixed costs into their variable and fixed components Copyright © Houghton Mifflin Company. All rights reserved. 23– 13
The Behavior of Costs • Cost behavior can be observed – As it relates to products and services – In selling, administrative, and general activities • If managers can predict how costs will behave, then costs become manageable Copyright © Houghton Mifflin Company. All rights reserved. 23– 14
The Behavior of Costs (cont’d) • Variable costs – Vary with volume or operating activity • Fixed costs – Remain fixed as volume changes • Mixed costs – Exhibit characteristics of both variable and fixed costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 15
Variable Costs … are total costs that change in direct proportion to changes in productive output or any other measure of volume Copyright © Houghton Mifflin Company. All rights reserved. 23– 16
Variable Costs (cont’d) Variable cost Total cost of tires is a variable cost because it changes in direct proportion to the number of vehicles produced On a per unit basis, a variable cost remains constant Copyright © Houghton Mifflin Company. All rights reserved. 23– 17
Variable Costs (cont’d) Variable cost Total cost of tires is a variable cost because it changes in direct proportion to the number of vehicles produced On a per unit basis, a variable cost remains constant The cost of tires may vary depending on the number purchased if discounts apply for large purchases Copyright © Houghton Mifflin Company. All rights reserved. 23– 18
Examples of Variable, Fixed, and Mixed Costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 19
Operating Capacity … is the upper limit of an organization’s productive output capacity, given its existing resources • Any increase in volume or activity over operating capacity requires additional expenditures for buildings, machinery, personnel, and operations Copyright © Houghton Mifflin Company. All rights reserved. 23– 20
Operating Capacity (cont’d) • Can be expressed in several ways, including – Total labor hours – Total machine hours – Total units of output For purposes of the following discussion, assume that operating capacity is constant and that all activities occur within the limits of current operating capacity Copyright © Houghton Mifflin Company. All rights reserved. 23– 21
Operating Capacity (cont’d) • Three common measures (or types) of operating capacity – Theoretical capacity • Also called ideal capacity – Practical capacity – Normal capacity Copyright © Houghton Mifflin Company. All rights reserved. 23– 22
Theoretical (Ideal) Capacity … is the maximum production output for a given period in which all machinery and equipment are operating at optimum speed, without interruption • No company ever actually operates at such an ideal level • Long-term goal in a JIT operating environment – Approach theoretical capacity through continuous improvement Copyright © Houghton Mifflin Company. All rights reserved. 23– 23
Practical Capacity … is theoretical capacity reduced by normal and expected work stoppages • Work stoppages – Machine breakdowns – Downtime for retooling, repairs, and maintenance – Employees’ breaks • Not realistic when planning operations Copyright © Houghton Mifflin Company. All rights reserved. 23– 24
Normal Capacity … is the average annual level of operating capacity needed to meet expected sales demand • Used to plan operations • Is a realistic measure of what an organization is likely to produce, not what it can produce Copyright © Houghton Mifflin Company. All rights reserved. 23– 25
Normal Capacity (cont’d) • Relate variable costs to an appropriate measure of normal capacity – Operating costs can be related to • Machine hours used • Total units produced – Sales commissions can be related to • Total sales dollars Copyright © Houghton Mifflin Company. All rights reserved. 23– 26
Normal Capacity (cont’d) • Two reasons to select basis for measuring the activity of variable cost carefully 1. An appropriate activity base simplifies cost planning and control 2. Many variable costs must be combined (aggregated) with the same activity base 1. So that costs can be analyzed in a reasonable way 2. Provides information for predicting future costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 27
Normal Capacity (cont’d) • General guide for selecting an activity base – Relate costs to their most logical or causal factor • Example – Machinery setup costs should be considered variable in relation to the number of setups needed for a particular job • Allows machinery setup costs to be budgeted and controlled more effectively Copyright © Houghton Mifflin Company. All rights reserved. 23– 28
Labor Cost Linear Relationships and the Relevant Range Units • Each unit of output requires $2. 50 of labor cost • Total labor costs grow in direct proportion to the increase in units of output Copyright © Houghton Mifflin Company. All rights reserved. 23– 29
Other Variable Cost Behavior Patterns: Nonlinear Relationships • Graph A – Behavior of power costs as usage increases and unit cost of power consumption falls • Graph B – Behavior of rental costs when each additional hour of computer usage costs more than the previous hour • Graph C – Shows how labor costs vary as efficiency increases or decreases Copyright © Houghton Mifflin Company. All rights reserved. 23– 30
Linear Relationships and the Relevant Range (cont’d) • All costs must be included in an analysis if the results are to be useful – Variable costs with linear relationships • Easy to analyze – Variable costs with nonlinear relationships • More difficult to analyze • Linear approximation – Method to convert nonlinear variable costs into linear variable costs – Relies on the concept of relevant range Copyright © Houghton Mifflin Company. All rights reserved. 23– 31
Linear Relationships and the Relevant Range (cont’d) • Relevant Range – The span of activity in which a company expects to operate – Within that range, it is assumed that both total fixed costs and per unit variable costs are constant – Under that assumption, many nonlinear costs can be estimated using the linear approximation approach • These costs can be treated as part of the other variable costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 32
The Relevant Range and Linear Approximation Copyright © Houghton Mifflin Company. All rights reserved. 23– 33
Linear Relationships and the Relevant Range • Linear approximation – Is not a precise measure – Allows the inclusion of nonlinear variable costs in cost behavior analysis – Loss of accuracy is not significant – Helps accomplish the goal of estimating costs and preparing budgets Copyright © Houghton Mifflin Company. All rights reserved. 23– 34
Fixed Costs … are total costs that remain constant within a relevant range of volume or activity • This is the range in which actual operations are likely to occur Fixed costs behave differently from variable costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 35
Fixed Costs (cont’d) • According to economic theory – All costs tend to be variable in the long run • A cost is only fixed within a limited period – A one-year period is usually considered for management purposes – Fixed costs are expected to remain constant within that period Copyright © Houghton Mifflin Company. All rights reserved. 23– 36
Fixed Costs (cont’d) The Manufacturer of aluminum cans needs one supervisor for an 8 -hour work shift. Production can range from zero to 500, 000 units per month per shift. The supervisor’s salary is $4, 000 per month • The relevant range is from zero to 500, 000 units – Any output above 500, 000 units would require another work shift and another supervisor If another shift is added, the new fixed cost remains constant in total within the new relevant range Copyright © Houghton Mifflin Company. All rights reserved. 23– 37
Fixed Costs (cont’d) • Fixed unit costs vary inversely with activity or volume – On a per unit basis, fixed costs go down as volume goes up At 600, 000 units, the activity is above the relevant range, which means another shift must be added another supervisor hired Copyright © Houghton Mifflin Company. All rights reserved. 23– 38
A Common Fixed Cost Behavior Pattern Copyright © Houghton Mifflin Company. All rights reserved. 23– 39
Mixed Costs … have both variable and fixed components • Part of a mixed cost changes with volume or usage • Part is fixed over a particular period Copyright © Houghton Mifflin Company. All rights reserved. 23– 40
Behavior Patterns of Mixed Costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 41
Mixed Costs • For planning and control purposes, mixed costs must be divided into their variable and fixed components – These components can then be grouped with other variable and fixed costs for analysis Copyright © Houghton Mifflin Company. All rights reserved. 23– 42
Mixed Costs (cont’d) • Four methods used to separate mixed costs into variable and fixed components 1. Engineering method 2. Scatter diagram method 3. High-low method 4. Statistical method Multiple approaches are often used because the results yielded by these methods are likely to differ Copyright © Houghton Mifflin Company. All rights reserved. 23– 43
The Engineering Method …of separating costs measures the work required by performing step-by-step analysis of tasks, costs, and processes involved • Is generally used to estimate the cost of activities and new products Copyright © Houghton Mifflin Company. All rights reserved. 23– 44
The Engineering Method • Example – U. S. Postal service • Conducts studies of how many letters a postal worker should be able to deliver on a particular mail route within a certain period – This type of analysis sometimes called a time and motion study • Is expensive – Very detailed – Requires the expertise of engineers to determine the cost of a new product or activity for which no prior data exists Copyright © Houghton Mifflin Company. All rights reserved. 23– 45
The Scatter Diagram Method … plots past costs and measures of volume scatter diagram Copyright © Houghton Mifflin Company. All rights reserved. related in a 23– 46
The Scatter Diagram Method (cont’d) • Scatter diagram – A chart of plotted points that helps determine whether a linear relationship exists between a cost item and its related activity measure – Is a form of linear approximation – If a linear relationship can be suggested, a cost line can be imposed on the data by • Visual means • Statistical analysis Copyright © Houghton Mifflin Company. All rights reserved. 23– 47
The Scatter Diagram Method (cont’d) • Piedmont Corporation’s Park Division incurred the following machine hours and electricity costs last year Copyright © Houghton Mifflin Company. All rights reserved. 23– 48
Scatter Diagram of Machine Hours and Electricity Costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 49
The Scatter Diagram Method (cont’d) • The diagram suggest a linear relationship between machine hours and electricity costs – A line is added to the diagram to represent the linear relationship • Estimated fixed electricity cost – Occurs at the point where the line intersects the vertical axis • Variable cost per unit – Can be estimated by determining the slope of the line Copyright © Houghton Mifflin Company. All rights reserved. 23– 50
The High-Low Method … identifies a linear relationship between activity level and cost by analyzing the highest and lowest volumes in an accounting period and their related costs • Is a common, simple method – Somewhat crude Copyright © Houghton Mifflin Company. All rights reserved. 23– 51
The High-Low Method (cont’d) • Three steps 1. Calculate the variable cost per activity base 2. Calculate the total fixed costs 3. Calculate the formula to estimate the total costs within the relevant range Copyright © Houghton Mifflin Company. All rights reserved. 23– 52
The High-Low Method (cont’d) • Step 1 – Calculate the variable cost per activity base • Select the periods of highest and lowest activity within the accounting period • Find the difference between the highest and lowest amounts for both machine hours and their related electricity costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 53
The High-Low Method (cont’d) Copyright © Houghton Mifflin Company. All rights reserved. 23– 54
The High-Low Method (cont’d) • Variable cost per machine hour – Difference in cost divided by difference in machine hours The variable cost per machine hour will be used to calculate total fixed costs in Step 2 and total cost per month in Step 3 Copyright © Houghton Mifflin Company. All rights reserved. 23– 55
The High-Low Method (cont’d) • Step 2 – Calculate the total fixed costs – Select the information from the month with either the highest or lowest volume Copyright © Houghton Mifflin Company. All rights reserved. 23– 56
The High-Low Method (cont’d) • December – – Total Costs = $24, 700 Total Variable Costs = 6, 450 MH x $2. 75 per MH • August – – You can check your answer by recalculating total fixed costs using the month with the lowest activity Total Costs = $23, 600 Total Variable Costs = 6, 050 MH x $2. 75 per MH The total fixed costs in Step 2 will be used to calculate total cost per month in Step 3 Copyright © Houghton Mifflin Company. All rights reserved. 23– 57
The High-Low Method (cont’d) • Step 3 – Calculate the formula to estimate the total costs within the relevant range From Step 2 Copyright © Houghton Mifflin Company. All rights reserved. From Step 1 23– 58
The High-Low Method (cont’d) • The cost formula will work only within the relevant range – In this case, for amounts between 6, 050 and 6, 450 machine hours • To estimate electricity costs for amounts outside of this range, a new formula must be calculated Copyright © Houghton Mifflin Company. All rights reserved. 23– 59
Statistical Methods • Regression analysis – Mathematically describes the relationship between costs and activities – All data observations are used • Resulting linear equation is more representative of cost behavior than either the high-low or scatter diagram methods Copyright © Houghton Mifflin Company. All rights reserved. 23– 60
Statistical Methods (cont’d) • Simple regression analysis – Overhead costs are predicted using one activity • Machine hours to predict electricity costs • Multiple regression analysis – Overhead costs are predicted using more than one activity • Machine hours and labor hours to predict electricity costs – Both activities affect overhead Copyright © Houghton Mifflin Company. All rights reserved. 23– 61
Discussion Q. What are three steps in the high-low method of determining the fixed and variable components of mixed costs? A. Step 1 – Calculate the variable cost per activity base Step 2 – Calculate total fixed costs Step 3 – Calculate the formula to estimate total costs within the relevant range Copyright © Houghton Mifflin Company. All rights reserved. 23– 62
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 Copyright © Houghton Mifflin Company. All rights reserved. 23– 63
Cost-Volume-Profit Analysis … is an examination of the cost behavior patterns that underlie the relationships among cost, volume of output, and profit Copyright © Houghton Mifflin Company. All rights reserved. 23– 64
Cost-Volume-Profit Analysis (cont’d) • Usually applies to a single product, product line, or division of a company – Therefore, the term profit is used • Only part of an entire company’s operating income • In cases involving the income statement of an entire company – The term operating income is more appropriate • In the context of C-V-P analysis, both mean the same thing Copyright © Houghton Mifflin Company. All rights reserved. 23– 65
Cost-Volume-Profit Analysis (cont’d) • C-V-P is a tool for – Short-range planning • Calculate net income when sales volume is known • Decide the level of sales needed to reach a targeted amount of income • Budgeting – Control • Compare actual costs with expected costs • Measure the effects of alternate courses of action – Changing variable or fixed costs – Expanding or contracting sales volume – Increasing or decreasing selling prices Copyright © Houghton Mifflin Company. All rights reserved. 23– 66
Cost-Volume-Profit Analysis (cont’d) • Useful only under certain conditions and when certain assumptions hold true 1. The behavior of variable and fixed costs can be measured accurately 2. Costs and revenues have a close linear approximation 3. Efficiency and productivity hold steady within the relevant range of activity Copyright © Houghton Mifflin Company. All rights reserved. 23– 67
Cost-Volume-Profit Analysis (cont’d) 4. Cost and price variable also do not change during the period being planned 5. The sales mix does not change during the period being planned 6. Production and sales volume are roughly equal If one or more of these conditions and assumptions are absent, the C-V-P analysis may be misleading Copyright © Houghton Mifflin Company. All rights reserved. 23– 68
Discussion Q. What are some ways that managers use C-V-P analysis as a tool for planning? A. Managers can use C-V-P to calculate net income when sales volume is known, decide the level of sales needed to reached a targeted amount of net income, and for budgeting purposes Copyright © Houghton Mifflin Company. All rights reserved. 23– 69
Breakeven Analysis • Objective 4 – Define breakeven point and use contribution margin to determine a company’s breakeven point for multiple products Copyright © Houghton Mifflin Company. All rights reserved. 23– 70
Breakeven Analysis … uses the basic elements of costvolume-profit analysis to determine the breakeven point • Breakeven point – The point at which • Total revenues equal total costs • The company begins to earn a profit Copyright © Houghton Mifflin Company. All rights reserved. 23– 71
Breakeven Analysis (cont’d) • Margin of safety – The number of sales units or amount of sales dollars by which actual sales can fall below planned sales without resulting in a loss Copyright © Houghton Mifflin Company. All rights reserved. 23– 72
Breakeven Analysis (cont’d) • General equation for finding the breakeven point Copyright © Houghton Mifflin Company. All rights reserved. 23– 73
Breakeven Analysis (cont’d) Valley Metal Products, Inc. makes ornamental iron plant stands. Variable costs are $50 per unit, and fixed costs average $20, 000 per year. Each plant stand sells for $90 Compute the breakeven point for plant stands in sales units, where x equals sales units Compute the breakeven point in sales dollars Copyright © Houghton Mifflin Company. All rights reserved. 23– 74
Breakeven Analysis (cont’d) Valley Metal Products, Inc. makes ornamental iron plant stands. Variable costs are $50 per unit, and fixed costs average $20, 000 per year. Each plant stand sells for $90 Compute the breakeven point using a scatter graph Copyright © Houghton Mifflin Company. All rights reserved. 23– 75
Breakeven Analysis (cont’d) • The graph has five parts 1. Horizontal axis for units of output 2. Vertical axis for dollars of revenue 3. A horizontal line running from the vertical axis at the level of fixed costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 76
Breakeven Analysis (cont’d) 4. A total cost line – Begins where the fixed costs line crosses the vertical axis and slopes upward to the right – Slope depends on variable cost per unit Copyright © Houghton Mifflin Company. All rights reserved. 23– 77
Breakeven Analysis (cont’d) 5. A total revenue line – Begins at the origin of the vertical and horizontal axes and slopes upward to the right – Slope depends on the selling price per unit Copyright © Houghton Mifflin Company. All rights reserved. 23– 78
Breakeven Analysis (cont’d) • Revenues equal total costs – At the point at which the total revenue line crosses the total cost line Copyright © Houghton Mifflin Company. All rights reserved. 23– 79
Breakeven Analysis (cont’d) • Breakeven point – Found by extending lines from this point to the axes – Valley Metal Products will break even when it has sold 500 plant stands for $45, 000 Copyright © Houghton Mifflin Company. All rights reserved. 23– 80
Using Contribution Margin to Determine the Breakeven Point • Contribution margin (CM) – Is the amount that remains after all variable costs are subtracted from sales • A product line’s contribution margin represents its net contribution to paying off fixed costs and earning a profit – Profit is what remains after fixed costs are paid and subtracted from contribution margin Copyright © Houghton Mifflin Company. All rights reserved. 23– 81
Using Contribution Margin to Determine the Breakeven Point (cont’d) • Breakeven point (BE) – Can be expressed as the point where • Contribution margin minus total fixed costs equals zero • Contribution margin equals fixed costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 82
Using Contribution Margin to Determine the Breakeven Point (cont’d) Compute the breakeven point in units for Valley Metal Products Copyright © Houghton Mifflin Company. All rights reserved. 23– 83
Using Contribution Margin to Determine the Breakeven Point (cont’d) Compute the breakeven point in sales dollars by multiplying BE in units by the selling price (SP) per unit Copyright © Houghton Mifflin Company. All rights reserved. 23– 84
Using Contribution Margin to Determine the Breakeven Point (cont’d) Compute the breakeven point in sales dollars using the CM Ratio * Difference due to rounding up Copyright © Houghton Mifflin Company. All rights reserved. 23– 85
The Breakeven Point for Multiple Products • To calculate the breakeven point for each product, its unit contribution must be weighted by the sales mix • Sales mix – Proportion of each product's unit sales relative to the organization’s total unit sales Copyright © Houghton Mifflin Company. All rights reserved. 23– 86
The Breakeven Point for Multiple Products (cont’d) Valley Metal Products sells two types of plant stands: a floor stand model and a smaller tabletop model. The company sells 500 stands, of which 300 are floor stand models and 200 are tabletop models Determine the sales mix • For every three floor stands sold, 2 tabletop models are sold • The sales mix is 3: 2 or, • Of the 500 units sold, 60% (300 ÷ 500) are floor stands and 40% (200 ÷ 500) are tabletop models Copyright © Houghton Mifflin Company. All rights reserved. 23– 87
The Breakeven Point for Multiple Products (cont’d) Valley Metal Products sells two types of plant stands: a floor stand model and a smaller tabletop model. The company sells 500 stands, of which 300 are floor stand models and 200 are tabletop models. Total fixed costs are $32, 000 Step 1 • Compute the weighted-average contribution margin – Multiply the contribution margin for each product by its percentage of the sales mix Copyright © Houghton Mifflin Company. All rights reserved. 23– 88
The Breakeven Point for Multiple Products (cont’d) Valley Metal Products sells two types of plant stands: a floor stand model and a smaller tabletop model. The company sells 500 stands, of which 300 are floor stand models and 200 are tabletop models. Total fixed costs are $32, 000 Step 2 • Calculate the weighted-average breakeven point – Divide total fixed costs by the weighted-average contribution margin Copyright © Houghton Mifflin Company. All rights reserved. 23– 89
The Breakeven Point for Multiple Products (cont’d) Valley Metal Products sells two types of plant stands: a floor stand model and a smaller tabletop model. The company sells 500 stands, of which 300 are floor stand models and 200 are tabletop models. Total fixed costs are $32, 000 Step 3 • Calculate the breakeven point for each product – Multiply the weighted-average breakeven point by each product’s percentage of sales mix Copyright © Houghton Mifflin Company. All rights reserved. 23– 90
The Breakeven Point for Multiple Products (cont’d) Valley Metal Products sells two types of plant stands: a floor stand model and a smaller tabletop model. The company sells 500 stands, of which 300 are floor stand models and 200 are tabletop models. Total fixed costs are $32, 000 • Verify – Determine the contribution margin of each product and subtract the total fixed costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 91
Discussion Q. What is the general equation for finding the breakeven point in units? A. Sales – Variable Costs – Fixed Costs = 0, or, S – VC – FC = 0 The breakeven point is the point at which total revenues equal total costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 92
Using C-V-P Analysis to Plan Future Sales, Costs, and Profits • Objective 5 – Use C-V-P analysis to project profitability of products and services Copyright © Houghton Mifflin Company. All rights reserved. 23– 93
Using C-V-P Analysis to Plan Future Sales, Costs, and Profits • Primary goal of a business venture is to generate profits, not to break even • To estimate the profitability of a venture – Adjust C-V-P analysis for targeted profit • Different scenarios can be analyzed for the amount of profit or loss they might generate Copyright © Houghton Mifflin Company. All rights reserved. 23– 94
Applying C-V-P to a Manufacturing Business Van Bryce, the president of Valley Metal Products, has set this year’s profit goal for plant stands at $4, 000. All previous data for the company remains the same Calculate how many plant stands must be sold to reach the targeted profit (P) Copyright © Houghton Mifflin Company. All rights reserved. 23– 95
Applying C-V-P to a Manufacturing Business Van Bryce, the president of Valley Metal Products, has set this year’s profit goal for plant stands at $4, 000. All previous data for the company remains the same Check the answer by inserting all known data into the equation Copyright © Houghton Mifflin Company. All rights reserved. 23– 96
Applying C-V-P to a Manufacturing Business (cont’d) • The contribution margin approach can also be used for profit planning – Add the targeted profit to the numerator of the contribution margin breakeven equation Copyright © Houghton Mifflin Company. All rights reserved. 23– 97
Applying C-V-P to a Manufacturing Business (cont’d) • Contribution income statements – Prepared for internal use – Are useful in planning and making decisions about operations Copyright © Houghton Mifflin Company. All rights reserved. 23– 98
Applying C-V-P to a Manufacturing Business (cont’d) • Focus of contribution margin statement – Cost behavior, not cost function • Costs related to production, selling, and administration – Variable costs are subtracted from sales to determine total contribution margin – Fixed costs are subtracted from contribution margin to determine operating income Van Bryce wants his company’s planning team to consider three alternatives to the original plan shown in the contribution income statement Copyright © Houghton Mifflin Company. All rights reserved. 23– 99
Alternative 1: Decrease Variable Costs, Increase Sales Volume The planning team estimated what operating income would be if the company purchased and used aluminum rather than iron to make plant stands. If aluminum were used, direct materials costs per unit would decrease by $3. If the aluminum were painted to meet the needs of a new customer group, sales volume would increase by 10 percent Determine the estimated operating income for this alternative A decrease in direct materials costs of $3 results in an $1, 800 increase in total CM and operating income ($3 x 600) Copyright © Houghton Mifflin Company. All rights reserved. 23– 100
Alternative 1: Decrease Variable Costs, Increase Sales Volume The planning team estimated what operating income would be if the company purchased and used aluminum rather than iron to make plant stands. If aluminum were used, direct materials costs per unit would decrease by $3. If the aluminum were painted to meet the needs of a new customer group, sales volume would increase by 10 percent Determine the estimated operating income for this alternative A sales increase of 60 units (. 10 x 600) increases the total CM and operating income by $2, 580 ($43 x 60) Copyright © Houghton Mifflin Company. All rights reserved. 23– 101
Alternative 1: Decrease Variable Costs, Increase Sales Volume The planning team estimated what operating income would be if the company purchased and used aluminum rather than iron to make plant stands. If aluminum were used, direct materials costs per unit would decrease by $3. If the aluminum were painted to meet the needs of a new customer group, sales volume would increase by 10 percent Determine the estimated operating income for this alternative Copyright © Houghton Mifflin Company. All rights reserved. 23– 102
Alternative 2: Increase Fixed Costs, Increase Sales Volume The planning team estimated what operating income would be if the company increased advertising costs instead of changing the direct materials. The Marketing Department suggested that a $500 increase in advertising costs would increase sales volume by 5 percent Determine the estimated operating income for this alternative Additional advertising costs affects both sales volume and fixed costs Copyright © Houghton Mifflin Company. All rights reserved. 23– 103
Alternative 2: Increase Fixed Costs, Increase Sales Volume The planning team estimated what operating income would be if the company increased advertising costs instead of changing the direct materials. The Marketing Department suggested that a $500 increase in advertising costs would increase sales volume by 5 percent Determine the estimated operating income for this alternative Sales volume increases 30 units (. 05 x 600), which increases the total CM and operating income by $1, 200 ($40 x 30 units) Copyright © Houghton Mifflin Company. All rights reserved. 23– 104
Alternative 2: Increase Fixed Costs, Increase Sales Volume The planning team estimated what operating income would be if the company increased advertising costs instead of changing the direct materials. The Marketing Department suggested that a $500 increase in advertising costs would increase sales volume by 5 percent Determine the estimated operating income for this alternative Fixed costs increase from $20, 000 to $20, 500, which decreases operating income by $500 Copyright © Houghton Mifflin Company. All rights reserved. 23– 105
Alternative 2: Increase Fixed Costs, Increase Sales Volume The planning team estimated what operating income would be if the company increased advertising costs instead of changing the direct materials. The Marketing Department suggested that a $500 increase in advertising costs would increase sales volume by 5 percent Determine the estimated operating income for this alternative Copyright © Houghton Mifflin Company. All rights reserved. 23– 106
Alternative 3: Increase Selling Price, Decrease Sales Volume The planning team evaluated the impact of a $10 increase in selling price on the company’s operating income. The team believes that competitors are selling the same product at a lower price and that sales volume will decrease by 15 percent if the selling price is raised to $10 Determine how this alternative affects operating income A sales decrease of 90 units (. 15 x 600) decreases the sales revenue by $3, 000 [(600 x $90) – (510 x 100)] Copyright © Houghton Mifflin Company. All rights reserved. 23– 107
Alternative 3: Increase Selling Price, Decrease Sales Volume The planning team evaluated the impact of a $10 increase in selling price on the company’s operating income. The team believes that competitors are selling the same product at a lower price and that sales volume will decrease by 15 percent if the selling price is raised to $10 Determine how this alternative affects operating income A sales decrease of 90 units (. 15 x 600) decreases variable costs by $4, 500 ($90 x 50) Copyright © Houghton Mifflin Company. All rights reserved. 23– 108
Alternative 3: Increase Selling Price, Decrease Sales Volume The planning team evaluated the impact of a $10 increase in selling price on the company’s operating income. The team believes that competitors are selling the same product at a lower price and that sales volume will decrease by 15 percent if the selling price is raised to $10 Determine how this alternative affects operating income Copyright © Houghton Mifflin Company. All rights reserved. 23– 109
Comparative Summary of Alternatives at Valley Metal Products, Inc. Copyright © Houghton Mifflin Company. All rights reserved. 23– 110
Comparative Summary • Determining which alternative to choose – Alternative 1 • Results in the highest operating income of the three alternatives – Alternative 2 • Highest breakeven point – More units must be sold to cover increased fixed costs – Alternative 3 • Lowest breakeven point – Company will begin generating income more quickly than with other alternatives Copyright © Houghton Mifflin Company. All rights reserved. 23– 111
Applying C-V-P Analysis to a Service Business The manager of the Appraisal Department at Edmunds Mortgage Company estimates that over the next year her department will perform an average of 100 appraisals per month. The company charges $400 per appraisal. Variable costs are $160 for professional labor and $99 for a county survey map. Monthly service overhead costs were highest in March (180 appraisals at $23, 380) and lowest in February (98 appraisals at $20, 018) Estimate service overhead costs Step 1 – Calculate the variable service overhead cost per appraisal Copyright © Houghton Mifflin Company. All rights reserved. 23– 112
Applying C-V-P Analysis to a Service Business (cont’d) The manager of the Appraisal Department at Edmunds Mortgage Company estimates that over the next year her department will perform an average of 100 appraisals per month. The company charges $400 per appraisal. Variable costs are $160 for professional labor and $99 for a county survey map. Monthly service overhead costs were highest in March (180 appraisals at $23, 380) and lowest in February (98 appraisals at $20, 018) Estimate service overhead costs Step 2 – Calculate the total fixed service overhead costs Use data for March Copyright © Houghton Mifflin Company. All rights reserved. 23– 113
Applying C-V-P Analysis to a Service Business (cont’d) The manager of the Appraisal Department at Edmunds Mortgage Company estimates that over the next year her department will perform an average of 100 appraisals per month. The company charges $400 per appraisal. Variable costs are $160 for professional labor and $99 for a county survey map. Monthly service overhead costs were highest in March (180 appraisals at $23, 380) and lowest in February (98 appraisals at $20, 018) Estimate service overhead costs Step 3 – Calculate the total service overhead costs for one month Copyright © Houghton Mifflin Company. All rights reserved. 23– 114
Applying C-V-P Analysis to a Service Business (cont’d) The manager of the Appraisal Department at Edmunds Mortgage Company estimates that over the next year her department will perform an average of 100 appraisals per month. The company charges $400 per appraisal. Variable costs are $160 for professional labor and $99 for a county survey map. Monthly service overhead costs were highest in March (180 appraisals at $23, 380) and lowest in February (98 appraisals at $20, 018) Estimate service overhead costs Step 4 – Calculate the total service overhead costs for one month assuming that 100 appraisals will be made Copyright © Houghton Mifflin Company. All rights reserved. 23– 115
Determining the Breakeven Point The variable rate of $300 includes the $41 variable service OH rate plus $160 direct professional labor and $99 county survey map fee Copyright © Houghton Mifflin Company. All rights reserved. 23– 116
Determining the Effect of a Change in Operating Costs The Appraisal Department performs an average of 100 appraisals per month and its estimated breakeven point is 160 appraisals. Increasing the appraisal fee is not an option because of strong competition. The manager has determined that costs must be reduced by improving appraiser’s scheduling to reduce travel time. She estimates this could reduce travel time by 50 percent, cutting the professional labor cost to $80 per appraisal. The new process will also increase fixed costs by $200 per month Determine the new breakeven point Copyright © Houghton Mifflin Company. All rights reserved. 23– 117
Determining the Effect of a Change in Operating Costs (cont’d) How many appraisals would the department have to be perform each month to achieve a targeted profit of $18, 000 per month? Copyright © Houghton Mifflin Company. All rights reserved. 23– 118
Discussion Q. If a company sells its product for $10 per unit, variable costs are $2 per unit, and fixed costs are $10, 000 per month, how many units would it need to sell to achieve a profit of $20, 000 per month? A. Copyright © Houghton Mifflin Company. All rights reserved. 23– 119
Time for Review 1. Define cost behavior and explain how managers use this concept in the management cycle 2. Identify variable, fixed, and mixed costs, and separate mixed costs into their variable and fixed components 3. Define cost-volume-profit (C-V-P) analysis and discuss how managers use it as a tool for planning and control Copyright © Houghton Mifflin Company. All rights reserved. 23– 120
And Finally… 4. Define breakeven point and use contribution margin to determine a company’s breakeven point for multiple products 5. Use C-V-P analysis to project profitability of products and services Copyright © Houghton Mifflin Company. All rights reserved. 23– 121
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