The Behavior of Costs (966)
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Variable Costs
o ^total costs that change in direct proportion to changes in productive output
o Operating Capacity  the max an organization can accomplish in a period, given its
existing resources
 Theoretical (ideal) Capacity^ when all machines and equipment are operating
at optimum speeds without interruptions
 Practical Capacitytheoretical but with practical breaks for machine repairs, etc
 Normal Capacityaverage level of operating capacity needed to meet expected
sales demand
 More about what its LIKELY to produce, not what it CAN produce
o Linear Approximation (968)
 Changing non-linear graphs into linear graphs
 Relevant Range the span of activity in which a company expects to operate
 Assumed that total fixed costs and per unit variable costs are constant
 NOT 100% ACCURATE
Fixed Costs (970)
o ^total costs that remain constant within the range in which actual operations are likely
to occur
o Changes when outside the relevant range
Mixed Costs (971)
o ^have both variable and fixed cost components
o Partially fixed, but varies with usage or volume
 Ex. to start you have to pay $20/month, & pay whatever else you spend on top
of that
o **Must separate variable and fixed costs within the mixed costs
 The High-Low Method
o Common
o Based on idea that only 2 data points are necessary to define a
linear cost-volume relationship
 ADVANTAGE: can be used with limited data
 DISADVANTAGE: if one or both points is not really
representative of the rest of the data, not accurate
o Three steps:
1. Calculate the variable cost per activity base
 Select the periods of highest and lowest activity
within an accounting period
 Find difference between activity levels & costs
 = Difference in cost / difference in activity
2. Calculate the total fixed costs
 Pick month w/ either highest or lowest volume
 Total fixed costs= total costs-total variable costs
3. Calculate the formula to estimate the total costs within
the relevant range
 add the answer to steps 1 & 2 to get total costs
per month
Break-even Analysis (977) [diagram of scatter graph on page 978]
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Breakeven point point at which total revenues = total costs
o point at which organizations begin to earn profits
o Sx- VCx – FC= $0
o ***can use Contribution Margin (CM)  amt that remains after all variable costs are
subtracted from sales (S – VC = CM) and (CM-FC= Profit)
o BE Units = (FC / CM per Unit) OR (CM per Unit x BE Units) – FC = $0
Margin of Safety number if sales units or amount of sales dollars by which actual sales can fall
below planned sales without resulting in a loss
Using C-V-P Analysis to Plan Future Sales, Costs and Profits (982)
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Estimates the profitability of a venture (a “what if” idea)
Managers select scenarios and compute and compare the profits
Sales =Variable Costs + Future Cost + Profit
Targeted Sales Units = (FC + P) / CM per Unit
About cost BEHAVIOR, NOT cost FUNCTION
Alternatives:
o Decrease Variable Costs, Increase Sales Volume
o Increase Fixed Costs, Increase Sales Volume
o Increase Selling Price, Decrease Sales Volume
Incremental Analysis (Differential Analysis) for Short-Run Decisions
o ^comparing alternatives by focusing on the differences in their projected revenues and costs
o Irrelevant Costs and Revenues
o Differential / incremental cost a cost that changes between alternatives
o Irrelevant cost a cost that doesn’t change between alternatives
 Sunk Costcost that was incurred bc of a previous decision and can no
longer be recovered through a current decision
o Opportunity Costs
o Benefits that are forfeited when one alternative is chosen over another
Application of Incremental Analysis to Short-Run Decision (1167)
 Incremental Analysis for Outsourcing Decisions
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Outsourcing using suppliers outside the organization to perform services or produce
goods that could be performed or produced internally
1. Benefit: reduces investments in physical assets, human resources, and operating
expenses (increased cash flow and improved operating income)
Make-or-Buy Decision decision of whether to make a part internally or buy it from
supplier (outsourcing)
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Incremental Analysis for Segment Profitability Decisions (1171)
o Purpose: to identify the segments with negative segment margins so managers can drop
them or take corrective action
o Segment margin segments sale’s revenue – direct costs
o Avoidable costs a cost that could be avoided if management were 2 drop the segment
o Direct fixed costs fixed costs that are traceable to the segments
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Incremental Analysis for Sales Mix Decisions (1173)
o ^select the alternative that maximizes the contribution margin per constrained resource
based on the organization’s strategic plan and tactical objectives, the relevant revenues
and costs and qualitative factors
o Two steps:
1. Need to calculate the CONTRIBUTION MARGIN per constrained resource for
each PRODUCT or SERVICE
 Selling price per unit – variable costs per unit
2. Calculate the CONSTRIBUTION MARGIN / unit of the CONSTRAINED RESOURCE
 CM per unit / quantity of constrained resources required per unit
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Incremental Analysis for Sell or Process—Further Decisions (1175)
o ^ decision about whether to sell a joint product at the split-off point or sell it after
further processing
1. OBJECTIVE: select the alternative that maximizes op income
o Joint Products 2 or more products, made from a common material or process that
cannot be identified as separate products r services during some or all of the processing
o Split-off Point joint products or services become separate and identifiable
o Steps:
1. Calculate incremental revenue
 Total revenue from split-off point – total rev from further processing
2. Compare incremental revenue to the incremental costs to process further
3. Make decision (IGNORE JOINT COSTS)
 If costs > revenue, sell at split-off point
 If costs < revenue, sell after processing further
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Depreciation Expense and income Taxes
 Depreciation expense can allow for significant income tax savings
 Operating income after income taxes + non-cash expenses (depreciation) – noncash revenues = NET CASH INFLOWS
The Time Value of Money (1180)
 ^the concept that cash flows of equal dollar amts separated by an interval of time have
different present values bc of the effect of compound interest
 Interest
o ^cost associated with the use of money for a specific period of time
o Simple interest the interest cost for one or more periods when the amt on which
the interest is computed stays the same from period to period
o Compound Interest interest cost for two or more periods when the amt on which
interest is computed changes in each period to include all interest paid in previous
periods
o Interest Expense = Principal x Rate x Time
o Total Maturity Value = Principal + Interest
 Present Value
o Present vs. future value
o Present Value x (1 + Interest Rate) = FUTURE VALUE
 Present Value of a Single Sum Due in the Future
o Future Value x Present-Value Factor = Present Value
 Present Value of an Ordinary Annuity
o ^ a series of equal payments or receipts that will begin one time period from the
current date
Analyzing Capital Investments Proposals: The Net Present Value Method (1184)
 ^ evaluates a capital investment by discounting its future cash flows to their present values
and subtracting the amount of initial investment from their sum
 Advantages of the Net Present Value Method
o Incorporates the time value of money into the analysis of proposed capital investments
o Cost of capital the weighted-average rate of return a company must pay to its longterm creditors and shareholders for the use of their funds
o Tables 3 & 4 are used to discount each future cash inflow and cash outflow over the life
of the asset to the present
 If positive, GOOD means there is a high rate of return project accepted!
 If negative, BAD means there is a low rate of return project rejected!
 If zero, OK means the rate of return is adequate project accepted!
Other Methods of Capital Investment Analysis (1187)
 The Payback Period Method
o Simple to use see which option will take a shorter amt of time to pay off debts
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Payback Period = Cost of Investment / Annual Net Cash Flow (i.e. revenue - expenses)
Annual Depreciation = (Cost – Residual Value) / Life of Asset
If payback period is 5 years or less APPROVED
Disadvantages:
 Does NOT measure profitability
 Does NOT adjust cash flows for the time value of money (i.e. it ignores the
present values of cash flows from different periods)
 Emphasizes the amt of time it takes to get return on investment, not long-term
return on the investment
 It ignores all future cash flows after the payback period is reached
The Accounting Rate of Return Method
o ^ an imprecise but easy way to measure the estimated performance of a capital
investment since it uses financial statement information
o Two variables :
 1) estimated annual net income from the project
 2) average investment cost
o Accounting Rate of Return = Project’s Average Annual Net Income / Average Investment
Cost (below here)
o Average Investment Cost = [(Total investment – Residual Value) / 2] + Residual Value
o Disadvantages:
 Net income is averaged over the life of the investment not a reliable figure
 Method is unreliable when estimated annual net income differs over the years
 Cash flows are IGNORED
 The time value of money is not considered (i.e. future and present $ are treated
Cost-Based Pricing Methods (1221)
 Gross Margin Pricing
o Emphasizes the use of the INCOME STATEMENT
o GM = sales - total production costs
o Cost-based pricing method in which the price is computed using a markup percentage
based on a product’s total production costs
 Markup percentage covers:
 Selling, general and administrative expenses and desired profit
o Markup % = (desired profit + total ^ expenses) / total production costs
o Gross Margin-Based Price = total production costs per unit + (markup % x total
production costs per unit)
o Gross Margin-Based Price (based on desired profit)= (total production costs + total
selling, general and administrative costs + desired profit) / total units produced
 Return on Asset Pricing
o Emphasizes the use of the BALANCE SHEET
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Based on earning a profit equal to a specified rate of return on the assets employed in
the operation
Return on Assets-Based Price = total costs and expenses per unit + (desired rate of
return x cost of assets employed per unit)
Return on Assets-Based Price = [(total production costs + total selling, general and
administrative costs) / units to be produced] + [desired rate of return x (total cost of
assets employed / units to be produced)]
Pricing Based on Target Costing (1227)
 Designed to enhance a company’s ability to compete
 Target Costing is a pricing method that:
o Identifies a price at which a product will be competitive in the market place
o Defines the desired profit to be made on the product
o Computes the target cost for the product by subtracting the desired profit from the
competitive mark price
 Target Cost = Target Price – Desired Profit
 Target cost is viewed as a MAXIMUM possible cost
 Allows the assessment of a product’s potential before allocating resources for its production
Differences between Cost-Base Pricing and Target Costing (1228)
 Cost-based designs the product before worrying about a price
o Committed costs the costs of design, development, engineering, testing and
production that are engineered into a product or service at the design stage of
development
o Incurred costs actual costs incurred in making the product
 Price-basedcomputes the best price, then starts to designing the product based on price
limitations
 A new product is designed only if its projected costs are equal to or lower than its target cost