CHAPTER REVIEW
Cost Behavior Analysis
1.
(L.O. 1) Cost behavior analysis is the study of how specific costs respond to changes in the level of
business activity. A knowledge of cost behavior helps management plan operations and decide between
alternative courses of action.
2.
The activity index identifies the activity that causes changes in the behavior of costs; examples include
direct labor hours, sales dollars, and units of output. Once an appropriate activity index is chosen, costs
can be classified as variable, fixed or mixed.
Variable and Fixed Costs
3.
(L.O. 1) Variable costs are costs that vary in total directly and proportionately with changes in the
activity level. Examples of variable costs include direct materials and direct labor, cost of goods sold,
sales commissions, and freight-out. A variable cost may also be defined as a cost that remains the
same per unit at every level of activity.
4.
Fixed costs are costs that remain the same in total regardless of changes in the activity level. Examples
include property taxes, insurance, rent, supervisory salaries, and depreciation. Fixed costs per unit vary
inversely with activity; as volume increases, unit cost declines and vice versa.
Relevant Range
5.
The range over which a company expects to operate during the year is called the relevant range.
Although a linear (straight-line) relationship for costs may not be realistic, the linear assumption
produces useful data for CVP analysis as long as the level of activity remains within the relevant
range.
Mixed Costs
6.
(L.O. 2) Mixed costs are costs that contain both a variable element and a fixed element; they increase
in total as the activity level increases, but not proportionately. For purposes of CVP analysis, mixed costs
must be classified into their fixed and variable elements.
7.
The high-low method uses the total costs incurred at the high and low levels of activity. The difference
in costs represents variable costs, since only the variable cost element can change as activity levels
change.
8.
The steps in computing fixed and variable costs under the high-low method are:
a. Determine variable cost per unit from the following formula:
Change in
Total Costs
b.
÷
High minus Low
Activity Level
=
Variable Cost
per Unit
Determine the fixed cost by subtracting the total variable cost at either the high or the low activity
level from the total cost at that activity level.
Cost-Volume-Profit Analysis
9.
10.
(L.O. 3) Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume on
a company’s profits. It is a critical factor in such management decisions as profit planning, setting selling
prices, determining product mix, and maximizing use of production facilities.
CVP analysis considers the interrelationships among the following components: (a) volume or level of
activity, (b) unit selling prices, (c) variable cost per unit, (d) total fixed costs, and (e) sales mix.
Basic CVP Components
11.
The following assumptions underlie each CVP analysis:
a. The behavior of both costs and revenues is linear throughout the relevant range of the activity index.
b. Costs can be classified accurately as either variable or fixed.
c. Changes in activity are the only factors that affect costs.
d. All units produced are sold.
e. When more than one type of product is sold, the sales mix will remain constant. That is, the
percentage that each product represents of total sales will stay the same.
Contribution Margin
12.
Contribution margin is the amount of revenue remaining after deducting variable costs. The formula for
contribution margin per unit is:
Unit Selling
–
Price
13.
Unit Variable
=
Costs
Unit Contribution
Margin
Contribution margin per unit indicates the amount available to cover fixed costs and contribute to income.
The formula for the contribution margin ratio is:
Contribution
Margin Per Unit
÷
Unit Selling
=
Price
Unit Contribution
Margin
The ratio indicates the portion of each sales dollar that is available to apply to fixed costs and to
contribute to income.
Break-Even Analysis
14.
(L.O. 4) The break-even point is the level of activity at which total revenue equals total costs (both fixed
and variable). Knowledge of the break-even point is useful to management when it decides whether to
introduce new product lines, change sales prices on established products, or enter new market areas.
15.
A common equation used for CVP analysis is as follows:
Sales - Variable Costs - Fixed Costs = Net Income
16.
Under the contribution margin technique, the break-even point can be computed by using either the
unit contribution margin or the contribution margin ratio.
17.
The formula, using unit contribution margin, is:
Fixed
Costs
18.
Margin
=
Break-even
Point in Units
The formula using the contribution margin is:
Fixed
Costs
19.
Unit Contribution
÷
÷
Contribution
Margin Ratio
=
Break-even
Point in Dollars
A chart (or graph) can also be used as an effective means to determine and illustrate the break-even
point. A cost-volume-profit (CVP) graph is as follows:
Dollars (000)
Sales Line
900
Total Cost Line
800
700
600
Break-even Point
Variable Costs
500
400
300
Fixed Cost Line
200
100
0
Fixed Costs
200 400 600 800 1000 1200 1400 1600 1800
Units of Sales
Target Net Income
20.
(L.O. 5) Target net income is the income objective for individual product lines. The following equation is
used to determine target net income sales:
Required Sales - Variable Costs - Fixed Costs = Target Net Income
21.
Using the contribution margin technique, we can compute in either units or dollars the sales required to
meet a target net income. To compute the sales required in units the following formula is used:
(Fixed Costs + Target Net Income) ÷ Unit Contribution Margin = Required Sales in Units
To compute the sales required in dollars, the contribution margin ratio is used rather than the unit
contribution margin, as follows:
(Fixed Costs + Target Net Income) ÷ Contribution Margin Ratio = Required Sales in Dollars
Margin of Safety
22.
Margin of safety is the difference between actual or expected sales and sales at the break-even point.
a.
The formula for stating the margin of safety in dollars is:
Actual (Expected)
Sales
b.
–
Break-even
Sales
=
Margin of Safety
in Dollars
The formula for determining the margin of safety ratio is:
Margin of Safety
in Dollars
÷
Actual (Expected)
Sales
=
Margin of
Safety Ratio
The higher the dollars or the percentage, the greater the margin of safety.
LECTURE OUTLINE
A.
Cost Behavior Analysis.
1. Cost behavior analysis is the study of how specific costs respond to changes
in the level of business activity.
2. The activity index identifies the activity that causes changes in the
behavior of costs. With an appropriate activity index, companies can classify
the behavior of costs into three categories: variable, fixed, or mixed.
3. Variable costs are costs that vary in total directly and proportionately with
changes in the activity level. A variable cost remains the same per unit at
every level of activity.
4. Fixed costs are costs that remain the same in total regardless of changes in the
activity level.
a.
Because total fixed costs remain constant as activity changes, it follows
that fixed costs per unit vary inversely with activity.
b.
Examples of fixed costs include property taxes, insurance, rent,
supervisory salaries, and depreciation on buildings and equipment.
MANAGEMENT INSIGHT
As the population increases and farmable land becomes more scare, growing food
hydroponically in skyscrapers has been studied as an alternative way to grow food without
incurring some of the common costs associated with farming (transportation to cities,
pesticides, etc.). But, even while some costs are reduced by farming hydroponically, other
costs are likely to increase.
What are some of the variable and fixed costs that are impacted by hydroponic
farming?
Answer:
Compared to traditional methods, hydroponic farming would reduce the use
of pesticides, herbicides, fuel, and water. Soil erosion would be eliminated,
and land requirements would drop. But, fixed costs related to constructing
greenhouses, suitable vertical planters, as well as investments in artificial
lighting could be high.
5. The relevant range is the range of activity over which a company expects to
operate during a year. It is important in CVP analysis because the behavior of
costs is assumed to be linear (straight-line) throughout the relevant range.
Although
the
linear
relationship
may
not
be
completely
realistic, the linear assumption produces useful data for CVP analysis as long
as the level of activity remains within the relevant range.
6. Mixed costs are costs that contain both a variable element and a fixed
element. Mixed costs change in total but not proportionately with changes in the
activity level.
a.
For purposes of CVP analysis, mixed costs must be classified into their
fixed and variable elements. One method that management may use to
classify these costs is the high-low method.
b.
The high-low method uses the total costs incurred at the high and low
levels of activity. The difference in costs between the high and low levels
represents variable costs, since only the variable cost element can
change
as
activity
levels
change.
Fixed
costs
are
determined by subtracting the total variable cost at either the high or low
activity level from the total cost at that activity level.
MANAGEMENT INSIGHT
The recent recession produced a surprise for some manufacturers— the number of jobs
lost was actually lower than in previous recessions. In the years preceding the
recession, many factories adopted lean manufacturing practices that relied less on
large numbers of low skilled workers, and more on machines and a few highly skilled
workers. Because the employees are highly skilled, employers are reluctant to lose
them.
Would you characterize labor costs as being a fixed cost, a variable cost, or something
else in this situation?
Answer: Because these labor costs are essentially unchanged for most levels of
production, they are primarily fixed. However, it could be described as being
a “step function.” If production gets too far outside the normal range,
workers’ hours will change. If production goes too low, hours are cut, and if it
goes too high, overtime hours are needed.
B.
Cost-Volume-Profit Analysis.
1. Cost-volume-profit (CVP) analysis is the study of the effects of changes in
costs and volume on a company’s profits. CVP analysis is important in profit
planning. It is useful in setting selling prices, determining product mix, and
maximizing use of production facilities.
2. CVP analysis
components:
considers
the
a.
Volume or level of activity.
b.
Unit selling prices.
c.
Variable cost per unit.
d.
Total fixed costs.
e.
Sales mix.
interrelationships
among
the
following
3. The following assumptions underlie each CVP analysis:
a.
The behavior of both costs and revenues is linear throughout the relevant
range of the activity index.
b.
Costs can be classified accurately as either variable or fixed.
c.
Changes in activity are the only factors that affect costs.
d.
All units produced are sold.
e.
When more than one type of product is sold, the sales mix will
remain constant (the percentage that each product represents of total
sales will stay the same).
4. Contribution margin is the amount of revenue remaining after deducting
variable costs. It can be expressed as a per unit amount or as a ratio.
a.
Unit Contribution Margin = Unit Selling Price – Unit Variable Costs.
b.
Contribution Margin Ratio = Unit Contribution Margin ÷ Unit Selling Price.
C.
Break-even Analysis.
1. At the break-even point, the company will realize no income but will suffer no
loss.
2. Knowledge of the break-even point is useful to management when it
decides whether to introduce new product lines, change sales prices on
established products, or enter new market areas.
3. The break-even point can be:
a.
Computed from a mathematical equation: Sales – Variable Costs – Fixed
Costs = Net Income. In the case of the break-even point, we set the net
income equal to zero.
b.
Computed by using contribution margin: Break-even Point in Units = Fixed
Costs ÷ Contribution Margin per Unit. Break-even Point in Dollars = Fixed
Costs ÷ Contribution Margin Ratio.
c.
Derived from a CVP graph at the intersection of the total-cost line and the
total-sales line.
4. The income objective set by management is called target net income. To meet
target net income, required sales must be determined.
a.
Mathematical equation: Required Sales - Variable Costs - Fixed Costs =
Target Net Income. Required sales may be expressed in either sales units
or sales dollars.
b.
Contribution margin technique: (Fixed Costs + Target Net Income) ÷
Contribution Margin Ratio = Required Sales in Dollars. Alternatively, to
compute required sales in units: (Fixed Costs + Target Net Income) ÷
Contribution Margin Per Unit = Required Sales in Units.
c.
Graphic presentation: In the profit area of the CVP graph, the distance
between the sales line and the total cost line at any point equals net
income. A company can find required sales by analyzing the differences
between the two lines until the desired net income is found.
SERVICE COMPANY INSIGHT
FlightServe, a chartered aircraft company, decided to match up executives with charter
flights in small “private jets”. The company noted that the average charter jet had eight
seats, but it would break even at an average of 3.3 seats per flight.
How did FlightServe determine that it would break even with 3.3 seats full per flight?
Answer: FlightServe determined its break-even point with the following formula: Fixed
costs ÷ Contribution margin per seat occupied = Break-even point in seats.
5. Margin of safety is the difference between actual or expected sales and sales
at the break-even point. The margin of safety can be expressed in dollars or
as a ratio.
a.
Margin of Safety in Dollars = Actual (Expected) Sales – Break-even
Sales.
b.
Margin of Safety Ratio = Margin of Safety in Dollars ÷ Actual
(Expected) Sales.
MANAGEMENT INSIGHT
The promoter for the Rolling Stones’ tour guaranteed $1.2 million to the group. In
addition, 20% of the gross goes to the stadium where the performance is staged and
another $400,000 for other expenses such as ticket takers and advertising.
What amount of sales dollars are required for the promoter to break even?
Answer: Fixed costs = $1,200,000 + $400,000 = $1,600,000
Contribution margin ratio = 80%.
Break-even sales = $1,600,000 ÷ .80 = $2,000,000.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 5-1
________________is a variable cost because it increases in total directly and
proportionately with the change in the activity level.
_______________is a fixed cost because it remains the same in total regardless of
changes in the activity level.
________________is a mixed cost because it increases in total but not proportionately
with changes in the activity level.
BRIEF EXERCISE 5-2
VARIABLE COST
Relevant Range
FIXED COST
Relevant Range
$10,000
$10,000
8,000
8,000
6,000
6,000
4,000
4,000
2,000
2,000
0
20
40
60
80 100
Activity Level
0
20
40
60
80 100
Activity Level
BRIEF EXERCISE 5-3
$60,000
Total Cost Line
COST
45,000
Variable Cost Element
30,000
15,000
Fixed Cost Element
0
500
1,000
1,500
2,000
2,500
Direct Labor Hours
BRIEF EXERCISE 5-4
High
Low
–
–
Difference
=
=
—Variable cost per mile.
High
Total cost
Less: Variable costs
Total fixed costs
The mixed cost is
Low
BRIEF EXERCISE 5-5
High
Low
–
–
Difference
=
=
per unit.
Activity Level
High
Low
Total cost
Less: Variable costs
000,000
Total fixed costs
BRIEF EXERCISE 5-6
BRIEF EXERCISE 5-7
RUSSELL INC.
CVP Income Statement
For the Quarter Ended March 31, 2017
Sales ..................................................................................
Variable costs ...................................................................
Contribution margin .........................................................
Fixed costs .......................................................................
Net income ........................................................................
BRIEF EXERCISE 5-8
(a)
(b)
BRIEF EXERCISE 5-9
Contribution margin ratio =
Required sales in dollars =
BRIEF EXERCISE 5-10
BRIEF EXERCISE 5-11
Margin of safety =
Margin of safety ratio =
BRIEF EXERCISE 5-12
Contribution margin per unit
Required sales in units =