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Cost Behaviour

Topic 3A

2012 McGraw-Hill Education (Asia)

Preview of This Weeks Class

Classify costs by behaviour and use it to answer the


following questions:

How will my profits change if I change my selling price,


volume, or costs?

Breakeven and target profit analysis (this week)

How can the income statement be presented for better


control purposes?

Variable costing vs. absorption costing (next week)

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Slide 2

Topic 3A Learning Objectives


1.

Understand various types of cost behaviour

2.

Variable
Fixed
Mixed

Use various methods to analyze cost behaviour

Scattergraph Method
High-low Method
Least Squares Regression Method

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Slide 3

Learning Objective 1

Understand Various Types


of Cost Behaviour:
Variable, Fixed and Mixed.

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Slide 4

Cost Classifications for Predicting Cost


Behavior (Recap)

Behavior of Cost (within the relevant range)


Cost

In Total

Per Unit

Variable

Total variable cost changes


as activity level changes.

Variable cost per unit remains


the same over wide ranges
of activity.

Fixed

Total fixed cost remains


the same even when the
activity level changes.

Average fixed cost per unit goes


down as activity level goes up.

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Slide 5

The Activity Base (also called a cost driver)


Activity Base:
A measure of what causes the incurrence of a variable
cost
Variable costs

Activity base (cost driver)

Direct materials

Number of units produced

Equipment maintenance cost

Number of machine hours

Direct labor cost/Employee fringe


benefits

Number of labor hours

Delivery/Shipping cost

Number of miles driven

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Slide 6

The Linearity Assumption and the Relevant Range


A relevant range is the range of activity within which the assumptions
made about cost behaviors are reasonably valid

Total Cost

Economists
Curvilinear Cost
Function

Relevant
Range

A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.

Accountants Straight-Line
Approximation (constant unit
variable cost)

Activity
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Slide 7

1a. True Variable Costs

Cost

The amount of a true variable cost used during the


period varies in direct proportion to the activity level.
The apps download charge on a cell phone bill was
one example of a true variable cost.

Volume
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Direct material is
another example
of a cost that
behaves in a true
variable pattern.
Slide 8

1b. Step-Variable Costs

Cost

A step-variable cost is a resource that is obtainable only


in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.

E.g., A maintenance worker is


required for every 1,000 units
of production

Volume
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Slide 9

1b. Step-Variable Costs

Cost

Small changes in the level of production are not


likely to have any effect on the number of
maintenance workers employed.

Volume
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Slide 10

1b. Step-Variable Costs

Cost

Only fairly wide changes


in the activity level will
cause a change in the
number of maintenance
workers employed.

Volume
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Slide 11

2. Types of Fixed Costs

Committed

Discretionary

Long-term, cannot be
significantly reduced in
the short term.

May be altered in the


short-term by current
managerial decisions

Examples

Examples

Depreciation on Buildings
and Equipment and Real
Estate Taxes

Advertising and
Research and
Development

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Slide 12

2. Fixed Costs and the Relevant Range


For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.
Fixed costs would increase
in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.

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Slide 13

Rent Cost in Thousands


of Dollars

2. Fixed Costs and the Relevant Range

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90
Relevant

60

Range

30
0

The relevant range


of activity for a fixed
cost is the range of
activity over which
the graph of the
cost is flat.

1,000
2,000
3,000
Rented Area (Square Feet)
Slide 14

2. Fixed Costs and the Relevant Range

How does this


step-function
pattern differ from a
step-variable cost?
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Step-variable costs
can be adjusted more
quickly as conditions
change and . . .
The width of the activity
steps is much wider for
the fixed cost.
Slide 15

Is Labor a Variable or a Fixed Cost?


The behavior of wage and salary costs can differ
across countries, depending on labor regulations,
labor contracts, and custom.
In France, Germany, China, and Japan, management has
little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.
In the United States and the United Kingdom, management
has greater latitude. Labor costs are more variable in nature.
Within countries managers can view labor costs differently
depending upon their strategy. Most companies in the
United States continue to view direct labor as a variable cost.
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Slide 16

Quick Check

Which of the following statements about


cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.
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Slide 17

3.Mixed Costs
A mixed cost (also called semi-variable cost)
contains both variable and fixed elements.
Consider the example of utility cost.
Total Utility Cost

Variable
Cost per KW

X
Activity (Kilowatt Hours)
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Fixed Monthly

Utility Charge
Slide 18

3.Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:

Y
a

Total Utility Cost

b
X

= The total mixed cost.


= The total fixed cost (the
vertical intercept of the line).
= The variable cost per unit of
activity (the slope of the line).
= The level of activity.

Variable
Cost per KW

X
Activity (Kilowatt Hours)
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Fixed Monthly

Utility Charge
Slide 19

3.Mixed Costs An Example


If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, what is
the amount of your utility bill?

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Slide 20

Analysis of Mixed Costs


Account Analysis and the Engineering Approach
In account analysis, each account is
classified as either variable or fixed based
on the analysts knowledge of how
the account behaves.
The engineering approach classifies
costs based upon an industrial
engineers evaluation of production
methods, and material, labor and
overhead requirements.
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Slide 21

Learning Objective 2
Use Various Methods to Analyze Cost
Behavior.
1. Scattergraph Method
2. High-Low Method
3. Least-Squares Regression
Method

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Slide 22

1. The Scattergraph Method


Plot the data points on a graph
(Total Cost Y vs. Activity X).

Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s
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Slide 23

1. The Scattergraph Method


Draw a line through the data points with about an
equal numbers of points above and below the line.

Maintenance Cost
1,000s of Dollars

Y
20

* *
* *

10

* ** *
**

Patient-days in 1,000s
McGraw-Hill Education (Asia)

Slide 24

1. The Scattergraph Method

Maintenance Cost
1,000s of Dollars

Use one data point to estimate the total level of activity


and the total cost.
Y Total maintenance cost = $11,000
20

* *
* *

10

* ** *
**

Intercept = Fixed cost: $10,000

Patient days = 800


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Patient-days in 1,000s
Slide 25

1. The Scattergraph Method


Make a quick estimate of variable cost per unit and
determine the cost equation.
Total maintenance at 800 patients
Less: Fixed cost
Estimated total variable cost for 800 patients

Variable cost per unit = $1,000


800

$ 11,000
10,000
$ 1,000

= $1.25/patient-day

Y = $10,000 + $1.25X
Total maintenance cost
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Number of patient days


Slide 26

2. The High-Low Method An Example


Assume the following hours of maintenance work
and the total maintenance costs for six months.

7,350

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Slide 27

2. The High-Low Method An Example

7,350

The variable cost


per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400
= $6.00/hour
400

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Slide 28

2. The High-Low Method An Example

Total Fixed Cost = Total Cost Total Variable Cost

Total Fixed Cost = $9,800 ($6/hour 850 hours)


Total Fixed Cost = $9,800 $5,100

Total Fixed Cost = $4,700


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Slide 29

2. The High-Low Method An Example

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
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Slide 30

Quick Check 1
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is the
variable portion of sales salaries and commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit

McGraw-Hill Education (Asia)

Slide 31

Quick Check 2
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000

McGraw-Hill Education (Asia)

Slide 32

3. Least-Squares Regression Method


A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.

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The goal of this method is


to fit a straight line to the
data that minimizes the
sum of the squared errors.
Slide 33

3. Least-Squares Regression Method

Software can be used to fit a


regression line through the data
points.

The cost analysis objective is


the same: Y = a + bX

=1[( )( )

2
=1( )

; =

Least-squares regression also provides a statistic, called


the R2, which is a measure of the goodness
of fit of the regression line to the data points.
McGraw-Hill Education (Asia)

Slide 34

3. Least-Squares Regression Method

Total Cost

R2 is the percentage of the variation in the dependent


variable (total cost) that is explained by variation in the
independent variable (activity).
Y
20

* *
* *2

10

* ** *
**

R varies from 0% to 100%, and


the higher the percentage the better.

0
0
McGraw-Hill Education (Asia)

2
3
Activity

Slide 35

Comparing Results From the Three Methods


The three methods just discussed provide
slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method
uses differing amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all the data
points.
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Slide 36

End of Topic 3A

McGraw-Hill Education (Asia)

Slide 37

Cost-Volume-Profit Analysis
Topic 3B

2012 McGraw-Hill Education (Asia)

Topic 3B Learning Objectives


1.

2.

Prepare an income statement using the contribution


format
Understand cost-volume-profit (CVP) relations using
four approaches:

3.

Equation Method
Formula Method
BE Percentage Method
Graphical Method

Understand the meaning of, and be able to deal with:

Sensitivity Analysis
Margin of Safety
Operating Leverage
Multiple Products CVP

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Slide 39

Learning Objective 1

Prepare an income
statement using the
contribution format.

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Slide 40

The Contribution Format


Sales Revenue
Less: Variable costs
Contribution margin

Total
$ 100,000
60,000
$ 40,000

Less: Fixed costs


Net operating income

30,000
$ 10,000

Unit
$ 50
30
$ 20

The contribution margin format emphasizes cost


behavior. Contribution margin covers fixed costs
and provides for income.
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Slide 41

The Contribution Format

Used primarily for


external reporting.
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Used primarily by
management.
Slide 42

Learning Objective 2
Understand cost-volume-profit (CVP)
relations using four approaches:
1) Equation Method
2) Formula Method
3) BE Percentage Method

4) Graphical Method

McGraw-Hill Education (Asia)

Slide 43

Basics of Cost-Volume-Profit Analysis


The contribution income statement is helpful to managers in judging the impact
on profits of changes in selling price, cost, or volume. The emphasis is on cost
behavior.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles)
$
250,000
Less: Variable expenses
150,000
Contribution margin
100,000
Less: Fixed expenses
80,000
Net operating income
$
20,000

Contribution Margin (CM) is the amount remaining from sales revenue after
variable expenses have been deducted.

CM is used first to cover fixed expenses. Any remaining CM contributes to


net operating income.
McGraw-Hill Education (Asia)

Slide 44

Basics of Cost-Volume-Profit Analysis


Sales, variable expenses, and contribution margin can
also be expressed on a per unit basis. If Racing sells an
additional bicycle, $200 additional CM will be generated
to cover fixed expenses and profit.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
$
250,000
$
500
Less: Variable expenses
150,000
300
Contribution margin
100,000
$
200
Less: Fixed expenses
80,000
Net operating income
$
20,000

McGraw-Hill Education (Asia)

Slide 45

Basics of Cost-Volume-Profit Analysis


Each month, RBC must generate at least
$80,000 in total contribution margin to break-even
(which is the level of sales at which profit is zero).
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
$
250,000
$
500
Less: Variable expenses
150,000
300
Contribution margin
100,000
$
200
Less: Fixed expenses
80,000
Net operating income
$
20,000

McGraw-Hill Education (Asia)

Slide 46

Basics of Cost-Volume-Profit Analysis

If RBC sells 400 units in a month, it will be


operating at the break-even point.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (400 bicycles)
$
200,000
$
500
Less: Variable expenses
120,000
300
Contribution margin
80,000
$
200
Less: Fixed expenses
80,000
Net operating income
$
-

McGraw-Hill Education (Asia)

Slide 47

Basics of Cost-Volume-Profit Analysis


If RBC sells one more bike (401 bikes), net
operating income will increase by $200.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (401 bicycles)
$
200,500
$
500
Less: Variable expenses
120,300
300
Contribution margin
80,200
$
200
Less: Fixed expenses
80,000
Net operating income
$
200

McGraw-Hill Education (Asia)

Slide 48

Basics of Cost-Volume-Profit Analysis


We do not need to prepare an income statement to
estimate profits at a particular sales volume. Simply
multiply the number of units sold above break-even
by the contribution margin per unit.
If Racing sells
430 bikes, its net
operating income
will be $6,000.

McGraw-Hill Education (Asia)

Slide 49

CVP Relationships in Equation Form


The contribution format income statement can be
expressed in the following equation:

Profit = (Sales Variable expenses) Fixed expenses


= (SP x Q VC x Q) Fixed expenses
= (SP VC) x Q Fixed expenses
= Unit CM x Q Fixed expenses
where:
Unit CM = Selling price per unit Variable expenses per unit
= SP - VC

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Slide 50

CVP Relationships in Equation Form


To compute RBCs profit where 401 bikes are sold
using the equation method:

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Slide 51

Break-even Analysis
Assume the following information for Racing Bicycle
Company (RBC). Determine the breakeven point in:
1) unit sales; 2) dollar sales
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
$ 250,000
$ 500
Less: Variable expenses
150,000
300
Contribution margin
100,000
$ 200
Less: Fixed expenses
80,000
Net operating income
$ 20,000

McGraw-Hill Education (Asia)

Percent
100%
60%
40%

VC Ratio

CM Ratio

Slide 52

Contribution Margin Ratio (CM Ratio)


The contribution margin ratio at Racing Bicycle is:

CM per unit
=
CM Ratio =
SP per unit

$200
$500

= 40%

OR

$100,000
Total CM
= 40%
=
CM Ratio =
$250,000
Total Sales
The relationship between profit and the CM ratio can be
expressed using the following equation:
Profit = CM ratio Sales Fixed expenses

The CM ratio indicates the change in contribution margin


for every dollar change in sales. For e.g. if sales increase
by $50,000, total contribution margin will increase by
$20,000 (40% x $50,000)
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Slide 53

Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139

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Slide 54

Break-even in Unit Sales:


1. Equation Method

Profits = Unit CM Q Fixed expenses


Profits are zero at the break-even point, hence

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Slide 55

Break-even in Unit Sales:


2. Formula Method

Lets apply the formula method to solve for


the break-even point.
Unit sales to
=
break even

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Fixed expenses
CM per unit

Slide 56

Break-even in Dollar Sales:


1. Equation Method
Profit = CM ratio Sales Fixed expenses

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Slide 57

Break-even in Dollar Sales:


2. Formula Method
Now, lets use the formula method to calculate the
dollar sales at the break-even point.
Dollar sales to
Fixed expenses
=
break even
CM ratio

McGraw-Hill Education (Asia)

Slide 58

Break-even:
3. The BE Percentage Method
Now, lets use the 3rd method: the break-even percentage
(BE%) method to calculate the break-even point in units as
well as in sales $. This method also efficiently calculates
break-even for multiple products.
BE% =

Since BE Sales $ =
BE% =

BE Sales $
Total Sales $

x 100%

FE
CM%

FE
CM%

Total Sales $

x 100% =

FE
CM%

1
Total Sales $

x 100%

Since CM% x Total Sales $ = CM


% =
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%
Slide 59

Break-even in Unit and Dollar Sales:


3. The BE Percentage Method
Applying the BE% formula to the same company RBC

% =
% =

$,
$,

% = %

This means that the company requires 80% of its current


sales in order to break-even.
Currently, the companys sales are $250,000 or 500 units.
A BE% of 80% means if the company sales are $200,000
($250,000 x 80%) or 400 units (500 units x 80%), the
company is break-even.
These figures are consistent with both the equation and
the formula methods.
McGraw-Hill Education (Asia)

Slide 60

Quick Check 1
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the break-even sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129

McGraw-Hill Education (Asia)

Slide 61

Quick Check 2
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups

McGraw-Hill Education (Asia)

Slide 62

Target Profit Analysis in Unit Sales


1. Equation Method
Suppose Racing Bicycle management wants to
know how many bikes must be sold to earn a
target profit of $100,000.

Profit = Unit CM Q Fixed expenses

McGraw-Hill Education (Asia)

Slide 63

Target Profit Analysis in Unit Sales


2. Formula Method
Suppose Racing Bicycle management wants to
know how many bikes must be sold to earn a
target profit of $100,000.
Unit sales to attain
Target profit + Fixed expenses
=
the target profit
CM per unit

McGraw-Hill Education (Asia)

Slide 64

Target Profit Analysis in Dollar Sales


1. Equation Method
Profit = CM ratio Sales Fixed expenses
Our goal is to solve for the unknown Sales
which represents the dollar amount of sales
that must be sold to attain the target profit.
Suppose RBC management wants to know the
sales volume that must be generated to earn a
target profit of $100,000.

McGraw-Hill Education (Asia)

Slide 65

Target Profit Analysis in Dollar Sales


2.Formula Method
We can calculate the dollar sales needed to
attain a target profit (net operating profit) of
$100,000 at Racing Bicycle.
Dollar sales to attain
Target profit + Fixed expenses
=
the target profit
CM ratio

McGraw-Hill Education (Asia)

Slide 66

Target Profit Analysis:


3. The BE Percentage Method
Modifying the BE% formula to add target profit to FE
+
Target Profit% =
%

$,+$,
Target Profit% =
x % =
$,

This means that the company requires 180% of its current


sales in order to obtain the target profit.
Currently, the companys sales are $250,000 or 500 units.
A Target Profit % of 180% means if the company sales
are $450,000 ($250,000 x 180%) or 900 units (500 units x
180%), the company has a target profit of $100,000.
These figures are consistent with both the equation and
the formula methods.
McGraw-Hill Education (Asia)

Slide 67

Quick Check 1
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense per month is $1,300.
Use the formula method to determine how many cups of
coffee would have to be sold to attain target profits of
$2,500 per month.
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
McGraw-Hill Education (Asia)

Slide 68

Quick Check 2
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense per month is $1,300.
Use the formula method to determine the sales dollars
that must be generated to attain target profits of $2,500
per month.
a. $2,550
b. $5,011
c. $8,458
d. $10,555
McGraw-Hill Education (Asia)

Slide 69

CVP Relationships in Graphic Form


The relationships among revenue, cost, profit and volume
can be expressed graphically by preparing a CVP graph.
Racing Bicycle developed contribution margin income
statements at 0, 200, 400, and 600 units sold. We will
use this information to prepare the CVP graph.
Units Sold
200

0
Sales

100,000

400
200,000

600
$

300,000

Total variable expenses

60,000

120,000

180,000

Contribution margin

40,000

80,000

120,000

80,000

80,000

80,000

80,000

Fixed expenses
Net operating income (loss)

McGraw-Hill Education (Asia)

(80,000)

(40,000)

40,000

Slide 70

Preparing the CVP Graph


$350,000

$300,000

$250,000

$200,000

$150,000

In a CVP graph, unit volume is usually


represented on the horizontal (X) axis
and dollars on the vertical (Y) axis.

$100,000

$50,000

$0

100

200

300

400

500

600

Units
McGraw-Hill Education (Asia)

Slide 71

Preparing the CVP Graph

Draw a line parallel to the volume axis


to represent total fixed expenses.

$350,000

$300,000

$250,000

$200,000

Fixed expenses
$150,000

$100,000

$50,000

$0

100

200

300

400

500

600

Units
McGraw-Hill Education (Asia)

Slide 72

Preparing the CVP Graph

Choose some sales volume, say 400 units, and plot the point representing
$300,000
total expenses
(fixed and variable). Draw a line through the data point
back to where the fixed expenses line intersects the dollar axis.
$350,000

$250,000

$200,000

Total expenses

Fixed expenses

$150,000

$100,000

$50,000

$0

100

200

300

400

500

600

Units
McGraw-Hill Education (Asia)

Slide 73

Preparing the CVP Graph

Choose some sales volume, say 400 units, and plot the point representing
$300,000
total sales.
Draw a line through the data point back to the point of origin.
$350,000

$250,000

$200,000

Sales
Total expenses
Fixed expenses

$150,000

$100,000

$50,000

$0

100

200

300

400

500

600

Units
McGraw-Hill Education (Asia)

Slide 74

Preparing the CVP Graph


Break-even point
(400 units or $200,000 in sales)

$350,000

Profit Area

$300,000

$250,000

$200,000

Sales
Total expenses
Fixed expenses

$150,000

$100,000

$50,000

$0

Loss Area
McGraw-Hill Education (Asia)

100

200

300

400

500

600

Units
Slide 75

Preparing the CVP Graph


Profit = Unit CM Q Fixed Costs
$ 60,000
$ 40,000

Profit

$ 20,000
$0
-$20,000

An even simpler form of


the CVP graph is called
the profit graph.

-$40,000
-$60,000
0

McGraw-Hill Education (Asia)

100

200
300
400
Number of bicycles sold

500

600

Slide 76

Preparing the CVP Graph


$ 60,000

Break-even point, where


profit is zero , is 400
units sold.

$ 40,000

Profit

$ 20,000
$0
-$20,000
-$40,000
-$60,000
0

McGraw-Hill Education (Asia)

100

200
300
400
Number of bicycles sold

500

600

Slide 77

Learning Objective 3
Understand the meaning of, and be
able to deal with:
1) Sensitivity Analysis
2) Margin of Safety
3) Operating Leverage

4) Multiple Products CVP

McGraw-Hill Education (Asia)

Slide 78

1. Sensitivity Analysis: Example 1


Changes in Fixed Costs and Sales Volume

What is the profit impact if Racing


Bicycle can increase unit sales from
500 to 540 by increasing the monthly
advertising budget by $10,000?

McGraw-Hill Education (Asia)

Slide 79

1. Sensitivity Analysis: Example 1


Changes in Fixed Costs and Sales Volume
$80,000 + $10,000 advertising = $90,000

Sales
Less: Variable expenses
Contribution margin
Less: Fixed expenses
Net operating income

500 units
$ 250,000
150,000
100,000
80,000
$
20,000

540 units
$ 270,000
162,000
108,000
90,000
$
18,000

Sales increased by $20,000, but net operating


income decreased by $2,000.
McGraw-Hill Education (Asia)

Slide 80

1. Sensitivity Analysis: Example 1


Changes in Fixed Costs and Sales Volume

A shortcut solution using incremental


analysis
Increase in CM (40 units X $200)
Increase in advertising expenses
Decrease in net operating income

McGraw-Hill Education (Asia)

$ 8,000
10,000
$ (2,000)

Slide 81

1. Sensitivity Analysis: Example 2


Change in Variable Costs and Sales Volume

What is the profit impact if Racing


Bicycle can use higher quality raw
materials, thus increasing variable costs
per unit by $10, to generate an increase
in unit sales from 500 to 580?

McGraw-Hill Education (Asia)

Slide 82

1. Sensitivity Analysis:
Change in Variable Costs and Sales Volume
580 units $310 variable cost/unit = $179,800

Sales
Less: Variable expenses
Contribution margin
Less: Fixed expenses
Net operating income

500 units
$ 250,000
150,000
100,000
80,000
$
20,000

580 units
$ 290,000
179,800
110,200
80,000
$
30,200

Sales increase by $40,000, and net operating income


increases by $10,200.
McGraw-Hill Education (Asia)

Slide 83

2. The Margin of Safety in Dollars

The margin of safety in dollars is the


excess of budgeted (or actual) sales over
the break-even volume of sales.
Margin of safety in dollars = Total sales - Break-even sales

Lets look at Racing Bicycle Company and


determine the margin of safety.

McGraw-Hill Education (Asia)

Slide 84

2. The Margin of Safety in Units


The margin of safety can be expressed in terms of
the number of units sold. The margin of safety at
RBC is $50,000, and each bike sells for $500;
hence, RBCs margin of safety is 100 bikes.
Margin of
=
Safety in units

$50,000
= 100 bikes
$500
OR

Margin of
=
Safety in units
McGraw-Hill Education (Asia)

500 400 = 100 bikes


Slide 85

2. The Margin of Safety in Percentage


If we assume that RBC has actual sales of $250,000, given that
we have already determined the break-even sales to be
$200,000, the margin of safety is $50,000 as shown.
Break-even
sales
400 units
Sales
$ 200,000
Less: variable expenses
120,000
Contribution margin
80,000
Less: fixed expenses
80,000
Net operating income
$
-

Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000

RBCs margin of safety can be expressed as 20% of sales


($50,000 $250,000). This is also known as margin of
safety percentage or MoS%
McGraw-Hill Education (Asia)

Slide 86

Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

McGraw-Hill Education (Asia)

Slide 87

Linking Margin of Safety % (to sales) and


Breakeven % (to sales)
Margin of safety in dollars = Total sales - Break-even sales
Margin of safety in dollars
Total sales in dollars

= Margin of safety percentage (MoS%)


Total sales Breakeven sales
=
Total sales
Breakeven in dollars
=1
Total sales in dollars
= 1 Breakeven percentage
= 1 BE%

Therefore:
McGraw-Hill Education (Asia)

BE% = 1 MoS %
Slide 88

Calculate Breakeven given MOS (%)

RBCs margin of safety = 20% of sales

Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net operating income

Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000

Breakeven sales of RBC = 1 20% = 80% of sales (or BE%)


= $250,000 x 80%
= $200,000
= Breakeven Sales on slide 86
McGraw-Hill Education (Asia)

Slide 89

3. Operating Leverage:
Cost Structure and Profit Stability
Cost structure refers to the relative proportion
of fixed and variable costs in an organization.
Managers often have some latitude in
determining their organizations cost structure.

McGraw-Hill Education (Asia)

Slide 90

3. Operating Leverage:
Cost Structure and Profit Stability
There are advantages and disadvantages to high fixed cost
(or low variable cost) and low fixed cost (or high variable
cost) structures.

An advantage of a high fixed


cost structure is that income A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies
will be lower in bad years
with lower proportion of
compared to companies
fixed costs.
with lower proportion of
fixed costs.
Companies with low fixed cost structures enjoy greater
stability in income across good and bad years.
McGraw-Hill Education (Asia)

Slide 91

3. Operating Leverage:
Managing fixed costs

Typical fixed costs: production facilities, rentals, employees


salaries and related benefits and utilities

Converting them into variable may reduce risk of financial commitment


and provide flexibility of capacity utilization

Outsourcing - switching to variable costs


Business with fast and regular change and/or large varieties of
products most likely will benefit from this approach e.g. Nike and
Apple
Non-core business functions with lower value-add to majority
customers e.g. call centers for enquiries, 3rd party logistics, brokerdealers securities back office operations

Offshoring - reducing fixed costs


Honda and Toyota Thailand plants
HSBC back office functions in China

McGraw-Hill Education (Asia)

Slide 92

3. Operating Leverage
Operating leverage is a measure of how sensitive net
operating income is to percentage changes in sales.
It is a measure, at any given level of sales, of how a
percentage change in sales volume will affect profits.
Contributi on Margin
DOL Degree of Operating Leverage
Net Operating Income * *
** Profit Before Tax is a commonly used alternative to Net Operating
Income in the degree of operating leverage calculation

McGraw-Hill Education (Asia)

Slide 93

3. Operating Leverage
To illustrate, lets revisit the contribution income statement
for RBC.

Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income

Degree of
Operating
Leverage

McGraw-Hill Education (Asia)

Actual sales
500 Bikes
$ 250,000
150,000
100,000
80,000
$
20,000

Slide 94

3. Operating Leverage

With an operating leverage of 5, if RBC


increases its sales by 10%, net operating
income would increase by 50%.
Percent increase in sales
Degree of operating leverage
Percent increase in profits

10%
5
50%

Heres the verification!


McGraw-Hill Education (Asia)

Slide 95

3. Operating Leverage
Actual sales
(500)
Sales
$ 250,000
Less variable expenses
150,000
Contribution margin
100,000
Less fixed expenses
80,000
Net operating income
$
20,000

Increased
sales (550)
$ 275,000
165,000
110,000
80,000
$
30,000

10% increase in sales from


$250,000 to $275,000 . . .

. . . results in a 50% increase in


income from $20,000 to $30,000.
McGraw-Hill Education (Asia)

Slide 96

Quick Check 1
Coffee Klatch is an espresso stand in a
downtown office building. The average selling
price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average
fixed expense per month is $1,300. 2,100 cups
are sold each month on average. What is the
operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
McGraw-Hill Education (Asia)

Slide 97

Quick Check 2
At Coffee Klatch the average selling price of a cup of
coffee is $1.49, the average variable expense per cup
is $0.36, the average fixed expense per month is
$1,300 and an average of 2,100 cups are sold each
month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%

McGraw-Hill Education (Asia)

Slide 98

What does higher value of Operating


Leverage mean?

High Operating Leverage ratio

signals the existence of high fixed costs.


increases risk of making loss in adverse market
conditions.
increases opportunity to make profit when higher
demand exists.
has lower margin of safety percentage (MoS%)

1
DOL
MoS%

McGraw-Hill Education (Asia)

Slide 99

Proof of Operating Leverage and Profit


Movement Relationship
Benchmark Co.

High F.C. Co.

$3,200,000

$3,200,000

$800

$800

($300)

($150)

Unit Contribution margin

$500

$650

Unit sales (Same)

4,000

4,000

$2,000,000

$2,600,000

($1,500,000)

($2,100,000)

(P)

500,000

500,000

Degree of operating leverage (CM/P)

4.0

5.2

Total Sales (Same)


Unit selling price (Same)
Unit variable costs

Contribution margin

(CM)

Fixed costs
Net Operating Profit (Same)

McGraw-Hill Education (Asia)

Slide 100

Proof of Operating Leverage and Profit


Movement Relationship
Benchmark Co.

High F.C. Co.

12.5%

12.5%

Degree of operating leverage

X 4.0

X 5.2

Increase in profits

50%

65%

Unit contribution margin

$500

$650

Unit change in sales (4,000 x 12.5%)

x 500

x 500

$250,000

$325,000

50%

65%

Increase in sales

Proof:

Change in profits
Percentage increase from the original
$500,000 profit

McGraw-Hill Education (Asia)

Slide 101

Proof of Operating Leverage and MoS%


Relationship
Benchmark Co.

High F.C. Co.

Total Sales (Same)

(S)

$3,200,000

$3,200,000

Contribution margin

(CM)

$2,000,000

$2,600,000

Fixed costs

(F)

($1,500,000)

($2,100,000)

Net Operating Profit (Same)

(P)

500,000

500,000

Degree of operating leverage (CM/P)

4.0

5.2

2,400,000

2,584,615

75%

80.77%

25%

19.23%

4.0

5.2

Breakeven Sales Dollars [F/(CM/S)]


Breakeven % (to sales)

MoS% = 1 BE%
1/MoS%
= Degree of operating leverage

McGraw-Hill Education (Asia)

Slide 102

4. The Concept of Sales Mix


Sales mix is the relative proportion in which a
companys products are sold.
Different products have different selling prices,
cost structures, and contribution margins.
When a company sells more than one product,
break-even analysis becomes more complex as
the following example illustrates.

McGraw-Hill Education (Asia)

Slide 103

Multi-Product Break-Even Analysis


1. The BE% Method
Virtual Journeys Le Louvre and Le Vin sales and profit data are as follows:
Le Louvre (200)
Sales
$ 20,000
Variable expenses
15,000
Contribution margin
5,000
Fixed expenses
Net operating income
Sales

$ 20,000

Le Vin (400)
$ 80,000
40,000
40,000

$80,000

x
BE% = 60%
Breakeven sales

$12,000

$48,000

Total breakeven sales = $60,000


Breakeven units

120 units

240 units

Total
$ 100,000
55,000
45,000
27,000
$ 18,000
Contribution Margin
1

Net Operating Income MoS%


Net Operating Income
MoS%
Contribution Margin
18,000
MoS%
40%
45,000
MoS% 1 BE%
BE% 1 MoS% 1 40% 60%
DOL

Total breakeven units = 360 units


McGraw-Hill Education (Asia)

Slide 104

Multi-Product Break-Even Analysis


2. The Weighted-Average CM Ratio Method
Le Louvre comprises 20% of Virtual Journeys total sales
revenue and Le Vin comprises the remaining 80%. Virtual
Journey provides the following information:
Le Louvre (200 units)
Sales
$ 20,000
100%
Variable expenses
15,000
75%
Contribution margin
5,000
25.0%
Fixed expenses
Net operating income

Le Vin (400 units)


$
80,000
100%
40,000
50%
40,000
50%

Total
$ 100,000
100.0%
55,000
55.0%
45,000
45.0%
27,000
$ 18,000

Sales mix

$ 100,000

20,000

20%

Weighted-average CM Ratio
= (20% x 25%) + (80% x 50%) OR
= 45%

McGraw-Hill Education (Asia)

80,000

80%

100%

Weighted-average CM Ratio
= 45,000/100,000
= 45%

Slide 105

Multi-Product Break-Even Analysis


2. The Weighted-Average CM Ratio Method
Dollar sales to
Fixed expenses
=
break even
CM ratio

Dollar sales to
break even

$27,000
45%

= $60,000

Le Louvre (200 units)


Sales
$
12,000
100%
Variable expenses
9,000
75%
Contribution margin
3,000
25%
Fixed expenses
Net operating income

Le Vin (400 units)


$ 48,000
100%
24,000
50%
24,000
50%

Sales mix

McGraw-Hill Education (Asia)

12,000

20%

48,000

80%

Total
60,000
33,000
27,000
27,000
-

60,000

100.0%
55.0%
45.0%

100.0%

Slide 106

Multi-Product Break-Even Analysis


3. The Weighted-Average CM Method
Le Louvre comprises 33.33% of Virtual Journeys total unit
sales and Le Vin comprises the remaining 66.66%. Virtual
Journey provides the following information:
Le Louvre (200 units)
Sales
$ 20,000
100%
Variable expenses
15,000
75%
Contribution margin
5,000
25.0%
Fixed expenses
Net operating income
Unit CM
Sales mix (in units)

$25
200 units

33.33%

Le Vin (400 units)


$
80,000
100%
40,000
50%
40,000
50%

$100
400 units

66.66%

Total
$ 100,000
100.0%
55,000
55.0%
45,000
45.0%
27,000
$ 18,000

600 units

100%

Weighted-average CM
= (1/3 x $25) + (2/3 x $100)
= $75

McGraw-Hill Education (Asia)

Slide 107

Multi-Product Break-Even Analysis


3. The Weighted-Average CM Method
Unit sales to
break even

Unit sales to
break even

Le Louvre (200 units)


Sales
$
12,000
100%
Variable expenses
9,000
75%
Contribution margin
3,000
25%
Fixed expenses
Net operating income
Sales mix (in units)

McGraw-Hill Education (Asia)

120 units

33%

Fixed expenses
Unit CM
$27,000
$75

= 360 units

Le Vin (400 units)


$ 48,000
100%
24,000
50%
24,000
50%

$
240 units

67%

Total
60,000
33,000
27,000
27,000
360 units

100.0%
55.0%
45.0%

100.0%

Slide 108

Key Assumptions of CVP Analysis


Selling price is constant.
Costs are linear and can be accurately divided into
variable (constant per unit) and fixed (constant in
total) elements.
In multiproduct companies, the sales mix is
constant.
In manufacturing companies, inventories do not
change (units produced = units sold).

McGraw-Hill Education (Asia)

Slide 109

Quick Check

McGraw-Hill Education (Asia)

Slide 110

Quick Check

McGraw-Hill Education (Asia)

Slide 111

Quick Check

McGraw-Hill Education (Asia)

Slide 112

Quick Check

McGraw-Hill Education (Asia)

Slide 113

End of Topic 3B

McGraw-Hill Education (Asia)

Slide 114