Unformatted text preview: Topic 4:
Topic 4:
Cost Behaviour and Planning Introduction
Introduction How do managers know what price to charge, whether to make or buy, or answer other questions related to costs?
They need to have an understanding of how costs change in relation to various factors.
Costvolumeprofit analysis examines the behaviour of total revenues, total costs, and operating profit as changes occur in the output level, selling price, variable costs per unit, or fixed costs. Structure of lecture
Structure of lecture Cost estimation and behaviour
Other types of costs
Assumption in costbehaviour estimation
Cost estimation methods
CostVolumeProfit (CVP) Analysis
–
–
– Break even point
Contribution method
Sensitivity analysis Modelling taxes
Modelling multiple products Concept of Cost Estimation
Concept of Cost Estimation
1. Estimate . . . Relationship
between
activities
and costs 3. This results
in reduced . . . Costs We estimate
costs to:
manage 2. Manage . . . Activities costs
make decisions
plan & set
standards. Cost Estimation ...
Cost Estimation ...
is the attempt to measure a past cost relationship between costs and the level of an activity. Managers are interested in estimating past costbehaviour functions primarily because these estimates can help them make more accurate cost predictions.
– Cost Behavior Patterns
Cost Behavior Patterns
Summary of Variable and Fixed Cost Behavior
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. Total fixed cost remains
the same even when the
a ctivity level changes. Fixed cost per unit
goes down as activity
level goes up. Fixed Other types of Costs
StepVariable Costs Cost Total cost remains
constant within a
narrow range of
activity. Activity Other types of Costs
StepVariable Costs Cost Total cost increases to a
new higher cost for the next
higher range of activity. Activity Other types of Costs
Rent Cost in
Thousands of Dollars StepFixed Costs
90
60
30
00 Total cost doesn’t change
for a wide range of activity,
and then jumps to a new
higher cost for the next
higher range of activity.
1,000
2,000
3,000
Rented Area (Square Feet) Other types of Costs How does this type
of fixed cost differ
from a stepvariable
cost? Stepvariable costs
can be adjusted more
quickly and . . .
The width of the
activity steps is much
wider for the
stepfixed cost. Semivariable Cost Total Utility Cost Slope is
variable cost
per unit
of activity. m
se
tal
To l
ab
ari
iv t
os
ec Variable
Utility Charge
Fixed Monthly
Utility Charge Activity (Kilowatt Hours) Nonlinear Costs
Nonlinear Costs
A nonlinear cost is one which has a curved
component.
For example, the per unit cost of an item may get
increasingly cheaper as the quantity purchased
increases.
A learning curve relates cost behavior to the time it takes
to learn a job.
For example, the greater the experience, the less labor
hours are required to complete the job. Learning Curve
Learning Curve Average Labor
Time per Unit Learning effects
are large initially.
Learning effects
become smaller, eventually
reaching steady state. Cumulative Production Output Assumptions in Cost
Assumptions in Cost
behaviour Estimation
1 Changes in total costs can be explained by changes in the level of a single activity.
– Variation in machinehours can explain variations in total cost .
– Variation in labourhours can explain variations in total cost. Assumptions in Cost
Assumptions in Cost
behaviour Estimation
2 Cost behaviour can adequately be approximated by a linear function of the activity level within the relevant range. – A linear cost function is a cost function in which the graph of total cost versus the level of a single activity is a straight line. Cost Function ...
Cost Function ...
– is a mathematical expression describing how costs change with changes in the level of an activity.
– Output produced
– Direct manufacturing labourhours
– Machinehours
– Batches of production One Cost Driver and Fixed/Variable One Cost Driver and Fixed/Variable Cost Behavior
This model ignores
other cost
behaviors and
other cost drivers. Choice of Cost Object
Choice of Cost Object A cost item may be variable with respect to one cost item and fixed with respect to another. – If the number of taxis owned by a taxi company is the cost object, annual taxi registration and licence costs would be a variable cost.
– If miles driven during a year on a particular taxi is the cost object, registration and licence costs for that taxi are fixed costs. Time Span
Time Span Whether a cost is variable or fixed with respect to a particular activity depends on the time span. More costs are variable with longer time spans. Relevant Range
Relevant Range Variable and fixed cost behaviour patterns are valid for linear cost functions only within the given relevant range. Costs may be nonlinear outside the range. Cost Estimation Methods
Cost Estimation Methods
AccountClassification Method
VisualFit Method
HighLow Method
LeastSquares Regression Method
Conference and Engineering Method Account Analysis ...
Account Analysis ...
– estimates cost functions by classifying cost accounts in the ledger as variable, fixed, or mixed with respect to the identified activity. – Typically, managers use qualitative rather than quantitative analysis when making these costclassification decisions.
– The cost analyst uses experience and judgement to separate total costs into fixed and variable. Account Classification Method Account Classification Method Example
Account
Indirect Labor
I ndirect Material
Depreciation
Property Taxes
I nsurance
Utilities
Maintenance
Totals Overhead
Total
Cost
$
450
700
1,000
200
300
400
600
$ 3,650 Costs for 1,000 Units
Variable
Fixed
Cost
Cost
$
450
700
1,000
200
300
350
50
500
100
$ 2,000
$ 1,650 Advantages and Disadvantages
Advantages and Disadvantages Advantage – Easy to use. Disadvantage – Hard to make comparisons as classification is subjective. VisualFit Method
A scatter diagram of past cost behavior
A scatter diagram of past cost behavior
may be helpful in analyzing mixed costs. VisualFit Method Total Cost in
1,000’s of Dollars Plot the data points on a
graph (total cost vs. activity). 20 10 0 **
** * ** *
** 0
1
2
3
4
Activity, 1,000’s of Units Produced VisualFit Method Total Cost in
1,000’s of Dollars Draw a straight line through the plotted data points that
is as close as possible to ALL data points. 20 10 0 **
** * ** *
** 0
1
2
3
4
Activity, 1,000’s of Units Produced VisualFit Method Total Cost in
1,000’s of Dollars Estimated fixed cost = $10,000
20 10 0 **
** * ** *
Vertical distance
**
is total cost,
approximately
$16,000. 0
1
2
3
4
Activity, 1,000’s of Units Produced VisualFit Method
Total variable cost = Total cost – Total fixed cost
Total variable cost = $16,000 – $10,000 = $6,000 Total Cost in
1,000’s of Dollars Estimated fixed cost = $10,000
20 10 0 **
** * ** *
Vertical distance
**
is total cost,
approximately
$16,000. 0
1
2
3
4
Activity, 1,000’s of Units Produced VisualFit Method
Total variable cost = Total cost – Total fixed cost
Total variable cost = $16,000 – $10,000 = $6,000
Unit variable cost = $6,000 ÷ 3,000 units = $2 Total Cost in
1,000’s of Dollars Estimated fixed cost = $10,000
20 10 0 **
** * ** *
Vertical distance
**
is total cost,
approximately
$16,000. 0
1
2
3
4
Activity, 1,000’s of Units Produced Advantages and Disadvantages
Advantages and Disadvantages Advantage – Easy to use.
– Managers find it easier to understand.
– Uses all available data to derive cost function. Disadvantage – Highly subjective as line is based on visual, which means cost function could be different for different people. HighLow Method
HighLow Method Choose the highest and lowest value of the cost driver and their respective costs. Determine a and b using algebra. HighLow Method
HighLow Method High capacity December: 55,000 machinehours Cost of electricity: $80,450 Low capacity September:
30,000 machinehours Cost of electricity: $64,200 What is the variable rate? HighLow Method
HighLow Method ($80,450 – $64,200) ÷ (55,000 – 30,000) $16,250 ÷ 25,000 = $0.65 What is the fixed cost? HighLow Method
HighLow Method 480,450 = Fixed cost + 55,000 x $0.65 Fixed cost = $80,450 – $35,750 = $44,700 $64,200 = Fixed cost + 30,000 × $0.65 Fixed cost = $64,200 – $19,500 = $44,700 y = a + bx y = $44,700 + ($0.65 × Machinehours) Advantages and Disadvantages
Advantages and Disadvantages Advantage – Easy to use.
– Highly objective as there is no choice as to the highest and lowest data. Disadvantage – Compared to the first two, insufficient data used.
– Could be outliers. Regression Analysis ...
Regression Analysis ...
– is used to measure the average amount of change in a dependent variable, such as electricity, that is associated with unit increases in the amounts of one or more independent variables, such as machine
hours. Regression Analysis
Regression Analysis Simple regression analysis estimates the relationship between the dependent variable and one independent variable. Multiple regression analysis estimates the relationship between the dependent variable and multiple independent variables. Regression Analysis
Regression Analysis The regression equation and regression line are derived using the leastsquares technique. The objective of leastsquares is to develop estimates of the parameters a and b. Regression Analysis
Regression Analysis The vertical difference (residual term) measures the distance between the actual cost and the estimated cost for each observation. Goodness of Fit
Goodness of Fit The coefficient of determination (r2) expresses the extent to which the changes in (x) explain the variation in (y). An (r ) of 0.80 indicates that more than 80 per cent of the change in the dependent variable can be explained by the change in the independent variable.
2 Slope of Regression Line
Slope of Regression Line A relatively steep slope indicates a strong relationship between the cost driver and costs. A relatively flat regression line indicates a weak relationship between the cost driver and costs. Slope of Regression Line
Slope of Regression Line The closer the value of the correlation coefficient (r) to ±1, the stronger the statistical relation between the variables. As (r) approaches +1, a positive relationship is implied, meaning the dependent variable (y) increases as the independent variable (x) increases. Slope of Regression Line
Slope of Regression Line As (r) approaches –1, a negative, or inverse, relationship is implied, meaning the dependent variable (y) decreases as the independent variable (x) increases. Advantages and Disadvantages
Advantages and Disadvantages Advantage – Highly Objective.
– Regression analysis uses all available data to estimate the cost function.
– The regression method is more accurate than the highlow method. Disadvantage – More difficult to use. Engineering Method ...
Engineering Method ...
– is also called the workmeasurement method.
It estimates cost functions by analysing the relationship between inputs and outputs in physical terms. Criteria to Evaluate and Criteria to Evaluate and Choose Cost Drivers
1 Economic plausibility
2 Goodness of fit
3 Slope of the regression line CostVolumeProfit Analysis
(CVP) General versus special case of CVP
General versus special case of CVP Using a general case of profit planning, we realise that a business has many cost drivers and revenue streams that are fundamental to its profitability In CVP analysis, we assume a much more simple model, where there are restrictions on these setting, as outlined in the following slides: CostVolumeProfit CostVolumeProfit Assumptions and Terminology
1. The behaviour of total revenue is linear. 1. The behaviour of total expenses is linear over the relevant range. CostVolumeProfit CostVolumeProfit Assumptions and Terminology
The analysis either covers a single product or assumes that the sales mix when multiple products are sold will remain constant as the level of total units sold changes.
2. In manufacturing firms, inventory levels at the beginning and end of the period are the same.
1. CostVolumeProfit CostVolumeProfit Assumptions and Terminology Operating profit = Total revenues from operations – Cost of goods sold and operating costs (excluding taxes) Net Profit = Operating profit + Non operating revenues (such as interest revenue) – Nonoperating costs (such as interest cost) – Profit taxes Operating profit versus Net profit
Operating profit versus Net profit Operating profit statement emphasises operating profit (contribution margin). Revenues – Variable cost of goods sold – Variable operating costs = Contribution margin Contribution margin – Fixed operating costs = Net profit Operating profit versus Net profit
Operating profit versus Net profit Financial accounting profit statement emphasises operating profit. Revenues – Cost of goods sold = Operating profit (Gross profit) Operating profit – Operating costs = Net profit Breakeven Point ...
Breakeven Point ...
– is the sales level at which operating profit is zero. At the breakeven point, sales minus variable expenses equals fixed expenses. Total revenues = Total costs Methods for Determining Methods for Determining Breakeven Point Breakeven can be computed by using either the equation method, the contribution margin method, or the graph method. BreakEven Model – BreakEven Model – Equation Method Example
Planet, Inc. sells Model XT telescopes for
$2,000 each. Fixed costs totaled $300,000,
variable costs were $800 per unit.
How many units does Planet need to sell in
order to BreakEven point?
(SP × Sales Units) = (VC × Sales Units) + FC ? BreakEven Model – Equation Method Example
Planet, Inc. sells Model XT telescopes for
$2,000 each. Fixed costs totaled $300,000,
variable costs were $800 per unit.
How many units does Planet need to sell in
order to BreakEven point?
(SP × Sales Units) = (VC × Sales Units) + FC
Break Even Sales Units = FC ÷ (SP  VC)
= $300,000 ÷ ($2,000  $800)
= $300,000 ÷ $1,200
= 250 Telescopes Contribution Margin Method
In the previous
In
example, we used:
example,
FC ÷ (SP  VC)
to compute BreakEven Units. (SP  VC)
(SP
is referred to as
is
Contribution Margin (CM)
Contribution Contribution Margin Ratio
Contribution Margin Ratio
Calculate the breakeven point in sales dollars rather than units by using the contribution margin ratio. Contribution margin
Contribution
Sales
Sales
Fixed expense
Fixed
CM Ratio
CM = CM Ratio Breakeven point
=
(in sales dollars) Graph Method
Graph Method In this method, we plot a line for total revenues and total costs. The breakeven point is the point at which the total revenue line intersects the total cost line. The area between the two lines to the right of the breakeven point is the operating profit area. Graph Method Cost & Revenues The Revenue and Cost lines can be overlaid to get a picture
of the CVP relationship.
of
CVP Graph: Fairfield Blues
$1,250,000
$1,000,000
$750,000
$500,000
$250,000
$0
0 50,000 90,000 130,000 170,000 Quantity of Tickets Sold The Fairfield
The
Blues sell
tickets for $7.
Fixed Costs
are $450,000
and Variable
Costs per unit
are $2 per
ticket. Graph Method
Revenue = $7 × Units Sold
Fixed Costs = $450,000
Cost & Revenues CVP Graph: Fairfield Blues
$1,250,000
$1,000,000
$750,000
$500,000
$250,000
$0
0 50,000 90,000 130,000 170,000 Quantity of Tickets Sold Total Cost = ($2 × Units Sold) + $450,000 Graph Method Cost & Revenues Loss is the amount by which total
Loss
cost exceeds revenue.
cost
CVP Graph: Fairfield Blues BreakEven is
BreakEven
where the two
lines intersect.
lines $1,250,000
$1,000,000
$750,000
$500,000
$250,000
$0
0 50,000 90,000 130,000 170,000 Quantity of Tickets Sold Profit is the
Profit
amount by
which revenue
exceeds total
cost.
cost. Target Operating Profit ...
Target Operating Profit ...
can be determined by using any of three methods:
1 The equation method
2 The contribution margin method 3 The graph method
– CVP and Target Income
CVP and Target Income
BreakEven analysis uses $0 for profit. Target Profit
BreakEven
analysis, puts a $ target in the profit variable, but uses the
same model as BreakEven analysis.
same
Planet, Inc. sells Model XT telescopes for $2,000 each.
Fixed costs are $300,000, variable costs are $800 per unit.
How many units does Planet need to sell in order to have
target profit of $120,000? Target Π = (SP  VC) × Sales Units  FC
Target
Target Π = (SP  VC) × Sales Units  FC
Target
Sales Units = (Target Π + FC) ÷ CM per unit
Sales
= ($120,000 + $300,000) ÷ $1,200
= 350 Telescopes ? Sensitivity Analysis and Sensitivity Analysis and Uncertainty Sensitivity analysis is a “what if” technique that examines how a result will change if the original predicted data are not achieved or if an underlying assumption changes. Modeling Taxes
Modeling Taxes
Aftertax ∏ = Beforetax ∏ × (1  Tax Rate)
Aftertax
Adding the tax rate to your profit model, will have no
Adding
effect on the computation of breakeven.
effect
Adding the tax rate to your profit model will increase
Adding
the number of sales units necessary to reach target
profit.
profit. Operating Leverage ...
Operating Leverage ...
– measures the relationship between a company’s variable and fixed expenses. It is greatest in organisations that have high fixed expenses and low per unit variable expenses. The degree of operating leverage shows how a percentage change in sales volume affects profit. Degree of operating leverage = Contribution margin ÷ Operating profit Modeling Multiple Products
Modeling Multiple Products
When a company sells
When
multiple products,
modeling requires:
modeling
1. An estimate of the
1.
relative proportion of
each product in the “sales
each
sales
mix”.
mix
2. A computation of the
2.
Weighted Average Unit
CM.
CM. Modeling Multiple Products
Modeling Multiple Products
Planet plans to add two new telescopes to it’s line, The Earth II
Model and the Junior Model. Fixed cost is $300,000. Relative sales
and cost estimates are: (CM1 × Sales %1) + (CM2 × Sales %2) + (CM3 × Sales %3)
= ($1,200 × 25%) + ($700 × 40%) + ($350 × 35%)
($1,200
= $300.00 + $280.00 + $122.50
= $702.50 Modeling Multiple Products
Modeling Multiple Products
At a weighted average unit contribution margin of $702.50, we
would need to sell 428 telescopes to cover the $300,000 in fixed
costs. CVP Analysis in Service and CVP Analysis in Service and Nonprofit Organisations CVP can also be applied to decisions by manufacturing, service, and nonprofit organisations. The key to applying CVP analysis in service and nonprofit organisations is measuring their output. End of Topic 4
End of Topic 4
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