L04-Cost behaviour and planning_1

L04-Cost behaviour - Topic 4 Topic 4 Cost Behaviour and Planning Introduction Introduction How do managers know what price to charge whether to

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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 Step-Variable Costs Cost Total cost remains constant within a narrow range of activity. Activity Other types of Costs Step-Variable 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 step-variable cost? Step-variable costs can be adjusted more quickly and . . . The width of the activity steps is much wider for the step-fixed 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 Account-Classification Method Visual-Fit Method High-Low Method Least-Squares 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. Visual-Fit 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 Visual-Fit 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 Visual-Fit 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 Visual-Fit 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 Visual-Fit 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 Break-Even 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 Break-Even 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 Break-even 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 Break-Even is Break-Even 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 Break-Even analysis uses $0 for profit. Target Profit Break-Even analysis, puts a $ target in the profit variable, but uses the same model as Break-Even 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 After-tax ∏ = Before-tax ∏ × (1 - Tax Rate) After-tax Adding the tax rate to your profit model, will have no Adding effect on the computation of break-even. 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 We made it! ...
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This note was uploaded on 09/19/2011 for the course ACCOUNTING 211 taught by Professor Min during the Three '11 term at Curtin.

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