COST BEHAVIOR
When levels of activity change some costs
change; others remain the same.
A knowledge of cost behavior helps
management plan operations and decide
between alternative courses of action.
Cost Behavior Analysis is:
the study of how specific costs respond to changes in
the level of business activity
Cost behavior analysis applies to all types of
entities
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COST BEHAVIOR
The classification of variable and fixed costs is
relative. It is valid in a relevant range of
activity only
Relevant range is the limit of activity level
within which a specific relationship between
costs and the activity is valid
VARIABLE COSTS
Variable costs are costs that vary in total
directly and proportionately with changes in
the activity level.
If the activity level increases 10 percent, total
variable costs will increase 10 percent .
Variable costs remain the same per unit at
every level of activity
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VARIABLE COSTS
FIXED COSTS
Fixed costs are costs that remain the same in
total regardless of changes in the activity
level.
Fixed costs per unit cost vary inversely with
activity:
As volume increases, unit cost declines, and
vice versa.
Examples include:
Depreciation on buildings and equipment,
Property taxes Insurance, and Rent.
FIXED COSTS
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BREAK EVEN ANANLYSIS
Is based on the classification of cost into
variable and fixed costs
Breakeven point
The point at which total revenue is just equal to the
total cost
Measured in units or dollar amount
BREAK-EVEN ANALYSIS
Break-even analysis can be approached
in two ways:
Equation method
Contribution margin method
DETERMINATION OF BREAKEVEN POINT
Equation method
Based on the definition of the break-even point
Solve the break-even equation
Revenue – Variable – Fixed = Profit
cost cost
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DETERMINATION OF BREAKEVEN POINT
Contribution margin method
Basis of the method is the concept of
“contribution margin”
Contribution margin is the difference
between selling price and variable costs
Meaning: to cover fixed cost and generate
profit
Expressed in: Per unit, Ratio, Total
contribution
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CONTRIBUTION MARGIN
Formulas
Units
Dollar amount
Break-even point Fixed expenses
=
in units sold CM per unit
Break-even point in Fixed expenses
total sales dollars =
CM ratio
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MARGIN OF SAFETY
The margin of safety is the excess of
budgeted (or actual) sales over the break-
even volume of sales
Measures the “cushion” that management
has, allowing it to break-even even if
expected sales fail to materialize.
May be expressed in dollars or as a ratio
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MARGIN OF SAFETY
formula
Total Sales Breakeven sales
Or
Total Sales Breakeven Sales
(%)
Total Sales
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COST-VOLUME-PROFIT ANALYSIS
Profit is the function of factors
Selling price
Fixed cost
Variable cost
Volume
CVP analysis is to find the optimal combination
of the factors above
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PROFIT
SALES SELLING
VOLUME PRICE
VARIABLE FIXED
COST COST
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USING CVP ANALYSIS FOR
MANAGEMENT DECISION MAKING
Common applications include
changes in fixed expenses
changes in the unit contribution margin
multiple changes in key variables
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CHANGES IN FIXED EXPENSES
When estimates of fixed costs are revised, the
break-even point will change
percentage change in fixed expenses will lead to
similar increase in the break-even point (in units or
dollars)
Different fixed costs may apply to different
levels of sales volume
more than one break-even point
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CHANGES IN THE UNIT
CONTRIBUTION MARGIN
Change in unit variable expenses
changes the unit contribution margin
a new break-even point
an increase in unit variable expenses will increase
the break-even point
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CHANGES IN THE UNIT
CONTRIBUTION MARGIN
Change in sales price
changes the unit contribution margin
a new break-even point
an increase in unit price will lower the break-even
point
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MULTIPLE CHANGES IN KEY
VARIABLES
May involve
increasing unit prices
undertaking an advertising campaign
hiring a new storage facility
An incremental approach
focuses on the difference in the total
contribution margin, fixed expenses and profits
under the two alternatives
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BREAKEVEN – MULTIPLE
PRODUCT MIX
Most companies provide more than one types
of products/services
Different products and services have different
levels of profit
The purpose of the management is to have the
product mix that maximizes profit of the
company
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EXAMPLE
Product Product Product Total
A B C
Selling price/unit $20 $10 $5
Variable costs/unit 15 6 2
Total fixed costs $627.000
Sales volume (units) 90.000 90.000 60.000
Sales volume (dollar) $1.800.000 $900.000 $300.000 $3.000.000
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BREAKEVEN – MULTIPLE
PRODUCT MIX
Total revenue Total costs
Product mix
60-30-10 Break even
Profit
$ 336,000
Loss
1.9 3 Sales volume (Mil. $)
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BREAKEVEN POINT
constraints with multiple product mix
Different products/services have different
characteristics and physical forms
Breakeven point of a multiple product mix
should be measured in dollar amount (revenue)
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BREAKEVEN POINT-PRODUCT MIX
calculation
Determine contribution margin (ratio) of the
sales mix, contribution margin of the mix is
dependent of
CM of each product/service in the mix
Sales structure (percentage of each product/service
in the mix)
Calculate the breakeven point of the sales mix
In dollar amount
In unit
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BREAKEVEN POINT
formula for a product mix
Total Total
CM of sales Variable costs
product mix
Total sales
Total fixed costs
Break-even
($) CM of product mix
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EXAMPLE
Product mix
60 – 30 – 10 Contribution
Product Sales Per unit Total %
A $1,800,000
B 900,000
C 300,000
Total $3,000,000
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EXAMPLE
Product mix
40 – 40 – 20 Contribution
Product Sales Per unit Total %
A $1,200,000
B 1,200,000
C 600,000
Total $3,000,000
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BREAKEVEN – MULTIPLE
PRODUCT MIX
Total revenue Total costs
Product mix
40-40-20
Profit
Break even
$ 513.000
Loss
1.6 3 Sales volume (Mil. $)
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PROFIT AND SALES STRUCTURE OF
PRODUCT MIX
Total profit of the company is determined by the % of
contribution margin of each product and contribution
margin of the mix
Total profit will be changed when sales ratio of the
mix changes
Total profit may be declined if the company switches
from selling high CM products to low CM products
though total revenues may increase
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EXAMPLE
Product Product Product
A B C
Selling price/unit $100 $80 $60
Variable costs/unit 60 50 40
Contribution/unit 40 30 20
Direct labor hours to produce 1 unit
Total direct labor hours are limited
at 100,000 hours
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Total labor Labor Total units to Contribution Total
hours hours/unit be produced /unit contribution
Product A 100,000 10 10,000 $40
Product B 100,000 5 20,000 30
Product C 100,000 2 50,000 20
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CONTRIBUTION AND PROFIT
Contribution margin is the source of profit
Maximization of profit means maximization of
contribution margin
The purpose of management is to maximize
profit based on current resources
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MAXIMIZATION OF CONTRIBUTION
PRINCIPLE
Decision is based on the contribution per
unit of limited resources
Rank products in order of contribution per
unit of limited resource
Produce product with highest contribution
per unit of limited resource, then the second
…
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Price/unit VC per Contribution/ Labor Contribution
unit unit hours/unit per labor hour
Product A $100 $60 $40 10 $4
Product B 80 50 30 5 6
Product C 60 40 20 2 10
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Assume the market demand for product A is 7,000 units,
While demand for product B is unlimited and
market for product C is 10,000 units
DECISION???
Determine the sales mix that maximize the company’s profit
If total fixed costs is $590,000, what is the maximized profit?
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CVP analysis and longer-term
decisions
CVP analysis is usually regarded as a short-
term or tactical decision tool
Classification of costs as variable or fixed is
usually based on cost behaviour over the
short term
The financial impact of long-term decisions
is best analysed using capital budgeting
techniques
Takes into account the time value of money
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TREATING CVP ANALYSIS WITH
CAUTION
CVP analysis is merely a simplified model
The usefulness of CVP analysis may be greater
in less complex smaller firms
For larger firms, CVP analysis can be valuable
as a decision tool for the planning stages of
new projects and ventures
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