Managerial accounting 6e jams jambalvo chapter 04

Prepared by
Debby Bloom-Hill
CMA, CFM


CHAPTER 4
Cost-Volume-Profit Analysis

Slide 4-2


Management Questions
 Planning
 What level of profit should be in the budget
for the coming year?

 Control
 Did the manager responsible for
production costs do a good job of
controlling costs?

 Decision making
 Should the price be increased?
Slide 4-3

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Common Cost Behavior Patterns

 Variable Costs
 Costs which change directly in
proportion to changes in quantity or
activity

 Fixed Costs
 Costs which do not change when
quantity or activity volume changes

Slide 4-4

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Common Cost Behavior Patterns
 Mixed Costs
 Costs that have both variable and fixed
elements

 Step Costs
 Fixed for a range of output, but increase
when upper bound of range is exceeded

Slide 4-5

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.

Variable Costs
 Costs that change in proportion to
changes in volume or activity
 An automobile manufacturer will need 400
tires to make 100 cars, but 4,000 tires to
make 1,000 cars
 A bakery will need 2 eggs to make 1 cake
and 20 eggs to make 10 cakes

 If activity increases by a certain
percentage, cost increases by that same
percentage
Slide 4-6

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Test Your Knowledge 1
A company has decided that direct labor costs
are 100% variable. Last month total direct
labor costs were $125,000 and total direct
labor hours worked were 10,000.
1.What is the direct labor cost per hour?
$125,000 / 10,000 hours = $12.50 per hour
3.Predict labor costs in a month when 12,000
labor hours are worked

$12.50 per hour × 12,000 hours = $150,000
Slide 4-7

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Variable Costs

Total Variable Cost = $91 × Units produced
Slide 4-8

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Fixed Costs
 Do not change in response to changes in
activity level
 Typical fixed costs are depreciation,
supervisory salaries, and building
maintenance
• Rent for a bakery will not double if output
increases from 100 to 200 cakes

 If activity increases by a certain
percentage, costs remain unchanged
Slide 4-9

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Fixed Costs

Total fixed cost = $94,000
Slide 4-10

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Fixed Costs
 Discretionary fixed costs
 Management can easily change, e.g.
advertising, research & development
 Many companies cut back on these costs when
sales drop. This can be shortsighted.
 A cut in research & development can have a
negative effect on long run profitability
 A cut in repair and maintenance can have a
negative effect on the life of valuable assets

 Committed fixed costs
 Cannot be easily changed, e.g. rent, insurance
Slide 4-11

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Mixed Costs
 Contain both variable and fixed cost
elements
 Can separate mixed costs into variable and
fixed components
 Salesperson with base salary (fixed) and
commission on sales (variable)
 Base salary included with fixed costs
 Commission included with variable costs

Slide 4-12

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Mixed Costs

Total cost = ($91 × Units produced) + $94,000
Slide 4-13

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity

using account analysis and the high-low method.


Step Costs
 Fixed cost for a specific range of volume
 Increases to higher level when upper bound of
range is exceeded
 At that point, costs again remain fixed until
another upper bound is exceeded

 Step costs are often classified as either:
 Step variable costs, if the range of activity where
the cost is fixed is small, or
 Step fixed costs, if the range of activity where the
cost is fixed is large
Slide 4-14

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Step Variable Cost

Slide 4-15

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.

Step Fixed Cost

Slide 4-16

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Relevant Range
 The relevant range is the range of activity for
which assumptions as to how costs behave are
reasonably valid
 If it is known that production is going to be
within the relevant range, we can use
assumptions about the fixed and variable costs
 Making assumptions about fixed and variable
costs at production levels well above or below
this range would not be valid

Slide 4-17

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


The Relevant Range

Total step costs =
$7,000 for relevant range 0 – 3,000 units produced
$14,000 for relevant range 3,001 – 6,000 units
$21,000 for relevant range 6,001 – 9,000 units
Slide 4-18

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Cost Estimation Methods
 Account Analysis
 Classify costs into variable and fixed pools

 Scattergraphs
 Can see cost relationships visually

 High-Low Method
 Linear estimation connects high and low
volume observations

 Regression Analysis
 Linear estimation is best fit to observed values
Slide 4-19

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.

Account Analysis
 Most common approach
 Requires professional judgment of
management
 Management classifies costs as fixed,
variable, or mixed
 Total variable costs divided by activity
equals variable cost per unit
 Variable cost per unit and total fixed costs
can be used in cost equation
Slide 4-20

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Slide 4-21

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Scattergraphs
 Utilization of cost information from several
previous periods
 Weekly, monthly, or quarterly cost reports
are useful

 Plot the actual costs at the observed activity
levels
 Look for relationship between cost and
activity, linear is ideal
 Use relationship to predict future costs
Slide 4-22

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


Scattergraphs

Is there a relationship between units produced and
production costs? Describe the relationship.
Slide 4-23

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


High-Low Method
 Utilization of cost information from previous
periods
 Fits a straight line from lowest activity level to
highest activity level
 Slope of the line is the estimate of the unit
variable cost

 The slope measures the change in cost per unit
in relation to the change in activity level
 Total cost at lowest or highest activity level minus
variable cost at that level equals fixed cost

Slide 4-24

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.


High-Low Method

Total cost
at high
activity
level

Total cost at
low activity
level

Slide 4-25

Learning objective 1: Identify common cost behavior
patterns, and estimate the relation between cost and activity
using account analysis and the high-low method.