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Class 5

The document discusses cost behavior analysis and different types of costs including variable, fixed, and mixed costs. It also covers calculating break-even points using mathematical equations, contribution margin, and graphs. Determining target net income and margin of safety are also discussed.

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carla
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27 views

Class 5

The document discusses cost behavior analysis and different types of costs including variable, fixed, and mixed costs. It also covers calculating break-even points using mathematical equations, contribution margin, and graphs. Determining target net income and margin of safety are also discussed.

Uploaded by

carla
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Class 5

1.Explain variable, fixed, and mixed costs as well as the relevant range.

Cost behavior analysis is the study of how specific costs respond to changes in the level of
business activity. As you might expect, some costs change when activity changes and others
remain the same.

The activity index identifies the activity that causes changes in the behavior of costs. With an
appropriate activity index, companies can classify the behavior of costs in response to changes in
activity levels into three categories: variable, fixed, or mixed.

Variable costs are costs that vary in total directly and proportionately with changes in the
activity level. If the level increases 10%, total variable costs will increase 10%. If the level of
activity decreases by 25%, variable costs will decrease 25%.

Fixed costs are costs that remain the same in total regardless of changes in the activity level.
Examples include property taxes, insurance, rent, supervisory salaries, and depreciation on
buildings and equipment. Because total fixed costs remain constant as activity changes, it
follows that fixed costs per unit vary inversely with activity: As volume increases, unit cost
declines, and vice versa.
Relevant Range

In Illustration 5.1 part (a), a straight line is drawn throughout the entire range of the activity
index for total variable costs. In essence, the assumption is that the costs are linear. If a
relationship is linear (that is, straight-line), then changes in the activity index will result in a
direct, proportional change in the total variable cost.
In most business situations, a straight-line relationship does not exist for variable costs
throughout the entire range of possible activity.
The relationship between the behavior of a variable cost and changes in the activity level is often
curvilinear. In the curved sections of the line, a change in the activity index will not result in a
direct, proportional change in the variable cost.

Some fixed costs will not change. But it is possible for management to change other fixed costs.
Fixed costs that may be changed by managers include research, such as new product
development, and management training programs.
The range over which a company expects to operate during a year is called the relevant range of
the activity index. The relevant range is also called the normal or practical range.
Although the linear (straight-line) relationship may not be completely realistic, the linear
assumption produces useful data for CVP analysis as long as the level of activity remains
within the relevant range.

Mixed costs are costs that contain both a variable- and a fixed-cost element. Mixed costs,
therefore, change in total but not proportionately with changes in the activity level.

2.Apply the high-low method to determine the components of mixed costs.

For purposes of cost-volume-profit analysis, mixed costs must be classified into their fixed
and variable elements.

The high-low method uses the total costs incurred at the high and low levels of activity to
classify mixed costs into fixed and variable components. The difference in costs between the
high and low levels represents variable costs, since only the variable-cost element can change as
activity levels change.
1. Determine variable cost per unit from the formula shown in Illustration 5.6. This is the
slope of the cost function.

2. Determine the total fixed costs by subtracting the total variable costs at either the high or
the low activity level from the total cost at that activity level.

3.Prepare a CVP income statement to determine the contribution margin.


Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume
on a company’s profits. CVP analysis is important in profit planning. It also is a critical factor in
such management decisions as setting selling prices, determining product mix, and maximizing
use of production facilities.

Basic Components

CVP Income Statement


Because CVP is so important for decision-making, management often wants this information
reported in a cost volume-profit (CVP) income statement format for internal use. The CVP
income statement classifies costs as variable or fixed and computes a contribution margin.
Contribution margin (CM) is the amount of revenue remaining after deducting variable costs.
It is often stated both as a total amount and on a per unit basis.

The unit contribution margin indicates the increase in income that results from every additional
unit sold after the break-even point.
The contribution margin ratio indicates by how much every dollar of sales will increase income
after the break-even point.
4.Compute the break-even point using three approaches.

Break-even analysis indicates the amount of sales units or sales dollars that a company needs to
cover its costs.
The break-even point can be:
1. Computed from a mathematical equation.
2. Computed by using contribution margin.
3. Derived from a cost-volume-profit (CVP) graph.
The break-even point can be expressed either in sales units or sales dollars.

Mathematical Equation

Contribution Margin Technique

Contribution Margin in Units

Contribution Margin Ratio

Graphic Presentation

An effective way to find the break-even point is to prepare a break-even graph. Because this
graph also shows costs, volume, and profits, it is referred to as a cost-volume-profit (CVP)
graph.
5.Determine the sales required to earn the target net income and determine the margin of safety.

Target Net Income

Rather than simply “breaking even,” management usually sets an income objective often called
target net income. It then determines the sales necessary to achieve this specified level of
income. Companies determine the sales necessary to achieve target net income by using one of
the three approaches discussed earlier.

Mathematical Equation

Contribution Margin Technique


Margin of safety is the difference between actual or expected sales and sales at the break-even
point. It measures the “cushion” that a particular level of sales provides. It tells us how far sales
could fall before the company begins operating at a loss. The margin of safety is expressed in
dollars or as a ratio.

The higher the margin of safety in dollars or the percentage, the lower the risk that the
company will operate at a loss.

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