Lesson 2: Cost Behaviour

Cost behaviour refers to the sensitivity of costs to change in an underlying

activity. For example:

- How do raw material costs change the more we produce?

- How do rental costs change the more we produce?
- How do selling costs change the more we sell?

Cost behaviour

- How a cost changes in response to an activity level

o Sales volume
o Production volume
o Electricity usage
o No of setups

Broad categories

- Variable costs
- Fixed costs
- Step costs
- Mixed costs

Fixed cost

- Constant cost with changes in activity (within the relevant range)

- Relevant range
o Important – capacity
o Often assumed away
- E.g., paintball venue hire
o Capacity is limited per day
o Cost is fixed until capacity reached
o Hire another day or hire another venue

Step cost
 - Cost increases with changes in activity but in intervals
- Fixed costs outside of relevant range are actually step costs
- E.g., paintball instructor cost
o Capacity is limited (10 people)
o Cost increases in batches of 10
o Decision will need to consider batches
 i.e., step occurs within the relevant range

Variable cost

- increasing cost in line with changes in activity

o constant cost per unit
o e.g., paintball gun hire per game
 marginal cost constant per game
 total cost varies with the number of games
o theoretically perectly linear
 relevant ranger
 plays a small role – model fit

Mixed cost

- One cost name but

 o Two underlying behaviours
o Need to separate the two underlying costs
- E.g., ticketing costs
o Commission + fixed platform fee
o Analyse using the high/low method to estimate each element

Illustrative example 1

Scenario
Imagine that you are the owner of a new company called Explosive
events. Explosive events began when you had an idea to start holding
regular paintball tournaments on weekends on a farm outside of Cape
Town. Initially it was done casually because you had an interest in
paintball games, but now the business is becoming more popular and you
need to get a better handle on how it runs. You are concerned that one of
the reasons it is popular is because you are running the tournament too
cheaply and the business may not be sustainable.

From your limited experience you are aware of the following costs

- The venue, a farm outside of Cape Town, needs to be rented.

Currently you pay per day but are thinking of paying a fixed monthly
cost.
- At the venue 20 paintball games can be played each day
- Each game can have up to 16 players at a time
- The paintball guns are hired from an external company who charges
a rate per game and a rate to servicer the guns at the end of the
day
- Instructors need to be hired to supervise each game and you would
need 1 instructor per 10 players. They are paid a rate per day
- Paintballs are bought and an initial amount of 20 balls are allocated
to each player per game. Thereafter the players must buy more
paintballs.
- There are various social media marketing costs incurred.

Question

Look at the following table, and based on the information that was
provided, decide for both the costs and incomes what the behaviour
classification should be i.e., are they variable, fixed, step costs or mixed
costs (and incomes)

Just tick the column that you see as appropriate.

Cost Assignment

Cost assignment: Refers to how costs are traced or allocated to various

cost objects

Cost object: Is the item that we want to trace or allocated the costs to

The distinction is important because when we need cost information, we

don’t just need information in general, we need the information for a
particular thing (the object). For example, if a company wants to
determine the cost of:

- A product, then the product is the thing you need the information for
(the object)
- A service, then the service is the thing you need the information for
(object)
- A customer, then the customer is the thing you need the information
for (object)
- Its support department, then the support department is the thing
you need the information for (object)

Cost assignment

- The process of tracing or allocating costs to a cost object

Cost object

- The item for which cost information is desired

- The type of decision or level of control determines the object
- Paintball tournament
o Different objects depending on what type of information is
needed
 Cost of a participant (object is participant)
 Cost of a paintball game (object is the 30 min game)
 Cost of the day (object is the day)
- Typical objects
o Product sold (e.g., a car)
o Process (e.g., the car painting process)
o Activity (e.g., sheet metal processing)
o Project (e.g., the development of a new car)
o Support service (e.g., support helpdesk)
o Customer (e.g., the cost of each customer)
Tracing vs allocating

Not all costs can be traced to an object easily

- Sometimes it is not possible to trace a cost to the object

o Factory rent cannot be traced to the product (object)
o Venue hire cannot be traced to the paintball game ticket
- Sometimes the cost/benefit of tracing does not make sense
o Electricity to run the factory can be traced to objects
o Paintball costs can be traced to a paintball game
 Value of the accuracy may not be worth the cost of
tracing
- Direct costs are defined as costs that are easily or worth tracing
- Indirect costs are costs that cannot be or are not worth tracing
o Allocated instead of traced

Direct costs

Costs that can be easily traced to a cost object

Can be manufacturing or selling, admin and general costs

- Raw material costs (manufacturing) are traceable to a product and

therefore are a direct cost with regards to that product (object)
- Sales commission (non-manufacturing) is traceable to a sale and
therefore is a directo cost with regards to that sale (object)

Direct costs are not the same as variable costs

But direct costs are usually variable costs

- Direct costs can be traced to the object

o Paintball gun hire can be traced to a game ticket
- Variable costs change with changes in activity
o Paintball gun hire costs vary with the number of game tickets
sold
Indirect costs

Costs that cannot be easily traced to a cost object

- Factory rent (manufacturing) is not traceable to a product and

therefore is an indirect cost with regard to that product (object)
- General marketing costs (non-manufacturing) are not traceable to a
sale and therefore are indirect costs with regards to that sale
(object)

Indirect costs are not the same as fixed costs

Indirect costs can be fixed or variable

- Indirect costs cannot be easily traced to the object

- Fixed costs don’t change with changes in activity

Variable indirect

Factory electricity (not always)

- Products are the object (i.e., aim is to determine product costs)

- Electricity cannot be (easily) traced to individual products made –
indirect costs
- Electricity cost changes with kw hours – variable in nature

Fixed indirect

Rent to lease a factory

- Products are the object (i.e., aim is to determine product cost)

- Rental cannot be traced to individual products made, therefore
indirect costs
- Rental costs does not change with any activity – fixed in nature
Illustrative example 2

Refer to the same question

Lesson 4 – Cost Function

We want to look at how costs can be classified according to the purpose

(function) that the costs serve in the company. We also want to clarify the
difference between period and product costs.

Functions of costs

Costs can be classified into their function

- According to the purpose the costs serve

- This is typically for financial reporting purposes (IAS) not necessarily
for decision making and control

Inventoriable

- Direct labour
- Direct materials
- Manufacturing overheads
o Variable manufacturing overheads
o Fixed manufacturing overheads

Non-inventoriable

- Selling
- General
- Administrative

Period vs product costs

IFRS (IAS 2) Product costs

- Purchase costs (direct materials etc)

- Conversion costs (labour, indirect overheads)
- Costs getting inventory to present location and condition (railage in)

Product costs
 - Direct manufacturing costs
- Allocated indirect manufacturing costs (see absorption costing)

Period costing

- All other non-manufacturing costs

o Fixed and variable or Direct and Indirect
- Note: Variable costing system
- treats fixed manufacturing costs as period costs (NOT IFRS
compliant)
Lesson 5 – Cost Estimation

Determining how costs will change with changes in activity

- i.e., the cost function – mathematical relationship

- NB Principle as many tools depend on this process
o Scenario and sensitivity analysis
o Budgeting and standard costing
o Bidding and decision making
- Need to identify a cost driver (the activity)
o E.g., inspection costs
 High level – number of items produced
 Deeper level – number of items inspected
 Deepest level – number of hours spent inspecting
o Cost driver chosen must logically explain the cost
o Some drivers explain the cost better than others
 Ideally we would like the best driver
 Cost/benefit

Cost estimation

Many methods

- Inspection of accounts
- Scatter graph method
- High-low method
- Least squares regression
High-low cost estimation

Mixed costs – combination of fixed and variable costs

- High-low is a method to separate the fixed and variable elements

o i.e., determining the linear relationship
o y = mx + c

Calculation

- Based on changes between two observations

- Usually the highest and the lowest activity level
o Variable cost (change in cost)/(change in activity)
o Total cost – (VC x activity) = fixed cost

Complexities

- Fixed costs do increase over time period (inflation etc)

o You need to isolate the change due to activity only
 i.e., remove price effects
- Relevant range is important
o Both points used must be based on the same fixed cost level
o Look for capacity changes or indicators of fixed costs changing
o Pick the highest and lowest output levels within the relevant
range

Example

- Output and electricity cost for the past 12 months

- Highest and lowest activity level has been extracted below
Illustrative example 3

Scenario

You have decided to open a new product line. Your analyst has provided
you with the following expected annual cost schedule for different
production levels. Each production machine has a production capacity of
3000 and is operated by labour who are paid equally and are in abundant
supply.

Question

Analyse the cost information above and use it to produce a budgeted

income statement assuming:

- Sale of 3000 units

- Selling price of R50 per unit
- No opening stock
- Production of 5000 units
- Prepared on a direct costing basis (overheads are treated as period
costs/no overheads absorbed in inventory)
Step 1: Analyse and classify costs

Activity level 2500 3500 4500 5500

6500

Raw material costs 10 000 14 000 18 000

22 000 26 000

RM/Activity level 4 4 4 4 4
(variable)

Labour 26 250 28 750 31 250

33 750 36 250

Labour/activity level 10.50 8.21 6.94 6.14

5.58 (mixed)

Factory rental 30 000 30 000 30 000

30 000 30 000 (fixed)

Machinery OH 22 500 40 500 43 500

46 500 64 500

Other/activity level 9 11.57 9.67 8.45

9.92

Step 2: Estimate how the costs respond to changes in activity level

Fixed

Factory rental 30 000

Variable

Raw materials 4 per unit

Mixed
Labour ? n1

Machinery overheads ? n2

Step 3: Produce budget based on cost estimates

Variable cost profit budget

Sales 150 000

Less: Cost of sales 28 500

Add: Inventory o/b -

Add: Variable production costs (5000 units) 47 500

Direct material 20 000

Direct labour 12 500

Variable production costs 15 000

Less: Inventory c/b (2000 units) 19 000

Direct material 8000

Direct labour 5000

Variable production overheads 6000

Contribution margin 121 500

Less: Period costs

Fixed labour 20 000

Fixed production overheads 30 000

Factory rental 30 000

Profit 41 500

Note

Impact of the relevant range

Remember to think about the relevant range. The idea with a high low
calculation is to isolate the change in cost caused only by the change in
activity. If we know already that there is another reason why the cost
differs between the two observations other than because of activity, we
need to first remove the amount due to other reasons. We know that when
you move out of the relevant range the cost will change and so either we
need to adjust for this (if possible) or to ensure we only use points within
the relevant range. In this case 3500 units and 6500 units was outside the
relevant range for machinery overheads as machines have a capacity of
400 units each and so the relevant range was from 3000 units to 6000
units

Use activity levels and not cost levels

Remember we are trying to see how costs respond to a change in activity.

This means that the activity level is the dependent variable i.e., the cost
depends on the activity level. As a result, we are looking for the highest
and lowest activity level and not the highest and lowest cost. This will give
us the widest data points and therefore, hopefully, the most accurate cost
function.
Lesson 6a – Cost Volume Profit analysis

Cost volume profit analysis

CVP is a tool that companies use to figure out how changes in costs and
volume affect their expenses and profitability. CVP works through
understanding different relationships, such as the cost of operating and
producing products, the volume of products sold, and the profit generated
from the sale of those products.

By separating costs into fixed and variable elements, CVP analysis

provides very good insight into the profitability of a company’s product or
service. This insight is the real value of CVP analysis. The analysis and
understanding of the unique relationship between costs, volumes and
profits provides management with a back of the envelope tool to assess
decisions quickly but also an intuition on the business that improves your
ability to manage.

Tool used to help make good decisions

- Relationship between revenues, costs and volume

- Scenario analysis
- Sensitivity analysis
o Answers basic ‘what if’ question to help in the decision?
- What will happen to profitability if:
o Sales volume/sales price/ variable costs change
- How many units do I need to sell to…
o Breakeven/make a certain profit
- What is my margin of safety between
o Current sales and breakeven sales/minimum sales level

Extension of costs classification principles

- Depends on ability to analyse variable and fixed costs

- High low often used to determine variable costs in a mixed cost

Accountants vs economists model

 - Accountants model assumes linear relationship
- Simpler therefore not perfectly accurate
- Cost benefit of analysis
- Relevant range important
o Particularly fixed costs

Variable costing

- Fixed costs and decision making

o Irrelevant in short term
- CVP is about decision making
o Use variable cost information

Profit formula

Contribution margin (CM)

- Variable revenue less all variable costs

o Variable due to the volume changing
o Includes variable selling costs
- Amount available to start offsetting fixed costs ten making a profit
o Can refer to:
 CM per unit (SP – VC)
 CM ratio (CM/SP)
 Total CM (CM x units sold)

Fixed costs

- Fixed despite the volume changing

- Which fixed costs? All costs that relate to the decision being made
 o Are you making a company decision?
o Are you making a product decision?

CVP Tools

Breakeven analysis

- Number of unit sales required to pay for fixed costs

Target profit

- Number of unit sales required to pay for fixed costs and the total
target profit

Pricing decisions

- What should the selling price be to make a fixed profit on fixed sales
- How much can the price drop before I breakeven

Sensitivity analysis

- Measure of the difference between two points

- Usually the difference between the planned result and breakeven
o Rand is difference in profit
o Unit is difference in units
o % change is always based on the planned result

Scenario analysis

- If you change a few variables effect on profit

- Is it worth spending on marketing and lowering the price to get a
certain number of new sales

Multi – product CVP

- 2 choices
o Either do multiple CVP per product
 Provided you can allocate fixed costs correctly
o Or use a constant sales mix
 Result in ‘one’ product
 Sales are based on sales mix
 Recalculate the CM for ‘mixed product’
There are many types of questions CVP analysis can be used to answer
and so learning a particular formula for each ‘type of questing is limited
and not helpful. Rather work on your understanding of the following
common principles:

- CVP is ultimately only about the profit function: Revenues – costs =

profit
- CVP depends on your ability to group revenues and costs into 2
categories:
o Revenues and costs that depend on sales (variable revenues
and variable costs = contribution margin); and
o Revenues and costs that don’t depend on sales (fixed
revenues (if any) and fixed costs)
- CVP can only solve for one variable at a time
o So, start by asking yourself: What variable am I trying to find
out?
o All the other information MUST be provided in the scenario
Illustrative example 4 – CVP – Single Product

Scenario

Hot Stuff Enterprises operates in the leisure and entertainment industry.

Currently the company is evaluating a potential concern in Cape Town.

The performers have agreed to be paid 70 per ticket sold. Commission of

22 needs to be paid to the ticket sales stores. Pre-packed meals to be
included is expected to cost 30. The selling price of each ticket is
expected to be 220. Actual ticket sales are expected to be 8000.

Question

Using the cost information above calculate:

1. The breakeven point

2. Ticket sales to earn 300 000 profit
3. The margin of safety
4. Selling price and also variable cost sensitivity to breakeven
5. If company spends 120 000 on marketing and 5% on additional
sales commission sales are likely to increase by 3000 – is it worth it?
CVP is always the analysis of Fixed Costs, Variable Costs, Selling Price and
Volume i.e., the profit equation

As a start lets determine the various elements

Determine fixed costs, variable costs and CM

Expected volume 8000 units

Total fixed costs (300 + 100 + 200) 600 000

Selling price per unit 220

Variable cost per unit (70 + 22 + 30) 122

CM per unit 98

1. The breakeven point

The breakeven point is where total contribution = total fixed costs

Required contribution = fixed costs 600 000

Number of units to achieve the required contribution

Required contribution/CM per unit

= 600 000/98 (rounded up) 6123

 2. Unit sales to reach required profit of 300 000

Required total contribution = fixed costs + required profit

Required contribution = (600 000 + 300 000) 900 000

Number of units to achieve required contribution

Required contribution/CM per unit

= 900 000/98 (rounded up) 9184

3. Determine the margin of safety

The difference as a percentage between expected and breakeven sales

Expected sales (given in scenario) 8000

Breakeven sales (see question 1) 6123

Difference 1877

% (difference/where I am (expected sales) 23%

In other words, we expect to sell 8000 units but to breakeven we need to

sell 6123 units. Our margin (or breathing room) of safety is the 1877 units
we can afford to lose and still breakeven. That is 23% drop from 8000
units.

4. Selling price or variable cost sensitivity to breakeven

How much can we reduce the selling price by and still breakeven (i.e.,
achieve a total contribution equal to fixed costs)
Remember changes in selling price, sales volume, variable cost really just
result in a change in contribution margin.

This question can be seen as asking what the contribution margin can
drop by in order to breakeven. To know this we need to know what our
current total contribution margin is.

Current total contribution

= expected sales x CM per unit (8000 x 98)

784 000

Minimum required total contribution

Breakeven point where the total contribution = fixed costs

Required minimum total contribution 600 000

Excess contribution above breakeven (i.e., profit)

184 000

Excess contribution per unit (184 000/8000) 23

i.e., we have 23 available to reduce CM per unit by and still breakeven (at
the current sales volume of 8000)

Either selling price can decrease by 23 or variable costs can increase by

23

Current selling price 220

% decrease 10%

Current variable cost 122

% increase 19%
 5. Scenario analysis

If company spends 120 000 on marketing and 5% on additional sales

commission sales are likely to increase by 3000 – is it worth it.

Logically for a question that’s only about financial benefit we are really
asking is does the decision increase profit?

The question goes back to decision making (which we will do later in the
module)

There are 2 approaches to thin about this

1. Does the change increase profit or

2. Is the profit after the change more than the profit before the change

Determine current profit

Profit = Sales x (SP – VC) – FC

= 8000 x (220 – 122) – 600 000 184 000

Determine new profit

= (8000 + 3000) x (220 – 122 – 11) – 600 000 – 120 000

237 000

Additional profit 53 000

Some comments to read through

With CVP analysis the key is not to try to rote learn an equation but
instead try to understand what you are trying to achieve. The solution
presented above avoid using formulas to solve them (although the
formula approach will work)

Ask yourself

1. What have you been given?

2. What do you need to calculate?
3. How can I rework my understanding of the CVP relationship

Remember CVP requires all other variable to stay constant which means if
you know what you are trying to calculate then that is he only unknown
variable. The other variables must be given to you.

Example 5 – CVP – Multi Product

Scenario

Super Bright sells two types of washing machines – a deluxe model and a
standard mode. The following information is a sales forecast for the next
period:

Question

Using the cost information above calculate:

1. The breakeven point per product

2. The breakeven point for the company as a whole
 1. The breakeven point per product:

Required total contribution

Breakeven point is where total contribution = product fixed costs

Deluxe Standard

Required contribution 90 000 27 000

Number of units to achieve required contribution

Required contribution/CM per unit (given) 600 300

2. The breakeven for the company as a whole

Shared fixed costs cannot be allocated – we need to determine a sales mix

Determine average CM per unit based on sales mix

Sales mix = 1200 deluxe:600 standard

Average CM per unit [(1200 x 150) + (600 x 90)]/1800

130

Determine required total contribution

Breakeven point is where total contribution = total fixed costs

Required contribution (90 000 + 27 000 + 39 000)

156 000

Number of units (in mix) to achieve required contribution

Required contribution/CM per unit

= 156 000/130 (rounded up) 1200

Split total units into different products

1200 units in mix needs to be allocated to specific product based on mix

Deluxe units = (1200/1800) x 1200 800

Standard units = (600/1800) x 1200

400

The above introduces you to the weighted average contribution method to

perform multi-product CVP analysis. Another method that can also be
used is to divide the total fixed costs by the aggregte contribution for a
batch of product which comprises the respective products in proportion to
the sales mix.

This will give you the total break-even batches which can be multiplied by
the respective number of each product included in one batch to get break-
even units per product.

Lets now look at this illustrative example again by applying the batch
approach

1. Batch contribution (being a batch of 2 Deluxe and 1 standard) = (2 x

R150) + (1 x R90) = R390
2. Break even batches (R117 000 + R39 000)/R390 = 400 batches

This then means a break-even of 800 Deluxe units (400 x 2) and 400
standard units (400 x 1)
Multi-Product CVP and Separate Analysis per Product

We often get questions from students asking why you cant just do
separate CVP analysis per product in a multi-product situation rather than
trying to do a combined CVP analysis with products in a set mix.

Both are valid analysis but are making different assumptions

Option 1 – create a “combined: product based on the sales mix and then
do a single CVP analysis on the whole company

Option 2 – separate costs between products and then do a separate CVP

for each product

The issue with option 2 is that not all (actually very few) fixed costs are
able to be properly connected to the product in order for you to do a
separate analysis. The whole point of a company having multiple products
is to create efficiency by sharing resources. And so invariably you will
have shared costs. You could allocate the shared costs to products but
then you run into allocation assumptions i.e., how to properly allocate. You
could do a product level analysis with only the costs that can be well
allocatd but then you aren’t including all costs and so cant do company
level analysis

The issue with option 1 is that you are connecting the products together in
a fixed relationship in order to work with a “combined” product. This
allows you to easily do company level analysis because you eliminate the
issue of allocating costs, but it introduces an issue with the product mix
staying the same which may not be treated and should be interrogated.
So, depending on the analysis you want to do, you can legitimately go
either way. However, for company level analysis you should see it is
probably more appropriate to follow option 1.

Lesson 6b – CVP assumptions

Independence of variables

- E.g., if you change sales, it does not affect fixed costs, variable costs
or selling price
- Reality – in order to increase sales volume, you need to decrease
selling price or increase marketing costs etc.

Either single product or constant sales mix

- Reality – a constant sales mix is unlikely for different sales volume

levels
- Constant sales mix turns multiple products into a ‘single product’

Costs can be classified perfectly into either fixed or variable

- Reality – not all costs care easily put into either category – step
costs

Fixed costs remain fixed

- Reality – costs are only fixed within relevant range

o Any decision/sensitivity analysis has to take this into account
o Not always in question

Variable costs remain constant per unit

- Reality – inefficiencies/efficiencies of scale

o Relevant range
Profits calculated on a variable cost basis

- Reality – indirect costs can be allocated to inventory causing true

profit effect to be different to variable costing

CVP analysis only applies to short term time horizon

- Inappropriate to use a longer time horizon as relationships change

over time