Accounting Exam 3 Chapter 11 Notes Cost Behavior A manner in which a cost changes as a related activity changes This allows managers to predict profits as sales and production volumes change Understanding the behavior of a cost depends on 1 Activity bases an activity that causes the cost to change 2 Relevant range the range of activity over which changes in cost are of interest to management Cost are normally classified as variable costs fixed costs or mixed costs Variable Costs Costs that vary in total dollar amount as the level of activity changed When the activity base is units produced DM or DL costs they are normally classified as variable costs Characteristics of Variable costs o Cost per unit remains the same regardless of changes in the activity base o Total cost changes in proportion to changes in the activity base Look at graphs on page 433 of your book Fixed Costs costs that remain the same in total dollar amount as the activity base changes When the activity base is units produced many FOH costs such as straight line depreciation are classified as fixed costs Characteristics of Fixed Costs o Cost per unit changes inversely to changes in the activity base o Total cost remains the same regardless of changes in the activity base Mixed Costs costs that have characteristics of both a variable and a fixed cost also called semivariable or semifixed Uses the high low method o High low method a technique that uses the highest and lowest total cost as a basis for estimating the variable cost per unit and the fixed cost component of a mixed cost The total fixed cost does not change with changes in production The change in total variable cost is the difference of the highest level cost lowest level cost 1 Variable cost per unit Difference in total cost Difference in production Or Variable cost per unit Highest cost Lowest cost Highest units produced lowest units produced Fixed Cost Total Cost Variable cost per unit X Units produced Total Cost Variable cost per unit X Units produced Fixed costs Variable Costing Often referred to as direct costing it is a method of reporting variable and fixed costs that includes only the variable manufacturing costs in the cost of the product Only variable manufacturing costs DL DM FOH are included in the product cost The fixed FOH is treated as an expense of the period of which it is incurred Cost Volume Profit Relationships Cost volume profit analysis the examination of the relationships among selling prices sales and production volume costs expenses and profits Useful for managerial decision making Cost volume profit analysis is used to 1 2 3 4 5 6 Analyze the effects of changes in selling prices on profits Analyze the effects of changes in costs on profits Analyze the effects of changes in volume on profits Setting selling prices Selecting the mix of products to sell Choosing among marketing strategies Contribution Margin the excess of sales over variable costs Shows insight into the profit potential of a company Contribution Margin Sales Variable costs Any additional CM increases income from operations 2 Contribution Margin Ratio CM expressed as a ratio sometimes called profit volume ratio the percentage of each sales dollar that is available to cover the fixed costs and provide income from operations Useful in developing business strategies Contribution Margin Ratio Contribution Margin Sales Change in income from operations Change in sales dollars x CM ratio Variable costs as a percentage of sales 100 CM ratio x Sales Total CM Sales x CM ratio Unit Contribution Margin the dollars available from each unit of sales to cover fixed costs and provide income from operations Unit CM Sales price per unit Variable Cost per unit Change in income from operations Change in sales units x Unit CM Total CM Units x Unit CM Mathematical Approach to Cost Volume Profit Analysis The mathematical approach to cost volume profit analysis uses equations to determine 1 Sales necessary to break even 2 Sales necessary to make a target or desired profit Revenues Costs Break Even Point Break Even Point the level of operations at which a company s revenues and expenses are equal A company reports neither an income nor a loss from operations Break Even Sales units Fixed Costs CM Unit 3 Break Even Sales dollars Fixed Costs CM ratio Contribution Margin ration Unit Contribution Margin Unit Selling Price The break even point is affected by changes in the fixed costs unit variable costs and the unit selling price Effect of Changes in fixed costs Changes in fixed costs affect the break even point 1 Increases in fixed costs increase the break even point 2 Decreases in fixed costs decrease the break even point Changes in Variable costs affect the break even point as follows 1 Increases in unit variable costs increase the break even point 2 Decreases in unit variable costs decrease the break even point Changes in unit selling price affect the break even point as follows 1 Increases in the unit selling price decrease the break even point 2 Decreases in the unit selling price increase the break even point Target Profit The goal of most companies is to make a profit and by modifying the break even equation the sales required to earn a target or desired amount of profit may e computed Sales Units Fixed Costs Target Profit Unit Contribution Margin Sales dollars Fixed Costs Target Profit Contribution Margin Ratio Special Cost volume profit relationship Sales Mix Consideration Many companies sell more than one product at different selling prices These products normally have different variable costs thus different CM Break even analysis can still be performed by considering the sales mix Sales Mix the relative distribution of sales among the products sold by a company available for sale Go on page 452 to see how this process is done it s too hard to explain here 4