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Chapter-2


Introduction to Cost Behavior and CostVolume Relationships
Chapter 2
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2-1

Learning Objective 1

Explain how cost drivers affect cost behavior.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cost Behavior
It is how the activities of an organization affect its costs.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cost Drivers
Any output measure that causes the use of costly resources is a cost driver.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Examples of Value Chain Functions, Costs, and Cost Drivers
Value Chain Function and Example Costs
Research and development · Salaries of marketing research personnel, costs of of market surveys Production · Labor wages Marketing · Cost of advertisements Distribution · Wages of shipping personnel Customer service · Salaries of service personnel Example Cost Drivers Number of new product proposals

Labor hours Number of advertisements Labor hours Hours spent servicing products
2-5

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Learning Objective 2

Show how changes in cost-driver activity levels affect variable and fixed costs.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Comparing Variable and Fixed Costs
A variable cost changes in direct proportion to changes in the cost-driver level.

A fixed cost is not immediately affected by changes in the cost-driver level.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Rules of Thumb

Think of fixed costs as a total.

Total fixed costs remain unchanged regardless of changes in cost-driver activity.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Rules of Thumb

Think of variable costs on a per-unit basis.

The per-unit variable cost remains unchanged regardless of changes in the cost-driver activity.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Relevant Range
The relevant range specifies the limits of cost-driver activity within which a specific relationship between a cost and its cost driver will be valid.

Relevant Range

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Relevant Range
$115,000 100,000

Fixed Costs

60,000

Relevant range

0

20

40

60

80

100
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Volume in Thousands of Units
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Learning Objective 3

Calculate break-even sales volume in total dollars and total units.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cost-Volume-Profit Analysis (CVP)
What is cost-volume-profit analysis? It is the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit).

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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CVP Scenario
Selling price Variable cost of each item Selling price less variable cost Percentage Per Unit of Sales $.50 100% .40 80 $.10 20%

Monthly fixed expenses: Rent Wages Other Total fixed expenses

$1,000 4,500 500 $6,000
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?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Break-Even Point – ContributionMargin and Equation Methods
The break-even point is the level of sales at which revenue equals expenses and net income is zero.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Break-Even Point – ContributionMargin and Equation Methods

Contribution margin Equation

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Contribution Margin Method
Per Unit Selling price Variable costs Contribution margin $.50 .40 $.10

$6,000 fixed costs ÷ $.10 = 60,000 units (break even)

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Contribution Margin Method
60,000 units × $.50 = $30,000 of sales to break even)

$6,000 fixed costs ÷ 20% (contribution-margin percentage) = $30,000 of sales to break even
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 18

Equation Method
Net income equals zero at the break-even point. Sales


– =

Variable expenses
Fixed expenses Zero net income (break-even point)
2 - 19

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Equation Method
Let N = number of units to be sold to break even. $.50N – $.40N – $6,000 = 0 $.10N = $6,000 N = $6,000 ÷ $.10 N = 60,000 Units

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Equation Method
Let S = sales in dollars needed to break even. S – .80S – $6,000 = 0 .20S = $6,000 S = $6,000 ÷ .20 S = $30,000

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Learning Objective 4

Create a cost-volume-profit graph and understand the assumptions behind it.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cost-Volume-Profit Graph
$60000 $50000 Dollars $40000 $30000 $20000 $10000 0 Break-even sales point 60,000 units or $30,000

Fixed expense line 0 10 20 30 40 50 60 70 80 90 100
Units (thousands)

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Assumptions
Expenses can be classified into variable and fixed categories. The behavior of revenues and expenses is linear over the relevant range. Expect no changes in efficiency and productivity.
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 24

Assumptions
Sales mix remains constant.

The difference in inventory level at the beginning and at the end of a period is insignificant.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Learning Objective 5

Calculate sales volume in total dollars and total units to reach a target profit.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Target Net Profit

Managers can also use CVP analysis to determine the total sales, in units and dollars, needed to reach a target net profit.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Target Net Profit
$480 per month is the minimum acceptable net income.

Target sales – Variable expenses – Fixed expenses = Target net income

S – 0.80S – $6,000 = $480 .20S = $6,480 S = $6,480 ÷ .20 S = $32,400
2 - 28

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Target Net Profit
Target sales volume in units = (Fixed expenses + Target net income) ÷ Contribution margin per unit ($6,000 + 480) ÷ $.10 = 64,800 units

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Multiple Changes in Key Factors

Construct and solve equations

Incremental approach

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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CVP Analysis and Computer-Based Spreadsheets
The use of spreadsheets simplifies the examination of multiple changes in key factors in a CVP model.

Use of these models is a cost-benefit issue.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Additional Uses of Cost-Volume Analysis
Best cost structure

Operating leverage

Margin of safety

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Learning Objective 6

Differentiate between contribution margin and gross margin.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Contribution Margin and Gross Margin
Gross margin = Sales price – Cost of goods sold

Contribution margin = Sales price – All variable expenses

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Contribution Margin and Gross Margin
Per Unit Selling price $.50 Variable costs (acquisition cost) .40 Contribution margin and gross margin are equal $.10 Suppose that the firm had to pay a commission of 4? per unit sold.
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 35

Contribution Margin and Gross Margin
What are the margins? Per Unit Selling price $.50 Acquisition cost .40 Commission .04 Contribution margin $.06 Gross margin Per Unit $.50 .40

$.10
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?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Nonprofit Application
Suppose a city has a $100,000 lump-sum budget appropriation to conduct a counseling program. Variable costs per prescription is $400 per patient per day. Fixed costs are $60,000 in the relevant range of 50 to 150 patients.
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 37

Nonprofit Application
If the city spends the entire budget appropriation, how many patients can it serve in a year?

$100,000 = $400N + $60,000 $400N = $100,000 – $60,000 N = $40,000 ÷ $400 N = 100 patients
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 38

Learning Objective 7

Explain the effects of sales mix on profits. (Appendix 2A)

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Sales Mix Analysis
Sales mix is the relative proportions or combinations of quantities of products that comprise total sales.

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Sales Mix Analysis
Ramos Company Example
Wallets (W)
Sales in units Sales @ $8 and $5 Variable expenses @ $7 and $3 Contribution margins @ $1 and $2 Fixed expenses Net income 300,000 $2,400,000 2,100,000

Key Cases (K)
75,000 $375,000 225,000

Total 375,000 $2,775,000 2,325,000

$ 300,000

$150,000

$ 450,000 180,000 $ 270,000
2 - 41

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Sales Mix Analysis
Assume a constant mix of 4 units of W for every unit of K. What is the contribution margin of the mix? (4 × $1) + (1 × $2) = $6

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Sales Mix Analysis
$180,000 fixed costs ÷ $6 = 30,000 packages What is the breakeven in units? 30,000 × 4 30,000 × 1 Total units 120,000 W 30,000 K 150,000
2 - 43

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Sales Mix Analysis
What is the weighted-average budgeted contribution margin?

Wallets: 4 × $1

+

Key cases: 1× $2

=

$6 ÷ 5 = $1.20
2 - 44

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Sales Mix Analysis
The break-even point for the two products is: $180,000 ÷ $1.20 = 150,000 units

150,000 × 4/5 = 120,000 W 150,000 × 1/5 = 30,000 K

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Sales Mix Analysis
Suppose total sales were equal to the budget of 375,000 units. However, Ramos sold only 50,000 key cases. What is the net income?

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

2 - 46

Sales Mix Analysis
Ramos Company Example
Wallets (W)
Sales in units Sales @ $8 and $5 Variable expenses @ $7 and $3 Contribution margins @ $1 and $2 Fixed expenses Net income 325,000 $2,600,000 2,275,000

Key Cases (K)
50,000 $250,000 150,000

Total 375,000 $2,850,000 2,425,000

$ 325,000

$100,000

$ 425,000 180,000 $ 245,000
2 - 47

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Learning Objective 8
Compute cost-volume-profit relationships on an after-tax basis. (Appendix 2B)

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Impact of Income Taxes
Suppose that a company earns $480 before taxes and pays income tax at a rate of 40%.

What is the after-tax income?
$480 – (40% × $480) = $288

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Impact of Income Taxes
Target income before taxes = Target after-tax net income ÷ (1 – tax rate) $480 = $288 ÷ (1 – 0.40) Suppose the target net income after taxes was $288.
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 50

Impact of Income Taxes
What is the equation? Target sales – Variable expenses – Fixed expenses = Target after-tax net income ÷ (1 – tax rate)

$.50N – $.40N – $6,000 = $288 ÷ (1 – 0.40) $.10N = $6,000 + $480 N = $6,480 ÷ $.10 N = 64,800 units
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 51

In-Class Sample Questions Pg. 69 P25 Step 1: List all costs

VC = 50x SP = 10x FC = 1,600,000 200 Rooms, 365 days a year operation

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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In-Class Sample Questions Pg. 69 P25 Cont…

Step 2: Set-up your equation N.I = SP – (VC+FC)
a. N.I = (50*200*365)-(10*200*365) – (1,600,000)

Answer: $1,320,000

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cont…

b. N.I = (50*100*365) – (10*100*365)-1,600,000

Answer: (140,000) Loss

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cont…
Part 2 0=50x-(10x+1,600,000) X=40,000 rooms per year Percentage of Occupancy = 40,000/73,000 =54.79%

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Pg. 69 P2-6

Step 1: FC = $350,000 per month SP = $65 per day VC= $15 per day

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cont…

Part 1: Setup your equation: 0=(65x*30)-(15x*30)-$350,000 1. Answer = 234 Rooms per day

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cont… Part 2: $120,000 = $50x-$350,000 X=9,400 rooms per month
?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 2 - 58

Cont…
Part 3 (A little tricky ?)

80% occupancy rate means 80% of the rooms are occupied
.80*400 = 320

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Cont… Setup your equation:
$120,000 = 320*30x-(15*320*30)+$172,400-$350,000 Answer = $46 per rented room

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Answers to Last Week’s Homework
Question P2-7 a. Strawberries CM = $1-$.65=$.35 Raspberries CM = $1.35 - $.85 = $.50 Weighted Average = (2*.35)+(1*.50) =.70+.50=$1.20

1.20/3 = $.40
Break Even For Sales Mix = 0 = .40x-$14,400 X = 36,000 units

ANSWER: Strawberries = 36,000 * (2/3) = 24,000 liters of strawberries
Raspberries = 36,000 * (1/3) = 12,000 liters of raspberries

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Answers Cont…
Part B: 0 = .35x - $14,400 = 41,143 Liters of Strawberries Part C: 0 = $.50x - $14,400

X = 28,800 Liters of Raspberries

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Answers Problem P2-10

$42,000 = .60(.30-$440,000) ANSWER = $1,700,000

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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Problem P2-13
1.

$8,400 = $8.40x - $21,000 ANSWER: 3,500 meals

2. 0 = $8.40x - $21,000 ANSWER: 2,500 meals 3. $8,400 = $10.50x - $29,400 ANSWER: 3,600 meals 4. $10.50 (3,500*.90) - $29,400 ANSWER: $3,675 5. $10.50 (3,450) - $31,400 ANSWER: $4,825

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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End of Chapter 2

?2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

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