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Chapter 2

Introduction to Cost Behavior


and Cost-Volume Relationships

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Learning Objective 1
Explain how cost drivers
affect cost behavior.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Cost Behavior
What is cost behavior?
It is how costs are related to, and affected
by, the activities of an organization.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Cost Drivers
What are cost drivers?
Output measures of resources and
activities are called cost drivers.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Cost Drivers
Production Example
Example costs:
Example cost drivers:
Labor wages
Labor hours
Supervisory salaries
No. of people supervised
Maintenance wages
No. of mechanic hours
Depreciation
No. of machine hours
Energy
Kilowatt hours
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Cost Drivers

How well the accountant does at identifying


the most appropriate cost drivers determines
how well managers understand cost behavior
and how well costs are controlled.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Learning Objective 2
Show how changes in cost-driver
activity levels affect variable
and fixed costs.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Comparison of
Variable and Fixed Costs
A variable cost is a cost that changes in direct
proportion to changes in the cost driver.
A fixed cost is not immediately affected
by changes in the cost driver.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/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.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/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.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Relevant Range
This rule of thumb holds true only within
reasonable limits.
The relevant range is the limit of costdriver activity within which a specific
relationship between costs and the cost
driver is valid.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Relevant Range

Fixed Costs

$16,000
$12,000
Relevant Range

$8,000

500

1,000 1,500 2,000


Volume in Units

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

$4,000
2,500
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Learning Objective 3
Calculate break-even sales
volume in total dollars
and total units.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/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).

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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CVP Scenario
Selling price
Variable cost
Difference

Per Unit
$5
4
$1

Percentage
100
80
20

Total monthly fixed expenses = $8,000


Rent
$2,000
Labor
$5,500
Other
$ 500
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Break-Even (BE) Point

The break-even point is the level of sales


at which revenue equals expenses and net
income is zero.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Margin of Safety

The margin of safety shows how far sales


can fall below the planned level before
losses occur.
Planned unit sales

Break-even unit sales


=
Margin of safety

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Break-Even Point
Techniques

1
2

There are two basic techniques for


computing break-even point:
Contribution margin
Equation

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Contribution Margin
Technique to find BE in Units
Per Unit
Selling price
$5
Variable cost
4
Contribution margin
$1
$8,000 $1 = 8,000 units
i.e. Fixed Cost Contribution per unit
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Contribution Margin
Technique - to find BE in $
8,000 units $5.00 = $40,000
i.e. BE point in units x Selling price per unit
OR
$8,000 20% = $40,000
i.e. Fixed Cost Contribution to Sales ratio
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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

Variable expenses

Fixed expenses

= Zero net income (break-even point)


2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Equation Technique
to find BE in Units
Let N = number of units to be sold to break even
$5N $4N $8,000 = 0
$1N = $8,000
N = $8,000 $1
N = 8,000 Units

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Equation Technique
- to find BE in $
Let S = sales in dollars needed to break even
S 0.80S $8,000 = 0
.20S = $8,000
S = $8,000 .20
S = $40,000

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Learning Objective 4
Create a cost-volume-profit
graph and understand the
assumptions behind it.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Cost-Volume-Profit Graph
Break even sales point
8,000 units or $40,000

$50,000

Dollars

$40,000
$30,000

ne
i
l
e
lin
ue
e
n
s
e
n
e
v
p
e
r
ex
s
l
e
a
l
Tot
Sa

$20,000
$10,000

Fixed expense line

$0
0

10

12

Units (thousands)
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/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.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Target Net Profit


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

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Target Net Profit


Contribution Margin Technique
Target sales volume in units =
Fixed expenses + Target net income
Contribution margin per unit

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Target Net Profit


Equation Technique
Target sales
Variable expenses
Fixed expenses
= Target net income

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Operating Leverage
The ratio of fixed to variable costs is called
operating leverage.
In high leveraged companies, small changes
in sales volume result in large changes in net
income.
Companies with less leverage are not
affected as much by changes in sales
volume.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Learning Objective 6
Calculate contribution
margin and gross margin.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Contribution Margin
and Gross Margin
Gross margin (which is also called gross profit)
is the excess of sales over the cost of goods sold.
Contribution margin is the excess of sales over
all variable costs.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Learning Objective 7
Explain the effects of sales
mix on profits.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income

Sales mix is the combination of products


that a business sells.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
Avishas Dresses Example
Selling price:
$90
Less variable cost:
32
Equals contribution margin per dress: $58
Fixed costs = $96,000
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
Assume that Avisha is considering selling
blouses.
This will not require any additional fixed
costs.
She expects to sell 2 blouses at $30 each for
every dress she sells.
The variable cost per blouse is $19.
What is the new breakeven point?

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
Contribution margin per blouse: $30 $19 = $11
What is the contribution margin of the mix?

$58 + (2 $11) =
$58 + $22 = $80
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
$96,000 fixed costs $80 = 1,200 packages

1,200 2 = 2,400 blouses


1,200 1 = 1,200 dresses
Total units = 3,600
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
What is the breakeven in dollars?
2,400 blouses $30 =
1,200 dresses $90 =

$ 72,000
108,000
$180,000

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
What is the weighted-average budgeted
contribution margin?

Dresses: 1 $58
=

Blouses: 2 $11

$80 3 = $26.67

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
The break even point for the two products is:
$96,000 $26.667 = 3,600 units

3,600 1/3 = 1,200 dresses


3,600 2/3 = 2,400 blouses

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
Sales mix can be stated in sales dollars:
Dresses Blouses
Sales price
$90
$60
Variable costs
32
38
Contribution margin
$58
$22
Contribution margin ratio
64.4% 36.6%
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
Assume the sales mix in dollars is 60% dresses
and 40% blouses.
Weighted contribution would be:
64.4% 60% = 38.64% dresses
36.6% 40% = 14.64% blouses
53.28%
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Effects of Sales Mix


on Income
Break even sales dollars is $96,000 53.28%
= $180,000 (rounding)

$180,000 60% = $108,000 dress sales


$180,000 40% = $ 72,000 blouse sales

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Learning Objective 8
Compute cost-volume-profit
relationships on an after-tax
basis.

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Target Net Income


and Income Taxes
Management of Avishas Dresses would
like to earn an after-tax income of $35,721.
The tax rate is 30%.
What is the target operating income?
Target operating income
= Target net income (1 tax rate)
TOI = $35,721 (1 0.30)
TOI = $51,030

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Target Net Income


and Income Taxes
How many units must she sell?
Revenues Variable costs Fixed costs
= Target net income (1 tax rate)
$90Q $32Q $96,000 = $35,721 0.70
$58Q = $51,030 + $96,000
Q = $147,030 $58
Q = 2,535 dresses

2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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Target Net Income


and Income Taxes
Revenues (2,535 $90)
Variable costs (2,535 $32)
Contribution margin:
Fixed costs:
Operating income:
Income taxes: ($51,030 .30)
Net income

$228,150
81,120
$147,030
96,000
$ 51,030
15,309
$ 35,721

THE END
2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

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