Session–7

Cost Analysis for Decision Making

PGP 2022-24

Prof. M. Shameem Jawed

McGraw-Hill/Irwin
 Introduction

Cost Cost Cost

estimation behavior prediction

Process of Relationship Using knowledge

determining between of cost behavior
cost behavior, cost and to forecast
often focuses activity. level of cost at
on historical a particular
data. activity. Focus
is on the future.

6-2
 Total Variable Cost Example
Your total Pay Per View bill is based on how many Pay
Per View shows that you watch.
Total Pay Per View Bill

Number of Pay Per View shows

watched 6-3
 Variable Cost Per Unit Example
The cost per Pay Per View show is constant. For example,
$4.95 per show.

Cost per Pay Per View

show

Number of Pay Per View shows

watched 6-4
 Step-Variable Costs

Total cost remains

constant within a
narrow range of
activity.

Cost
Activity

6-5
 Step-Variable Costs
Total cost increases to a
new higher cost for the next
higher range of activity.

Cost
Activity

6-6
 Total Fixed Cost Example
Your monthly basic cable TV bill probably does not change no
matter how many hours you watch.
Monthly Basic Cable
Bill

Number of hours watched

6-7
 Fixed Cost Per Unit Example
The average cost per hour decreases as more hours are
spent watching cable television.

Monthly Basic cable Bill

per hour watched

Number of hours watched

6-8
 Step-Fixed Costs

Example: Office space is

available at a rental rate of
$30,000 per year in
increments of 1,000 square
feet. As the business grows
more space is rented,
increasing the total cost.

Continue

6-9
 Step-Fixed Costs
Total cost doesn’t change for a wide range of activity, and
then jumps to a new higher cost for the next higher range
of activity.

90
Rent Cost in Thousands of

60
Dollars

30

0 1,000 2,000 3,000

Rented Area (Square Feet) 6-10
 Step-Fixed Costs

Step-variable costs can be

adjusted more quickly
How does this type of and . . .
fixed cost differ from a The width of the activity
step-variable cost? steps is much wider for
the
step-fixed cost.

6-11
 Semivariable Cost

A semivariable
cost is partly
fixed and partly
variable.
Consider the
following example:.

6-12
 Semivariable Cost
The slope is
the variable
cost per unit
of activity.
Total Lease Cost

o st
ab le c
a r i
iv Variable Lease
se m
ta l Charge Per Hour
To

Fixed Monthly
Rental Charge
Rental Charge Per Hour
6-13
 Curvilinear Cost
Curvilinear
Cost Function

A straight-line
Total Cost

(constant unit variable

cost) closely
approximates a
curvilinear line within
Relevant Range the relevant range.

Activity
6-14
 Curvilinear Cost
Curvilinear
Cost Function

A straight-Line
Total Cost

(constant unit variable

cost) closely
approximates a
curvilinear line within
Relevant Range the relevant range.

Activity
6-15
 Engineered, Committed, and Discretionary
Costs
Committed Discretionary
Long-term, cannot be May be altered in the
reduced in the short term. short term by current
managerial decisions.

Engineered
Physical relationship with
activity measure.

Depreciation on Advertising and

Buildings and Direct Research and
equipment Materials Development
6-16
 Cost Behavior in Other Industries
Merchandisers Service Organizations
Cost of Goods Sold Supplies and travel

Examples of variable costs

Manufacturers Merchandisers and

Direct Material, Direct Labor,
Manufacturers
and Variable Manufacturing Sales commissions and
Overhead shipping costs
6-17
Cost Behavior in Other Industries
Examples of fixed costs

Merchandisers, manufacturers, and service

organizations
Real estate taxes
Insurance
Sales salaries
Depreciation

6-18
 Cost Estimation

Account-Classification Method

Visual-Fit Method

High-Low Method

Least-Squares Regression Method

6-19
Account Classification Method

Cost estimates are based on a

review of each account making up
the total cost being analyzed.
6-20
 Visual-Fit Method

A scatter diagram of past cost behavior

may be helpful in analyzing mixed costs.

6-21
 Visual-Fit Method
Plot the data points on a graph
(total cost vs. activity).

20
* ** *
1,000’s of Dollars

* *
Total Cost in

**
10 * *

0
0 1 2 3 4
Activity, 1,000’s of Units Produced
6-22
 Visual-Fit Method
Draw a line through the plotted data points so that about equal
numbers of points fall above and below the line.

20
* ** *
1,000’s of Dollars

* *
Total Cost in

**
10 * *

0
0 1 2 3 4
Activity, 1,000’s of Units Produced
6-23
 Visual-Fit Method

Estimated fixed cost = $10,000

20
* ** *
1,000’s of Dollars

* *
Total Cost in

** Vertical distance
10 * * is total cost,
approximately
$16,000.
0
0 1 2 3 4
Activity, 1,000’s of Units Produced
6-24
 The High-Low Method
Owl Co recorded the following production activity & maintenance
costs for two months:

Using these two levels of activity, compute:

the variable cost per unit.
the total fixed cost.
6-25
The High-Low Method

6-26
 The High-Low Method

in cost
Unit variable cost = in units

6-27
 The High-Low Method

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

6-28
 The High-Low Method

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

Fixed cost = Total cost – Total variable cost

6-29
 The High-Low Method

Unit variable cost = $3,600 ÷ 4,000 units = $0.90 per unit

Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)

6-30
 The High-Low Method

Unit variable cost = $3,600 ÷ 4,000 units = $.90 per unit

Fixed cost = Total cost – Total variable cost
Fixed cost = $9,700 – ($.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600

6-31
Least-Squares Regression Method
Regression is a statistical procedure used
to determine the relationship between variables such
as activity and cost.

The objective of
Total Cost

the regression
method is the
general cost equation:

Y = a + bX
Activity
6-32
Equation Form of Least-Squares Regression
Line

Y = a + bX

Total Cost is the The activity (X) is the

dependent variable. independent variable.

The intercept term (a) is The X term coefficient (b)

the estimate of fixed costs. is the estimate of variable
cost per unit of activity,
the slope of the cost line.
6-33
 Multiple Regression
Multiple regression includes two or more
independent variables:

Y = a + b1X1 + b2X2

Terms in the equation have the same

meaning as in simple regression with
only one independent variable.

6-34
 Engineering Method
of Cost Estimation

Cost estimates are based on measurement

and pricing of the work involved.

6-35
 Engineering Method
of Cost Estimation

Direct Labor Direct Material

• Analyze the kind • Material required

of work performed. for each unit is
• Estimate the time required obtained from engineering
for each labor skill for each drawings and specification
unit. sheets.
• Use local wage rates to • Material prices are
obtain labor cost determined from
per unit. vendor bids.

6-36
 Effect of Learning
on Cost Behavior
As I make more of these I’ve noticed the same thing.
things it takes me less And if you include all the
time for each one. It must variable overhead costs that
be the learning curve effect are also declining, that must
that the boss was be the experience curve.
talking about.

6-37
 Learning Curve

Learning effects
are large initially.
Average Labor
Time per Unit

Learning effects
become smaller, eventually
reaching steady state.

Cumulative Production Output

6-38
 Data Collection Problems
1. Missing data.
2. Outlier data points.
3. Mismatched time periods costs.
4. Trade-offs in choosing the time period.
5. Allocated and discretionary costs.
6. Inflation.

6-39
Cost-Volume-Profit Analysis
 The Break-Even Point
The break-even point is the point in the volume of
activity where the organization’s revenues and
expenses are equal.

7-41
 Equation Approach
Sales revenue – Variable expenses – Fixed expenses = Profit

Unit Sales Unit Sales

sales × volume variable × volume
price in units expense in units

($500 × X) – ($300 × X) – $80,000 = $0

($200X) – $80,000 = $0
X = 400 surf boards
7-42
 Contribution-Margin Approach
Consider the following information developed
by the accountant at Curl, Inc.:
For each additional surf board sold, Curl
generates $200 in contribution margin.

7-43
 Contribution-Margin Approach

Fixed expenses Break-even point

=
Unit contribution margin (in units)

$80,000
= 400 surf boards
$200
7-44
 Contribution-Margin Approach

Here is the proof!

400 × $500 = $200,000 400 × $300 = $120,000

7-45
 Contribution Margin Ratio

Calculate the break-even point in sales dollars rather

than units by using the contribution margin ratio.

Contribution margin
= CM Ratio
Sales

Fixed expense Break-even point

=
CM Ratio (in sales dollars)
7-46
Contribution Margin Ratio

$80,000
= $200,000 sales
40%
7-47
Graphing Cost-Volume-Profit Relationships

Viewing CVP relationships in a graph gives managers

a perspective that can be obtained in no other way.
Consider the following information for Curl, Inc.:

7-48
Cost-Volume-Profit Graph

Fixed expenses

7-49
Cost-Volume-Profit Graph

en ses
l exp
Tota
Fixed expenses

7-50
Cost-Volume-Profit Graph

en ses
l exp
Tota
Fixed expenses

7-51
Cost-Volume-Profit Graph

s
l sale
a
Tot

en ses
l exp
Tota
Fixed expenses

7-52
Cost-Volume-Profit Graph

a les
ta ls rea
Break-even To fit a
Pro
point

en ses
l exp
Tota
Fixed expenses
a rea
s
Los

7-53
 Profit-Volume Graph
Some managers like the profit-volume
graph because it focuses on profits and volume.

Break-even
point re a
ofi ta
P r

rea
s a
Los

7-54
 Target Net Profit

We can determine the number of surfboards that Curl

must sell to earn a profit of $100,000 using the
contribution margin approach.

Fixed expenses + Target profit Units sold to earn

=
Unit contribution margin the target profit

$80,000 + $100,000
= 900 surf boards
$200

7-55
 Equation Approach

Sales revenue – Variable expenses – Fixed expenses = Profit

($500 × X) – ($300 × X) – $80,000 = $100,000

($200X) = $180,000

X = 900 surf boards

7-56
 Applying CVP Analysis
Safety Margin
• The difference between budgeted sales revenue
and break-even sales revenue.
• The amount by which sales can drop before
losses occur.

7-57
 Safety Margin
Curl, Inc. has a break-even point of $200,000
in sales. If actual sales are $250,000, the safety margin is
$50,000, or 100 surf boards.

7-58
 Changes in Fixed Costs

• Curl is currently selling 500 surfboards per year.

• The owner believes that an increase of $10,000 in
the annual advertising budget, would increase
sales to 540 units.

 Should the company increase the advertising

budget?

7-59
 Changes in Fixed Costs

540 units × $500 per unit = $270,000

$80,000 + $10,000 advertising = $90,000

7-60
 Changes in Fixed Costs
Sales will increase by
$20,000, but net income
decreased by $2,000.

7-61
 Changes in Unit
Contribution Margin

Because of increases in cost of raw materials, Curl’s

variable cost per unit has increased from $300 to
$310 per surfboard. With no change in selling price
per unit, what will be the new break-even point?

($500 × X) – ($310 × X) – $80,000 = $0

X = 422 units (rounded)

7-62
 Changes in Unit
Contribution Margin

Suppose Curl, Inc. increases the price of each

surfboard to $550. With no change in
variable cost per unit, what will be the new
break-even point?

($550 × X) – ($300 × X) – $80,000 = $0

X = 320 units
7-63
 Predicting Profit Given Expected Volume

Fixed expenses
Given: Unit contribution margin Find: {req’d sales volume}
Target net profit

Fixed expenses
Given: Unit contribution margin Find: {expected profit}
Expected sales volume

7-64
 Predicting Profit Given
Expected Volume
In the coming year, Curl’s owner expects to sell 525
surfboards. The unit contribution margin is
expected to be $190, and fixed costs are expected to
increase to $90,000.

Total contribution - Fixed cost = Profit

($190 × 525) – $90,000 = X

X = $99,750 – $90,000
X = $9,750 profit 7-65
 CVP Analysis with Multiple Products

For a company with more than one product, sales mix

is the relative combination in which a company’s
products are sold.
Different products have different selling prices, cost
structures, and contribution margins.

Let’s assume Curl sells surfboards and sail boards

and see how we deal with break-even analysis.

7-66
 CVP Analysis with Multiple Products

Curl provides us with the following: information:

7-67
CVP Analysis with Multiple Products

Weighted-average unit contribution margin

$200 × 62.5%

$550 × 37.5%
7-68
CVP Analysis with Multiple Products

Break-even point
Break-even Fixed expenses
=
point Weighted-average unit contribution margin

Break-even $170,000
=
point $331.25

Break-even 514 combined unit sales

=
point

7-69
CVP Analysis with Multiple Products

Break-even point
Break-even
= 514 combined unit sales
point

7-70
 Assumptions Underlying
CVP Analysis
1. Selling price is constant throughout the
entire relevant range.
2. Costs are linear over the relevant range.
3. In multi-product companies, the sales
mix is constant.
4. In manufacturing firms, inventories do
not change (units produced = units sold).

7-71
CVP Relationships and the Income Statement

7-72
CVP Relationships and the Income Statement

7-73
 Cost Structure and Operating Leverage

• The cost structure of an organization is the relative

proportion of its fixed and variable costs.
• Operating leverage is:
– the extent to which an organization uses fixed costs in
its cost structure.
– greatest in companies that have a high proportion of
fixed costs in relation to variable costs.

7-74
Measuring Operating Leverage
Operating leverage Contribution margin
=
factor Net income

$100,000
= 5
$20,000 7-75
 Measuring Operating Leverage
A measure of how a percentage change in sales
will affect profits. If Curl increases its sales by
10%, what will be the percentage increase in net
income?

7-76
 Measuring Operating Leverage

A firm with proportionately high fixed costs has

relatively high operating leverage. On the other hand, a
firm with high operating leverage has a relatively high
break-even point.
7-77
 CVP Analysis, Activity-Based Costing, and
Advanced Manufacturing Systems

An activity-based costing system provides a much

more complete picture of cost-volume-profit
relationships and, thus, it provides better
information to managers.
Break-even = Fixed costs
point Unit contribution margin

7-78
 A Move Toward JIT and
Flexible Manufacturing
Overhead costs like setup, inspection, and material
handling are fixed with respect to sales volume, but
they are not fixed with respect to other cost drivers.

This is the fundamental distinction between a traditional

CVP analysis and an activity-based costing CVP
analysis.

7-79
 Effect of Income Taxes
Income taxes affect a company’s CVP
relationships. To earn a particular after-
tax net income, a greater before-tax
income will be required.

Target after-tax net income Before-tax

=
1 - t net income

7-80
End of Session-7

7-81