Slide Set 5 Flashcards
1. Explain variable, fixed, and mixed costs and the relevant range. 2. Apply the high-low method to determine the components of mixed costs. 3. Prepare a CVP income statement to determine contribution margin. 4. Compute the break-even point using three approaches. 5. Determine the sales required to earn target net income and determine margin of safety.
What is a Cost Behavior Analysis?
What is it needed for?
Step one is..
The study of how specific costs respond to changes in the level of business activity.
Helps management plan operations and decide between
alternative courses of action.
..measuring Key business activity levels
Examples for Key business activity levels
► Sales dollars (in a retail company)
► Miles driven (in a trucking company)
► Room occupancy (in a hotel)
► Dance classes taught (by a dance studio)
What is an Activity/Volume index?
What are requirements for this index?
► Identifies the activity that causes changes in the behavior of costs.
► Allows costs to be classified as variable, fixed, or mixed.
→ Companies should choose activity/volume indexes that
show a high correlation with cost
Define Variable Costs
Costs that vary in total directly and proportionately with changes in the activity level.
Variable costs remain the same per unit at every level of activity.
Define Fixed Costs
Name Examples
Costs that remain the same in total regardless of changes in the activity level within a relevant range.
Fixed cost per unit varies inversely with activity: As volume increases, unit cost declines, and vice versa
► Insurance
► Rent
► Depreciation on buildings and equipment
Relationship of variable and fix cost with ranges of activity
- Relationship between variable costs and changes in activity level is often curvilinear.
- For fixed costs, the relationship is also nonlinear – some fixed costs will not change over the entire range of activities, while other fixed costs may change.
- Throughout the range of possible levels of activity, a straight-line relationship usually does not exist for either variable costs or fixed costs.
Define Relevant Range
Normalauslastung
Range of activity over which a company expects to
operate during a year.
Activity level between 40% and 80%.
Define Mixed Costs
- Costs that have both a variable element and a fixed element.
- Change in total but not proportionately with changes in activity level.
What is the High-Low Method?
- It disaggregated mixed costs into a fixed and variable components.
- High-Low Method uses the total costs incurred at the high and the low levels of activity to classify mixed costs into fixed and variable components.
- The difference in costs between the high and low levels represents variable costs, since only variable-cost element can change as activity levels change.
- just an estimate approach
Steps of the High-Low Method
- Determine variable cost per unit
Changes in Total Cost/(High Activity Level-Low Activity Level)= Variable Cost per Unit - Determine the fixed cost by subtracting the total variable cost at either the high or the low activity level from the total cost at that activity level.
What is a Cost-volume-profit (CVP) analysis?
What is it needed for?
Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume on a company’s profits.
Distinguish between fixed and variable costs needed for the analysis.
- profit planning
What are Basic Components of the Cost-Volume-Profit Analysis?
- Volume or level of activity
- unit selling price
- variable cost per unit
- total fixed costs
- sales mix
Name the 5 basic assumptions of the Cost-Volume-Profit Analysis
- Behavior of both costs and revenues is linear throughout the relevant range of the activity index.
- Costs can be classified accurately as either variable or fixed.
- Changes in activity are the only factors that affect costs.
- All units produced are sold.
- When more than one type of product is sold, the sales mix will remain constant.
What is a CVP Income Statement?
- A statement for internal use.
- Classifies costs and expenses as fixed or variable.
- Reports contribution margin in the body of the statement.
- Reports the same net income as a traditional income statement.
What is a Contribution margin
Contribution margin – amount of revenue remaining after deducting variable costs. (in German: Deckungsbeitrag)
- contributes to cover fix costs and after that contributes to net income
CVP Income Statement layout
Sales - Variable Costs = Contribution Margin - Fixed Costs =Net income
contribution margin per unit
Unit Selling Price- Unit variable Costs = Unit contribution Margin
contribution margin ratio
Shows the percentage of each sales dollar available to apply towards fixed costs and profits.
Unit contribution margin/unit selling price= contribution margin ratio
What is a Break-Even Analysis?
Process of finding the break-even point level of activity at which total revenues equal total costs (both fixed and variable).
3 Approaches of calculation:
► from a mathematical equation,
► by using contribution margin, or
► from a cost-volume profit (CVP) graph (Sales = Total Costs).
- Expressed either in sales units or in sales dollars
Define the Target Net Income
Level of sales necessary to achieve a specified income.
- Can be determined from each of the approaches used to
determine break-even sales/units:
► from a mathematical equation,
► by using contribution margin technique, or
► from a cost-volume profit (CVP) graph.
- Expressed either in sales units or in sales dollars
What is the Margin of Safety?
- Difference between actual or expected sales and sales at the break-even point.
- Measures the “cushion” that a particular level of sales provides.
- May be expressed in dollars or as a ratio.
Actual (Expected) Sales - Break even Sales = Margin of safety in dollars
Calculation of the Margin of Safety ratio
Margin of Safety in Dollar/Actual (Expected) Sales= Margin of safety ratio
