Session–7

Cost Analysis for Decision Making

PGP 2023-25

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
Consider the
variable. following example:.

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

o st
l e c
va ria b Variable Lease
m i
l s e
To ta Charge Per Hour

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:

Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100

Using these two levels of activity, compute:

the variable cost per unit.
the total fixed cost.
6-25
 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

6-26
 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

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

6-27
 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

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

6-28
 The High-Low Method
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

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
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

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
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600

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 + b 1 X 1 + b2 X 2

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.
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 100,000
Net income $ -

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.

Total Per Unit Percent

Sales (500 surf boards) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

7-43
 Contribution-Margin Approach

Fixed expenses Break-even point

=
Unit contribution margin (in units)

Total Per Unit Percent

Sales (500 surf boards) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

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

Here is the proof!

Total Per Unit Percent

Sales (400 surf boards) $200,000 $ 500 100%
Less: variable expenses 120,000 300 60%
Contribution margin $ 80,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ -

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

Total Per Unit Percent

Sales (400 surf boards) $200,000 $ 500 100%
Less: variable expenses 120,000 300 60%
Contribution margin $ 80,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ -

$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.:
300 units 400 units 500 units
Sales $ 150,000 $ 200,000 $ 250,000
Less: variable expenses 90,000 120,000 150,000
Contribution margin $ 60,000 $ 80,000 $ 100,000
Less: fixed expenses 80,000 80,000 80,000
Net income (loss) $ (20,000) $ - $ 20,000

7-48
 Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000

250,000
Dollars

200,000

150,000

100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units

7-49
 Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000

250,000
Dollars

ses
200,000
e n
tal exp
150,000
To
100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units

7-50
 Cost-Volume-Profit Graph
450,000

400,000

350,000

300,000

250,000
Dollars

ses
200,000
e n
tal exp
150,000
To
100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units

7-51
 Cost-Volume-Profit Graph
450,000

400,000
s
l sale
350,000 a
Tot
300,000

250,000
Dollars

ses
200,000
e n
tal exp
150,000
To
100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units

7-52
 Cost-Volume-Profit Graph
450,000

400,000
a les
350,000
tals rea
Break-even To fit a
300,000 Pro
point
250,000
Dollars

ses
200,000
e n
tal exp
150,000
To
100,000
Fixed expenses
re a
s a
50,000 Los

100 200 300 400 500 600 700 800

Units

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

100,000

80,000

60,000
Break-even
point re a
ta
40,000

rofi
20,000 P
Profit

0 `

(20,000) 100 200 300 400 500 600 700

re a Units

s a
(40,000)
Los
(60,000)

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. Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net income $ - $ 20,000

7-58
 Changes in Fixed Costs

•• Curl
Curl is
is currently
currently selling
selling 500
500 surfboards
surfboards
per
per year.
year.
•• The
The owner
owner believes
believes that
that an
an increase
increase of
of
$10,000
$10,000 in in the
the annual
annual advertising
advertising
budget,
budget, would
would increase
increase sales
sales to
to 540
540
units.
units.

 Should
Should the
the company
company increase
increase the
the
advertising
advertising budget?
budget? 7-59
 Changes in Fixed Costs

Current Proposed
Sales Sales
(500 Boards) (540 Boards)
Sales $ 250,000 $ 270,000
Less: variable expenses 150,000 162,000
Contribution margin $ 100,000 $ 108,000
Less: fixed expenses 80,000 90,000
Net income $ 20,000 $ 18,000

540 units × $500 per unit = $270,000

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

7-60
 Changes in Fixed Costs
Sales will increase by Current Proposed
$20,000, but net income Sales Sales
decreased by $2,000. (500 Boards) (540 Boards)
Sales $ 250,000 $ 270,000
Less: variable expenses 150,000 162,000
Contribution margin $ 100,000 $ 108,000
Less: fixed expenses 80,000 90,000
Net income $ 20,000 $ 18,000

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
7-66
 CVP Analysis with Multiple
Products
Curl provides us with the following:
information:
Unit Unit Number
Selling Variable Contribution of
Description Price Cost Margin Boards
Surfboards $ 500 $ 300 $ 200 500
Sailboards 1,000 450 550 300
Total sold 800

Number % of
Description of Boards Total
Surfboards 500 62.5% (500 ÷ 800)
Sailboards 300 37.5% (300 ÷ 800)
Total sold 800 100.0%

7-67
 CVP Analysis with Multiple
Products

Weighted-average unit contribution

margin
Contribution Weighted
Description Margin % of Total Contribution
Surfboards $ 200 62.5% $ 125.00
Sailboards 550 37.5% 206.25
Weighted-average contribution margin $ 331.25

$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

Breakeven % of Individual
Description Sales Total Sales
Surfboards 514 62.5% 321
Sailboards 514 37.5% 193
Total units 514

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

A. Traditional Format
ACCUTIME COMPANY
Income Statement
For the Year Ended December 31, 20x1

Sales $500,000
Less: 380,000
Gross margin $120,000
Less: Operating expenses:
Selling expenses $35,000
Administrative expenses 35,000 70,000
Net income $50,000

7-72
CVP Relationships and the Income
Statement
B. Contribution Format
ACCUTIME COMPANY
Income Statement
For the Year Ended December 31, 20x1

Sales $500,000
Less: Variable expenses:
Variable manufacturing $280,000
Variable selling 15,000
Variable administrative 5,000 300,000
Contribution margin $200,000
Less: Fixed expenses:
Fixed manufacturing $100,000
Fixed selling 20,000
Fixed administrative 30,000 150,000
Net income $50,000
7-73
 Cost Structure and Operating
Leverage
•• The
The cost
cost structure
structure of of an
an organization
organization isis the
the
relative
relative proportion
proportion of of its
its fixed
fixed and
and variable
variable
costs.
costs.
•• Operating
Operating leverage
leverage is: is:
–– the
the extent
extent to
to which
which an an organization
organization uses
uses
fixed
fixed costs
costs inin its
its cost
cost structure.
structure.
–– greatest
greatest inin companies
companies that that have
have aa high
high
proportion
proportion of of fixed
fixed costs
costs in
in relation
relation to
to
variable
variable costs.
costs.

7-74
Measuring Operating Leverage
Operating leverage Contribution margin
=
factor Net income
Actual sales
500 Board
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000

$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?

Percent increase in sales 10%

Operating leverage factor × 5
Percent increase in profits 50%

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