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The Behavior of Costs

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Behavior of Costs
Cost-volume relationships.
Fixed and variable costs.
Step-function costs.

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Relation of costs to volume


Higher volume causes higher costs.
Variable costs = items of cost that vary, in
total, directly and proportionately with volume.
Fixed costs = non-variable costs = items of
cost that, in total, do not vary with volume
Semivariable costs = semifixed costs = partly
variable costs = mixed costs = costs that
include a combination of variable and fixed
cost items.
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Variable Costs
Items of cost that vary, in total, directly and
proportionately with volume.
Volume refers to activity level.
Examples:
Material costs varies with units sold.
Electricity costs varies with production hours.
Stationery and postage costs varies with number
of letters written.

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Fixed costs
Non-variable costs = items of cost that, in
total, do not vary with volume.
Examples:
Building rent, property taxes, management salaries.

Fixed cost per unit of activity decreases as the


level of activity increases.
Fixed costs are fixed for a range of activity and a
limited period of time.
Fixed costs may change for reasons such as a
deliberate management decision to change them.
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Cost-volume (C-V) diagram


Y or vertical axis reflects total cost.
X or horizontal axis reflects volume.
y = mx + b.
y is the cost at a volume of x;
m is the rate of cost change per unit of
volume change, or the slope (variable costs).
b is the vertical intercept, which represents
the fixed cost component.

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TC = TFC +(UVC*X)
TC = total cost;
TFC = total fixed cost (per time period),
UVC = Unit variable cost (per unit of
volume),
X = volume.
Equations for:
Variable cost line: TC = UVC*X
Fixed cost line: TC = TFC
Semivariable cost: TC = TFC + (UVC*X).
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Cost Relations
Average costs = total cost/volume.
Average cost behaves differently than
total cost.
As volume goes up

Total fixed cost remains constant, total


variable costs goes up, per unit variable
costs stays the same, per unit fixed cost
goes down, per unit total cost goes down.
As volume increases without limit, unit cost
approaches variable unit cost and fixed cost
per unit approaches zero.
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Limitations of C-V Relations


A straight line approximates cost behavior
only within a certain range of volume, the
relevant range.
When volume approaches zero, management
takes steps to reduce fixed costs.
When volume exceeds relevant range, fixed
costs increase.

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Limitations (continued)
Amount of variable costs depends on the
time period over which behavior is
estimated (the relevant time period).
If the time period is one day, few costs are
variable.
Over an extremely long time period, no costs
are fixed.

Environmental assumptions must be made.


Wage rates, fringe benefits, material prices,
technology changes.
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Sticky Costs
Generally considered variable but fall less
with decreases of activity than they rise
with increases.
Managers tend to increase resources more
quickly than they decrease.
Examples:
Sales commissions with minimum guarantees.
Managers slower to fire employees than to
hire.
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Step-function costs
Some items of costs may vary in steps
Incurred when costs are added in discrete
chunks, e.g. a supervisor for every 10.
Adding the chunk of costs increases capacity.
Height of a stair step (riser) indicates cost of
adding incremental capacity.
Step width (tread) shows how much additional
volume of activity can be serviced by an
additional increment of capacity.
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Step function (continued)


If treads are narrow and risers are low (i.e.
steps are small), then steps can be
approximated by a variable cost line.
If it is believed within relevant time period,
cost will remain within relevant range for a
single stair step (tread), then cost is
appropriately treated as a fixed cost for time
period.
Step functions are often hidden in C-V
diagrams as either variable or fixed costs.
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Estimating C-V relationship


First method: Judgment or account-byaccount method.
Each account in cost structure is estimated
and divided between fixed and variable costs.

Second: Scatter diagram


Plot a number of observations (perhaps prior
period results) of costs and volumes on a
graph and visually draw a line of best fit.
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Third method: High-Low


method
Estimate total costs for two volume
levels, preferably one high level and one
low level.
To determine slope or variable cost per unit:
Change in total cost between the two points
divided by change in units of output.

To determine fixed costs:


Subtract from total costs at either one of the
points unit volume times unit variable costs.
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Measures of volume
Have assumed a single-product.
If multiple products, with different cost
structures, unlikely that units would be a
reliable measure of activity.
Possible common denominators include: labor
hours, labor dollars, machine hours,
homogeneous quantities such as tons or
barrels and sales value.
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Questions to consider in
selecting a volume measure
Input (resources used) or output (goods or
services produced)?
Money or non-monetary quantities?

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Input or output?
Input measures: resources used: labor
hours worked, labor cost, machine hours,
kilowatt hours of electricity, pounds of
material.
Output measures: units or dollars.
Manufacturing costs might use input
measures such as labor or machine hours.
Retail stores might use dollar sales.
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Money or non-monetary
quantities?
A non-monetary measure is not affected by
price changes and therefore may have some
advantages.
If price changes affect all costs equally, use of
labor costs as an activity measure implicitly
allows for price changes.
Best volume measure should be related to
the activity that causes cost.

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Profit-graph

Add revenue line to C-V diagram.


Assumes constant selling price.
UP = unit price= selling price
TR = total revenue

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Contribution Analysis

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Breakeven volume

TR = UP*X
TC = TFC + (UVC*X)
Breakeven: TR = TC
Substituting: UP*X = TFC + (UVC*X)
X = TFC/(UP - UVC)

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Target Profit
Add to breakeven analysis to show units
or dollar of sales to achieve a target (T)
level of profit:
UP*X = TFC + (UVC*X) + T
X = (TFC+T)/(UP - UVC)
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Break-even volume
In units = Fixed costs/unit contribution
In revenue dollars = Fixed costs /
contribution percent
Contribution percent = contribution margin
percentage = contribution as a percent of
revenues = (UP - UVC)/ UP

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Cash versus accrual profitgraphs


So far we have considered profit and costs
on an accrual basis.
To look at a profit-graph on a cash basis:
Major difference is depreciation (a non-cash
expense)
Also to be meaningful sales volume should
equal production volume.

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Profit-graph shows how to


improve profit performance:

Increase selling price.


Decrease variable cost.
Decrease fixed cost.
Increase volume.

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C-V-P with Several products


Relationships hold if each product has a
similar contribution margin percentage.
Profit-graph can be constructed by
using sales revenue rather than units.
Complicates C-V-P relationships:
Particularly if different contribution margin
percentages unless product mix remains
constant.
If product mix is constant, can use a weighted
average unit contribution.
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Contribution
Unit contribution = unit contribution margin
= marginal income = unit selling price variable cost per unit = UP - UVC.
I = total income = (UP - UVC) * X - TFC.
What is contribution:
First: contribution to cover fixed costs.
Then: contribution toward profit.

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Contribution (Contd..)
Contribution Margin per Unit equals unit selling price less
variable cost per unit
CMu = SP VCu

Contribution Margin also equals contribution margin per unit


multiplied by the number of units sold (Q)
CM = CMu x Q

Contribution Margin Ratio (percentage) equals contribution


margin per unit divided by Selling Price
CMR = CMu SP
Interpretation: how many $/Rs. out of every sales $/Rs are represented
by Contribution Margin.
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Margin of safety
The amount or ratio by which current volume
exceeds breakeven volume.
One indicator of risk, the Margin of Safety (MOS)
measures the distance between budgeted sales
and breakeven sales:
MOS = Budgeted Sales BE Sales

The MOS Ratio removes the firms size from the


output, and expresses itself in the form of a
percentage:
MOS Ratio = MOS Budgeted Sales
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Thank You

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