Cost Behavior Patterns & CVP Analysis: Chapter Six
Cost Behavior Patterns & CVP Analysis: Chapter Six
Cost Behavior Patterns & CVP Analysis: Chapter Six
(a) Fixed costs: also known as non-variable costs, stand-by costs, period
costs, or capacity costs are those costs which do not vary with change in
volume of output over a given period of time and within a relevant range of
activity.
Examples: Rent & Taxes of buildings, insurance charges & depreciation of plant,
machinery and buildings, salaries of foremen, workers, managers, permanent
staff and executives.
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There is an inverse relationship between volumes of output and fixed costs per
unit; whereas, remain constant in total per period. The equation for fixed costs is:
(b) Variable costs: are costs which fluctuate, in total, in direct proportion to
the volume of output or sales.
Examples include the costs of direct materials, direct labor, supplies and direct
expenses like sales commissions.
Variable costs are uniform (linear) incremental costs per unit of output. The
equation for Variable costs is:
(c) Semi-Variable (Mixed) Costs: are a combination of fixed and variable costs
and are, thus, also known as “mixed costs.” Such costs are neither
perfectly variable nor absolutely fixed in relation to changes in the volume
of output. Examples: utility bills, such as power costs, telephone charges,
repairs and maintenance costs, etc.
The fixed component of such costs represents the cost of providing capacity and
the variable component is caused by using the capacity. For example, power
costs include a “fixed portion” a “minimum charge’ that will be charged even if
you do not consume power, and “variable charges” based on consumption of
power. The equation for mixed costs is:
Total Costs = Fixed Costs + Variable costs Per Unit X Units (volume)
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In the equation for total costs fixed costs and fixed element of fixed costs are
both included in the “Fixed Costs.” Likewise, variable costs and variable
elements of mixed costs are both included in “variable Costs.”
The equation for total costs corresponds to the general equation for a “straight-
line.”
Y = a + bx
Operating Income is operating revenues for the accounting period minus all
operating costs, including cost of goods sold:
In the example that follows, the measure of output is the number of units
manufactured or units sold.
Example:
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Setting operating income equals to zero in the above equation:
This gives us a general formula for a single product and based on output units:
In our example, fixed costs are $400,000 and the unit contribution margin is $8:
= 50,000 units
Thus,
Target volume = $400,000 + $120,000
(Number of Units) $8
= $520,000
$8
= 65,000 units
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Role of Income Taxes
The only change in the equation method of CVP analysis is to modify the target
operating income to allow for taxes.
Thus,
Q3. To earn an after tax profit of $48,000; how many units must be sold?
Small Business Specialities Company is subject to income tax rate of 40%.
Solutions:
Substituting numbers from our Small Business Specialities Company
example, the equation would now be:
$8N = $480,000
N = 60,000units
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Proof:
Total
Revenues, $20 x 60,000 units $1,200,000
Variable costs, $12 x 60,000 720,000
Contribution margin, $8 x 60,000 480,000
Fixed costs 400,000
Operating Income $ 80,000
Income Taxes, $80,000 x 0.40 $ 32,000
Net Income $ 48,000
The presence of income taxes will not change the breakeven point. Why?
Because, by definition, operating income at the breakeven point is zero and
thus no income taxes will be paid.
In sum, CVP Analysis must be done carefully because one or more initial
assumptions may not hold. When the assumed conditions change; the
breakeven point and the expected operating income at various output levels also
change. Of course, the breakeven points are frequently incidental data. Instead,
the focus is on the effects on operating income under various production and
sales strategies.
How do we cope with uncertainty? There are many complex models available
that formally analyze expected values in conjunction with probability
distributions. But, the application of Sensitivity Analysis to an original solution
is the most widely used approach.
In the context of CVP, sensitivity analysis answers such questions as, what will
operating income be if the output levels decreases by 5% from the original
prediction? And what will operating income be if variable costs per unit increases
by 10%?
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A tool of sensitivity analysis is the margin of safety (M.S.), which is the excess of
budgeted revenues over the breakeven revenues. The margin of safety is the
answer to the “what ... if’ question: If budgeted revenues are above breakeven
point and drop, how can they fall below budget before the breakeven point is
reached?
M.S. = $1,200,000 (or 60,000 units) - $1,000,000 (or 50,000 units) x 100
$1,200,000 (or 60,000 units)
M.S. = 16.7%
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