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Example of Managerial Decision
A customer offers to buy electrical engines from your
company. They are of an old design and a slight modification
to its electricity intake is needed to make them work. You have
plenty of those old engines in stock and have no prospect ofbeing able to sell themto anyone else. Their scrap value isnegligible. Both the workers and the supervisors of your
factory are paid fixed monthly salaries. You expect to have
some spare production capacity over the coming weeks. The
material cost of one old engine was $500. To manufacture thealtered design specified in the order, you would have to modify
some of your production machinery. An engineer would have
to work on it for eight hours
and use materials worth $30,000. The customer offers to pay
$300 per engine after the alterations have been made.
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Managerial Decision
Is it worth considering this order? What further information doyou require to decide whether you should accept the order?
A typical mistake would be to turn the order down because theselling price is lower than the production cost. In fact, the
production cost is a sunk cost, hence irrelevant to the decision.
However, $30,000 is an emerging cost, hence relevant to thedecision. You should accept the order only if the emerging
revenues cover the emerging cost and this happens if the orderis in excess of 100 engines. $30,000 / $300 = 100. Beforeaccepting the order you will also have to check that yourworkers and supervisors have enough spare productioncapacity available to fulfill the order.
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Managerial Decision
be influenced by a managerial decision are irrelevant tothat decision. However, there are other costs that will notactually materialise and yet are relevant to the decision-
making process. These are opportunity costs. If wedefine cost as any decrease in wealth brought about by adecision to use a particular resource or set of resources,
by measuring the decrease in wealth by reference to thenext best alternative, we are effectively using the
economic concept of opportunity cost. Economists defineopportunity cost as the benefits foregone by not adoptingthe next best alternative, where benefits can relate to
any economic benefit, not only cash.
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Module 7: Cost Behavior & Cost-Volume-
Profit AnalysisACG 2071
Created by: M. MariFall 2007-1
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Cost-Volume-Profit Analysis (CVP)
Which helps them predict how changes in costs and
sales levels affect income
CVP analysis involves computing the sales level at
which a company neither earns an income nor incurs
a lossbreak even point
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Cost Behavior
refers to the manner in which a cost changes as a
related activity changes.
Activity basesactivities that are thought to cause
the cost to be incurred.
Relevant rangerange of activity over which the
changes in the cost that are of interest.
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Cost Classifications
Three types
Variable Cost
Fixed Cost Mixed Cost
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Variable costs
costs that vary in
proportion to changes
in the level of activity.
Direct materials
Direct labor
Units Produced Direct Materialsper unit
Total DirectMaterial Costs
5,000 units $10 $ 50,000
10,000 units $10 100,000
15,000 units $10 150,000
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Fixed Costs
costs that remain the
same in total dollar
amounts as the level of
activity changes.
Number of Bottles Total Salary forSupervisor
Salary per bottleproduced
50,000 $75,000 $1.50
100,000 $75,000 $0.75
150,000 75,000 $0.50
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Mixed Costs has characteristics of both a variable and a fixed cost.
Could behave as a fixed costs for part of the relevant range and
then variable cost
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Contribution Margin Concept
Contribution margin = SalesVariable costs
Contribution margin ratio =
SalesVariable costs
Sales Is most useful when the increase or decrease in sales
volume is measured in sales dollars
Unit contribution margin
= Sales price per unitVariable costper unit
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Example
The Company has sales of $1,000,000, variable costs of$800,000. The company sold 50,000 units. Compute thecontribution margin and the contribution margin ratio.
Contribution margin = SalesVariable cost
= $1,000,000 - $800,000 = $200,000
Contribution margin ratio = (SalesVC)/Sale
= $4
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= (1,000,000800,000)/1,000,000
= 20%
Unit Contribution margin = Contribution margin
Units sold
= $200,000
50,000
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Break-even Analysis to determine the units of sales necessary to achieve the break even
pint in operations
to determine the units of sales necessary to achieve a target or
desired profit
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Break-Even Point
Is the level of operations at which a businesss
revenues and expired costs are exactly equal?
A business will have neither an income nor a loss
from operations.
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Break Even Point
RevenuesExpenses
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Break even formula
BEP = Fixed Costs__________
Unit contribution margin
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Example
Suppose that selling price is $25, variable cost $15 and fixedcosts are $90,000. What is break even point?
BEP = Fixed costs / Unit Contribution Margin
= $90,000/ (2515) = $90,000/$10 = 9,000 units
At sales level of 9,000 units will result in no gain or loss to thecompany.
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Example
Proof:
Sales: ($25 X 9,000) $225,000
Variable cost: ($15 x 9,000) 135.000
Contribution margin 90,000
Fixed costs
90,000 Operating income -0-
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Changes in fixed costs
Example: Suppose that selling price is $25, variable cost $15
and fixed costs are $90,000. What is break even point if fixed
costs increase to $100,000?
BEP = Fixed costs/ Unit Contribution margin
= $100,000/ (25-15) = 10,000 units
Due to an increase in fixed costs from $90,000 to $100,000,
break even point increased
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Changes in variable costs
Example: Suppose that selling price is $25, variable cost$15 and fixed costs are $90,000. What is break even pointif variable costs decrease to $10?
BEP = Fixed costs/ Unit Contribution margin
= $90,000/ (25-10) = 6,000 units
Due to a decrease in variable costs from $15 to $10,break even point decreased to 6,000 units from9,000 units or a decrease of 3,000 units
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Changes in selling price
Example: Suppose that selling price is $25, variable cost$15 and fixed costs are $90,000. What is break even pointif selling price increase to $30?
BEP = Fixed costs/ Unit Contribution margin
= $90,000/ (30-15) = 6,000 units
Due to an increase in sales price from $25 to $30,break even point decreased to 6,000 units from9,000 units or a decrease of 3,000 units.
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Desired or Target Profit
BEP = Fixed costs + Desired Profit
Unit contribution margin
Example: Suppose that selling price is $45, variable cost $30, andfixed costs are $60,000. The company wants a desired profitof $45,000. What is break even point?
BEP = Fixed costs + Desired profit/ Unit Contribution margin
= ($60,000)/ (45-30) = 4,000 units
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Desired or Target Profit
BEP = Fixed costs + Desired profit/ UnitContribution margin
= ($60,000 + $45,000)/ (45-30) = 7,000 units
To create $45,000 of profit, must sell 7,000 units or3,000 more than break even point
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Charts
Costs
Units
Fixed costs
Variable
Total cost
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Graphical Break even point
$
Units0
Total costs
Sales
Break even point
Sales = TC
Profit
Loss
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Sales Mix Consideration
More than one product is
sold at varying selling
prices
Products often havedifferent unit variable costs
Products have different
contribution margin
Sales volume necessary
must a mix of both
products
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Example 6:
Cascade Co produces two products Yuk and Gunk.
Yuk has a selling price of $90 per unit and variable
cost of $70. Gunk has a selling price of $140 andvariable cost of $95. Fixed costs are $200,000.
Gunks sales are approximately 80% of total sales
for the company. What is the break even point for
the sales mix?
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Example 6:
Product SellingPrice
VariableCost
ContributionMargin
Sales
%
Sales mixContribution
Margin
Yuk $90 $70 $20 80% $16
Gunk $140 $95 $45 20% $9
Sales mix $25
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Example 6:BEP = Fixed Costs
Sales mix CM
= $200,000
$25
BEP = 8,000 units
Of what products:
YUK: 8,000 units * 80% = 6,400 units
GUK: 8,000 units * 20% = 1,600 units
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Example 7:
ABC Company has two products Y and X. Y has a
selling price of $100 and variable costs of $60. It is
70% of total sales. X has a selling price of $50 andvariable cost of $25. Fixed costs are $248,500.
What is BEP?
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Margin of Safety
Indicates possible
decrease in sales that
may occur before an
operating loss occurs.
Margin of Safety =
SalesSales at BEP
Sales
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Margin of Safety
If sales are $400,000 and sales at break even are
$300,000 what is margin of safety?
Ms = SalesSales BEP = $400 - $300
Sales $400
= 25%
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High-Low Method Cost estimation techniques
Steps
1. Find the highest and lowest
level of production
2. Find the difference in total
cost from highest to lowest
level of production
3. Find the difference in total
units from highest to lowest
level of production
4. Variable cost per unit
Difference in Total cost
Difference in Total units
5. Find fixed cost by solving this
equation
Total cost = Fixed cost plus
Variable cost
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Example 1
Month Production Total Cost
June 1,000 $45,550July 1,500 $52,000
Aug 2,100 $61,500
Sept 1,800 $57,500Oct 750 $41,250
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Example
Step 1: Find highest and lowest level of production.
Month Units Total Cost
High August 2,100 $61,500
Low October 750 $41,250
Step 2: Get the difference
Difference 1,350 $20,250
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Example continued
Step 3: Compute Variable cost per unit
Variable cost = Difference in Total Cost
Difference in Units
=$20,250
1,350
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= $15 per unit
Total cost = FC + VC
$61,500 = FC + ($15 *2,100 units)
$61,500 = FC + 31,500
FC = $30,000
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Example Contd
Step 4: Compute Fixed costs
Total cost = Fixed Costs + Variable Cost
using the data at 2,100 units of production, we
solve for fixed costs
$61,500 = FC + ($15 *2,100 units)
$61,500 = FC + 31,500
FC = $30,000
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Example Continued
Given the information in the prior slide, what is the
total cost at 2,000 units of output?
Total cost = Fixed costs + Variable costs
Total cost = $30,000 + ($15 X 2,000)
Total cost = $60,000
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Example 2
Month Production Total Cost
June 2,500 $45,000July 2,000 $40,000
Aug 1,500 $35.000
Sept 3,000 $50,000Oct 1,800 $38,000What is the variable cost per unit and fixed cost?
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Operating Leverage
o The relative mix of a businesss variable costs andfixed costs is measured by the operating leverage
Since the difference between contribution marginand income from operations is fixed costs,companies with large amounts of fixed costs willgenerally have a high operating leverage. Indicates that a small increase in sales will yield a large
percentage increase in income from operations.
Low operating leverage Indicates that a large increase in sales is necessary to
significantly increase income from operations
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Operating Leverage
Operating Leverage
= Contribution Margin
Income from operations