1102AFE Lecture Notes - Lecture 8: Contribution Margin, Unit Price, Sunk Costs

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30 May 2018

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Week 8 Accounting for Decision Making Lecture Notes

Cost-volume- profit

(CVP) Analysis

1. Cost Behavior Patterns

There are three cost behavior patterns:

• Variable costs (VC)

• Fixed costs (FC)

• Mixed costs

These terms have very strict ACCOUNTING DEFINITIONS, and you must focus on these

defiitios, ot o the usual eaig of the ods a ad fied

Variable Costs

• In total change in direct proportion to changes in volume/activity

• Do not change per unit

• Graph slide 6→ these costs vary with the level of activity

Fixed Costs

Fixed costs:

• In total do not change in relation to changes in volume (activity) within a relevant

range

• Change per unit

Relevant Range:

• The range of activity over which the cost behavior is assumed to be valid. If the

activity level goes outside the relevant range, then the expected behavior of costs

may change

• Graph slide 8→ as the volume of activity increases, the total fixed costs stay the

same

Why is this distinction important?

• In whatever field you are working, the distinction is critical for decision-making

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• If you use fixed costs and variable costs incorrectly, you will make incorrect decisions

• Assume unrealistically that the only costs of Australian Outback are the two we have

identified. Assume also that for BUDGETING purposes we assume 1,000 people

attending per night

Common Errors in describing fixed/variable costs

• Note that in accounting these terms have very strict definition, and any other

definition is incorrect. Common errors include:

o a fied ost ee hages. INCO‘‘ECT. Most osts oe tie ill hage. A

fixed cost does not change in relation to a change in activity/ volume

o A aiale ost aies ith the fis iustaes. INCO‘‘ECT. A aiale

cost varies in total in relation ONLY to activity level

o A aiale ost is ot essetial. The fi ill deide hethe it ats the

ost o ot. INCO‘‘ECT. Assue ou ae aking a ham and pineapple pizza.

Ha is a aiale ost if ou ake tie as a ha ad pieapple

pizzas the total cost of ham will be twice as high). The ham is essential for a

ham and pineapple pizza.

o A aiale ost aies ith the eoo, ith ho the business is

pefoig, aies oe tie…. ALL INCO‘‘ECT. Go ak to defiitio i

topic 1.

Mixed Costs

• Have both a fixed and a variable component

• Must split into fixed and variable components for CVP

2. What is CVP Analysis

• It is the analysis of the relationship between costs, volume (i.e. sales units) and profit

which enables firms to make important business decisions, in particular how many

units to sell to make a particular profit

• There are 3 methods of CVP analysis

o Contribution margin approach → most often used in practice and the

approach for our course

o Equation approach

o Graphical approach

• It is soeties alled eakee aalsis, though eakee aalsis is ol oe

aspect of CVP analysis

Breakeven point

• This is the level of sales at which the firm makes zero profit (and zero loss)

• It is a useful piece of information (particularly for commencing firms) for decision-

making

• The breakeven point is the point at which revenue MINUS all expenses (fixed +

variable) = zero

3. Questions answered by CVP

• Identifying the number of products or services required to be sold to meet profit

targets

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Document Summary

Week 8 accounting for decision making lecture notes. Cost-volume- profit (cvp) analysis: cost behavior patterns. There are three cost behavior patterns: variable costs (vc, fixed costs (fc, mixed costs. These terms have very strict accounting definitions, and you must focus on these defi(cid:374)itio(cid:374)s, (cid:374)ot o(cid:374) the usual (cid:373)ea(cid:374)i(cid:374)g of the (cid:449)o(cid:396)ds (cid:862)(cid:448)a(cid:396)(cid:455)(cid:863) a(cid:374)d (cid:862)fi(cid:454)ed(cid:863) In total change in direct proportion to changes in volume/activity: do not change per unit, graph slide 6 these costs vary with the level of activity. In total do not change in relation to changes in volume (activity) within a relevant range: change per unit. Relevant range: the range of activity over which the cost behavior is assumed to be valid. If the activity level goes outside the relevant range, then the expected behavior of costs may change: graph slide 8 as the volume of activity increases, the total fixed costs stay the same. In whatever field you are working, the distinction is critical for decision-making.

Related Questions

1. Which one of the following refers to a cost that remains the same as the volume of activity decreases within the relevant range?

A. Average cost per unit.

B. Variable cost per unit.

C. Unit fixed cost.

D. Total variable cost.

2. The relevant range refers to the activity levels over which

A. Cost relationships hold constant.

B. Costs fluctuate.

C. Production varies.

D. Relevant costs are incurred.

3. When identifying fixed and variable costs, which one of the following is a typical assumption concerning cost behavior?

A. General and administrative costs are assumed to be variable costs.

B. Cost behavior is assumed to be realistic for all levels of activity from zero to maximum capacity.

C. Total costs are assumed to be linear when plotted on a graph.

D. The relevant time period is assumed to be 5 years.

4. A management accountant is about to prepare graphs of total variable cost and per-unit variable cost for use in a short-term planning model. Dollars will be depicted on the vertical axis; activity will be shown on the horizontal axis. How will these graphs appear under completion?

Total Variable Cost; Per-Unit Variable Cost

A. Straight line, sloping upward to the right; Straight line, parallel to the horizontal axis

B. Curvilinear, sloping upward to the right; A line that basically parallels the horizontal axis, first decreasing and then increasing

C. Straight line, sloping upward to the right; Straight line, sloping upward to the right

D. Straight line, parallel to the horizontal axis; Straight line, sloping upward to the right

5. A company has found that its total electricity cost has both a fixed component and a variable component within the relevant range. The variable component seems to vary directly with the number of units produced. Which one of the following statements concerning electricity cost is incorrect?

A. The total electricity cost will increase as production volume increases.

B. The total electricity cost per unit of production will increase as production volume increases.

C. The variable electricity cost per unit of production will remain constant as production volume increases.

D. The fixed electricity cost per unit of production will decline as production volume increases.

silversnake284

The following data have been extracted from the records of Puzzle, Inc.:

	February		August
Production level, in units		11,800		25,960
Variable costs	$	33,040	$	?
Fixed costs		?		32,500
Mixed costs		29,120		?
Total costs	$	94,660	$	161,212

Required:

a. Calculate the missing costs. (Do not round intermediate calculations.)

b. Calculate the cost formula for mixed cost using the high-low method. (Do not round intermediate calculations. Round "Variable cost" to 2 decimal places.)

cost formula _____ + _____ per unit

c. Calculate the total cost that would be incurred for the production of 16,949 units. (Do not round intermediate calculations.)

Total cost ____

d. Identify the two key cost behavior assumptions made in the calculation of your answer to part c.

cost behavior pattern is ____ relevant range ____

If variable costs per unit increased because of an increase in hourly wage rates, the break-even point would:

a. increase.

b. remain the same.

c. decrease.

d. increase or decrease, depending upon the percentage increase in wage rates.

Zeke Company sells 25,000 units at $21 per unit. Variable costs are $10 per unit, and fixed costs are $75,000. The contribution margin ratio and the unit contribution margin are:

a. 53% and $7 per unit.

b. 47% and $11 per unit.

c. 52% and $11 per unit.

d. 47% and $8 per unit.

If sales are $500,000, variable costs are 75% of sales, and operating income is $40,000, what is the operating leverage?

a. 0

b. 1.3

c. 3.1

d. 1.25

Which of the following describes the behavior of the fixed cost per unit?

a. Increases with increasing production

b. Remains constant with changes in production