DiBella Coffee is a relatively new entrant to the coffee industry. Why coffee?
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COST BEHAVIOUR • Explains how costs respond to changes in the level of business activity • Three important CVP costs: – variable – fixed – mixed
• Must evaluate each cost incurred to determine the cost function that best describes the item’s cost behaviour 3
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Could you talk briefly about the nature of DiBella’s fixed and variable costs
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COST BEHAVIOUR continued
• A cost function is a relationship between cost and activity • All cost functions are assumed to be linear y = a + bx where y = total cost (dependent variable) a = fixed portion of total cost (y-intercept) b = variable cost rate (slope of function) x = measure of activity or volume (independent variable) 5
COST BEHAVIOUR continued
y=a a Activity level
y Cost
y Cost
Cost
y
a x
Fixed cost y = a + bx since b = 0 y=a
Activity level
x
Variable cost y = a + bx since a = 0 y = bx
Activity level
x
Mixed cost y = a + bx
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Variable cost behaviour • Few variable costs behave exactly in linear functions • Two notable exceptions: – A curvilinear function – A step function
• However, they are assumed to be linear within the relevant range • The relevant range is the range of activity in which the entity normally operates 7
Fixed cost behaviour • Total fixed costs will remain constant over a range of activity within the relevant range • Discretionary costs can be changed or discontinued by management if enough time is available e.g., advertising, R&D, employee training programs
• Committed costs are required even if the operation is closed down temporarily e.g., depreciation, rates, insurance, senior management salaries 8
Mixed cost behaviour • Divide into fixed and variable components • Techniques for separation: – Visual fit of a scatter diagram – High-low method – Linear regression analysis • Based on collection of historical data
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Assumptions of CVP analysis • • • •
Unit sales price remains constant Costs can be identified as variable or fixed Variable costs change with volume Total fixed costs remain constant over relevant range • Efficiency remains relatively unchanged • When more than one product is sold, total sales are in some predictable sales mix 10
COST BEHAVIOUR AND INCOME STATEMENT • Management must be able to evaluate how costs and profits fluctuate with changes in sales volume • Conventional income statement of limited value because it has no predictive value re sales volume
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COST BEHAVIOUR AND INCOME STATEMENT continued BUTLER ENTERPRISES Income Statement for the year ended 30 June 2010 INCOME Sales revenue Less: Cost of sales GROSS PROFIT EXPENSES Selling and distribution expenses Administrative expenses Finance and other expenses PROFIT
Amount
%
$ 1 000 000 520 000 480 000
100 52 48
200 000 140 000 20 000 360 000 $120 000
20 14 2 36 12
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Contribution margin • Equals sales revenue less all variable costs • Gives the amount of sales revenue available to: – absorb fixed costs, then – contribute to profit • Varies directly as a fixed % with sales volume • Emphasising CM makes income statement more useful for decision making • CM ratio equals CM divided by sales 13
Contribution margin continued BUTLER ENTERPRISES Income Statement for the year ended 30 June 2010 INCOME Sales revenue Variable cost of sales Variable operating expenses CONTRIBUTION MARGIN Fixed expenses Selling and distribution expenses Administrative expenses Finance and other expenses PROFIT
Amount
%
$ 1 000 000 400 000 200 000 400 000
100 40 20 40
120 000 140 000 20 000 280 000 $120 000
12 14 2 28 12
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PROFIT PLANNING WITH CVP ANALYSIS • CVP can answer questions about – Entity’s breakeven point – Impact on sales volume and profit of increased advertising costs – Sales level needed to make a profit – Impact of changes in selling price – Most profitable sales mix
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What tools/techniques do you use in the estimation/planning of your costs?
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PROFIT PLANNING WITH CVP ANALYSIS continued SUNSHINE STABILISERS LTD Condensed Income Statement for the year ended 30 June 2009 Sales revenue (8 000 units @ $50) Less: Variable cost of sales Manufacturing margin Other variable expenses Contribution margin Fixed costs Factory overhead Other fixed expenses PROFIT (LOSS)
BREAK-EVEN ANALYSIS • Break-even equation – Determined mathematically or graphically – Net profit zero Sales revenue = Variable expenses + Fixed expenses + Profit
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Break-even equation Example: Sunshine Stabilisers Fixed expenses = $150 000 Variable expenses = $280 000 8000 = $35 per unit Determine breakeven sales $50S $15S S
= $35S + $150 000 = $150 000 = 10 000 units 19
Contribution margin approach • Break-even sales in dollars Break-even sales in dollars
=
Fixed costs Contribution margin ratio
• Break-even sales in units Break-even sales in units
=
Fixed costs Unit contribution margin
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Contribution margin approach
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MARGIN OF SAFETY AND TARGET SALES • Determining a margin of safety – The amount by which sales can decrease before a loss occurs
• Determining target sales and profit – Profit goal expressed as either: • fixed amount of profit • percentage of sales Sales target = VC + FC + target profit before tax 22
MARGIN OF SAFETY AND TARGET SALES continued Example: Sunshine Stabilisers • Find target sales, given that desired profit before tax is $60 000 S $50S $15S S
= VC + FC + target profit before tax = $35S + $150 000 + $60 000 = $210 000 = 140 000 units 23
ANALYSING CVP RELATIONSHIPS FOR PROFIT PLANNING • Effective profit and marketing planning must be concerned with the impact on profits of – Change in selling price – Change in variable costs – Change in fixed and variable costs – Change in fixed costs and sales volume
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What role does cost and management accounting information play in the management of DiBella?
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Change in selling price Example: Sunshine Stabilisers • A price reduction of 10% (to $45) is expected to increase the budgeted number of units sold by 20%, from 10 000 units to 12 000 units • What is the impact on break-even sales? $50S = $30S + $150 000 $20S = $150 000 S = 7500 units or $375 000 26
Change in variable cost Example: Sunshine Stabilisers • Changes in the manufacturing process are expected to make labour use more efficient and reduce variable costs by $5 per unit • What is the impact on break-even sales? $50S = $30S + $150 000 $20S = $150 000 S = 7500 units or $375 000 27
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Change in fixed and variable costs Example: Sunshine Stabilisers • Mgt is considering paying sales representatives a fixed sum of $40 000 per year, instead of salaries on commission of 10% of sales • What is the impact on break-even sales? This will make VC be 70% – 10% = 60% $50S = $30S + $190 000 $20S = $190 000 S = 9500 units or $475 000 28
Change in fixed costs and sales volume Example: Sunshine Stabilisers • Mgt is considering an advertising campaign that will cost $30 000 per year and estimated to increase by 30% from 10 000 to 13 000 units • What is the impact on break-even sales? $50S = $35S + $180 000 $15S = $180 000 S = 12 000 units or $600 000 29
USING CVP ANALYSIS WITH MULTIPLE PRODUCTS • Weighted average contribution margin used – Determine break-even sales – Plan profits
Example: Sunshine Stabilisers Std model $50 35
Deluxe model $80 48
Contribution margin
$15
$32
Contribution margin ratio
30%
40%
Selling price Variable expenses
30
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USING CVP ANALYSIS WITH MULTIPLE PRODUCTS continued • Fixed costs are $184 000 • Expected product mix is 4 standard models for each deluxe • What is the weighted average CM margin? Total CM for 5 units of product ($15 x 4) + ($32 x 1) = $92.00 Divided by no. of units 5 Average CM per unit = $18.40 31
USING CVP ANALYSIS WITH MULTIPLE PRODUCTS continued • What is the break-even sales for the two products? S
=
Fixed costs Weighted avg CM per unit
S
=
$184 000 $18.40
S
=
10 000 units
i.e., 8000 standard models and 2000 deluxe models 32
CONTRIBUTION MARGIN VARIANCE ANALYSIS • Compare actual profit results with planned results to calculate: – Sales price variance – Sales volume variance – Variable cost variance
