Cost Behavior Analysis

1
Chapter 23

• Cost Behavior Analysis

2
Cost Behavior and the Management Cycle

• Objective 1
• Define cost behavior and explain how managers use
  this concept in the management cycle

3
Cost Behavior and the Management Cycle

• Cost behavior
• The way costs respond to changes in volume or
  activity
• Is a factor in almost every decision managers
  make
• Used to analyze alternative courses of action
• Select the course that will
• Generate income for owners
• Maintain liquidity for creditors

4
Planning

• Managers use cost behavior to determine
• Number of units or services that must be sold to
  generate targeted amount of profit
• How changes in planned operating, investing, and
  financing activities will affect operating income

5
Planning (contd)

• Manufacturing companies
• Decide how to adjust output to meet changing
  sales demand
• Service Organizations
• Determine the optimal mix of services offered
• Decide whether to charge by the service provided
  or a flat monthly fee

6
Executing

• Managers determine how decisions about current
  operating, investing, and financing activities
  affect operating income
• Must understand and anticipate cost behavior
• Manufacturing companies
• Understand the changes that will result in income
  from a decision to buy new, more productive
  manufacturing equipment

7
Reviewing and Reporting

• Variable costing income statements
• Used to analyze how changes in cost and sales
  affect the profitability of
• Product lines
• Sales territories
• Customers
• Departments
• Other segments

8
Reviewing and Reporting (contd)

• Other reports based on cost behavior
• Used to decide whether to
• Eliminate a product line
• Accept a special order
• Outsource services

9
The Behavior of Costs

• Objective 2
• Identify variable, fixed, and mixed costs, and
  separate mixed costs into their variable and
  fixed components

10
The Behavior of Costs

• Cost behavior can be observed
• As it relates to products and services
• In selling, administrative, and general
  activities
• If managers can predict how costs will behave,
  then costs become manageable

11
The Behavior of Costs (contd)

• Variable costs
• Vary with volume or operating activity
• Fixed costs
• Remain fixed as volume changes
• Mixed costs
• Exhibit characteristics of both variable and
  fixed costs

12
Variable Costs

• are total costs that change in direct
  proportion to changes in productive output
  or any other measure of volume

13
Variable Costs (contd)
Total cost of tires is a variable cost because it
changes in direct proportion to the number of
vehicles produced

On a per unit basis, a variable cost remains
constant
14
Variable Costs (contd)
Total cost of tires is a variable cost because it
changes in direct proportion to the number of
vehicles produced
On a per unit basis, a variable cost remains
constant
The cost of tires may vary depending on the
number purchased if discounts apply for large
purchases
15
Examples of Variable, Fixed, and Mixed Costs
16
Operating Capacity

• is the upper limit of an organizations
  productive output capacity,
  given its
  existing resources
• Any increase in volume or activity over operating
  capacity requires additional expenditures for
  buildings, machinery, personnel, and operations

17
Operating Capacity (contd)

• Can be expressed in several ways, including
• Total labor hours
• Total machine hours
• Total units of output

For purposes of the following discussion, assume
that operating capacity is constant and that all
activities occur within the limits of current
operating capacity
18
Operating Capacity (contd)

• Three common measures (or types) of operating
  capacity
• Theoretical capacity
• Also called ideal capacity
• Practical capacity
• Normal capacity

19
Theoretical (Ideal) Capacity

• is the maximum production output for a given
  period in which all machinery and equipment are
  operating at optimum speed, without interruption
• No company ever actually operates at such an
  ideal level
• Long-term goal in a JIT operating environment
• Approach theoretical capacity through continuous
  improvement

20
Practical Capacity

• is theoretical capacity reduced by normal and
  expected work stoppages
• Work stoppages
• Machine breakdowns
• Downtime for retooling, repairs, and maintenance
• Employees breaks
• Not realistic when planning operations

21
Normal Capacity

• is the average annual level of operating
  capacity needed to meet expected sales demand
• Used to plan operations
• Is a realistic measure of what an organization is
  likely to produce, not what it can produce

22
Normal Capacity (contd)

• Relate variable costs to an appropriate measure
  of normal capacity
• Operating costs can be related to
• Machine hours used
• Total units produced
• Sales commissions can be related to
• Total sales dollars

23
Normal Capacity (contd)

• Two reasons to select basis for measuring the
  activity of variable cost carefully
• An appropriate activity base simplifies cost
  planning and control
• Many variable costs must be combined (aggregated)
  with the same activity base
• So that costs can be analyzed in a reasonable way
• Provides information for predicting future costs

24
Normal Capacity (contd)

• General guide for selecting an activity base
• Relate costs to their most logical or causal
  factor
• Example
• Machinery setup costs should be considered
  variable in relation to the number of setups
  needed for a particular job
• Allows machinery setup costs to be budgeted and
  controlled more effectively

25
Linear Relationships and the Relevant Range

• Each unit of output requires 2.50 of labor cost
• Total labor costs grow in direct proportion to
  the increase in units of output

26
Other Variable Cost Behavior Patterns Nonlinear
Relationships

• Graph A
• Behavior of power costs as usage increases and
  unit cost of power consumption falls i.e. slope
  decreases tangent line (linear approximation)
  becomes less steep
• Graph B
• Behavior of rental costs when each additional
  hour of computer usage costs more than the
  previous hour i.e. slope increases tangent
  line (linear approximation) becomes steeper
• Graph C
• Shows how labor costs vary as efficiency
  increases or decreases

27
Linear Relationships and the Relevant Range
(contd)

• All costs must be included in an analysis if the
  results are to be useful
• Variable costs with linear relationships
• Easy to analyze
• Variable costs with nonlinear relationships
• More difficult to analyze
• Linear approximation
• Method to convert nonlinear variable costs into
  linear variable costs
• Relies on the concept of relevant range

28
Linear Relationships and the Relevant Range
(contd)

• Relevant Range
• The span of activity in which a company expects
  to operate
• Within that range, it is assumed that both total
  fixed costs and per unit variable costs are
  constant
• Under that assumption, many nonlinear costs can
  be estimated using the linear approximation
  approach
• These costs can be treated as part of the other
  variable costs

29
The Relevant Range and Linear Approximation
30
Linear Relationships and the Relevant Range

• Linear approximation
• Is not a precise measure
• Allows the inclusion of nonlinear variable costs
  in cost behavior analysis
• Loss of accuracy is not significant
• Helps accomplish the goal of estimating costs and
  preparing budgets

31
Fixed Costs

• are total costs that remain constant within a
  relevant range of volume or activity
• This is the range in which actual operations are
  likely to occur

Fixed costs behave differently from variable costs
32
Fixed Costs (contd)

• According to economic theory
• All costs tend to be variable in the long run
• A cost is only fixed within a limited period
• A one-year period is usually considered for
  management purposes
• Fixed costs are expected to remain constant
  within that period

33
Fixed Costs (contd)
The Manufacturer of aluminum cans needs one
supervisor for an 8-hour work shift. Production
can range from zero to 500,000 units per month
per shift. The supervisors salary is 4,000 per
month

• The relevant range is from zero to 500,000 units
• Any output above 500,000 units would require
  another work shift and another supervisor

If another shift is added, the new fixed cost
remains constant in total within the new relevant
range
34
Fixed Costs (contd)

• Fixed unit costs vary inversely with activity or
  volume
• On a per unit basis, fixed costs go down as
  volume goes up

At 600,000 units, the activity is above the
relevant range, which means another shift must be
added and another supervisor hired
35
A Common Fixed Cost Behavior Pattern
36
Mixed Costs

• have both variable and fixed components
• Part of a mixed cost changes with volume or usage
• Part is fixed over a particular period

37
Behavior Patterns of Mixed Costs
38
Mixed Costs (contd)

• Four methods used to separate mixed costs into
  variable and fixed components
• Engineering method
• Scatter diagram method
• High-low method
• Statistical method

Multiple approaches are often used because the
results yielded by these methods are likely to
differ
39
The Engineering Method

• of separating costs measures the work required
  by performing step-by-step analysis of tasks,
  costs, and processes involved
• Is generally used to estimate the cost of
  activities and new products

40
The Engineering Method

• Example
• U.S. Postal service
• Conducts studies of how many letters a postal
  worker should be able to deliver on a particular
  mail route within a certain period
• This type of analysis sometimes called a time and
  motion study
• Is expensive
• Very detailed
• Requires the expertise of engineers to determine
  the cost of a new product or activity for which
  no prior data exists

41
The Scatter Diagram Method

• plots past costs and related measures of volume
  in a scatter diagram

42
The Scatter Diagram Method (contd)

• Scatter diagram
• A chart of plotted points that helps determine
  whether a linear relationship exists between a
  cost item and its related activity measure
• Is a form of linear approximation
• If a linear relationship can be suggested, a cost
  line can be imposed on the data by
• Visual means
• Statistical analysis

43
The Scatter Diagram Method (contd)

• Piedmont Corporations Park Division incurred the
  following machine hours and electricity costs
  last year

44
Mixed Costs

• For planning and control purposes, mixed costs
  must be divided into their variable and fixed
  components
• These components can then be grouped with other
  variable and fixed costs for analysis

45
Scatter Diagram of Machine Hours and Electricity
Costs
46
The Scatter Diagram Method (contd)

• The diagram suggest (visually) a linear
  relationship between machine hours and
  electricity costs
• A line is added to the diagram to represent the
  linear relationship
• Estimated fixed electricity cost
• Occurs at the point where the line intersects the
  vertical axis
• Variable cost per unit
• Can be estimated by determining the slope of the
  line

47
The High-Low Method

• identifies a linear relationship between
  activity level and cost by analyzing the highest
  and lowest volumes in an accounting period and
  their related costs
• Is a common, simple method
• Somewhat crude

48
The High-Low Method (contd)

• Three steps
• Calculate the variable cost per activity base
• Calculate the total fixed costs
• Calculate the formula to estimate the total costs
  within the relevant range

49
The High-Low Method (contd)

• Step 1
• Calculate the variable cost per activity base
• Select the periods of highest and lowest activity
  within the accounting period
• Find the difference between the highest and
  lowest amounts for both machine hours and their
  related electricity costs

50
The High-Low Method (contd)
51
The High-Low Method (contd)

• Variable cost per machine hour
• Difference in cost divided by difference in
  machine hours

The variable cost per machine hour will be used
to calculate total fixed costs in Step 2 and
total cost per month in Step 3
52
The High-Low Method (contd)

• Step 2
• Calculate the total fixed costs
• Select the information from the month with either
  the highest or lowest volume

53
The High-Low Method (contd)

• December
• Total Costs 24,700
• Total Variable Costs 6,450 MH x 2.75 per MH
• August
• Total Costs 23,600
• Total Variable Costs 6,050 MH x 2.75 per MH

You can check your answer by recalculating total
fixed costs using the month with the lowest
activity
The total fixed costs in Step 2 will be used to
calculate total cost per month in Step 3
54
The High-Low Method (contd)

• Step 3
• Calculate the formula to estimate the total costs
  within the relevant range

55
The High-Low Method (contd)

• The cost formula will work only within the
  relevant range
• In this case, for amounts between 6,050 and 6,450
  machine hours
• To estimate electricity costs for amounts outside
  of this range, a new formula must be calculated

56
Statistical Methods

• Regression analysis
• Mathematically describes the relationship between
  costs and activities
• All data observations are used
• Resulting linear equation is more representative
  of cost behavior than either the high-low or
  scatter diagram methods

57
Statistical Methods (contd)

• Simple regression analysis
• Overhead costs are predicted using one activity
• Machine hours to predict electricity costs
• Multiple regression analysis
• Overhead costs are predicted using more than one
  activity
• Machine hours and labor hours to predict
  electricity costs
• Both activities affect overhead

58
Discussion

• What are the three steps in the high-low method
  of determining the fixed and variable components
  of mixed costs?

59
Discussion

• What are the three steps in the high-low method
  of determining the fixed and variable components
  of mixed costs?
• Step 1
• Calculate the variable cost per activity base
• Step 2
• Calculate total fixed costs
• Step 3
• Calculate the formula to estimate total costs
  within the relevant range

60
Cost-Volume-Profit Analysis

• Objective 3
• Define cost-volume-profit (C-V-P) analysis and
  discuss how managers use it as a tool for
  planning and control

61
Cost-Volume-Profit Analysis

• is an examination of the cost behavior patterns
  that underlie the relationships among cost,
  volume of output, and profit

62
Cost-Volume-Profit Analysis (contd)

• Usually applies to a single product, product
  line, or division of a company
• Therefore, the term profit is used
• Only part of an entire companys operating income
• In cases involving the income statement of an
  entire company
• The term operating income is more appropriate
• In the context of C-V-P analysis, both mean the
  same thing

63
Cost-Volume-Profit Analysis (contd)

• C-V-P is a tool for
• Short-range planning
• Calculate net income when sales volume is known
• Decide the level of sales needed to reach a
  targeted amount of income
• Budgeting
• Control
• Compare actual costs with expected costs
• Measure the effects of alternate courses of
  action
• Changing variable or fixed costs
• Expanding or contracting sales volume
• Increasing or decreasing selling prices

64
Cost-Volume-Profit Analysis (contd)

• Useful only under certain conditions and when
  certain assumptions hold true
• The behavior of variable and fixed costs can be
  measured accurately
• Costs and revenues have a close linear
  approximation
• Efficiency and productivity hold steady within
  the relevant range of activity

65
Cost-Volume-Profit Analysis (contd)

• Cost and price variable also do not change during
  the period being planned
• The sales mix does not change during the period
  being planned
• Production and sales volume are roughly equal

If one or more of these conditions and
assumptions are absent, the C-V-P analysis may be
misleading
66
Discussion

• What are some ways that managers use C-V-P
  analysis as a tool for planning?
• Managers can use C-V-P to calculate net income
  when sales volume is known, decide the level of
  sales needed to reach a targeted amount of net
  income, and for budgeting purposes

67
Breakeven Analysis

• Objective 4
• Define breakeven point and use contribution
  margin to determine a companys breakeven point
  for multiple products

68
Breakeven Analysis

• uses the basic elements of cost-volume-profit
  analysis to determine the breakeven point
• Breakeven point
• The point at which
• Total revenues equal total costs
• The company begins to earn a profit

69
Breakeven Analysis (contd)

• Margin of safety
• The number of sales units or amount of sales
  dollars by which actual sales can fall below
  planned sales without resulting in a loss

70
Breakeven Analysis (contd)

• General equation for finding the breakeven point

71
Breakeven Analysis (contd)
Valley Metal Products, Inc. makes ornamental iron
plant stands. Variable costs are 50 per unit,
and fixed costs average 20,000 per year. Each
plant stand sells for 90
Compute the breakeven point for plant stands in
sales units, where x equals sales units
Compute the breakeven point in sales dollars
72
Breakeven Analysis (contd)
Valley Metal Products, Inc. makes ornamental iron
plant stands. Variable costs are 50 per unit,
and fixed costs average 20,000 per year. Each
plant stand sells for 90
Compute the breakeven point using a scatter graph
73
Breakeven Analysis (contd)

• The graph has five parts
• Horizontal axis for units of output
• Vertical axis for dollars of revenue
• A horizontal line running from the vertical axis
  at the level of fixed costs

74
Breakeven Analysis (contd)

• A total cost line
• Begins where the fixed costs line crosses the
  vertical axis and slopes upward to the right
• Slope depends on variable cost per unit

75
Breakeven Analysis (contd)

• A total revenue line
• Begins at the origin of the vertical and
  horizontal axes and slopes upward to the right
• Slope depends on the selling price per unit

76
Breakeven Analysis (contd)

• Revenues equal total costs
• At the point at which the total revenue line
  crosses the total cost line

77
Breakeven Analysis (contd)

• Breakeven point
• Found by extending lines from this point to the
  axes
• Valley Metal Products will break even when it has
  sold 500 plant stands for 45,000

78
Using Contribution Margin to Determine the
Breakeven Point

• Contribution margin (CM)
• Is the amount that remains after all variable
  costs are subtracted from sales
• A product lines contribution margin represents
  its net contribution to paying off fixed costs
  and earning a profit
• Profit is what remains after fixed costs are paid
  and subtracted from contribution margin

79
Using Contribution Margin to Determine the
Breakeven Point (contd)

• Breakeven point (BE)
• Can be expressed as the point where
• Contribution margin minus total fixed costs
  equals zero
• Contribution margin equals fixed costs

80
Using Contribution Margin to Determine the
Breakeven Point (contd)
Compute the breakeven point in units for Valley
Metal Products
81
Using Contribution Margin to Determine the
Breakeven Point (contd)
Compute the breakeven point in sales dollars by
multiplying BE in units by the selling price (SP)
per unit
82
Using Contribution Margin to Determine the
Breakeven Point (contd)
Compute the breakeven point in sales dollars
using the CM Ratio
Difference due to rounding up
83
The Breakeven Point for Multiple Products

• To calculate the breakeven point for each
  product, its unit contribution must be weighted
  by the sales mix
• Sales mix
• Proportion of each product's unit sales relative
  to the organizations total unit sales

84
The Breakeven Point for Multiple Products (contd)
Valley Metal Products sells two types of plant
stands a floor stand model and a smaller
tabletop model. The company sells 500 stands, of
which 300 are floor stand models and 200 are
tabletop models
Determine the sales mix

• For every three floor stands sold, 2 tabletop
  models are sold
• The sales mix is 32
• or,
• Of the 500 units sold, 60 (300 500) are floor
  stands and 40 (200 500) are tabletop models

85
The Breakeven Point for Multiple Products (contd)
Valley Metal Products sells two types of plant
stands a floor stand model and a smaller
tabletop model. The company sells 500 stands, of
which 300 are floor stand models and 200 are
tabletop models. Total fixed costs are 32,000

• Step 1
• Compute the weighted-average contribution margin
• Multiply the contribution margin for each product
  by its percentage of the sales mix

86
The Breakeven Point for Multiple Products (contd)
Valley Metal Products sells two types of plant
stands a floor stand model and a smaller
tabletop model. The company sells 500 stands, of
which 300 are floor stand models and 200 are
tabletop models. Total fixed costs are 32,000

• Step 2
• Calculate the weighted-average breakeven point
• Divide total fixed costs by the weighted-average
  contribution margin

87
The Breakeven Point for Multiple Products (contd)
Valley Metal Products sells two types of plant
stands a floor stand model and a smaller
tabletop model. The company sells 500 stands, of
which 300 are floor stand models and 200 are
tabletop models. Total fixed costs are 32,000

• Step 3
• Calculate the breakeven point for each product
• Multiply the weighted-average breakeven point by
  each products percentage of sales mix

88
The Breakeven Point for Multiple Products (contd)
Valley Metal Products sells two types of plant
stands a floor stand model and a smaller
tabletop model. The company sells 500 stands, of
which 300 are floor stand models and 200 are
tabletop models. Total fixed costs are 32,000

• Verify
• Determine the contribution margin of each product
  and subtract the total fixed costs

89
Discussion

• What is the general equation for finding the
  breakeven point in units?
• Sales Variable Costs Fixed Costs 0, or, S
  VC FC 0
• The breakeven point is the point at which total
  revenues equal total costs

90
Using C-V-P Analysis to Plan Future Sales, Costs,
and Profits

• Objective 5
• Use C-V-P analysis to project profitability of
  products and services

91
Using C-V-P Analysis to Plan Future Sales, Costs,
and Profits

• Primary goal of a business venture is to generate
  profits, not to break even
• To estimate the profitability of a venture
• Adjust C-V-P analysis for targeted profit
• Different scenarios can be analyzed for the
  amount of profit or loss they might generate

92
Applying C-V-P to a Manufacturing Business
Van Bryce, the president of Valley Metal
Products, has set this years profit goal for
plant stands at 4,000. All previous data for
the company remains the same
Calculate how many plant stands must be sold to
reach the targeted profit (P)
93
Applying C-V-P to a Manufacturing Business
Van Bryce, the president of Valley Metal
Products, has set this years profit goal for
plant stands at 4,000. All previous data for
the company remains the same
Check the answer by inserting all known data into
the equation
94
Applying C-V-P to a Manufacturing Business
(contd)

• The contribution margin approach can also be used
  for profit planning
• Add the targeted profit to the numerator of the
  contribution margin breakeven equation

95
Applying C-V-P to a Manufacturing Business
(contd)

• Contribution income statements
• Prepared for internal use (just like in the
  Forest Gump case study)
• Are useful in planning and making decisions about
  operations

96
Applying C-V-P to a Manufacturing Business
(contd)

• Focus of contribution margin statement
• Cost behavior, not cost function
• Costs related to production, selling, and
  administration
• Variable costs are subtracted from sales to
  determine total contribution margin
• Fixed costs are subtracted from contribution
  margin to determine operating income

Van Bryce wants his companys planning team to
consider three alternatives to the original plan
shown in the contribution income statement
97
Alternative 1 Decrease Variable Costs, Increase
Sales Volume
The planning team estimated what operating income
would be if the company purchased and used
aluminum rather than iron to make plant stands.
If aluminum were used, direct materials costs per
unit would decrease by 3. If the aluminum were
painted to meet the needs of a new customer
group, sales volume would increase by 10 percent
Determine the estimated operating income for this
alternative
A decrease in direct materials costs of 3
results in an 1,800 increase in total CM and
operating income (3 x 600)
98
Alternative 1 Decrease Variable Costs, Increase
Sales Volume
The planning team estimated what operating income
would be if the company purchased and used
aluminum rather than iron to make plant stands.
If aluminum were used, direct materials costs per
unit would decrease by 3. If the aluminum were
painted to meet the needs of a new customer
group, sales volume would increase by 10 percent
Determine the estimated operating income for this
alternative
A sales increase of 60 units (.10 x 600)
increases the total CM and operating income by
2,580 (43 x 60)
99
Alternative 1 Decrease Variable Costs, Increase
Sales Volume
The planning team estimated what operating income
would be if the company purchased and used
aluminum rather than iron to make plant stands.
If aluminum were used, direct materials costs per
unit would decrease by 3. If the aluminum were
painted to meet the needs of a new customer
group, sales volume would increase by 10 percent
Determine the estimated operating income for this
alternative
100
Alternative 2 Increase Fixed Costs, Increase
Sales Volume
The planning team estimated what operating income
would be if the company increased advertising
costs instead of changing the direct materials.
The Marketing Department suggested that a 500
increase in advertising costs would increase
sales volume by 5 percent
Determine the estimated operating income for this
alternative
Additional advertising costs affects both sales
volume and fixed costs
101
Alternative 2 Increase Fixed Costs, Increase
Sales Volume
The planning team estimated what operating income
would be if the company increased advertising
costs instead of changing the direct materials.
The Marketing Department suggested that a 500
increase in advertising costs would increase
sales volume by 5 percent
Determine the estimated operating income for this
alternative
Sales volume increases 30 units (.05 x 600),
which increases the total CM and operating income
by 1,200 (40 x 30 units)
102
Alternative 2 Increase Fixed Costs, Increase
Sales Volume
The planning team estimated what operating income
would be if the company increased advertising
costs instead of changing the direct materials.
The Marketing Department suggested that a 500
increase in advertising costs would increase
sales volume by 5 percent
Determine the estimated operating income for this
alternative
Fixed costs increase from 20,000 to 20,500,
which decreases operating income by 500
103
Alternative 2 Increase Fixed Costs, Increase
Sales Volume
The planning team estimated what operating income
would be if the company increased advertising
costs instead of changing the direct materials.
The Marketing Department suggested that a 500
increase in advertising costs would increase
sales volume by 5 percent
Determine the estimated operating income for this
alternative
104
Alternative 3 Increase Selling Price, Decrease
Sales Volume
The planning team evaluated the impact of a 10
increase in selling price on the companys
operating income. The team believes that
competitors are selling the same product at a
lower price and that sales volume will decrease
by 15 percent if the selling price is raised to
10
Determine how this alternative affects operating
income
A sales decrease of 90 units (.15 x 600)
decreases the sales revenue by 3,000 (600 x
90) (510 x 100)
105
Alternative 3 Increase Selling Price, Decrease
Sales Volume
The planning team evaluated the impact of a 10
increase in selling price on the companys
operating income. The team believes that
competitors are selling the same product at a
lower price and that sales volume will decrease
by 15 percent if the selling price is raised to
10
Determine how this alternative affects operating
income
A sales decrease of 90 units (.15 x 600)
decreases variable costs by 4,500 (90 x 50)
106
Alternative 3 Increase Selling Price, Decrease
Sales Volume
The planning team evaluated the impact of a 10
increase in selling price on the companys
operating income. The team believes that
competitors are selling the same product at a
lower price and that sales volume will decrease
by 15 percent if the selling price is raised to
10
Determine how this alternative affects operating
income
107
Comparative Summary of Alternatives at Valley
Metal Products, Inc.
108
Comparative Summary

• Determining which alternative to choose
• Alternative 1
• Results in the highest operating income of the
  three alternatives
• Alternative 2
• Highest breakeven point
• More units must be sold to cover increased fixed
  costs
• Alternative 3
• Lowest breakeven point
• Company will begin generating income more quickly
  than with other alternatives

109
Applying C-V-P Analysis to a Service Business
The manager of the Appraisal Department at
Edmunds Mortgage Company estimates that over the
next year her department will perform an average
of 100 appraisals per month. The company charges
400 per appraisal. Variable costs are 160 for
professional labor and 99 for a county survey
map. Monthly service overhead costs were highest
in March (180 appraisals at 23,380) and lowest
in February (98 appraisals at 20,018)
Estimate service overhead costs
Step 1 Calculate the variable service overhead
cost per appraisal
110
Applying C-V-P Analysis to a Service Business
(contd)
The manager of the Appraisal Department at
Edmunds Mortgage Company estimates that over the
next year her department will perform an average
of 100 appraisals per month. The company charges
400 per appraisal. Variable costs are 160 for
professional labor and 99 for a county survey
map. Monthly service overhead costs were highest
in March (180 appraisals at 23,380) and lowest
in February (98 appraisals at 20,018)
Estimate service overhead costs
Step 2 Calculate the total fixed service
overhead costs
Use data for March
111
Applying C-V-P Analysis to a Service Business
(contd)
The manager of the Appraisal Department at
Edmunds Mortgage Company estimates that over the
next year her department will perform an average
of 100 appraisals per month. The company charges
400 per appraisal. Variable costs are 160 for
professional labor and 99 for a county survey
map. Monthly service overhead costs were highest
in March (180 appraisals at 23,380) and lowest
in February (98 appraisals at 20,018)
Estimate service overhead costs
Step 3 Calculate the total service overhead
costs for one month
112
Applying C-V-P Analysis to a Service Business
(contd)
The manager of the Appraisal Department at
Edmunds Mortgage Company estimates that over the
next year her department will perform an average
of 100 appraisals per month. The company charges
400 per appraisal. Variable costs are 160 for
professional labor and 99 for a county survey
map. Monthly service overhead costs were highest
in March (180 appraisals at 23,380) and lowest
in February (98 appraisals at 20,018)
Estimate service overhead costs
Step 4 Calculate the total service overhead
costs for one month assuming that 100 appraisals
will be made
113
Determining the Breakeven Point
The variable rate of 300 includes the 41
variable service OH rate plus 160 direct
professional labor and 99 county survey map fee
114
Determining the Effect of a Change in Operating
Costs
The Appraisal Department performs an average of
100 appraisals per month and its estimated
breakeven point is 160 appraisals. Increasing
the appraisal fee is not an option because of
strong competition. The manager has determined
that costs must be reduced by improving
appraisers scheduling to reduce travel time.
She estimates this could reduce travel time by 50
percent, cutting the professional labor cost to
80 per appraisal. The new process will also
increase fixed costs by 200 per month
Determine the new breakeven point
115
Determining the Effect of a Change in Operating
Costs (contd)
How many appraisals would the department have to
be perform each month to achieve a targeted
profit of 18,000 per month?
116
Discussion

• If a company sells its product for 10 per unit,
  variable costs are 2 per unit, and fixed costs
  are 10,000 per month, how many units would it
  need to sell to achieve a profit of 20,000 per
  month?