IDENTIFYING COST BEHAVIOR PATTERNS

For each of the following situations, identify the graph that illustrates the cost behavior pattern involved: 1. Cost of raw materials used 2. Electricity Bill a flat fixed charge, plus a variable cost after a certain number of kilowatt hours are used. 3. City water bill, which is computed as follows:
First 1,000,000 gallons or less Next 10,000 gallons Next 10,000 gallons Next 10,000 gallons Etc $1,000 flat fee $0.003 per gallon used $0.006 per gallon used $0.009 per gallon used Etc

City Water Bill

$1,200 $1,150 $1,100 $1,050 $1,000 $950 $900

City Water Bill

1,000,000

1,010,000

1,020,000

1,030,000

IDENTIFYING COST BEHAVIOR PATTERNS

Rent on a factory building donated by the city, where the agreement calls for a fixed fee payment unless 200,000 labor-hours or more are worked, in which case no rent need be paid. Salaries of maintenance workers, where one maintenance worker is needed for every 1,000 hours of machine-hours or less (that is, 0 to 1,000 hours require one maintenance worker, 1,001 to 2,000 requires two maintenance workers, etc.)

CONTRIBUTION FORMAT VS. TRADITIONAL FORMAT OF INCOME STATEMENT

TRADITIONAL FORMAT
Sales - COGS

CONTRIBUTION FORMAT
Sales - Variable expenses

= Gross Profit
- Selling & Administrative Expenses = Net Income

= Contribution Margin
- Fixed Expenses = Net Income

Marwicks Pianos, Inc., purchases pianos from a large manufacturer and sells them at the retail level. The pianos cost, on the average, $2,450 each from the manufacturer. Marwicks Pianos, Inc., sells the pianos to its customers at an average price of $3,125 each. The selling and administrative costs that the company incurs in a typical month are presented below:
SELLING COSTS Advertising..$700 per month Sales salaries and commissions..$950 per month, plus 8% of sales Delivery of pianos to customers$30/piano sold Utilities..$350 per month Depreciation of sales facilities..$800/month ADMINISTRATIVE COSTS Executive salaries..$2,500 per month Insurance..$400 per month Clerical..$1,000/month, plus $20/piano sold Depreciation of office equipment....$300/month

During August, Marwicks Pianos, sold and delivered 40 pianos.

TRADITIONAL FORMAT
Sales Less: Cost of Goods Sold Gross Margin Less: Operating Expenses Selling $14,000 Administrative $5,000 Net Income $125,000 $98,000 $27,000

$19,000 $8,000

CONTRIBUTION FORMAT INCOME STATEMENT

Sales Variable Expenses: Variable production Variable selling Variable admin Contribution margin Fixed Expenses: Fixed selling Fixed admin Net Operating Income $125,000 $98,000 $11,200 $800

$110,000 $15,000

$2,800 $4,200

$7,000 $8,000

COST VOLUME PROFIT ANALYSIS

Cost-volume-profit analysis is based upon determining the breakeven point of cost and volume of goods. CVP Analysis can help answer questions like: what products and services to offer and what prices to charge, etc. It can be useful for managers making short-term economic decisions. Running this analysis involves using several equations using price, cost and other variables and plotting them out on an economic graph.

COST VOLUME PROFIT ANALYSIS

CVP analysis has following assumptions:
All cost can be categorized as variable or fixed. Sales price per unit, variable cost per unit and total fixed cost are constant. All units produced are sold.

CONTRIBUTION INCOME STATEMENT FOR ABC COMPANY

Sales* Variable Expenses Contribution margin Fixed Expenses: Net Operating Income
Total $100,000 $60,000 $40,000 $35,000 $5,000 Per Unit $250 150 $100

*400 SPEAKERS SOLD

CONTRIBUTION INCOME STATEMENT If 1 speakers is sold!! Total $250 $150 $100 $35,000 $(34,900) Per Unit $250 150 $100

Sales Variable Expenses: Contribution margin Fixed Expenses: Net Operating Income

CONTRIBUTION INCOME STATEMENT If 2 speakers are sold! Sales Variable Expenses: Contribution margin Fixed Expenses: Net Operating Income
Total $500 $300 $200 $35,000 $(34,800) Per Unit $250 150 $100

CONTRIBUTION INCOME STATEMENT Sales of 350 Speakers Sales Variable Expenses Contribution margin Fixed Expenses: Net Operating Income
Total $87,500 $52,500 $35,000 $35,000 $ 0 Per Unit $250 150 $100

CONTRIBUTION INCOME STATEMENT Sales of 351 Speakers

Sales Variable Expenses Contribution margin Fixed Expenses: Net Operating Income
Total $87,750 $52,650 $35,100 $35,000 $ 100 Per Unit $250 150 $100

Once the break even point has been reached, net operating income will increase by the amount of the unit contribution margin for each additional unit sold.

Volume (400 speakers) Sales* Variable expenses** Contribution Margin Fixed Expense Net operating income $100,000 60,000 40,000 35,000 $5,000

Sales Volume (425 speakers)

Difference (25 speakers) $6,250 3,750 2,500 0 $2,500

Per Unit

$106,250 63,750 42,500 35,000 $7,500

$250 150 $100

*Sales= Price Volume: $250 400 = $100,000 **Variable expense = Variable expense per speaker Volume: $150 400 = $60,000

SUMMARY
If sales are zero, loss would equal fixed expenses. Each unit sold reduces the loss by the amount of unit contribution margin. After reaching break-even point, each additional unit sold increases the company's profit by the amount of the unit contribution margin.

CVP RELATIONSHIPS IN GRAPHIC FORM

$160,000 $140,000 $120,000 $100,000 $80,000 Fixed Expense

Total Sales Revenue

Total Expense

$60,000
$40,000 $20,000 $0 0 100 200 300 400 500 600 700 800

CONTRIBUTION MARGIN RATIO

CM Ratio = Total Contribution Margin Total Sales OR CM Ratio = Unit Contribution Margin Unit selling price

CONTRIBUTION MARGIN RATIO

Sales* Variable Expenses Contribution margin Fixed Expenses: Net Operating Income *400 SPEAKERS SOLD
Total $100,000 $60,000 $40,000 $35,000 $5,000 Per Unit $250 150 $100 % of sales 100% 60% 40%

$30,000 increase in sales?

Present Sales $100,000* Expected $130,000 Increase $30,000 % of sales 100%

Variable expenses
Contribution Margin

60,000**
40,000

78,000
52,000

18,000
12,000

60%
40%

Fixed Expense
Net operating income

35,000
$5,000

35,000
$17,000

0
$12,000

*Sales= Price Volume: $250 400 = $100,000 **Variable expense = Variable expense per speaker Volume: $150 400 = $60,000 OR 60% of sales

APPLICATIONS OF CVP CONCEPTS

Changes in Fixed Cost & Sales Volume Change in Variable Costs & Sales Volume Changes in Fixed Cost, Sales Price, & Sales Volume Changes in Variable Cost, Fixed Cost, and Sales Volume Change in Selling Price

CHANGES IN FIXED COST & SALES VOLUME

Current Sales Sales Variable Expenses Contribution Margin Fixed Expenses Net Operating Income $100,000 (60,000) 40,000 (35,000) $5,000 Sales with Difference % of Sales Additional Advertising Budget $130,000 78,000* 52,000 45,000** 7,000 $30,000 18,000 12,000 10,000 2,000 100% 60% 40%

*520 units $150 per unit = $78,000 **35,000 + additional $10,000 monthly advertising budget = $45,000.

ALTERNATIVE SOLUTION 1
Expected total contribution margin: $130,000 40% CM ratio Present total contribution margin $100,000 40% CM ratio $52,000 40,000

Incremental contribution margin

Change in fixed expenses Less incremental advertising expense

12,000
10,000

Increased net operating income

$2,000

ALTERNATIVE SOLUTION 2
Incremental contribution margin: $30,000 40% CM ratio. $12,000 Less Incremental advertising expense. 10,000 Increased net operating margin.. $ 2,000