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Cost Drivers and Cost Behavior

CHAPTER 5

part, except for use as permitted in a license distributed with a certain product or service or

otherwise on a password-protected website for classroom use.

PowerPoint Presentation by

LuAnn BeanProfessor of AccountingFlorida Institute of Technology

Managerial Accounting 11E

Maher/Stickney/Weil

1Distinguish between variable and fixed costs and between short run and long run, and define the relevant range.

LEARNING OBJECTIVE

VARIABLE COSTS: Definition

Are costs that change in total as the level of activity changes.

What are fixed costs?

Fixed costs do not changein total with changes in activity levels.

SHORT RUN, LONG RUN

In the short run, a firm has only the capacity of the existing plant. Management can change production only in the long run.

RELEVANT RANGE: Definition

Is the range of activity over which the firm expects a set of cost behaviors to be consistent.

EXHIBIT 5.1

Estimates of variable and fixed costs apply only if level of

activity lies within

relevant range.

EXAMPLE

Exotic Eats, a profitable restaurant located in the financial district and featuring Far Eastern dishes, opens from 11am – 2pm Monday through Friday. The maximum capacity of the restaurant is 210 and the daily average is 200 customers.

Management wants to know the effect of doubling the capacity.

Continued

EXOTIC EATS: Operating Profits

Revenues $1,000Less Variable costs $ 400

Less Fixed costs 350 750

Operating Profits $ 250

Continued

EXHIBIT 5.2

When analysis ignores

capacity limitations, projections

are unrealistic.

EXHIBIT 5.3

When capacity limitations

(relevant range) are considered, a more realistic profit picture

emerges.

EXOTIC EATS: Profit Projections

Revenues $ 1,000 $ 2,000 $ 2,000Less Variable costs 400 800 800

Contribution margin $ 600 $ 1,200 $ 1,200

Less Fixed costs 350 350 550

Operating Profits $ 250 $ 850 $ 650

Current capacity

Incorrect capacity

New capacity

Click the button to skip Exercise 8

EXERCISE 8

Press “Enter” or click left mouse button for answer.

True or False: “My variable costs are $2 per unit. If I want to increase production from

100,000 units to 150,000 units, my total costs should go up by only $100,000.”

FALSE. This reasoning does not consider relevant range and fixed costs.

2 Identify capacity costs, committed costs, and discretionary costs.

LEARNING OBJECTIVE

FIXED COSTS

Fixed (capacity) costs are divided between ¯Committed costs

¯Capacity costs that will continue to exist even if operations are temporarily reduced

¯Discretionary (programmed or managed) costs¯Need not be incurred in the short run to operate the

business

3 Describe the nature of the various cost behavior patterns.

LEARNING OBJECTIVE

VARIABLE and FIXED COSTS: A Reminder

Variable costs change with the volume of activity.

Fixed costs remain constant over the relevant range of activity.

CURVILINEAR VARIABLE COSTS: Definition

Are costs that vary with the volume of activity but not in

constant proportion.

What is an example of a curvilinear cost?

Costs become curvilinear when volume discounts are offered.

EXHIBIT 5.5

Volume discounts.

What is the significance of learning

curves?

Learning curves illustrate how costs that are initially high for a new process, decrease over time with experience.

EXHIBIT 5.6 A

Production time decreases as

volume increases due to learning from

experience.

EXHIBIT 5.6 B & C

Total labor time and costwill decrease

with increases in volume. Time

SEMIVARIABLE COSTS: Definition

Are costs that have both fixed and variable components. Also called

Mixed Costs.

What are examples of semivariable costs?

Two examples of semivariable costs are:

¯Repairs and Maintenance

¯Utility costs

EXHIBIT 5.7

Semifixed costs change because of changes in long-term

assets;semivariable costs do not.

Semivariable

Semifixed

SIMPLIFYING COST ANALYSESSome costs do not vary in the short run

over the relevant range (fixed costs). Some vary with volume (variable costs). Others are neither completely fixed or variable.

Decision makers can simplify these variations by treating costs as either fixed or variable.

Click the button to skip Exercise 4

EXERCISE 4

The simplifying assumptions on which cost estimations are based include which of the following?

a) Cost behavior depends on one activity variable (except multiple regression).

b) Cost behavior patterns are not linear within the relevant range.

c) Costs are only fixed.

d) All of the above.

(a) One activity variable

4 Describe how managers use cost behavior patterns.

LEARNING OBJECTIVE

EXERCISE 3

Name three methods of cost estimation.

Statistical regression, Account analysis, and Engineering estimation

5 Explain how to use historical data to estimate costs.

LEARNING OBJECTIVE

ANALYZING HISTORICAL COSTS

Two steps to analyze historical cost data¯Make an estimate of the past relation¯Update for current, future periods

¯Adjust costs for inflation and other changes

TOTAL COST EQUATIONLO 5

Total costs =

Fixed costs + (Variable costs × Activity)

Independent Variables

ANALYZING COSTSSteps in analyzing costs are:

¯Review alternative cost drivers (independent variables)

¯Plot the data¯Examine the data and method of

accumulation

6Describe how analysts estimate cost behavior using regression, account analysis, and engineering methods.

LEARNING OBJECTIVE

CHICAGO HOSPITAL 1

The Chicago Hospital operating room suite has 12 operating rooms. Can we estimate the overhead costs that can be directly traced to a particular surgery?

Continued

CHICAGO HOSPITAL: Overhead Costs

Continued

TOTAL OVERHEAD COST ESTIMATE

A computer program using least squares fits a straight line to observed data points to minimize the sum of squares of vertical distances between observed points and the regression line. The line will depict the best fit of projected costs.

Total overhead costs (estimated) = Fixed costs + (Variable costs × Activity) =$18,600 + ($908 × Operating room hours)

The hospital administrator estimates that there will be 600 operating

room hours next month. What will

the total overhead costs be?

$563,400

MULTIPLE REGRESSION: Definition

Has more than one independent variable.

CHICAGO HOSPITAL 2Our first regression example was simplified

by lumping all overhead costs into one variable. The Chicago Hospital operating room suite is used for different kinds of surgery. By looking at more than just hours and using multiple regression, we can get a better handle of these costs.

Continued

CHICAGO HOSPITAL: Multiple Cost Drivers

Continued

Cost Driver Volumes

TOTAL OVERHEAD COST ESTIMATE 2

A computer program using least squares fits a straight line to observed data points to minimize the sum of squares of vertical distances between observed points and the regression line.

Total overhead costs (estimated) = Fixed costs + (Hours + Setup + VIP + # rooms used + Special surgeries) =

$90,592 + ($175 ×Operating Room Hours) + ($257 ×Operating Room Setup Hours) + ($3,839 × VIP patients) + ($2,043 × # operating

rooms used) + ($6,050 × Special surgeries)

The hospital administrator estimates that there will be 600 operating

room hours, 280 setup hours, 6 VIP patients,8 operating rooms used on average,

and 40 special surgeries. What will

the total overhead costs be?

$548,930

CHICAGO HOSPITAL: Profitability Analysis

Chicago Hospital (CH) is considering an offer to become the site for knee and hip replacement surgeries for a flat fee. The administrator believe 3 overhead cost drivers will be affected:

1. Operating hours increase by 100 per month2. Setup hours increase by 40 per month3. Average operating rooms used increase by 1 per

dayContinued

CHICAGO HOSPITAL: Cost Projections

EXHIBIT 5.10B

CHICAGO HOSPITAL: Fixed Fee

Once the costs associated with becoming a knee and hip replacement center have been estimated and the HMO’s fixed fee offer is received, Chicago Hospital can decide whether the offer will be profitable.

Remember, the estimate has been made on the basis of historical costs which will change with inflation and other changes in cost drivers.

CHICAGO HOSPITAL: Account Analysis

Step 1: Using account analysis, the Chicago Hospital administrator will classify each overhead cost related to surgery to a cost driver. For example, staff wages for operating room clean up between surgeries will be classified as “Operating room setup.”

Continued

CHICAGO HOSPITAL: Account Analysis Step 2

EXHIBIT 5.11

Overhead costs are estimated

Cost ÷ Cost driver volume

CHICAGO HOSPITAL: Engineering Estimation

Engineering method of cost estimation indicates what costs should be. This is a very costly method to put into practice because it requires experts to make the estimates, especially for indirect costs.

DATA PROBLEMSRegardless of method used, results will only be

as good as the quality of the data used. Problems include

¯Missing data¯Outliers¯Allocated and discretionary costs¯Inflation¯Mismatched time periods¯Trade-offs in choosing time period

PRESSURE

Managers often pressure analysts to come up with the “right” answer. An answer that is too low will get pet projects approved. An answer that is too high will be easy to beat for a good review by a supervisor. Falsifying data carries a stiff penalty if caught.

LO 6E!!!

United Airlines (UAL) analysts estimated that 70% of costs were variable. Other analysts thought most costs

were fixed. How should UAL respond to extra passengers if 35% of seats on average

are empty?

UAL used a combination of increased numbers of

aircraft (fixed) and filling empty seats

(variable).

MANAGERIAL APPLICATION

7Explain the costs, benefits, and weaknesses of the various cost estimation methods.

LEARNING OBJECTIVE

EXHIBIT 5.12

Every method of

cost estimation

has strengths and

weaknesses.

COMMON SIMPLIFICATIONSIn general, more sophisticated methods provide

more accurate cost estimates than simpler ones. Methods of simplification are

¯Using only one cost driver¯Assuming cost behavior patterns are linear within the

relevant range¯Assume cost decreases are not “sticky”

What are sticky costs?

Sticky costs do not decrease when activity decreases. Example: keeping (not firing) workers when activity levels decrease.

EXHIBIT 5.13

8Identify the derivation of learning curves. (Appendix 5.1).

LEARNING OBJECTIVE

DERIVING LEARNING CURVES

¯Mathematically, the learning curve effect can be expressed by the equation: Y=aX b, where

¯Y = average number of labor hours required per unit for X units

¯a = number of labor hours required for the first unit¯X = cumulative number of units produced¯b = index of learning, equal to the log of the learning

rate divided by the log of 2.

9 Interpret the results of regression analyses. (Appendix 5.2).

LEARNING OBJECTIVE

STANDARD ERRORS OF THE COEFFICIENTS

¯The standard errors of the coefficients give an idea of the confidence we can have in the fixed and variable cost coefficients.

¯The smaller the standard error relative to its coefficient, the more precise the estimate.

¯Such computational precision does not necessarily indicate that the estimating procedure is theoretically correct, however.

T-STATISTIC¯The ratio between an estimated regression coefficient

and its standard error is known as the t-value or t-statistic.

¯If the absolute value of the t-statistic is approximately 2 or larger, we can be relatively confident that the actual coefficient differs from zero.

R-SQUARED¯The R2 attempts to measure how well the line fits the

data (that is, how closely the data points cluster about the fitted line).

¯If all the data points were on the same straight line, the R2 would be 1.00—a perfect fit. If the data points formed a circle or disk, the R2 would be zero, indicating that no line passing through the center of the circle or disk fits the data better than any other.

R-SQUARED (CONTINUED)

¯Technically, R2 is a measure of the fraction of the total variance of the dependent variable about its mean that the fitted line explains.

¯An R2 of 1 means that the regression explains all of the variance; an R2 of zero means that it explains none of the variance.

¯R2 is sometimes known as the “coefficient of determination.”

CAUTIONS WHEN USING REGRESSION

¯Users of regression analysis should be wary of drawing too many inferences from the results unless they are familiar with the following statistical estimation problems:¯Multicollinearity - independent variables are not

independent of each other but are correlated¯Autocorrelation - a linear regression is fit to data where a

nonlinear relation exists¯Heteroscedasticity - the dependent variable from the best-

fitting linear relation is systematically larger in one part of the range of independent variable(s) than in others

Financial Modeling for Short-Term

Decision-Making

CHAPTER 6

Managerial Accounting 11E

Maher/Stickney/Weil

PowerPoint Presentation by

LuAnn BeanProfessor of AccountingFlorida Institute of Technology

part, except for use as permitted in a license distributed with a certain product or service or

otherwise on a password-protected website for classroom use.

1Describe the use of financial modeling for profit-planning purposes.

LEARNING OBJECTIVE

FINANCIAL MODEL

Financial modeling enables analysts to test the interaction of economic variables in a variety of settings. It requires analysts to develop a set of equations that represents a company’s operating and financial relations.

BENEFITS: Financial Modeling

Once developed, analysts can use the model to ¯Review potential results before taking action¯Identify a bad project or decision in advance

¯Caveat¯GIGO- garbage in, garbage out¯A model is only as good as the assumptions it uses

2 Explain how to perform cost-volume-profit (CVP) analysis.

LEARNING OBJECTIVE

COST-VOLUME-PROFIT (CVP)

CVP can be used to answer questions such as ¯What effect on profit can GM expect if it builds a

larger SUV?¯How will NBC’s profit change if ratings increase

for its evening news program?¯How many subscribers must a Dish Network

obtain to break even for the year?¯What happens if Verizon reduces fees charged to

customers?

EXAMPLE: Early Horizons Daycare

Early Horizons Daycare is a daycare center that defines a unit of output as “service provided for 1 child for a month.” Building capacity is 30 children. An accountant developed the following estimates:

Continued

Price per child per month $ 600

Variable cost per child per month 200

Fixed costs per month 5,000

CAPACITY and COSTSEarly Horizons Daycare has a capacity of 20

units (relevant range), after which it must hire more staff.¯Variable costs include

¯Snacks and food¯ Supplies ¯A portion of insurance

¯Fixed costs include:¯Rent and utilities¯A portion of insurance¯Minimum staffing

LO 2EHD

BREAK-EVEN POINT: Definition

Is the point in the basic CVP model where revenues equal

costs.

Total Revenue = Total Costs

BREAK-EVEN: Table Format

Using break-even computations:

Sales Revenue (12.5 × $600) $ 7,500

Less Variable costs (12.5 × $200) 2,500

Contribution Margin (CM) $ 5,000

Less Fixed costs 5,000

Operating profit $ 0

CONTRIBUTION MARGIN: Definition

Is the excess of revenue over variable costs.

Total Revenue – Variable Costs

Can we use contribution margin

to compute break-even (BE) volume?

BE Volume =

Fixed cost / CM per child

LO 2MANAGERS WANT TO KNOW!EHD

CONTRIBUTION MARGIN APPROACH

Using the contribution margin approach:

LO 2EHD

Break-even Volume = Fixed Costs / CM per child= $5,000 / $400

= 12.5 children

Click the button to skip equation approach

EQUATION APPROACHUsing the equation approach (Operating profit at

break-even = 0):

LO 2EHD

Operating profit 0= Sales revenue - Costs= Sales revenue -Variable costs (VC) – Fixed costs (FC)= (Unit selling price (SP) × Sales volume)

- (VC per unit × Sales volume) - FC($600 - $200) × Sales volume = $5,000

Sales volumeBE = $5,000/$400 = 12.5 children/month

Can we graph the relationships in CVP

analysis?

LO 2MANAGERS WANT TO KNOW!

EXHIBIT 6.1

By graphing revenues

and costs on same graph,

you can find BE,

profit and loss areas.

Break-even Volume = Fixed Costs / CM

EXHIBIT 6.2

Slope of line is

variable cost per

Break-even Volume = Fixed Costs / CM

Can we calculate a target profit volume?

Target profit Volume =

(Fixed cost + Target profit) / CM

TARGET PROFIT: CM Approach

Target profit Volume = (Fixed costs + Target Profit) / CM= ($5,000 + $3,000) / $400

Sales revenue (20 × $600) $ 12,000

Less Variable costs (20 × $200) 4,000Contribution Margin $ 8,000Less Fixed costs 5,000Operating profit $ 3,000

Continued

# children = 20Click the button to

skip equation approach

TARGET PROFIT: Equation Approach

Sales revenue – Variable costs - Fixed costs = Operating Profit($600 - $200) × Sales volume - $5,000 = $3,000

$400*Sales volume = $8,000

Sales revenue (20 × $600) $ 12,000Less Variable costs (20 × $200) 4,000Contribution Margin $ 8,000Less Fixed costs 5,000Operating profit $ 3,000

Continued

Sales volume = 20 childrenClick the button to skip Exercise 10

EXERCISE 10

If companies that are operating below break-even cannot raise prices, what must they do

to break even?

A company can either (a) increase the contribution margin by 1) raising the selling

price or 2) reducing variable costs or (b) decrease fixed costs.

3 Describe the use of spreadsheets in financial modeling.

LEARNING OBJECTIVE

TARGET PROFIT: Reminder

Target profit Volume = (Fixed costs + Target Profit) / CM

Sales revenue (20 × $600) $ 12,000

Less Variable costs (20 × $200) 4,000Contribution Margin $ 8,000Less Fixed costs 5,000Operating profit $ 3,000

Continued

Can EHD improve operating profit by

changing cost or selling price?

First, look at the conditions in the base case.

EARLY HORIZONS DAYCARE: Sensitivity Analysis

AssumptionsPrice/child $ 600 $ 600 $ 600 $ 660VC/child $ 200 $ 200 $ 210 $ 200Monthly FC $5,000 $4,500 $5,000 $5,000Children enrolled 20 20 20 18

Model results: ISSales revenue $ 12,000 $ 12,000 $ 12,000 $ 11,880Less VC 4,000 4,000 4,200 3,600Total CM $8,000 $8,000 $7,800 $8,280

Less FC 5,000 4,500 5,000 5,000Operating profit $3,000 $3,500 $3,000 $3,280

Base Cost FC $500 VC $10 Price $60, Vol. 2

Click the button to go directly to solution

Alternative #1: What will the effect on profit

be if EHD can decrease FC by $500?

Operating profit willincrease by $500.

Base Cost FC $500 VC $10 Price $60, Vol. 2Alt #1

Alternative #2: What will the effect on profit

be if EHD can decrease VC by $10?

Operating profit willdecrease by $200.

Base Cost FC $500 VC $10 Price $60, Vol. 2Alt #1 Alt #2

Alternative #3: What will the effect on profit be if EHD can increase

price by $60 anddecrease volume by 2?

Operating profit willincrease by $280.

Model results: ISSales revenue $ 12,000 $ 12,000 $ 12,000 $ 11,880Less VC 4,000 4,000 4,200 3,600Total CM $8,000 $8,000 $7,800 $ 8,280

Less FC 5,000 4,500 5,000 5,000Operating profit $3,000 $3,500 $2,800 $ 3,280

Base Cost FC $500 VC $10 Price $60, Vol. 2Alt #1 Alt #2 Alt #3

Which situation would you choose: base cost

or one of the alternatives?

Alternative #1 is the best choice if EHD can

decrease FC by $500.

EXERCISE 5

What effect could the following changes have on 1) break-even point, 2) unit CM, and 3)

expected total profit?

a) Increase in FC?BE CM Total Profit

No EffectClick the button to skip

parts b & d.

EXERCISE 5

b) Decrease in wage rates of variable labor costs?

BE CM Total Profit

EXERCISE 5

d) Increase in production and sales volume?

BE CM Total Profit No Effect No Effect

EXHIBIT 5.7

Semifixed costs change because of changes in long-term

assets;semivariable costs do not.

Semivariable

Semifixed

REMINDER FROM CH. 5

EHD: Expanding Operations

EHD has been at full capacity (20 children). Adding 5 children would require $4,600 in additional fixed costs. In a second step, adding another 5 children would add $2,800 more in fixed costs. Building capacity: 30 children.

LO 3EHD

How many children (sales volume) provide

the best operating profit for EHD?

LO 3EHD

Break-even Volume = Fixed Costs / CM per child= $5,000 / $400 = 12.5 children

EHD: Step (Semifixed) Costs

1. Status quo: 0-20 children

2. 1st step: 21-25 children

3. 2nd step: 25-30 children

= 24 children

= 31 children

LO 3EHD

= 24 children

= 31 children

LO 3EHD

= 24 children

= 31 children

MARGIN OF SAFETY: Definition

Is the excess of projected (or actual) sales units over Break-

even unit sales level.

Sales units – BE Sales units or

Sales dollars – BE Sales dollars

MARGIN OF SAFETY: Early Horizons Daycare

LO 3EHD

Sales units – BE Sales units = 20 – 12.5 = 7.5

Sales dollars – BE Sales dollars = $12,000 – $7,500 = $4,500

4Identify the effects of cost structure and operating leverage on the sensitivity of profit to changes in volume.

LEARNING OBJECTIVE

COST STRUCTURE: Definition

Refers to the proportion of fixed and variable costs to total

costs.

OPERATING LEVERAGE: Definition

Is the extent to which an organization’s cost structure is

made up of fixed costs.

Note: the higher the fixed costs, the higher the break-even point.

What is the contribution margin

ratio?

Contribution margin ratio (CMR) is the contribution amount per dollar of sales.

CM / Sales

EXAMPLE: Variable Co. and Fixed Co.

Consider two companies: Variable Co. (VC) and Fixed Co. (FC), so named because of their cost structures.

Continued

If sales increase 10% (to $1,100,000), which company, FC or VC,

would be more profitable?

FC (assuming it is within the relevant range) because its contribution margin, and therefore profit is higher:

75% compared with 25% for VC.

5 Explain how to use sales dollars as the measure of volume.

LEARNING OBJECTIVE

SALES DOLLARS and VOLUME:A Relationship

LO 5EHD

BE Sales units = FC / CM= $5,000 / $400 = 12.5 children

BE Sales dollars = FC / CMR= $5,000 / ($400 / $600) = $7,500

If EHD wants to earn a $2,000 profit, what would target volume

(sales dollars) be?

BE Sales units = (FC + Profit) / CM= $7,000 / $400 = 17.5 children

BE Sales dollars = (FC + Profit) / CMR= $7,000 / ($400 / $600) = $10,500

6 Explain the effect of taxes on financial modeling.

LEARNING OBJECTIVE

Can EHD determine what the effect of taxeswill be on its profits?

After tax profits = Before tax profits X (1 – tax rate)

Click the button to skip example

By combining the equations for after tax profit with target profit ($1,800), we can calculate the number of children EHD must serve.

LO 6EHD TAXES and TARGET PROFIT

1. After-tax profits; 40% tax rate

2. Target profit in units

After tax profits = Before tax profits X (1 – tax rate)After tax profits / (1 – tax rate) = Before tax profits

$1,800 / (1 – 0.4) = $3,000 = Before tax profits

Volume = (Fixed Costs + Target profit) / CM per child= $8,000 / $400 = 20 children per month

By combining the equations for after tax profit with target profit ($1,800), we can calculate the number of children EHD must serve.

LO 6EHD TAXES and TARGET PROFIT

1. After-tax profits; 40% tax rate

2. Target profit in units

After-tax profits = Before tax profits × (1 - tax rate)After-tax profits / (1 – tax rate) = Before-tax profits

$1,800 / (1 – 0.4) = $3,000 = Before-tax profits

Volume = (Fixed Costs + Target profit) / CM per child= $8,000 / $400 = 20 children per month

Click the button to skip table approach

AFTER-TAX PROFIT: Table Format

Sales Revenue (20 × $600) $12,500

Less Variable costs (20 × $200) 4,000

Contribution Margin (CM) 5,000

Less Fixed costs 8,000

Profit before taxes 3,000

Income taxes ($3,000 × 0.4) 1,200

Operating profit $ 1,800

Three entrepreneurs borrowed money to start a

brewpub. Banks and investors wanted profit

projections and one owner was concerned that the

projections were too high. What analysis will help?

By using CMR in a break-even analysis,

sales could drop by more than 35% before the

brewpub would have a loss.

MANAGERIAL APPLICATION

7Describe the use of financial modeling in a multiple-product setting.

LEARNING OBJECTIVE

Financial modeling is useful when multiple products with varying contribution margins are sold. Assumptions must be made about sales mix. Remember the rule:GIGO—garbage in, garbage out

SPORTS AUTOS: Three Analyses

With multiple products and variable costs, how does Sports Autos determine how to reach its target profit?

1. Assume weighted-average CM2. Treat each product as separate entity3. Use sales dollars as measure of volume

LO 7SA

EXAMPLE: Sport Autos

Sport Autos is a car dealership selling two models: Sleek and Powerful. The relevant prices and costs are:

Continued

Average monthly fixed costs $100,000Selling price: Sleek $ 20,000Average VC: Sleek $ 15,000

Selling price: Powerful $ 30,000

Average VC: Powerful $ 20,000

What is the CM for each car?

Sleek = ($20,000-$15,000) = $5,000

Powerful = ($30,000-$20,000)= $10,000

What is the CM ratio for each car?

Sleek = ($5,000 ÷ $20,000) = 25%

Powerful = ($10,000 ÷ $30,000)= 33%

Break-even units = Fixed Costs / Weighted Ave. CM= $100,000 / $6,667 = 15 cars

SPORTS AUTOS: Alternatives

2. Treat each car separately

Break-even Sleeks = $40,000 / ($20,000 - $15,000) = 8 carsBreak-even Powerfuls = $60,000 / ($30,000 - $20,000) = 6 cars

1. Assume weighted average CM: Also assume product mix of 2/3 Sleeks; 1/3 Powerfuls (2/3*$5,000 + 1/3*$10,000 = $6,667)

Break-even units = Fixed Costs / Weighted Ave. CM= $100,000 / $6,667 = 15 cars

Alt #2. Treat each car separately

Break-even Units = FC / CM per unitBreak-even Sleeks = $40,000 / ($20,000 - $15,000) = 8 cars

Break-even Powerfuls = $60,000 / ($30,000 - $20,000) = 6 cars

Alt #1. Assume weighted average CM: Also assume product mix of 2/3 Sleeks; 1/3 Powerfuls (2/3*$5,000 + 1/3*$10,000 = $6,667)

Continued

Alt #3. Use Sales dollars as measure of volume. Assume 20 Sleeks, 10 Powerfuls sold monthly.

Weighted Ave. CMR = Total CM / Total Sales= (20×$5,000 + 10×$10,000) / (20×$20,000 + 10×$30,000)

= $200,000/ $700,000 = 0.286

Break-even Sales dollars = FC / Weighted Ave. CMR= $100,000 / 0.286

= $350,000

Financial modeling can help with product decisions when there are constraints on the product mix.

SPORTS AUTOS: Product Decisions

Suppose Sports Autos wants to sell inexpensive sports cars and can sell one but not both.

LO 7SA

Continued

Price VC CMSportster Coupe $12,000 $ 7,000 $ 5,000Sportster Convertible 15,000 11,000 4,000

If Sports Autos can only sell one car, that is either the Sportster Coupe or

Convertible, which should it be?

SUMMARY OF SIMPLIFYING CVP ASSUMPTIONS

¯Can separate total costs into fixed and variable¯Cost and revenue behavior is linear. Implies

the following in the relevant range¯Total fixed costs do not change ¯Variable costs per unit remain constant¯Selling price per unit remains constant

¯Product mix remains constant over relevant range

8 Explain financial modeling with multiple cost drivers.

LEARNING OBJECTIVE

USING ABC FOR EHD

Previously, Early Horizons Daycare used a financial model with only volume (number of children) as the cost driver. What if multiple cost drivers using the cost hierarchy are identified and used?

LO 8EHD

Activity Category ExampleCapacity Size limitations Building size: 30 children

Customer Needs Children transported

Product Production needs Field trips

Batch Batch A room of 5 children

Unit Variable costs Child

HIERARCHY OF COSTS: Reminder

COST EQUATIONLO 8E

Total Cost = (Unit-level cost × #children) + (Batch-level cost × # rooms) +(Product-level cost × #field trips) +(Customer-level cost × #children transported) +(Capacity-level costs × #facilities)

Continued

When we have identified cost drivers

can we conduct sensitivity analysis?

Yes! Let’s consider what happens if the number of children increases to 22or decreases to 15.

Click the button to skip to final solution

EHD: ABC and Sensitivity Analysis

Sales $ 12,000 $ 13,200 $ 9,000Unit-level costs 400 440 300Batch-level costs 2,800 3,500 2,100Product-level costs 300 300 300Customer-level costs 800 800 500Facility-level costs 4,700 4,700 4,700Operating profits $ 3,000 $ 3,480 $ 1,100

Base Case

Continued

Base CaseIncrease to 22

Continued

Base CaseIncrease to 22

Decrease to 15

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uncovering the drivers of consumer recycling behavior

chapter 5 cost drivers and cost...

10 drivers of healthcare cost