ACCT 201

variable cost

total cost changes as activity changes
cost per unit stays the same

fixed cost

total cost stays the same as activity changes
cost per unit changes as activity changes

mixed cost

contains both fixed and variable costs
total cost and cost per unit change as activity changes

committed fixed cost

cannot easily be changed in the short run without having significant impact

discretionary fixed cost

can be changed in the short run without having a significant impact, but reducing can still significantly impact organization

short-term decision making assumption

when identifying cost behavior, assume mgmt is using cost info to make short term decision
short term period will vary depending on the company’s current production and time required to change capacity

in long term, all cost behavior will likely change

relevant range

the range of activity for which cost behavior patterns are likely accurate
the variable, fixed & mixed costs for a company will only be accurate within a relevant range
outside of the relevant range, cost estimates must be reevaluated and recalculated

how are cost behavior patterns used by managers?

best way to accurately predict cost is to understand how costs behave with changes in activity

managers answer questions such as:

How much will a 5% increase in sales affect cost?
What happens to costs if we add a product line?
What happens to costs if we increase automation in production processes?

How do companies estimate fixed and variable costs?

Typically do not know exactly how much of costs is fixed & variable

Four approaches

Account analysis
Regression
High Low
Scattergraph

Account Analysis Approach

requires experienced employee to review historical info and classify
fixed costs are totaled to provide an estimate of TFC
variable costs per unit are calculated by dividing variable cost by measure of activity
expressed in y=f+vX

high-low method

quick and easy
used with another more accurate technique
uses historical info from several reporting periods to estimate
highest and lowest act levels are used to form a straight line that is used to estimate future self

potential weakness in high low

considers high & low in establishing estimate of fixed and variable
points may not represent the data as a whole
cost accountants often throw out the highest and lowest points & use the next highest & lowest points to perform the analysis

scattergraph method

considers all data points
requires plotting all points on graph & fitting a line through the points
visual method that allows accountants to identify unusual data points called outliers
tends to yield more accurate results than high low

regression analysis

fits a straight line to a set of data points to estimate fixed & variable costs
uses a series of mathematical equation to find best possible fitting line to data points

summary of four estimation methods

different methods will produce different results
regression analysis is typically most accurate
account analysis is effective if a knowledgeable accountant performs the work

What is wrong with using a traditional statement for internal reporting?

Presents costs by functional area without cost behavior patterns
used for external financial reporting to comply with US GAAP
Does not show fixed and variable costs

What is a contribution margin income statement?

contribution margin inc statement shows which are fixed and variable
sales minus variable costs equal contribution margin
contribution margin minus fxed costs equal operating profit
clear picture of which costs change & which costs stay the same with activity levels

Two important assumptions that must be considered when using the methods described: relevant range & nonlinear costs

when costs are estimated for a specific level of activity, the assumption is that activity, the assumption is that activity level is within the relevant range
costs are assumed to behave in linear manner

Are these assumptions reasonable? Nonlinear and relevant range

The first assumption is reasonable as long as the relevant range is clearly

identified.

The second assumption is reasonable as long as the linearity assumption

does not significantly distort the resulting cost estimate

What is cost-volume-profit analysis?

CVP analysis involves finding the break-even point and target profit in units and sales dollars
the profit equation is used extensively in the analysis
the profit equation shows that profit equals total revenues minus total costs
the contribution margin income statement is a more refined version of this equation

key equation used to present the contribution margin in a mathematical format

Profit = total sales - total variable costs - total fixed costs
Profit = (S x Q) - (V x Q) - F

What is the break-even point?

The break-even point can be expressed in sales dollars or units
the break-even point in units is the number of units that must be sold to achieve zero profit
the break-even point in sales dollars is the total sales required to achieve zero profit

what information is needed to calculate the break-even point in sales dollars?

contribution margin per unit
contribution margin ratio

how do we calculate the contribution margin per unit?

calculated by subtracting variable costs per unit from the selling price per unit.
Contribution margin per unit = S - V

How do we calculate the contribution margin ratio?

measures the amount each sales dollar contributes to covering fixed costs and increasing profit
contribution margin ratio = (S - V) /S

How do we calculate break-even point in sales dollars?

Break even point = total fixed cost + target profit / contribution margin ratio
to find break-even point, set the target profit to zero
to find target profit, set target profit to desired profit amt

What does a CVP graph represent?

relationship between cost, volume, and profit
vertical axis: dollar amt for revenue, cost, profit
horizontal exis: volume of activity

margin of safety

represents the amount by which sales can fall before the company incurs a loss
equation: projected sales - break even sales