ACCTMIS 2300 Exam 1 (Marc Smith)

Cost Behavior

describes how costs change (react) to changes in the volume of activity

Three Classifications of Cost Behaviors

Variable, Fixed, Mixed

Variable Costs

PER UNIT are constant so they do not change when the volume of activity changes ex. direct materials, direct labor

Fixed Costs

IN TOTAL are constant. As volume of activity increases, fixed costs per unit decreases) ex. depreciation, rent, and advertising

Mixed Costs

contain both a variable and fixed element ex. utilities and overhead

Cost Behavior Assumptions

1. Cost Behaviors (variable, fixed, mixed) are assumed to exist over a relevant range

2. Cost Behaviors are assumed to be linear within the relevant range, plot as a straight line

3. A mixed cost does not have a constant element

Relevant Range

range of activity within which the assumptions made about cost behaviors by managers are valid

What do we do with Mixed Costs as they do not have a constant component?

High-Low Method

High-Low Method

method used to separate mixed costs into its variable and fixed components

High-Low Method Steps

1. Choose 2 data points - the high and the low activity level

2. Calculate the variable cost per unit

3. Calculate the total fixed cost

Variable Cost per Unit

= change in cost / change in activity

Contribution Income Statement

Sales Revenue - Variable Costs = Contribution Margin - Fixed Costs = Net Income

Contribution Margin

Money used to cover/pay fixed costs and contribute towards a profit

Cost-Volume-Profit Analysis (CVP)

helps mangers understand the relationships among cost, volume, and profit by focusing on the following interactions: price of products, volume or level of activity, per unit variable costs, total fixed costs

CVP Analysis Decisions

1. Deciding what products or services to offer

2. Determining what pricing policy to follow

3. Choosing a marketing strategy to employ

4. Deciding what basic cost structure to use

4 Basic Elements of CVP Analysis

1. Break-Even Calculations

2. Target Profit Analysis

3. Margin of Safety

4. Operating Leverage

Total Contribution Margin

=Sales Revenue - Variable Costs

Contribution Margin per Unit

= Selling Price per Unit - Variable Costs per Unit

Contribution Margin Ratio

=Contribution Margin/Sales Revenue

=Contribution Margin per Unit / Selling Price per Unit

Break-Even Point

No profit is earned and no loss is incurred, gives managers a minimum target revenue

Sales = Variable Costs + Fixed Costs

Net Income = 0

Break-Even Point in units vs. Break-Even Point in Sales Dollars

in units represents the number of units that must be sold to break-even vs. in sales dollars represents the amount of revenue that must be generated to break-even

Variable Cost Ratio

= Variable Costs / Sales Revenue

= Variable Costs per Unit / Selling Price per Unit

Margin of Safety

A measure of firm riskiness. It measures the amount sales can fall before losses occur. The higher the margin of safety, the lower the risk of reporting losses

Margin of Safety Equation

= Actual Sales Revenue - Break-Even Sales Revenue

Operating Leverage

A measure of how sensitive net income is to a percentage change in sales, tells us the percentage change in net income for every 1% change in sales

Degree of Operating Leverage

= Contribution Margin / Net Income

Sales Mix

the relative combination of products being sold by a firm ex. if ABC company sells 70,00 units of Product A and 30,000 units of Product B, the sales mix would be 7:3

always reduce the sales mix down to the smallest possible numbers for ease of calculations

Package Contribution Margin per Unit

Allows us to convert a multiple-product problem into a single-product CVP format

How to Calculate:

For each product --> product's contribution margin per unit x product's sales mix number

Then, add all these together

Tactical Decision Making

It consists of choosing among alternatives with an immediate or limited end in view that tend to be short-run in nature. The decision-making consists of comparing a handful of alternatives by analyzing the costs of each alternative and then the "least-cost" alternative is chosen.

Relevant Cost

a cost that differs between alternatives and they should be the only costs considered in deciding which alternative to pick

Avoidable Costs

ALWAYS RELEVANT

a cost that can be eliminated, either in whole or in part, by choosing one alternative over another

ex. direct materials, direct labor, all variable costs, some fixed costs (when specified)

Unavoidable Costs

NEVER RELEVANT

a cost that exists under all decision alternatives

ex. some fixed costs

Allocated Costs

NEVER RELEVANT

a cost that can not be directly linked to a product or activity. It is therefore assigned to the product or activity using some sort of arithmetic process

ex. rent & administrative salaries

Sunk Costs

NEVER RELEVANT

a cost that has been incurred and can not be recovered or "un-incurred" by a future action

ex. the original cost of a building is a sunk cost when you are trying to decide whether or not to sell the building years later

Opportunity Costs

ALWAYS RELEVANT

a benefit given up by choosing one alternative over another

Examples of Tactical Decisions

- Make or Buy

- Keep or Drop

- Special Orders

- Sell or Process Further

- Product Mix

Make or Buy Decision

a decision concerning whether an item should be produced internally or purchased from an outside supplier

Decision Rule:

Avoidable Costs + Opportunity Costs > Outside Purchase Price = BUY

Avoidable Costs + Opportunity Costs < Outside Purchase Price = MAKE

Keep or Drop Decision

the company must decide whether a segment of a business should be kept or eliminated

Decision Rule:

Avoidable Fixed Costs + Opportunity Costs > Lost Contribution Margin = DROP

Avoidable Fixed Costs + Opportunity Costs < Lost Contribution Margin = KEEP

Special Order Decision

one-time orders requested at a lower selling price that are not part of a company's regular sales

Decision Rule:

Actual Selling Price of Special Order > Minimum Acceptable Selling Price of Special Order = ACCEPT ORDER

Actual Selling Price of Special Order < Minimum Acceptable Selling Price of Special Order = REJECT ORDER

Minimum Acceptable Selling Price of Special Order

= Variable Costs per Unit of Special Order + Contribution Margin Lost From "Given Up" Regular Sales

Contribution Margin Lost From "Given Up" Regular Sales

= Contribution Margin per Unit of Regular Sales x Units of Regular Sales Given Up / Units in the special order

Sell or Process Further Decision

A decision as to whether a joint product should be sold at the split-off point or sold after further processing

Decision Rule:

Process Further only if

(Sales value from further processing - additional processing costs) > sales value at the split-off point

Joint Products

two or more products produced from the same raw material input

Split-Off Point

the point in the manufacturing process where each joint product can be recognized as a separate product

Joint Costs

The costs incurred up to the split-off point. These costs are not relevant in the decision making process because they are sunk costs and cannot be recovered.

Product Mix Decision

the company should produce those products that have the highest contribution margin per unit of scarce resource

Contribution Margin per Unit of Scarce Resource

= Contribution Margin per Unit / Scarce Resource Needs per Unit

Product Mix Decision Steps

1. Determine the contribution margin per unit for each product

2. Determine the contribution margin per unit of scarce resource

3. Rank the products in terms of desirability, from the highest to the lowest

4. Determine Optimal Product Mix starting by producing the most of rank #1 and so on

What happens when a company is faced with more than one resource constraint?

use linear programming to determine the optimal mix of products

Linear Programming Steps

1. Define your decision variables (x, y, etc.)

2. Determine the objective function (will always be to MAX contribution margin)

3. Determine the resource constraints

4. Solve the linear program to determine the optimal product mix (algebra and graphing)

Economic Indifference

= avoidable costs + opportunity costs = outside purchase price