The Behavior
of Costs
McGraw-Hill/Irwin
Cost-Volume
Relationships
Higher volume causes higher costs.
However, percentage increase in costs
is usually less than increase in volume.
Depends on behavior of costs.
Variable costs.
Fixed costs.
Semivariable costs.
Part variable, part fixed.
Also called semifixed costs or mixed costs.
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Variable Costs
In TOTAL, varies directly and
proportionately with volume of activity.
Cost PER UNIT of activity remains
constant.
Examples:
Material costs varies with units sold.
Vehicle fuel costs varies with miles driven.
Salespersons commissions varies with
sales dollars generated.
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Fixed Costs
In TOTAL, does not change with
volume of activity.
However, are fixed for a range of
activity and a limited period of time.
Cost PER UNIT of activity decreases
as the level of activity increases.
Examples:
Building rent.
Property taxes.
Management salaries.
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Semivariable Costs
Part variable cost, part fixed cost.
In TOTAL, varies less than
proportionately with volume of activity.
Example: Electricity cost in a factory.
Variable component: Cost of powering
production equipment.
Fixed component: Cost of lighting.
Cost-Volume (C-V)
Diagram
TC = TFC +(UVC*X)
TC = total cost;
TFC = total fixed cost (per time period),
UVC = Unit variable cost (per unit of
volume),
X = volume.
Equations for:
Variable cost line: TC = (UVC*X).
Fixed cost line: TC = TFC.
Semivariable cost: TC = TFC +
(UVC*X).
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Unit Costs
Average cost per unit.
Total cost volume of activity.
As volume goes up
Type of
Cost
Variable
Total Cost
Fixed
Stays the
same
Increases
Semivariabl
Increases
Cost Per
Unit
Stays the
same
Decreases
Decreases
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Inherent Conditions of
C-V Analysis
Relevant range.
A straight line approximates cost
behavior only within a certain range of
volume.
When volume approaches zero,
management takes steps to reduce
fixed costs.
When volume exceeds relevant range,
fixed costs increase.
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Inherent Conditions of
C-V Analysis
Relevant time period.
Amount of variable costs depends
on the time period over which
behavior is estimated.
If the time period is one day, few
costs are variable.
Over an extremely long time
period, no costs are fixed.
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Inherent Conditions of
C-V Analysis
Sticky Costs.
Many costs considered variable actually
fall less with decreases of activity than
they rise with increases.
Why? Managers tend to increase
resources more quickly than they
decrease.
Examples:
Sales commissions with minimum guarantees.
Managers slower to fire employees than to hire.
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Inherent Conditions of
C-V Analysis
Environment.
C-V analysis only shows how costs
vary with volume.
Many other environmental
influences affecting cost.
E.g., changes in wage rates, fringe
benefits, material prices,
technology.
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Inherent Conditions of
C-V Analysis
Linear assumption.
C-V relationship is often not linear.
Some cost functions are curved or occur
in steps (i.e., curvilinear, step-function).
Solution? Segments of the C-V
relationship can be approximated by a
straight line, each with its own relevant
range.
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Step-Function Costs
Incurred when costs are added in discrete
chunks.
E.g., a supervisor is needed for every 10 workers.
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4. Linear regression
A statistical method to determine line of best
fit.
Best to eliminate outliers or unusual
observations (e.g., a period during which
there was a strike).
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Potential Problems
with Estimating The CV
Relationship
Use of past data to predict the future.
Other factors (other than volume) may
be affecting cost.
E.g., may be due to trend (or drift) of cost
over time, not relationship of cost to volume.
Measures of Volume
Best measure is one that is the
cause of the change in cost.
Units produced?
Questions to Consider
in Selecting a Volume
Measure
Input measure (resources used)
or output measure (goods or
services produced)?
Monetary measure (e.g., labor
dollars) or Nonmonetary
measure (e.g., labor hours)?
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Monetary vs.
Nonmonetary Measures
Nonmonetary measure is
unaffected by price changes.
However, if price changes affect all
costs equally, use of dollars as an
activity measure implicitly allows
for price changes (e.g., labor
costs).
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Selecting a Volume
Measure: General
Considerations
Profitgraph
Add revenue line to C-V diagram.
Assumes constant selling price.
UP = unit selling price.
TR = total revenue.
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Break-even Analysis
TR = (UP*X).
TC = TFC + (UVC*X).
At break-even: TR = TC.
Break-even volume:
(UP*X) = TFC + (UVC*X), or
X = TFC (UP - UVC).
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Break-even Analysis
Unit contribution.
Amount each unit contributes to covering
fixed costs (first) and toward generating profit
(second).
(Unit selling price) (variable cost per unit).
UP - UVC.
Constant (unchanging) for all volumes within
relevant range.
Also known as unit contribution margin or
marginal income.
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Break-even Analysis
Contribution margin percentage.
Contribution as a percentage of
revenues.
(UP - UVC) UP.
Break-even in units:
Fixed costs unit contribution.
Related Analysis
Target Profit.
Calculate volume needed to achieve a target (T)
level of profit.
(UP*X) = TFC + (UVC*X) + T, or
X = (TFC+T) (UP - UVC).
Operating Leverage.
% change in profit caused by a % change in volume.
Caused by degree (%) of fixed cost in company.
Higher operating leverage means higher changes in
profit.
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Margin of safety.
The amount or ratio by which current
volume exceeds breakeven volume.
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Other Influences on
Costs
Changes in input prices.
Rate at which volume changes.
E.g., rapid changes in volume may
make it more difficult to change
personnel costs.
Duration of change.
Temporary changes affect costs less
than long-term changes.
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Other Influences on
Costs
Prior knowledge of change.
Allows planning to occur.
Productivity.
As productivity changes costs change.
Management discretion.
Learning curves.
Unit production costs decrease as a
company gains experience producing a
new product.
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