Hilton Chapter Thirteen

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• Day Seven
• Costing Basic Issues
• Cost volume profit
• Operating Leverage
• Transfer Pricing
• 4. Overhead - what and why?

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Vanessas Cappuccino Express
What is a cost?
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Vanessas Cappuccino Express
For decision makers what matters is the future.
Predicting costs is a key component of a
successful business. One important factor
causing costs to vary is level of activity.
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Fixed Cost - Total

Activity Level
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Variable Cost - Total

Activity Level
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Mixed Cost - Total

Activity Level
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VOLUME
Volume level of activity But this concept is
flexible. Volume should be measurable
and Should relate to changes in costs...
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Fixed versus Variable?
Not always easydepends on point of view. Think
of the passenger on the already scheduled
flight.variable costs are minimal. But what
about when the flight was originally scheduled?
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Assumptions
1. Linear, constant costs 2. Costs only fixed
or variable 3. Sales and Production are equal 4.
No capacity additions during period 5. Sales mix
remains constant 6. Inflation is ignored 7.
Technological assumptions remain
unchanged..productivity same.
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Slide 16-18
CVP as a Flow Diagram
Fixed Costs
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Equation Approach
Sales revenue Variable expenses Fixed
expenses Profit .
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Equation Approach
Assume Sales Price of 500 Variable cost/unit of
300 and Fixed Costs of 80,000 How many
units must Curl Co. sell to break even?
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Equation Approach
(500 X)
(300 X)


80,000 0
X Break Even in units
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Contribution Margin Approach
CONTRIBUTION MARGIN 500 - 300 or 200 per
unit At Break Even the TOTAL CM is equal to
Total FIXED Costs or.. 200 x X 80,000
X Break Even in units
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Contribution-Margin Approach

• Fixed expenses
• Unit contribution
• margin

Break-even point (in units)
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Contribution-Margin Ratio

• We can calculate the break-even point in sales
  dollars rather than units by using the
  contribution-margin ratio.

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Contribution-Margin Ratio Approach
CM Ratio Sales Price - Var Co Sales
Price I.E. What of the selling price is left
after paying variable unit cost?
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Contribution-Margin Ratio Approach
CM Ratio Sales Price - Var Cost Sales
Price In our example, 500 - 300 200 CM.
200 is 40 of SP. Fixed Costs of 80,000,
divided by 40 ?
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Cost-Volume-Profit Graphed
Sales in Dollars
Units Sold
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Cost-Volume-Profit Graph
Break-even point

Units
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Slide 16-19
Improving Profit Performance

• Increase selling price per unit (SP)
• Decrease variable cost per unit (UVC)
• Decrease fixed costs (TFC)
• Increase volume (X)

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Three more Important Cost Terms
1. Opportunity 2. Sunk 3. Differential or
Incremental
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Opportunity Cost

• The potential benefit that is given up when one
  alternative is selected over another.
• Example If you were notattending college, you
  couldbe earning 15,000 per year. Your
  opportunity costof attending college for one
  year is 15,000.

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Sunk Costs

• All costs incurred in the past that cannot be
  changed by any decision made now or in the
  future.
• Sunk costs should not be considered in
  decisions.

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Sunk Costs

• Example You bought an automobile that cost
  10,000 two years ago. The 10,000 cost is sunk
  because whether you drive it, park it, trade it,
  or sell it, you cannot change the 10,000 cost.

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Sunk Costs

• Examples..
• Beloved of politicians
• Knee Deep..

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Sunk Costs

• Basketball players

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Incremental Costs

• Costs that differ between alternatives.

Example You can earn 1,500 per month in
yourhometown or 2,000 per month in a nearby
city.Your commuting costs are 50 per month in
yourhometown and 300 per month to the city.
What is your incremental cost?
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Incremental Costs

• Costs that differ between alternatives.

Example You can earn 1,500 per month in
yourhometown or 2,000 per month in a nearby
city.Your commuting costs are 50 per month in
yourhometown and 300 per month to the city.
What is your incremental cost? 300 - 50 250
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Incremental or Diffferential or Marginal Costs

• Often these are related to
• Variable and Fixed patterns, i.e.
• they are driven by volume
• changes.
• Another Boeing 757? Another Palm Pilot? Another
  Windows XT?

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Marginal Costs and Average Costs
The total cost toproduce a quantitydivided by
thequantity produced.
The extra costincurred to produceone additional
unit.
Marginal and average costs arelargely a function
of cost behavior -- variable and fixed costs.
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Cost Structure and Operating Leverage

• The cost structure of an organization is the
  relative proportion of its fixed and variable
  costs.
• Operating leverage is . . .
• the extent to which an organization uses fixed
  costs in its cost structure.
• greatest in companies that have a high proportion
  of fixed costs in relation to variable costs.

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Operating Leverage
The extent to which costs are fixed rather than
variable Defined as S - VC
S - VC - FC
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Operating Leverage
The extent to which costs are fixed rather than
variable S - VC S
- VC - FC
What happens as FIXED Costs increase?
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Operating Leverage
S - VC Cont Margin S - VC -
FC Income 1. Dependent on Current Sales, VC
FC, i.e. it is valid only for a point. 2.
Shows how change in Sales will change Income...
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Measuring Operating Leverage

• A measure of how a percentage change in sales
  will affect profits.If Curl increases its sales
  by 10, what will be the percentage increase in
  net income?

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Measuring Operating Leverage
S - VC S - VC - FC
Operating leverage

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Measuring Operating Leverage

• A measure of how a percentage change in sales
  will affect profits.

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Measuring Operating Leverage

• Lets work it out...

Sales 250,000 x 1.10 275,000 Var cost 60 or
150,000 X 1.10 (165,000) Cont margin
110,000 Fixed Costs (
80,000) Net Income 30,000
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Operating Leverage - a Graphical Look
Cost or Revenue??
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Cost Structure 1
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Cost Structure 2
Which is high and which is low leverage?
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CVP Graph for High Leverage
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CVP Graph for Low Leverage
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Numerical Examples
Hy Loe Sales 500,000 500,000 less
VC ( 100,000) ( 350,000) CM 400,000
150,000 less FC (340,000) (90,000) Op
Inc. 60,000 60,000 Leverage 400,000
150,000 60,000 60,000
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Questions re Operating Leverage...
Does H or L fit better 1. Relatively low CM
ratio 2. When sales are increasing, income
increases more rapidly 3. When sales are
decreasing, income will decrease slowly 4.
Volatility of income as sales changes will be high
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Questions re Operating Leverage...
Does H or L fit better 5. Break even point will
often be lower 6. Margin of safety for a given
level of sales will usually be higher 7.
Latitude to management in times of economic
stress is less 8. Appeals to those who like risk
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5. Transfer Price
The amount charged when one division sells goods
or services to another division
Batteries
Battery Division
Auto Division
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Transfer Pricing

• The transfer price affects the profit measure
  for both the selling division and the buying
  division.

A higher transferprice for batteriesmeans . . .
greater profits for the battery division.
Auto Division
Battery Division
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Transfer Pricing

• The transfer price affects the profit measure
  for both the selling division and the buying
  division.

A higher transferprice for batteriesmeans . . .
lower profitsfor the auto division.
Auto Division
Battery Division
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General-Transfer-Pricing Rule
Additional outlaycost per unitincurred
becausegoods aretransferred
Opportunity costper unit to the organizationbeca
use ofthe transfer
Transfer price


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Goal Congruence

• Conflicts may arise between the companys
  interests and an individual managers interests
  when transfer-price-based performance measures
  are used.

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Goal Congruence
The ideal transfer price allowseach division
manager to makedecisions that maximize
thecompanys profit, whileattempting to
maximize his/herown divisions profit.
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Setting Transfer Prices

• The general rule.

• Additional outlay.

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Setting Transfer Prices

• Opportunity Cost

• Additional outlay.

• The general rule.

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Setting Transfer Prices

• Opportunity Cost

• Additional outlay.

• Goal Congruence

• The General Rule

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The goal of Setting Transfer Prices

• The value placed on transfer goods is used to
  make it possible to transfer goods between
  divisions while allowing them to retain their
  autonomy.