Cost Determinants of Price

Variable Cost
Cost that varies with changes in the level of output

Fixed Cost
Cost that does not change as output is increased or decreased

Cost Behavior Basics

Example: PC Corporation has a plant that produces PCs. One the departments of the plant inserts a CD-ROM disk drive into each computer. The activity is drive insertion and the activity driver is the number of computers processed. The production workers are supervised by a production manager who is paid P 540,000 annually.

For production of up to 10,000 units, only one manager is needed. For production between 10,001 and 20,000 units, two managers are needed.

Fixed Costs
Costs that in total are constant within the relevant range as the level of activity driver varies

Fixed Costs
Example: Cost of supervision for several levels of production for the plant
Supervision P 540,000 P 540,000 P 540,000 Computers Processed 4,000 8,000 10,000 Unit Cost P 135 P 675 P 540

P 1,080,000
P 1,080,000 P 1,080,000

12,000
16,000 20,000

P 900
P 675 P 540

Fixed Cost Behavior

Supervision Cost

Fixed Cost = P 1,080,000 P 1,080,000

P 540,000

10,000 units

4,000 8,000 12,000 16,000 20,000 Number of Computers Processed

Variable Costs
Costs that in total vary in direct proportion to changes in an activity driver

Variable Costs
Example: Total cost of disk drives for various levels of production
Total Cost of Disk Drivers P 1,200,000 P 2,400,000 P 3,600,000 Number of Computers Produced 4,000 8,000 12,000 Unit Cost of Disk Drives P 300 P 300 P 300

P 4,800,000
P 6,000,000

16,000
20,000

P 300
P 300

Total Variable Costs = Variable Cost per Unit x Number of Units of the Driver

Variable Cost Behavior

Y = VX Cost P 6,000,000

Fixed Cost = P 1,080,000

Y = total variable costs V = variable cost per unit X = no. of units of the driver

P 4,800,000
P 3,600,000 P 2,400,000 P 1,200,000

Y = P 300 X

4,000 8,000 12,000 16,000 20,000 Number of Computers Processed

Mixed Costs
Costs that have both a fixed and a variable component

Example: Sales representative are often paid with a salary plus a commission on commission

Mixed Costs
Y = Fixed Cost + Variable Cost Y = F + VX Where: Y = Total Cost

Cost Behavior Basics

Example: PC Corporation has 10 sales representatives each earning a salary of P 300,000 annually plus a commission of P 500 per computer sold. The activity is selling and the activity driver is units sold. 10,000 computers were sold. What would be the total selling cost?

Cost Behavior Basics

Example: Total selling cost = Sum of fixed salary cost + commission cost Y = Fixed Cost + Variable Cost = (P 300,000 x 10 salesmen) + (P 500 x 10,000 units) = P 3,000,000 + P 5,000,000 = P 8,000,000

Mixed Costs Behavior

Example: Selling cost for different levels of sales activity
Total Fixed Cost of Selling P 3,000,000 P 3,000,000 P 3,000,000 P 3,000,000 P 3,000,000 Total Variable Cost of Selling P 2,000,000 P 4,000,000 P 6,000,000 P 8,000,00 P 10,000,000 Total Cost P 5,000,000 P 7,000,000 P 9,000,000 P 11,000,000 P 13,000,000 Computers Sold 4,000 8,000 12,000 16,000 20,000 Selling Cost per Unit P 1,250.00 P 875.00 P 750.00 P 687.50 P 650.00

Mixed Cost Behavior

Y = P 3,000,000 + (P 500 x no. of units sold) Cost P 15,000,000 P 13,000,000
Y = total variable costs V = variable cost per unit X = no. of units of the driver

P 11,000,000
P 9,000,000 P 7,000,000 P 5,000,000

Variable Costs

P 3,000,000
Fixed Costs 4,000 8,000 12,000 16,000 20,000 Number of Computers Processed

Cost Determinants of Price

Break-Even Pricing
Method of determining what sales volume must be reached before total revenue equals total costs

Break-Even Pricing
Exercise: Patricia de la Cruz, Product Manager of Sun Detergents Inc., has a fixed costs of P 200,000. The cost of labor and materials for each unit produced is P 50.00. It can sell up to 60,000 of its product at P 100.00 without having to lower its price. What should be its break-even volume?

Break-Even Pricing
Solution: Break-Even Volume = Fixed Costs Selling Price - Variable Costs P 200,000 P 100.00 - P 50.00

= 4,000 units

Breakeven Analysis

Breakeven Point
Point of zero profit Starting point of cost volume profit analysis Has two approaches namely:
Operating Income Approach Contribution Margin Approach

Operating Income Approach

Focuses on the income statement as a useful tool in organizing the companys costs into fixed and variable categories
Operating Income = Sales Revenues Variable Expenses Fixed Expenses

Operating Income = (Price per Unit x No. of Units) (Variable Cost per Unit No. of Units) Total Fixed Costs

Operating Income Approach

Example: Mercury Tool Corporation produces one type of power tool called drillers. It has the following projected operating income: Sales (72,500 units at P 400) Less Variable Expenses Contribution Margin Less Fixed Expenses Operating Income P 29,000,000 (P 17,400,000) P 11,600,000 (P 8,000,000) P 3,600,000

Operating Income Approach

Example: Variable Cost per Unit = P 17,400,000 72,500 = P 240

Operating Income Approach

Example: To get breakeven point, set operating income to zero

Operating Income = Sales Variable Costs Fixed Costs

P 0 = (P 400 x Units) (P 240 x Units) P 8,000,000 P 0 = (P 160 x Units) P 8,000,000 Units = 50,000

Operating Income Approach

Example: To double check:

Sales (50,000 units x P 400/unit) Less Variable Expenses Contribution Margin Less Fixed Expenses Operating Income

P 20,000,000 (P 12,000,000) P 8,000,000 (P 8,000,000) P 0

Contribution Margin Approach

Recognizes that at breakeven point, total contribution margin equals the fixed expenses Contribution Margin = Sales Revenues Total Variable Costs Breakeven No. of Units = Fixed Costs Unit Contribution Margin

Contribution Margin Approach

Example: Method 1

Contribution Margin per Unit = Total Contribution Units Sold = P 11,600,000 72,500 units = P 160 per unit

Contribution Margin Approach

Example: Method 2

Contribution Margin per Unit = Price per unit Variable Cost per unit = P 400 P 240 = P 160 per unit

Contribution Margin Approach

Example: Breakeven No. of Units = Fixed Costs Unit Contribution Margin = P 8,000,000 P 160 per unit = 50,000 units

Targeted Operating Income Approach

Gives company a method to determine how many units to be sold to earn a particular set targeted income Methodology
Use the operating income formula Instead of setting operating income at zero, use targeted operating income to get required no. of units to be sold

Targeted Operating Income Approach

Example: Mercury Tool Corporation has set a targeted operating income of P 4,240,000. How many units should be sold?

Operating Income = (Price per Unit x No. of Units) (Variable Cost per Unit No. of Units) Total Fixed Costs

Targeted Operating Income Approach

Solution: Operating Income = (Price per Unit x No. of Units) (Variable Cost per Unit No. of Units) Total Fixed Costs P 4,240,000 = (P 400 x Units) (P 24 x Units) P 8,000,000 = 76,500 units

Targeted Operating Income Approach

Example: To double check:

Sales (76,500 units x P 400/unit) Less Variable Expenses Contribution Margin Less Fixed Expenses Operating Income

P 30,600,000 (P 18,360,000) P 12,240,000 (P 8,000,000) P 4,240,000

Targeted Operating Income Approach

Example: Mercury Tool Corporation has set a targeted operating income of 15% of sales. How many units should be sold?

Operating Income = (Price per Unit x No. of Units) (Variable Cost per Unit No. of Units) Total Fixed Costs

Targeted Operating Income Approach

Solution: Operating Income = (Price per Unit x No. of Units) (Variable Cost per Unit No. of Units) Total Fixed Cos Operating Income = 15% x Sales = 15% x (P 400 x Units) 0.15 x (P 400 x Units) = (P 400 x Units) (P 240 x Units) P 8,000,000 Targeted No. of Units = 80,000 units

Revenue = Variable Cost + Contribution Margin

Contribution Margin

Revenues

Variable Cost

Units

Impact of Fixed Costs on Profit

Fixed Costs = Contribution Margin; Profit = 0
Fixed Costs

Contribution Margin
Revenues Total Variable Cost

Units

Impact of Fixed Costs on Profit

Fixed Costs < Contribution Margin; Profit > 0
Fixed Costs

Profit

Contribution Margin
Revenues Total Variable Cost

Units

Impact of Fixed Costs on Profit

Fixed Costs > Contribution Margin; Profit < 0
Fixed Costs

Loss

Contribution Margin
Revenues Total Variable Cost

Units

Multi Product Operating Income Analysis

Example: Mercury Tool Corporation has decided to offer two models of drillers - (a) a regular driller selling for P 400 and a mini driller selling for P 600. Its marketing department thinks it can sell 75,000 regular drillers and 30,000 mini drillers annually.

Multi Product Operating Income Analysis

Example: It prepared a projected income statement based on the sales forecast:
Regular Drillers Sales Less Variable Expenses Contribution Margin P 30,000,000 (P 18,000,000) P 12,000,000 Mini Drillers P 18,000,000 (P 9,000,000) P 9,000,000 Total P 48,000,000 (P 27,000,000) P 21,000,000

Less Direct Fixed Expenses*

Product Margin Less Common Fixed Expenses**

(P 2,500,000)
P 9,500,000

(P 4,500,000)
P 4,500,000

(P 7,000,000)
P 14,000,000 (P 6,000,000)

Operating Income

P 8,000,000

Multi Product Operating Income Analysis

Example: *Direct Fixed Expenses - fixed costs that can be traced to each segment and that would be avoided if the segment did not exist. ** Common Fixed Expenses - fixed costs that cannot be traced to the segments and that would remain even if one of those segments was eliminated.

Cost Volume Profit Analysis

Multi Product Breakeven Point Analysis

Example: Mercury Tool Corporation wants to know how many of its two product lines of drillers must be sold to break even. How should it derive it?

Multi Product Breakeven Point Analysis

Solution: Breakeven Volume = Fixed Costs Contribution Margin Fixed Costs (Price - Unit Variable Cost)

Multi Product Breakeven Point Analysis

Solution: Regular Drillers Breakeven Units

Breakeven Volume =

Fixed Costs (Price - Unit Variable Cost)

= P 2,500,000 (P 400 - P 240) = 15,625 units

Multi Product Breakeven Point Analysis

Solution: Mini Drillers Breakeven Units

Breakeven Volume =

Fixed Costs (Price - Unit Variable Cost)

= P 4,500,000 (P 600 - P 300) = 15,000 units

Using Sales Mix in Cost Volume Analysis

Example: Mercury Tool Corporation plans on selling 75,000 regular drillers and 30,000 mini drillers. The sales mix in unit terms is: 75,000:30,000 or 75:30 or 5:2 Translation: For every five regular drillers sold, two mini drillers are sold What should be its breakeven if the two products are sold as packages?

Using Sales Mix in Cost Volume Analysis

Solution:
Product Price Unit Variable Cost (P 240) (P 300) Unit Contribution Margin P 160 P 300 Sales Mix Package Unit Contribution Margin P 8001 P 6002 P 1400

Regular Driller Mini Driller Package Total

P 400 P 600

5 2

1No. 2No.

of driller units in package (5) x unit contribution margin (P 160) = P 800 of mini driller units in package (2) x unit contribution margin (P 300) = P 600

Using Sales Mix in Cost Volume Analysis

Solution: Breakeven Point Volume = Fixed Cost Package Contribution Margin = P 13,000,000 P 1400 = 9,285.71 packages

Translation:
Mercury must sell 5 x 9,285.71 = 46,429 regular drillers and 2 x 9,285.71 = 18,571 mini drillers to break even

Using Sales Mix in Cost Volume Analysis

Double Check:
Regular Driller Sales Less Variable Expenses Contribution Margin Less Direct Fixed Expenses Product Margin Less Common Fixed Expenses Operating Income P 18,571,600 (P 11,142,960) P 7,428,640 (P 2,500,000) P 4,928,640 Mini Driller P 11,142,600 (P 5,571,300) P 5,571,300 (P 4,500,000) P 1,071,300 Total P 29,714,200 (P 16,714,260) P 12,999,940 (P 7,000,000) P 5,999,940 P 6,000,000 (P 6)*

*Operating income is not exactly zero due to rounding

Shortcut: Using Sales to Derive Breakeven Point

Example: Below is the projected income statement of Mercury Tool Corporation. Sales Less Variable Expenses Contribution Margin Less Fixed Expenses Operating Income P 48,000,000 (P 27,000,000) P 21,000,000 (P 13,000,000) P 8,000,000

Compute for the breakeven sales needed?

Shortcut: Using Sales to Derive Breakeven Point

Solution: Breakeven Sales Volume = Fixed Costs Contribution Margin Ratio = Fixed Costs Contribution Margin/Sales = P 13,000,000 P 21,000,000/P 48,000,000 = P 13,000,000 0.4375 = P 29,714,290

Profit Analysis if CVP Variables Change

Example: The Sales Department of Mercury Tool Corporation conducted a market study for drillers that revealed the following choices: Choice 1 - If advertising expense increase by P 480,000, sales will increase from 72,500 units to 75,000 units

Profit Analysis if CVP Variables Change

Example: Choice 2 - A price decrease of P 20 from P 400 per unit to P 380 per unit would increase sales from 72,500 units to 80,000 units

Choice 3 - By decreasing prices to P 380 per unit and increasing advertising expense by P 480,000 will increase sales from 72,500 units to 90,000 units
What should Mercury do? Maintain status quo or pick one of the 3 choices?

Profit Analysis if CVP Variables Change

Solution (Choice 1):
Before the Proposed Advertising Increase Units Sold Unit Contribution Margin Total Contribution Margin Less Fixed Expenses Profit 72,500 X P 160* P 11,600,000 (P 8,000,000) P 3,600,000 After the Proposed Advertising Increase 75,000 X P 160* P 12,000,000 (P8,480,000) P 3,520,000

*Unit Contribution Margin = Unit Price - Variable Cost per Unit = P 400 per unit - P 240 per unit = P 160 per unit

Profit Analysis if CVP Variables Change

Solution (Choice 1):
Decrease in Profit Change in Sales Volume Unit Contribution Margin 2,500 X P 160

Change in Contribution Margin (from P 11,600,000 to P 12,000,000)

Less Increase in Fixed Expenses (from P 8,000,000 to P 8,480,000) Decrease in Profit

P 400,000
(P 480,000) P 80,000

Profit Analysis if CVP Variables Change

Solution (Choice 2):
Before the Proposed Advertising Increase Units Sold Unit Contribution Margin Total Contribution Margin Less Fixed Expenses Profit 72,500 X P 160 P 11,600,000 (P 8,000,000) P 3,600,000 After the Proposed Advertising Increase 80,000 X P 140** P 11,200,000 (P8,000,000) P 3,200,000

**Unit Contribution Margin = Lower Unit Price - Variable Cost per Unit = P 380 per unit - P 240 per unit = P 140 per unit

Profit Analysis if CVP Variables Change

Solution (Choice 2):
Difference in Profit Change in Contribution Margin (from P 11,600,000 to P 11,200,000) ( P 400,000)

Less Change in Fixed Expenses (from P 8,000,000 to P 8,000,000)

Decrease in Profit

(P 400,000)

Profit Analysis if CVP Variables Change

Solution (Choice 3):
Before the Proposed Advertising Increase Units Sold Unit Contribution Margin Total Contribution Margin Less Fixed Expenses Profit 72,500 X P 160 P 11,600,000 (P 8,000,000) P 3,600,000 After the Proposed Advertising Increase 90,000 X P 140 P 12,600,000 (P8,480,000) P 4,120,000

Profit Analysis if CVP Variables Change

Solution (Choice 3):
Difference in Profit Change in Contribution Margin (from P 11,600,000 to P 12,600,000) P 1,000,000

Less Change in Fixed Expenses (from P 8,000,000 to P 8,480,000)

Decrease in Profit

(P 480,000)
P 520,000

Operating Leverage

Operating Leverage
Use of fixed costs to extract higher % changes in profits as sales activity changes Degree of operating leverage is measured for a given level of sales by taking the ratio of contribution margin to profit Degree of Operating Leverage = Contribution Margin Operating Income If fixed costs are used to lower variable costs resulting in contribution margin increases and profit decreases, then the degree of operating leverage increases, thus signaling an increase in risk

Operating Leverage
Example: Adamson Corporation plans to add a new product line. In adding the new product line, the company can choose to depend on automation or manual labor.

If the company chooses automation, fixed costs will be higher, but unit variable costs will be lower.
Projected annual sales is 10,000 units.

Operating Leverage
Example:
Automated System Sales Less Variable Expenses Contribution Margin Less Fixed Expenses Operating Income Unit Selling Price Unit Variable Cost Unit Contribution Margin P 1,000,000 (P 500,000) P 500,000 (P 375,000) P 125,000 P 100* P 50** P 50*** Manual System P 1,000,000 (P 800,000) P 200,000 (P 100,000) P 100,000 P 100a P 50b P 20c

What would happen if sales increase by 40%?

Operating Leverage
Solution: Automated System *Unit Selling Price = Total Annual Sales No. of Units Sold = P 1,000,000 10,000 = P 100

Operating Leverage
Solution: Automated System **Unit Variable Cost = Variable Expenses No. of Units Sold = P 500,000 10,000 = P 50

Operating Leverage
Solution: Automated System ***Unit Contribution Margin = Contribution Margin No. of Units Sold = P 500,000 10,000 = P 50

Operating Leverage
Solution: Manual System
aUnit

Selling Price = Total Annual Sales No. of Units Sold = P 1,000,000 10,000 = P 100

Operating Leverage
Solution: Manual System
bUnit

Variable Cost = Variable Expenses No. of Units Sold = P 800,000 10,000 = P 80

Operating Leverage
Solution: Automated System
cUnit

Contribution Margin = Contribution Margin No. of Units Sold = P 200,000 10,000 = P 20

Operating Leverage
Solution: Automated System Degree of Operating Leverage = Contribution Margin Operating Income = P 500,000 P 125,000 =4x

Operating Leverage
Solution: Manual System Degree of Operating Leverage = Contribution Margin Operating Income = P 200,000 P 100,000 =2x

Operating Leverage

Solution: After 40% increase in sales

Automated System Sales Less Variable Expenses Contribution Margin Less Fixed Expenses Operating Income Unit Selling Price Unit Variable Cost Unit Contribution Margin P 1,400,000 (P 700,000) P 700,000 (P 375,000) P 325,000 P 100 P 50 P 50 Manual System P 1,400,000 (P 1,120,000) P 280,000 (P 100,000) P 180,000 P 100 P 80 P 20

Operating Leverage
Solution: Automated System *Unit Selling Price = Total Annual Sales No. of Units Sold = P 1,400,000 14,000 = P 100

Operating Leverage
Solution: Automated System **Unit Variable Cost = Variable Expenses No. of Units Sold = P 700,000 14,000 = P 50

Operating Leverage
Solution: Automated System ***Unit Contribution Margin = Contribution Margin No. of Units Sold = P 700,000 14,000 = P 50

Operating Leverage
Solution: Manual System
aUnit

Selling Price = Total Annual Sales No. of Units Sold = P 1,400,000 14,000 = P 100

Operating Leverage
Solution: Manual System
bUnit

Variable Cost = Variable Expenses No. of Units Sold = P 1,120,000 14,000 = P 80

Operating Leverage
Solution: Automated System
cUnit

Contribution Margin = Contribution Margin No. of Units Sold = P 280,000 14,000 = P 20

Operating Leverage
Analysis: Automated System
Profits would increase from P 125,000 to P 325,000 or an increase of P 200,000 or a 160% increase.

Manual System
Profits would increase from P 100,000 to P 180,000 or an increase of only P 80,000 or an 80% increase.

Reason is the automated system has a higher degree of operating leverage.