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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
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
P 540,000
10,000 units
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
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
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
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
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 = (Price per Unit x No. of Units) (Variable Cost per Unit No. of Units) Total Fixed Costs
Sales (50,000 units x P 400/unit) Less Variable Expenses Contribution Margin Less Fixed Expenses Operating Income
Contribution Margin per Unit = Total Contribution Units Sold = P 11,600,000 72,500 units = P 160 per unit
Contribution Margin per Unit = Price per unit Variable Cost per unit = P 400 P 240 = P 160 per unit
Operating Income = (Price per Unit x No. of Units) (Variable Cost per Unit No. of Units) Total Fixed Costs
Sales (76,500 units x P 400/unit) Less Variable Expenses Contribution Margin Less Fixed Expenses Operating Income
Operating Income = (Price per Unit x No. of Units) (Variable Cost per Unit No. of Units) Total Fixed Costs
Contribution Margin
Revenues
Variable Cost
Units
Contribution Margin
Revenues Total Variable Cost
Units
Profit
Contribution Margin
Revenues Total Variable Cost
Units
Loss
Contribution Margin
Revenues Total Variable Cost
Units
(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
Breakeven Volume =
Breakeven Volume =
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
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
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?
*Unit Contribution Margin = Unit Price - Variable Cost per Unit = P 400 per unit - P 240 per unit = P 160 per unit
P 400,000
(P 480,000) P 80,000
**Unit Contribution Margin = Lower Unit Price - Variable Cost per Unit = P 380 per unit - P 240 per unit = P 140 per unit
(P 400,000)
(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
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
Operating Leverage
Solution: Automated System
cUnit
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
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
Operating Leverage
Solution: Automated System
cUnit
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.