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Break-Even Analysis Interview Questions and Answers
Question: Are Direct Costs Fixed And Indirect Costs Variable?
Direct product costs such as raw materials are variable costs. Variable product costs increase in total as more units of products are manufactured.
Costs that are direct to a department could be variable or fixed. For example, a supervisor in the painting department would be a direct cost to the painting department. Since the supervisor’s salary is likely to be the same amount each month regardless of the quantity of products manufactured, it is a fixed cost to the department. The supplies furnished to the painting department will be a direct cost to the department, but will be a variable cost to the department if the total amount of supplies used in the department increases as the volume or activity in the department increases.
An indirect product cost is the electricity used to operate a production machine. The cost of the electricity is variable because the total electricity used is greater when more products are manufactured on the machine. Depreciation on the production machine is also an indirect product cost, except it is usually a fixed cost. That is, the machine’s total depreciation expense is the same each year regardless of volume produced on the machine.
As you can see, costs can be direct and indirect depending on the cost object: product, department, and others such as division, customer, geographic market. The cost is fixed if the total amount of the cost does not change as volume changes. If the total cost does change in proportion to the change in the activity or volume, it is a variable cost.
Question: Are Insurance Premiums A Fixed Cost?
The cost of the insurance premiums for a company’s property insurance is likely to be a fixed cost. The cost of worker compensation insurance is likely to be a variable cost. Whether a cost is a fixed cost, a variable cost, or a mixed cost depends on the independent variable.
Let’s illustrate this by looking at the cost of property insurance. The cost of insuring the factory building is a fixed cost when the independent variable is the number of units produced within the factory. In other words, the factory’s property insurance might be $6,000 per year whether its output is 2 million units, 3 million units, or 5 million units. On the other hand, if the independent variable is the replacement cost of the factory buildings, the insurance cost will be a variable cost. The reason is the insurance cost on $12 million of factory buildings will be more than the insurance cost on $9 million of factory buildings, and less than the insurance premiums on $18 million of factory buildings.
In the case of worker compensation insurance, the cost will vary with the amount of payroll dollars (excluding overtime premium) in each class of workers. For example, if the worker comp premiums are $5 per $100 of factory labor cost, then the worker comp premiums will be variable with respect to the dollars of factory labor cost. If the units of output in the factory correlate with the direct labor costs, then the worker compensation cost will also be variable with respect to the number of units produced. On the other hand, the worker compensation cost for the office staff is usually a much smaller rate and that worker compensation cost will not be variable with respect to the number of units of output in the factory. However, the worker compensation cost of the office staff will be variable with respect to the amount of office staff salaries and wages.
As you have seen, determining which costs are fixed and which are variable can be a bit tricky.
Question: How Do We Deal With A Negative Contribution Margin Ratio When Calculating Our Break-even Point?
The negative contribution margin ratio indicates that your variable costs and expenses exceed your sales. In other words, if you increase your sales in the same proportion as the past, you will experience larger losses.
My recommendation is to calculate the contribution margin and contribution margin ratio for each product (or service) that you offer. I suspect that some of your items have positive contribution margins, but the products with negative contribution margins are greater. You must get into the details.
You also need to look at each of your customers. Perhaps some customers are buying in huge quantities, but those sales are not profitable. See which customers have positive contribution margins.
By definition, the ways to eliminate the negative contribution margin are to 1) raise selling prices, 2) reduce variable costs, or 3) do some combination of the first two. If customers will not accept price increases in order for you to cover your variable costs, you are probably better off not having the sales. Remember that after covering the variable costs, those selling prices must then cover the fixed costs and expenses. A total negative contribution margin means your loss will be larger than the amount of the fixed costs and expenses.
When setting prices or bidding for new work, you must think of the bottom line—profits. Many people focus too much on the top line—sales.
Question: How Do You Calculate The Break-even Point In Terms Of Sales?
The break-even point in sales dollars can be calculated by dividing a company’s fixed expenses by the company’s contribution margin ratio.
The contribution margin is sales minus variable expenses. When the contribution margin is expressed as a percentage of sales it is referred to as the contribution margin ratio. (When we use the term “fixed expenses” we mean the company’s total amount of fixed costs plus its fixed expenses. When we say “variable expenses” we mean the total of the company’s variable costs plus its variable expenses.)
Let’s illustrate the break-even point in sales dollars with the following information. A company has fixed expenses of $100,000 per year. Its variable expenses are approximately 80% of sales. This means that the contribution margin ratio is 20%. (Sales minus the variable expenses of 80% of sales leaves a remainder of 20% of sales. In other words, after deducting the variable expenses there remains only 20% of every sales dollar to go towards the fixed expenses and profits. ) The fixed expenses of $100,000 divided by the contribution margin ratio of 20% equals $500,000. This tells you that if the company has sales of approximately $500,000 it will be at the break-even point—the point where sales will be equal to all of the company’s expenses.
It is wise to test your calculated break-even point. In our example the sales needed to be $500,000. If the variable expenses are 80% of sales, the variable expenses will be $400,000 (80% of $500,000). This leaves $100,000 as the contribution margin in dollars. After subtracting the fixed expenses of $100,000, the net income will be zero.
Question: How Do You Determine The Fixed Portion Of Overhead Cost?
I suggest that the first step in determining the fixed portion of a mixed cost (a cost that is partially fixed and partially variable) is to graph the data. Label the vertical or y-axis of the graph as Total Manufacturing Overhead (or Total Electricity Cost if you are analyzing the individual components of overhead). Label the horizontal or x-axis of the graph as total machine hours (or some other indicator of volume). Then put a point on the graph for each of the past 12 months. If January had $100,000 of overhead and 6,000 MHs, enter a point on the graph where those two amounts intersect. After plotting all 12 months, you might see a pattern and/or you might see something unusual. Investigate the unusual before proceeding.
Perhaps there was an accounting error or a very unusual situation that is not likely to recur. Once you are confident that the data is reasonable you can proceed. (Please note that the overhead costs need to be on an accrual basis. In other words, you need to have the costs that occurred when the machine hours occurred. Your data will be misleading if you relate this month’s machine hours to the electricity bill that was paid this month, if that bill is for the previous month’s electricity usage. Check the meter reading dates on the bill to be sure the dates of the electricity usage agree with the dates of the machine hours.)
Once you eliminated any “outliers” from the graph (or scattergraph) and you are confident that the dollar amounts are related to the activity on the x-axis, you can proceed. One technique is the High-Low method. This method uses only two of the points or months on your graph: the point where the MHs were the highest and the point where the MHs were the lowest…so long as those two points are not outliers. Let’s assume that the highest number of MHs occurred in September. At that point the MHs were 10,000 and the total overhead cost was $140,000.
Let’s assume that the lowest activity occurred in January when the MHs were 6,000 and the total overhead cost was $100,000. If the range of these MHs (6,000 to 10,000) are not outside the range of normal activity, we know by definition that the fixed manufacturing costs will not change in this range as the MHs change. That means that any change in the total manufacturing costs in this range must be the change in the variable costs. Here’s the formula: Variable Cost Rate = Change in total costs divided by the change in the MHs. In our example, Variable Cost Rate = $40,000 ($140,000 minus $100,000) divided by 4,000 MHs (10,000 MHs minus 6,000 MHs) equals $10 per MH. The total variable costs at the lowest activity = 6,000 MH times $10 variable rate = $60,000. Since the total overhead costs were $100,000 the fixed costs must have been $40,000. At the highest level of activity, the total variable costs = 10,000 MHs X $10 = $100,000. Since the total costs at this level were $140,000 the fixed costs must be $40,000. So we estimate (based on just two points) that the manufacturing overhead is $40,000 per month + $10 per MH.
A more sophisticated method for separating the fixed costs from the mixed costs would be to use all of the points (rather than only the highest and lowest). The technique to accomplish this is regression analysis. The use of regression analysis not only gives you the best equation for all the points, it also generates statistics on how much of the change in manufacturing overhead is caused by the MHs. Undoubtedly you will find that MHs are causing only part of the change in the overhead costs. This feedback is important if it prompts you to identify the other variables that are causing the manufacturing overhead costs to change.
In summary, the High-Low method is an overly simplistic tool. Be careful and spend time understanding the relationships between activities and costs. Manufacturing processes and costs are probably driven by many activities (not just MHs) and not all products may require the same activities.
Question: How Do You Reduce A Company’s Break-even Point?
The formula for a product’s break-even point expressed in units is: Total Fixed Costs divided by Contribution Margin per Unit. The contribution margin per unit is the product’s selling price minus its variable costs and expenses. Fixed costs and fixed expenses are those which do not change as volume changes. Variable costs and expenses increase as volume increases and they will decrease when volume decreases.
To reduce a company’s break-even point you could reduce the amount of fixed costs. When an automobile manufacturer cuts thousands of salaried positions and closes assembly plants that are not fully utilized, the company is reducing its fixed costs by hundreds of millions of dollars each year. Having fewer fixed costs means fewer car sales will be required to cover them.
You can also reduce the break-even point by increasing the contribution margin per unit. The contribution margin will increase if there is a reduction in variable costs and expenses per unit. For example, if a car company can obtain components at a reduced cost, the variable costs decrease. The reduced variable costs means that the contribution margin increased.
The contribution margin will also increase if the company is able to increase its selling prices. (Of course the company must be careful that the increased selling price does not cause fewer unit sales.)
Perhaps a combination of reduced fixed costs, reduced variable costs, and slight increases in prices is possible. Some products might be redesigned to provide unique features that customers will pay for and the additional revenue is greater than the variable costs required to add those features.
Reality is more complicated than a simple formula because companies have more than one product, competition may not allow for increasing selling prices, contracts may not allow certain actions, etc.
Question: How Do You Reduce The Break-even Point?
Ways to reduce a company’s break-even point include 1) reducing the amount of fixed costs, 2) reducing the variable costs per unit—thereby increasing the unit’s contribution margin, 3) improving the sales mix by selling a greater proportion of the products having larger contribution margins, and 4) increasing selling prices so long as the number of units sold will not decline significantly.
Question: How Much Of The Contribution Margin Is Profit On Units Sold In Excess Of The Break-even Point?
After the break-even point is reached, the entire contribution margin on the next units sold will be profit…provided the total fixed costs and expenses do not increase.
The reason lies in the definition of contribution margin: selling price minus the variable costs and expenses. Once the contribution margins have covered the total amount of fixed costs and expenses, the entire contribution margin on the next units will go to profit.
Question: Is Contribution Margin The Same As Operating Income?
Contribution margin is different from operating income.
Contribution margin is revenues minus the variable costs and expenses. For example, a retailer’s contribution margin is sales minus the cost of goods sold and the variable selling expenses and the variable administrative expenses and any variable nonoperating expenses. (Perhaps some interest expense varies with sales.)
A retailer’s operating income is sales minus the cost of goods sold and all selling and administrative expenses (fixed and variable). Operating income is the net income before the nonoperating items such as interest revenue, interest expense, gain or loss on the sale of plant assets, etc.
Question: Is The Cost Of Land, Buildings, And Machinery A Fixed Cost?
Some people refer to land, buildings, and machinery as fixed assets. They are also referred to as plant assets, or as property, plant, and equipment.
The depreciation expense on the buildings and machinery is often viewed as a fixed cost or fixed expense. Hence, in the calculation of the break-even point, the annual depreciation expense on the fixed assets other than land is part of the fixed costs or fixed expenses. There is no depreciation of land.
Question: What Are Mixed Costs?
The term mixed costs often refers to the behavior of costs and expenses. Mixed costs consist of a fixed component and a variable component. The annual expense of operating an automobile is a mixed cost. Some of the expenses are fixed, because they do not change in total as the number of annual miles change. Think insurance, parking fees, and some depreciation. Other expenses are variable, because they will increase for the year when the miles driven increase (and will decrease when the miles driven decrease). Think gas, oil, tires, and some depreciation.
The algebraic formula for a mixed cost is y = a + bx, where y is the total cost, a is the fixed cost per period, b is the variable rate per unit of activity, and x is the number of units of activity. For the annual expense of operating an automobile, the fixed cost, a, might be $5,000 per year; the variable rate, b, could be $0.20; and the number of units of activity, x, might be 15,000 miles per year. With these hypothetical assumptions, the annual expense, y, would be $8,000. If x were 10,000 miles, the annual expense y would be $7,000.
To gain insight on the behavior of a mixed cost, it is helpful to graph the cost: For each observation, indicate a point on the graph where the total mixed cost amount aligns with the amounts on y-axis and also aligns with the activity amounts on the x-axis. To compute the best fitting line through the graphed data, you could use a mathematical tool known as regression analysis. This will calculate the fixed expenses, a, and the variable rate, b, based on the historical data that is utilized.
Question: What Are Semivariable Costs?
Semivariable costs are costs or expenses whose behavior is partially fixed and partially variable. Semivariable costs are also referred to as mixed costs.
A common example of a semivariable cost is the annual cost of operating a vehicle. Some of the vehicle’s operating costs will vary with the number of miles driven while other costs will be the same in total regardless of the miles driven. For example, the vehicle’s fuel costs will be variable. However, the depreciation, insurance and licensing may be fixed. Looking only at the vehicle’s maintenance costs may indicate that some maintenance is done each November (regardless of the number of miles driven) while other maintenance is done every 6,000 miles.
A manufacturer’s electricity cost is another example of a semivariable cost. Part of the monthly electricity bill will include 1) a fixed amount, and 2) a separate amount based on the number of kilowatt hours of electricity actually used by the company.
The manufacturer’s electricity cost is also a semivariable cost in relationship with the company’s machine hours. The portion of the electricity cost used to operate the production equipment is variable, but the portion of the electricity cost used for lighting and air conditioning the manufacturing facility is a fixed cost.
These simple examples illustrate that it can be difficult to understand how costs behave. There are many factors, activities, and drivers that influence the level of costs.
Question: What Are The Methods For Separating Mixed Costs Into Fixed And Variable?
I know of three methods for separating mixed costs into their fixed and variable cost components:
- Prepare a scattergraph by plotting points onto a graph.
- High-low method.
- Regression analysis.
It is wise to prepare the scattergraph even if you use the high-low method or regression analysis. The benefit of the scattergraph is that it allows you to see if some of the plotted points are simply out of line. These points are referred to as outliers and will need to be reviewed and possibly adjusted or eliminated. In other words, you don’t want incorrect data to distort your calculations under any of the three methods.
Let’s assume that a company uses only one type of equipment and it wants to know how much of the monthly electricity bill is a constant amount and how much the electricity bill will increase when its equipment runs for an additional hour. The scattergraph’s vertical or y-axis will indicate the dollars of total monthly electricity cost. Its horizontal or x-axis will indicate the number of equipment hours. For each monthly electricity bill, a point will be entered on the graph at the intersection of the dollar amount of the total electricity bill and the equipment hours occurring between the meter reading dates shown on the electricity bill. If you plot this information for the most recent 12 months, you may see some type of pattern, such as a line that rises as the number of equipment hours increase.
If you draw a line through the plotted points and extend the line through the y-axis, the amount where the line crosses the y-axis is the approximate amount of fixed costs for each month. The slope of the line indicates the variable cost per equipment hour. The slope or variable rate is the increase in the total monthly electricity cost divided by the change in the total number of equipment hours.
The high-low calculation is similar but it uses only two of the plotted points: the highest point and the lowest point.
Regression analysis uses all of the monthly electricity bill amounts along with their related number of equipment hours in order to calculate the monthly fixed cost of electricity and the variable rate for each equipment hour. Software can be used for regression analysis and it will also provide statistical insights.
If a scattergraph of data shows no clear pattern, you should not place much confidence in the calculated amount of the fixed cost and variable rate regardless of the method used.
Question: What Causes An Increase In Break-even Point?
There are several reasons why a company’s break-even point will increase. One reason is an increase in the company’s fixed costs, such as rent, depreciation, salaries of managers and executives, etc.
A second reason for an increase in a company’s break-even point is a reduction in the contribution margin. Contribution margin is sales minus the variable costs and variable expenses. An increase in the variable costs and expenses without a corresponding increase in selling prices will cause the contribution margin to shrink. With less contribution margin, it will take more sales in order to cover the fixed costs and fixed expenses. Of course, a decrease in selling price will also increase the break-even point.
Another reason for a change in the break-even point is a change in the mix of products or services delivered. In other words, some products have higher contribution margins, and some products have lower contribution margins. If a company continues to sell the same total number of units of product, but a greater proportion of the units sold have a lower contribution margin, the company’s break-even point will increase.
Question: What Does Stepped Cost Mean?
Stepped cost refers to the behavior of the total cost of an activity at various levels of the activity. When a stepped cost is plotted on a graph (with the total cost represented by the y-axis and the quantity of the activity represented by the x-axis) the lines will appear as steps or stairs rising from left to right.
To illustrate a stepped cost, let’s assume that you are developing a website and find that the monthly cost of hosting the site is based on the number of visits. For 0 to 999 visits per month, the cost is $20 per month. When the visits are in the range of 1,000 to 2,999 the monthly cost jumps to $50. If the visits are 3,000 to 9,999 the cost will be $200 per month. For monthly visits of 10,000 to 24,999 the cost is $300, and so on. As the data indicates, the total monthly cost is constant or fixed only for a given range of activity (number of visits). When the number of visits exceeds the upper limit of a range, the monthly cost jumps to a higher level and remains fixed until the visits exceed the new upper limit.
A stepped cost is also referred to as a step cost, a step-variable cost, or a step-fixed cost. The difference between a step-variable cost and a step-fixed cost has to do with the width of the range of activity. If the total cost increases with small increases in activity, it may be referred to as a step-variable cost. If the total cost will change only with large increases in the quantity of activity, the term step-fixed cost is more likely to be used.
Knowing how costs behave is important for decision making. For example, a manufacturer will want to know how its costs will increase if a new product line is added (or how costs could decrease if an existing product line is eliminated).
Question: What Happens When The High-low Method Ends Up With A Negative Amount?
The high-low method of determining the fixed and variable portions of a mixed cost relies on only two sets of data: 1) the costs at the highest level of activity, and 2) the costs at the lowest level of activity. If either set of data is flawed, the calculation can result in an unreasonable, negative amount of fixed cost.
To illustrate the problem, let’s assume that the total cost is $1,200 when there are 100 units of product manufactured, and $6,000 when there are 400 units of product are manufactured. The high-low method computes the variable cost rate by dividing the change in the total costs by the change in the number of units of manufactured. In other words, the $4,800 change in total costs is divided by the change in units of 300 to yield the variable cost rate of $16 per unit of product. Since the fixed costs are the total costs minus the variable costs, the fixed costs will be calculated to a negative $400. This unacceptable answer results from total costs of $1,200 at the low point minus the variable costs of $1,600 (100 units times $16), or total costs of $6,000 at the high point minus the variable costs of $6,400 (400 units times $16).
The negative amount of fixed costs is not realistic and leads me to believe that either the total costs at either the high point or at the low point are not representative. This brings to light the importance of plotting or graphing all of the points of activity and their related costs before using the high-low method. (The number of units uses the scale on the x-axis and the related total cost at each level of activity uses the scale on the y-axis.) It is possible that at the highest point of activity the costs were out of line from the normal relationship—referred to as an outlier. You may decide to use the second highest level of activity, if the related costs are more representative.
If the $6,000 of cost at the 400 units of activity is an outlier, you might select the next highest activity of 380 units having total costs of $4,000. Now the variable rate will be the change in total costs of $2,800 ($4,000 minus $1,200) divided by the change in the units manufactured of 280 (380 minus 100) for a variable rate of $10 per unit of product. Using the variable rate of $10 per unit manufactured will result in the fixed costs being a positive $200. The positive $200 of fixed costs is calculated at either 1) the low activity: total costs of $1,200 minus the variable costs of $1,000 (100 units at $10); or at 2) the high activity: total costs of $4,000 minus the variable costs of $3,800 (380 units at $10).
Question: What Increases A Break-even Point?
The break-even point will increase when the amount of fixed costs and expenses increases. The break-even point will also increase when the variable expenses increase without a corresponding increase in the selling prices.
A company with many products can see its break-even point increase when the mix of products changes. In other words, if a greater proportion of lower contribution margin products are sold, the break-even point will increase. (Contribution margin is selling price minus variable expenses.)
Question: What Is A Fixed Cost?
A fixed cost is one that does not change in total within a reasonable range of activity. For example, the rent for a production facility is a fixed cost if the rent will not change when there are reasonable changes in the amount of output or input. (Of course, if there is a need to double the output the rent will change when the company occupies additional work space.)
While a fixed cost remains constant in total, the fixed cost per unit of output or input will change inversely with the change in the quantity of output or input. For instance, if the rent of the production facility is fixed at $120,000 per year and there are 30,000 machine hours of good output during the year, the rent will be $4 ($120,000/30,000) per machine hour. If there are 40,000 machine hours during the year, the rent will be $3 ($120,000/40,000) per machine hour.
Many manufacturing overhead costs are fixed and the amounts occur in large increments. Some examples include depreciation on a company-owned factory, depreciation on machinery and equipment, salaries and benefits of manufacturing supervisors, factory administration costs, etc. One challenge for accountants is the allocation or assigning of the large fixed costs to the individual units of product (which likely vary in size and complexity). This allocation (or assigning or absorbing) is required by the accounting and income tax rules for valuing inventories and the cost of goods sold. If the fixed overhead is assigned using machine hours, one must keep in mind that the cost rate per machine hour is not how the fixed costs behave or occur. In our example, the cost of the rent might be assigned to the products at the rate of $3 or $4 per machine hour but the rent actually occurs at the rate of $10,000 per month.
Question: What Is A Fixed Expense?
A fixed expense is an expense that will be the same total amount regardless of changes in the amount of sales, production, or some other activity. For example, a retailer’s monthly rent expense of $2,000 is a fixed expense because it will be a total of $2,000 whether the monthly sales are $15,000 or $30,000. We usually qualify the definition of a fixed expense by adding: within a relevant or reasonable range of activity. In other words, if the retailer needs to have monthly sales of $80,000 it is likely that the retailer will need to rent additional space, thereby increasing rent expense to be more than $2,000 per month.
The following are some examples of expenses that are likely to be fixed within a reasonable range of sales:
- the compensation of the store manager who receives the same salary and fringe benefits every month
- the depreciation expense for a store’s buildings, fixtures, and equipment
- the constant monthly amounts for security, maintenance fees, phones, internet service, insurance, lighting, advertising, etc.
Knowing the amount of a company’s fixed expenses assists in understanding how its net income will change as volume changes. The total amount of fixed expenses can also be used to quickly estimate a company’s break-even point.
Question: What Is A Learning Curve?
A common learning curve shows that the cumulative average time to complete a manual task which involves learning will decrease 20% whenever volume doubles. This is referred to as an 80% learning curve.
Let’s illustrate the 80% learning curve with a person learning to design and code websites of similar size and complexity. If the first website takes 100 hours, then after the second website the cumulative average time will be 80 hours (80% of 100 hours). The cumulative average of 80 hours consists of 100 hours for the first website plus only 60 hours for the second website resulting in a total of 160 hours divided by 2 websites. After the fourth website the cumulative average time will be 64 hours (80% of 80 hours). After the eighth website the cumulative average will be 51.2 hours (80% of 64 hours). In other words, the total time to have completed all eight websites will be 409.6 hours (8 websites times an average time of 51.2 hours).
Improvements in technology can mean time and cost reductions beyond those in the learning curve. For example, software may become available to assist in the design and coding, computer processing speeds might increase, there may be lower costs of processing and storage, etc.
The learning curve is important for setting standards, estimating costs, and establishing selling prices.
Question: What Is A Variable Cost?
A variable cost is a constant amount per unit produced or used. Therefore, the total amount of the variable cost will change proportionately with volume or activity. Generally, a product’s direct materials are a variable cost.
To illustrate, let’s assume that a bakery uses one pound of flour at a cost of $0.70 per pound for every loaf of bread it produces. If no bread is produced the total cost of flour is $0. If one loaf is produced the total cost of flour is $0.70. When 10 loaves are produced the total cost of flour is $7.00. At the volume of 30 loaves the cost of flour is $21 (30 loaves X 1 pound X $0.70 per pound).
An expense can also be a variable cost. For instance, if a company pays a 5% sales commission on every sale, the company’s sales commission expense will be a variable cost. When the company has no sales the total sales commission expense is $0. When sales are $100,000 the sales commission expense will be $5,000. Sales of $200,000 will mean total sales commission expense of $10,000. Sales of $400,000 will result in total sales commission expense of $20,000.
Question: What Is A Variable Expense?
An expense is a variable expense when its total amount changes in proportion to the change in sales, production, or some other activity.
To illustrate a variable expense, let’s assume that a website business sells a product and requires that the customer use a credit card. The credit card processor charges the business a fee of 3% of the amount charged. Therefore, in a month when sales are $10,000 the business will have a credit card expense of $300. If sales are $30,000 there will be a credit card expense of $900. The total credit card expense varies with sales because the fee has a fixed rate of 3% of sales.
Another example of a variable expense is a retailer’s cost of goods sold. For instance, if a company purchases a product for $30 and then sells it for $50, its cost of goods sold will be a constant rate of 60%. Hence when its sales are $10,000 the cost of goods will be $6,000. When the sales are $30,000 the cost of goods sold will be $18,000.
Knowing how costs behave when sales or other activities change will allow you to better understand how a company’s net income will change. It also allows you to quickly calculate a product’s contribution margin and to estimate the company’s break-even point.
Question: What Is Contribution Margin?
In accounting contribution margin is defined as revenues minus variable expenses. In other words, the contribution margin reveals how much of a company’s revenues will be contributing (after covering the variable expenses) to the company’s fixed expenses and net income. The contribution margin can be presented as
- the total amount for the company,
- the amount for each product line,
- the amount for a single unit of product, and
- as a ratio or percentage of net sales.
The contribution margin of a manufacturer is the amount of net sales that is in excess of the variable manufacturing costs and the variable SG&A expenses. To illustrate, let’s assume that a manufacturer has a single product and 80,000 units were produced and sold during a recent year.
The selling price was $10 per unit, variable manufacturing costs were $3 per unit, and variable SG&A expenses were $1 per unit. The company’s fixed manufacturing costs were $300,000 and its fixed SG&A expenses were $90,000. The company’s contribution margin was $480,000 ($800,000 – $240,000 – $80,000). The contribution margin per unit was $6 ($10 – $3 – $1). The contribution margin ratio was 60% ($6/$10 or $480,000/$800,000).
Question: What Is Cost Accounting?
Cost accounting involves the techniques for:
- determining the costs of products, processes, projects, etc. in order to report the correct amounts on the financial statements, and
- assisting management in making decisions and in the planning and control of an organization.
For example, cost accounting is used to compute the unit cost of a manufacturer’s products in order to report the cost of inventory on its balance sheet and the cost of goods sold on its income statement. This is achieved with techniques such as the allocation of manufacturing overhead costs and through the use of process costing, operations costing, and job-order costing systems.
Cost accounting assists management by providing analysis of cost behavior, cost-volume-profit relationships, operational and capital budgeting, standard costing, variance analyses for costs and revenues, transfer pricing, activity-based costing, and more.
Cost accounting had its roots in manufacturing businesses, but today it extends to service businesses. For example, a bank will use cost accounting to determine the cost of processing a customer’s check and/or a deposit. This in turn may provide management with guidance in the pricing of these services.
Question: What Is Cost Behavior?
Cost behavior is associated with learning how costs change when there is a change in an organization’s level of activity. The costs which vary proportionately with the changes in the level of activity are referred to as variable costs. The costs that are unaffected by changes in the level of activity are classified as fixed costs.
Cost behavior is not required for external reporting under U.S. GAAP. However, the understanding of cost behavior is very important for management’s efforts to plan and control its organization’s costs. Budgets and variance reports are more effective when they reflect cost behavior patterns.
The understanding of cost behavior is also necessary for calculating a company’s break-even point and for any other cost-volume-profit analysis.
Question: What Is Elastic Demand?
Elastic demand means that demand for a product is sensitive to price changes. For example, if the selling price of a product is increased, there will be fewer units sold. If the selling price of a product decreases, there will be an increase in the number of units sold. Elastic demand is also referred to as the price elasticity of demand.
The term inelastic demand means that the demand for a product is not sensitive to price changes.
Elastic demand is a major concern for a manufacturer that attempts to set product prices based on costs. For instance, if the manufacturer’s production and sales have declined and it fails to cut fixed costs, the manufacturer could be worse off by increasing selling prices.
Use the search box on AccountingCoach.com for our Q&A on death spiral which is pertinent to elastic demand.
Question: What Is Marginal Cost?
Marginal cost is the cost of the next unit or one additional unit of volume or output.
To illustrate marginal cost let’s assume that the total cost of producing 10,000 units is $50,000. If you produce a total of 10,001 units the total cost is $50,002. That would mean the marginal cost—the cost of producing the next unit—was $2.
The reason that the marginal cost was $2 instead of the previous average cost of $5 ($50,000 divided by 10,000 units) is that some costs did not increase when the additional unit was produced. For example, fixed costs such as salaries, depreciation, property taxes generally do not increase when one additional unit is produced.
Question: What Is Sales Mix?
Sales mix is the relative proportion or ratio of a business’s products that are sold. Sales mix is important because a company’s products are likely to vary in their profitability.
To illustrate sales mix, let’s assume that an automobile company plans to sell 100,000 units in the current year. The planned sales mix is 20,000 units of the low-profit models + 50,000 units of the medium-profit models + 30,000 units of the high-profit models. In other words, the planned sales mix is 20%, 50%, 30%.
Next, lets assume that the total units actually sold amounted to 95,000 units (which is 5,000 fewer units than planned). This could be a problem for the company attaining its planned earnings. However, it depends on the actual sales mix. What if the actual sales mix is 15%, 45%, 40%? This actual sales mix shows a smaller proportion of low-profit and medium-profit units being sold and a larger proportion of high-profit units being sold. In other words, this improved sales mix could mean greater earnings even though 5,000 fewer units were sold.
Sales mix also applies to service businesses since the services provided are likely to vary in their profitability.
Question: What Is Simple Linear Regression Analysis?
Simple linear regression analysis is a statistical tool for quantifying the relationship between just one independent variable (hence “simple”) and one dependent variable based on past experience (observations). For example, simple linear regression analysis can be used to express how a company’s electricity cost (the dependent variable) changes as the company’s production machine hours (the independent variable) change.
Fortunately there is software to compute the best fitting straight line (hence “linear”) that expresses the past relationship between the dependent and independent variable. Continuing our example, you will enter 1) the amount of the past monthly electricity bills, and 2) the number of machine hours occurring during the period of each of the bills. Next, the software will likely use the least squares method to produce the formula for the best fitting line. The line will appear in the form y = a + bx. In addition, the software will provide statistics regarding the correlation, confidence, dispersion around the line, and more.
(In all likelihood there are many independent variables causing a change in the amount of the dependent variable. Therefore, you should not expect that only one independent variable will explain a high percentage of the change in the dependent variable. To increase the percentage, you should think of the many independent variables that could cause a change in the dependent variable. Next you should test the effect of the combination of these independent variables or drivers by using multiple regression analysis software.)
Prior to using simple linear regression analysis it is important to follow these preliminary steps:
- seek an independent variable that is likely to cause or drive the change in the dependent variable
- make certain that the past amounts for the independent variable occur in the exact same period as the amount of the dependent variable
- plot the past observations on a graph using the y-axis for the cost (monthly electricity bill) and the x-axis for the activity (machine hours used during the exact period of the electricity bill)
- review the plotted observations for a linear pattern and for any outliers
- keep in mind that there can be correlation without cause and effect
Question: What Is The Break-even Point?
In accounting, the break-even point refers to the revenues needed to cover a company’s total amount of fixed and variable expenses during a specified period of time. The revenues could be stated in dollars (or other currencies), in units, hours of services provided, etc.
The break-even calculations are based on the assumption that the change in a company’s expenses is related to the change in revenues. This assumption may not hold true for the following reasons:
- A company is likely to have many diverse products with varying degrees of profitability.
- A company may have many diverse customers with varying demands for special attention. Hence some expenses will increase for reasons other than the sale of additional units of product.
- A company may be selling in a variety of markets. This could result in the selling prices in one market or country being lower than the selling prices in another market or country.
- The company may see frequent fluctuations in its sales mix.
The basic calculation of the break-even point in sales dollars for a year is: fixed expenses (fixed manufacturing, fixed SG&A, fixed interest) for the year divided by the contribution margin ratio or percentage.
The basic calculation of the break-even point in units sold for a year is: fixed expenses for the year divided by the contribution margin per unit of product.
If we assume that a company’s fixed expenses are $480,000 for a year, the variable expenses (variable manufacturing, variable SG&A, variable interest) average $8 per unit of product, and the selling prices average $20 per unit (resulting in a contribution margin of $12 or 60% of the selling price)…
- the break-even point in sales dollars is $800,000 [$480,000 divided by 60%]
- the break-even point in units of product is 40,000 [$480,000 divided by $12 per unit]
Question: What Is The Coefficient Of Correlation?
In simple linear regression analysis, the coefficient of correlation (or correlation coefficient) is a statistic which indicates the relationship between the independent variable and the dependent variable. The coefficient of correlation is represented by r and it has a range of -1.00 to +1.00.
When the coefficient of correlation is a positive amount, such as +0.80, it means an increase in the independent variable will result in an increase in the dependent variable. (Also, a decrease in the independent variable will mean a decrease in the dependent variable.) When the coefficient of correlation is negative, such as -0.80, there is an inverse relationship. (An increase in the independent variable will mean a decrease in the dependent variable. A decrease in the independent variable will mean an increase in the dependent variable.)
A coefficient of correlation of +0.8 or -0.8 indicates a strong correlation between the independent variable and the dependent variable. An r of +0.20 or -0.20 indicates a weak correlation between the variables. When the coefficient of correlation is 0.00 there is no correlation.
When the coefficient of correlation is squared, it becomes the coefficient of determination. This means that an r of +0.80 or -0.80 will result in a coefficient of determination of 0.64 or 64%. (This tells you that 64% of the change in the total of the dependent variable is associated with the change in the independent variable.) An r of +0.20 or -0.20 indicates that only 4% (0.20 x 0.20) of the change in the dependent variable is explained by the change in the independent variable.
It is important to realize that correlation does not guarantee that a cause-and-effect relationship exists between the independent variable and the dependent variable. However, a cause-and-effect relationship will mean there is correlation. It is also important to plot the data/observations used in the regression analysis in order to detect and review any outlier.
Question: What Is The Contribution Margin Ratio?
The contribution margin ratio is the percentage of sales, service revenues or selling price that remains after all variable costs and variable expenses have been covered. In other words, the contribution margin ratio is the percentage of revenues that is available to cover a company’s fixed costs, fixed expenses, and profit. (The contribution margin ratio is different from the gross margin ratio or gross profit percentage and cannot be computed directly from the reported amounts on the company’s external income statement.)
To illustrate the contribution margin ratio, we will assume that a company manufactures and sells a single product and has the following facts:
- selling price per unit of $20
- fixed manufacturing costs per month of $18,000
- variable manufacturing costs per unit of $4
- fixed SG&A expenses per month of $12,000
- variable SG&A expenses per unit of $2
- fixed interest expense per month of $1,000
In this example the contribution margin per unit is $14 (the selling price of $20 minus the variable manufacturing costs of $4 and variable SG&A expenses of $2). Hence, the contribution margin ratio is 70% (the contribution margin per unit of $14 divided by the selling price of $20). This contribution margin ratio tells us that 70% of the sales, revenues, or selling price is available to cover the $31,000 of monthly fixed costs and fixed expenses. Once the $31,000 has been covered, 70% of the revenues will flow to the company’s net income.
Question: What Is The Difference Between A Differential Cost And An Incremental Cost?
I use the terms differential cost and incremental cost interchangeably. In other words, I believe the terms mean the same thing: the difference in cost between two alternatives. For example, if a company determined that the annual cost of operating at 80,000 machine hours was $4,000,000 while the annual cost of operating at 70,000 machine hours was $3,800,000, then the differential cost or incremental cost of the additional 10,000 machine hours was $200,000.
Question: What Is The Difference Between Break-even Point And Payback Period?
Break-even point is the volume of sales or services that will result in no net income or net loss on a company’s income statement. In other words, the break-even point focuses on the revenues needed to equal exactly all of the expenses on a single income statement prepared under the accrual method of accounting.
The break-even point in dollars of revenues can be calculated by dividing a company’s total fixed expenses by its contribution margin ratio. The break-even calculation assumes that the selling prices, contribution margin ratio, and fixed expenses will not change.
Payback period is the number of years needed for a company to receive net cash inflows that aggregate to the amount of an initial cash investment. Hence the payback period focuses on the pertinent cash flows of multiple accounting years instead of the net income of a single accounting period. The payback period is often computed when evaluating potential capital expenditures. However, the payback period is considered to be flawed because it ignores 1) the cash flows occurring after the payback period, and 2) the time value of money.
Question: What Is The Difference Between Expense And Loss?
An expense is a cost used up in earning revenues in a company’s main operations. Some examples of expenses include advertising expense, commission expense, rent expense, cost of goods sold, salaries expense, and so on. Expenses also include costs used up during the accounting period such as interest expense, insurance expense, and depreciation expense.
A loss is associated with a “peripheral” or “incidental” transaction. Examples of losses include the loss on the sale of an asset used in the business, loss from a lawsuit settlement, and loss from retirement of bonds. However, there are some losses that are closer to operations, such as the loss on write-down of inventory from cost to market.
Question: What Is The Difference Between Gross Margin And Contribution Margin?
Gross Margin is the Gross Profit as a percentage of Net Sales. The calculation of the Gross Profit is: Sales minus Cost of Goods Sold. The Cost of Goods Sold consists of the fixed and variable product costs, but it excludes all of the selling and administrative expenses.
Contribution Margin is Net Sales minus the variable product costs and the variable period expenses. The Contribution Margin Ratio is the Contribution Margin as a percentage of Net Sales.
Let’s illustrate the difference between gross margin and contribution margin with the following information: company had Net Sales of $600,000 during the past year. Its inventory of goods was the same quantity at the beginning and at the end of year. Its Cost of Goods Sold consisted of $120,000 of variable costs and $200,000 of fixed costs. Its selling and administrative expenses were $40,000 of variable and $150,000 of fixed expenses.
The company’s Gross Margin is: Net Sales of $600,000 minus its Cost of Goods Sold of $320,000 ($120,000 + $200,000) for a Gross Profit of $280,000 ($600,000 – $320,000). The Gross Margin or Gross Profit Percentage is the Gross Profit of $280,000 divided by $600,000, or 46.7%.
The company’s Contribution Margin is: Net Sales of $600,000 minus the variable product costs of $120,000 and the variable expenses of $40,000 for a Contribution Margin of $440,000. The Contribution Margin Ratio is 73.3% ($440,000 divided by $600,000).
Question: What Is The High-low Method?
The high-low method is a simple technique for computing the variable cost rate and the total amount of fixed costs that are part of mixed costs. Mixed costs are costs that are partially variable and partially fixed. The cost of electricity used in a factory is likely to be a mixed cost since some of the electricity will vary with the number of machine hours, while some of the cost will not vary with machine hours. Perhaps this second part of the electricity cost is associated with circulating and chilling the air in the factory and from the public utility billing its large customers with a significant fixed monthly charge not directly tied to the kilowatt hours of electricity used.
The high-low method uses two sets of numbers: 1) the total dollars of the mixed costs occurring at the highest volume of activity, and 2) the total dollars of the mixed costs occurring at the lowest volume of activity. It is assumed that at both points of activity the total amount of fixed costs is the same. Therefore, the change in the total costs is assumed to be the variable cost rate times the change in the number of units of activity. Prior to using the high-low method, it is important to plot or graph all of the data available to be certain that the two sets of numbers being used are indeed representative.
To illustrate the high-low method, let’s assume that a company had total costs of electricity of $18,000 in the month when its highest activity was 120,000 machine hours. (Be sure to match the dates of the machine hours to the electric meter reading dates.) During the month of its lowest activity there were 100,000 machine hours and the total cost of electricity was $16,000. This means that the total monthly cost of electricity changed by $2,000 when the number of machine hours changed by 20,000. This indicates that the variable cost rate was $0.10 per machine hour.
Continuing with this example, if the total electricity cost was $18,000 when there were 120,000 machine hours, the variable portion is assumed to have been $12,000 (120,000 machine hours times $0.10). Since the total electricity cost was $18,000 and the variable cost was calculated to be $12,000, the fixed cost of electricity for the month must have been the $6,000. If we use the lowest level of activity, the total cost of $16,000 would include $10,000 of variable cost (100,000 machine hours times $0.10) with the remainder of $6,000 being the fixed cost for the month.
Question: What Is The Margin Of Safety?
Margin of safety is used in break-even analysis to indicate the amount of sales that are above the break-even point. In other words, the margin of safety indicates the amount by which a company’s sales could decrease before the company will become unprofitable.
Question: Why Does The Fixed Cost Per Unit Change?
Fixed costs such as rent or a supervisor’s salary will not change in total within a reasonable range of volume or activity. For example, the rent might be $2,500 per month and the supervisor’s salary might be $3,500 per month. This total fixed cost of $6,000 per month will be the same whether the volume is 3,000 units or 4,000 units.
On the other hand, the fixed cost per unit will change as the level of volume or activity changes. Using the amounts above, the fixed cost per unit is $2 when the volume is 3,000 units ($6,000 divided by 3,000 units). When the volume is 4,000 units, the fixed cost per unit is $1.50 ($6,000 divided by 4,000 units).
Question: Why Would The Cost Behavior Change Outside Of The Relevant Range Of Activity?
Cost behavior often changes outside of the relevant range of activity due to a change in the fixed costs. When volume increases to a certain point, more fixed costs will have to be added. When volume shrinks significantly, some fixed costs could be eliminated.
Here’s an illustration. A company manufactures products in its 100,000 square foot plant. The company’s depreciation on the plant is $1,000,000 per year. The capacity of the plant is 500,000 units of output and its normal output is 400,000 units per year. When the company is manufacturing between 300,000 and 500,000 units, it needs salaried managers earning $400,000 per year. Below 300,000 units of output, some of the salaried manager positions would be eliminated. Above 500,000 units, the company will need to add plant space and managers.
For this example, the relevant range is between 300,000 units and 500,000 units of output per year. In that range the total of the two fixed costs is $1,400,000 per year. Below 300,000 units, the fixed costs will drop to less than $1,400,000 because some salaries will be eliminated and some of the space might be rented. When the volume exceeds 500,000 units per year, the company will need to add fixed costs because of the additional space and the additional managers. Perhaps the total fixed costs will be $2,000,000 for output between 500,000 units and 700,000 units.