Monday, June 16, 2008

Break-even Point & Cost Estimation

Knowing how costs change as volume or activities change is helpful when making some business decisions. For example, if most of a product's costs are fixed, then a company's total costs will increase only slightly when more units are produced and sold. Understanding this cost behavior might lead to special promotions that will increase profits and sales.

Costs and expenses that do not increase with reasonable increases in volume are known as fixed costs. Examples of fixed costs are the salaries of managers, property tax and depreciation.

Costs and expenses that increase in total as volume increases are variable costs and expenses. A product's direct material, direct labor, and some overhead costs are variable costs. Two examples of variable overhead costs might be the electricity to power the equipment in the manufacturing process and factory supplies.

Some costs are mixed costs-partly fixed and partly variable. An example might be the maintenance costs. You can determine how much of a mixed cost is fixed and how much is variable by using several techniques. One technique is to plot the costs on a graph where the y-axis is the total cost and the x-axis is the amount of volume or activity. If the plotted points form a straight line, you can extend the line through the y-axis. The point where the line intersects the y-axis is the fixed cost. Another technique is the high-low method. With this method, you compare the total cost at the highest level of activity to the total cost at the lowest level of activity. The variable cost rate is the difference in total cost divided by the difference in the volume of activity. A more sophisticated technique for separating the fixed and variable costs in a mixed cost is regression analysis. This technique computes the best fitting line through the plotted points by utilizing the least-squares method.

Breakeven analysis utilizes the concept known as contribution margin. Contribution margin is sales dollars minus variable costs and variable expenses. If a product sells for $10 and its variable costs and variable expenses are $6, the contribution margin is $4 per unit. The formula for the breakeven point in units of product is the total fixed costs divided by the contribution margin per unit. For example, if the total fixed costs are $40,000 and the contribution margin per unit is $4, the breakeven point is 10,000 units ($40,000 divided by $4).

Sample Break-even Point & Cost Estimation Questions
1) When using one of the techniques for analyzing a mixed cost, it is important to prepare a scatter- ______ of all of the observations to be certain that the data does not contain an outlier.

2) The coefficient of _______________, represented by r2, indicates the percentage change in the dependent variable (e.g. total cost in the shipping department) that is explained by the change in the independent variable (e.g. the number of parcels shipped).

3) The breakeven point in sales dollars can be found by dividing the fixed costs and expenses by the contribution margin _______ or percentage.

4) Make or buy decisions usually rely on cost behavior in the ________-run.

5) A high degree of correlation does not guarantee that there is a _________-and-effect relationship between the independent and dependent variables.

6) A company has one product with a selling price of $20 and variable costs and expenses of $8 per unit. The fixed costs and expenses are $32,000 and the company has a target profit of $28,000. To reach the target profit, the company must sell ________ thousand units of the product.

7) A product sells for $20 and it has variable costs and expenses of $8 per unit. The contribution margin ratio for this product is ________ percent.

8) A product sells for $30 and has variable costs and expenses of $18 per unit. The fixed costs and expenses are $20,000. The breakeven point in sales dollars is _________ thousand dollars.

9) Total fixed costs and expenses divided by the contribution margin per unit gives you the breakeven point in ________.

10) The number of independent variables in multiple regression is ______ or more.

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