AC415 Fixed Variable Costs BreakEven 1 - 11 - 2017

AC415
Caterpillar, Inc.
Separate Fixed and Variable Costs
Wednesday 11 January 2017
Common Practice
● Put income statement in percentage of sales
● Thisimplicitly assumes that other line items vary

proportional to sales
● But some costs are fixed (at least in the short run)
1
Caterpillar 2002 (partial) Income Statement
(Dollars in millions) 2001 2002

Net Sales 20,450 20,152
Cost of Goods Sold (COGS) 14,752 14,709
Selling & General Adm (SG&A) 2,567 2,531
In percentage terms % %
Net Sales 100 100
Cost of Goods Sold (COGS) 72 73
Selling & General Adm (SG&A) 13 13
Note that Net Sales, COSG, and SG&A decreased with

$298, $43, and $36 million, respectively.
Proportional Variable Cost
Variable Total Cost

Cost
2
Mixed Cost: There are fixed costs
Total Cost
Variable
Cost
Fixed
Cost
Outline of Analysis
● Separate Cost of Goods Sold (COGS) and Selling General

and Administrative Expenses (SG&A) into (i) fixed costs
and (ii) variable cost from income statements.
Five steps outlined below
● Only imperfect estimate
3
1: Look at Changes
Caterpillar 2001 2002 Change

2001-2002
Revenue 20,450 20,152 - 298
Cost of Goods Sold 14,752 14,709 - 43
Gross Margin 5,698 5,443
SG&A 2,567 2,531 - 36
Operating Profit 3,131 2,912
COGS: 14% = (43/298). SG&A: 12% = (36/298)
● What were sales?

– $20,152 million
● How much of COGS was variable/fixed?

– Variable COGS = $0.14/$ sale; Rest is fixed
● How much of SG&A was variable/fixed?

– Variable SG&A= $0.12/$ sale; Rest is fixed
4
2: Calculate Variable Costs
Caterpillar 2002 Caterpillar 2002 2003
Revenue 20,152 Revenue 20,152 22,763
COGS 14,709 Variable

- Variable 2,821 - COGS
- Fixed - SG&A
Gross Margin 5,443 Contribution

Margin
SG&A 2,531 Fixed

- Fixed - SG&A
Operating Profit 2,912 Operating Profit
3: Remainder is Fixed Costs
Revenue 20,152 Revenue 20,152 22,763

- Fixed 11,888 - SG&A

Margin
SG&A 2,531 Fixed

- Fixed 113 - SG&A
5
4: Rearrange Income Statement
Revenue 20,152 Revenue 20,152 22,763

- Variable 2,821 - COGS 2,821
- Fixed 11,888 - SG&A 2,418
Gross Margin 5,443 Contribution 14,913
Margin
SG&A 2,531 Fixed 12,001 12,001

- Variable 2,418 - COGS 11,888
- Fixed 113 - SG&A 113
Operating Profit 2,912 Operating Profit 2,912
GAAP Financial Accounting
5: Forecast Revenues

Forecast
Revenue 20,152 Revenue 20,152 22,763
(estimate)
- Variable 2,821 - COGS 2,821 3,187
- Fixed 11,888 - SG&A 2,418 2,732
Gross Margin 5,443 Contribution 14,913 16,845
Margin
SG&A 2,531 Fixed 12,001 12,001

- Variable 2,418 - COGS 11,888 (same if
- Fixed 113 - SG&A 113 fixed)
Operating Profit 2,912 Operating Profit 2,912 4,844
6
Application: Break-even Analysis
● Uses Contribution Margin to analyze fixed and variable

cost
● How much revenues do we need to:

– cover our fixed cost
• Break-Even (BE) point
– make a desired level of profit
● What is our “safety margin” measured in revenues
Break-Even (BE) Analysis
Revenues
Target
Profit Total Cost
Output
BE Target Quantity
Quantity Quantity
7
Break-even Analysis in $Revenues
Fixed Costs (FC)

Break-Even (BE) quantity =
CM per $ Revenues
where:
(Total) Contrib. margin

CM per $Revenues =
$ Total Revenues
Break-even at Caterpillar
● What is the break-even revenues for Caterpillar in 2003?

– Total Contribution Margin = $16,845
– Total Revenues = $22,763
– CM per $Revenues
$16,845 / $22,763 = 0.74
= $1 revenues - $.14 (COGS) - $.12 (SG&A)
– Total Fixed Cost = 11,888 + 113 = $12,001

– Break-even Revenues = ($12,001 / 0.74) = $16,218
– Projected safety margin to break even (2003):
= $22,763 – $16,218 = $6,545
– What was the actual safety margin in 2002?

= $20,152 – $16,218 = $3,934
8
AC415
Revision Question
Based on Caterpillar, Inc. 2011
to improve forecasting
1
Caterpillar 2011 (partial) Income Statement
(Dollars in millions) 2010 2011

Net Sales 39867 57392
In percentage terms % %
Net Sales 100 100
Note that Net Sales, COSG, and SG&A increased with

$17,525, $13,211, and $955 million, respectively.
1
Mixed Cost: But there are fixed costs
Total Cost
Variable
Cost
Fixed
Cost
1: Look at Changes
Caterpillar 2010 2011 Change

2010-2011
Revenue 39,867 57,392
Cost of Goods Sold 30,367 43,578
Gross Margin 9,500 13,814
SG&A 4,248 5,203
Operating Profit (*) 5,252 8,631
COGS: ____%. SG&A: ____%.

4
2
● What was 2011 sales?

– $57,392 million
● How much of COGS was variable/fixed?
– Variable COGS = __________
– Rest is fixed
● How much of SG&A was variable/fixed?
– Variable SG&A = __________
– Rest is fixed
2: Estimate Variable Costs

Forecast
Revenue 57,392 Revenue 57,392 63,068

- Variable - COGS
- Fixed - SG&A

Margin
SG&A 5,203 Fixed

- Variable - COGS
- Fixed - SG&A
GAAP Financial Accounting in left two columns
3
1/11/2017
AC415
Management Accounting for
Decision Making
2015/16 Lent Term
Session 1.2
CLASS OBJECTIVES
• General about the course & Review
• Understand cost behavior
• Differentiate between the financial statement
format income statement and contribution
margin format income statement
• Perform break-even (BE) analysis
• Perform cost-volume-profit analysis
• Introduce manufacturing cost classifications
• Introduce overhead allocation
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AGENDA
General about the course & Review
• Ned’s New Wave Barber Shop case
discussion
• Introduction to overhead allocation
ACCOUNTING AND INCENTIVES

Chapman, C.J., and T.J. Steenburgh. 2011. An
Investigation of Earnings Management Through Marketing
Actions. Management Science.
Merchant, K.A., and J. Rockness. The Ethics of Managing

Earnings: An Empirical Investigation. Journal of Accounting
and Public Policy.
Oyer, P. 1998. Fiscal Year Ends and Non-Linear Incentive

Contracts: The Effect on Business Seasonality. The
Quarterly Journal of Economics.
Course overview
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AGENDA
General about the course & Review
discussion
RESPONSIBILITY ACCOUNTING: INCENTIVES

http://www.heraldsun.com.au/leader/south-
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skipping-stations-at-passengers-expense-to-
hit-targets/story-fngnvmhm-
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fa5c481f265d
Course overview
3
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RESPONSIBILITY ACCOUNTING: GOVERNANCE
4
1/11/2017

VW Stock Price
180
170
160
150
140
130
120
110
100
01-Sep-15 06-Sep-15 11-Sep-15 16-Sep-15 21-Sep-15
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AGENDA
• General about course & Review
Ned’s New Wave Barber Shop case
discussion
NED’S: BACKGROUND
• Revenue is $10 per haircut
• Costs
– 5 barbers, $18,000 each per year
– Fixtures and equipment leased for $4,500 per
year
– Building leased for $6,000 per year
Ned’s New Wave Barber Shop
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COST BEHAVIOR
• Which costs are fixed and which are
variable?
– Fixed costs do not change when the cost
driver changes
– Variable costs change with changes in a
particular cost driver
– Cost drivers are units of activity that drive
costs (e.g. number of haircuts, machine
setups, hours worked)
COST BEHAVIOR FOR NED’S?

• As given, all costs are fixed for now
• We will change Ned’s cost structure (i.e.,
whether costs are fixed or variable) later
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CONTRIBUTION MARGIN FORMAT INCOME STATEMENT
FS Format CM Format
Sales Sales
Less: COGS Less: Variable costs
Gross profit Contribution margin
Less: SG&A Less: Fixed costs
Net operating income Net operating income
Q1: NED’S CONTRIBUTION MARGIN PER

HAIRCUT
CM per haircut
Sales $10
Less: VC 0
Contribution margin $10
We can calculate the contribution margin

• Per unit of the cost driver (haircut)
• In total dollars
• As a percent of sales
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Q2: WHAT IS NED’S BREAK-EVEN POINT?
Fixed costs
Barbers $90,000
Equipment lease 4,500
Rent 6,000
Total $100,500
Break-even: $100,500/$10 per haircut = 10,050 haircuts
COST-VOLUME-PROFIT ANALYSIS
• Q3: Profit/loss at 15,000 haircuts
• Q4: Profit/loss at 16,500 haircuts
• Q4+: Profit/loss at 13,500 haircuts
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COST-VOLUME-PROFIT ANALYSIS
Scenario Per unit Q3 Q4 Q4+
Volume 15,000 16,500 (+10%) 13,500 (-10%)
Sales $10 $ 150,000 $ 165,000 $ 135,000

Variable costs 0 0 0 0
Contribution margin $10 150,000 165,000 135,000
Fixed costs 100,500 100,500 100,500
Net operating income
(NOI) $ 49,500 $ 64,500 $ 34,500
NOI per haircut $ 3.30 $ 3.91 $ 2.56

Is the change in profit proportional to the change in volume?
Why don’t we calculate the fixed cost per unit?
CHANGES TO NED’S COST STRUCTURE

• Scenario A: Barbers get 50% commission
per haircut
– What’s the contribution margin per haircut?
– What is the new annual break-even point in
number of haircuts?
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• Scenario B: Landlord receives monthly
rent of $100 plus 10% of the revenue per
haircut
– What’s the new annual break-even point in
haircuts?

• Scenario C=A&B: Ned changes both the
compensation system and the lease
agreement
– What is the new contribution margin per
haircut?
– What is the new annual break-even point in
number of haircuts?
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Scenario Scenario A Scenario B Scenario A&B
Per unit Total Per unit Total Per unit Total
Sales 10 10 10
Variable Costs 5 1 6
Contribution Margin 5 9 4
Fixed Costs
- Salaries 0 90,000 0
- Rent 6,000 1,200 1,200
- Equipment 4,500 4,500 4,500
Total Fixed Costs 10,500 95,700 5,700
BE in haircuts =FC/CM 2,100 10,633 1,425

BE in $Sales = FC/CM% 21,000 106,333 14,250
NED’S REVENUE AND COST FUNCTIONS

Ned's Cost Structure
250,000
200,000
150,000
Scenario a total cost:
Dollars
10,500 + 5q
Original total cost:
100,500 + 0q
100,000
Revenue: 10q
50,000
0
0 5,000 10,000 15,000 20,000 25,000
Number of haircuts
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NED’S PROFIT FUNCTIONS

Ned's Profit Structure
150,000
100,000 Firms with higher fixed

costs and lower variable
50,000 costs have greater
operating leverage. That
is, the sensitivity of
Dollars
0 Scenario a profit:
5q-10,500
profits to changes in sales
Original profit:
is higher.
10q-100,500
-50,000
-100,000
-150,000
0 5,000 10,000 15,000 20,000 25,000
Number of haircuts

Ned's Profit Structure - Operating leverage
160,000
120,000
Dollars
80,000 q
Lower operating leverage
Higher operating leverage
40,000
0
2008 2009 2010 2011 2012 2013 2014 2015 2016
Number of haircuts
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OPERATING LEVERAGE EXAMPLE

• Suppose that a $150,000 investment in
advertising will increase sales for each of the
following two companies by 10%
• Should both companies make the
investment?
Wonder Woman Bracelets Wayne Manufacturing
Current unit sales volume 300,000 300,000
Dollar sales $3,000,000 $3,000,000
Variable costs 300,000 2,550,000
Contribution margin $2,700,000 $ 450,000
Fixed costs 2,620,000 370,000
Net operating income $ 80,000 $ 80,000

• What’s the increase in sales for each firm?
• What’s the incremental benefit (cost) to
each firm of the investment?
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Wonder Woman Bracelets Wayne Industries Manufacturing
Per unit Total Per unit Total
Unit sales volume 300,000 300,000
Dollar sales $10 $3,000,000 $10 $3,000,000
Variable costs $1 $300,000 $8.50 $2,550,000
Contribution margin $9 $2,700,000 $1.50 $450,000
Contribution margin % 90% 15%
Expected additional CM $270,000 $45,000

Cost of investment $150,000 $150,000
Incremental cost (benefit) $120,000 -$105,000
What might Wayne invest in, instead, to increase profitability?
OPERATING LEVERAGE
• How does technological innovation affect
cost structure?
• How do firms choose “optimal” cost
structure?
– Lots of considerations: margin of safety,
break-even point, risk, risk preferences,
expected sales volume….
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NED’S: NUTS AND BOLTS TAKEAWAYS

• Fixed and variable costs
• Contribution format income statement
• Break-even analysis
• Cost-volume-profit analysis
• Which cost structure do you recommend?
NED’S: CONCEPTUAL TAKEAWAYS

• For a given volume you can figure out the
most profitable cost structure
• Each cost structure imposes different
incentives, which may lead to different
sales volumes
• Uncertainty (risk) also plays a part: lower
operating leverage reduces profit
variability when volume changes
16
1/11/2017
VOLT CVP
• “One obvious way to pull down costs is to
push up volume* but GM is paying a hefty
price to do so.”
– The automaker just ended a special Volt lease
program that offered customers a low monthly
payment of $279 a month for two years, with
some high-volume dealers dropping the payment
to $199 a month after receiving incentive money
from GM, with down payments as low as $250.
The company said about two-thirds of Volt
customers in July and August leased their
vehicles, compared with about 40 percent earlier
this year.
*Not true. Unitizing fixed costs! Ned’s New Wave Barber Shop
AGENDA
• General about course & Review
discussion
Introduction to overhead allocation
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COST CLASSIFICATIONS FOR MANAGERIAL

ACCOUNTING
• Period costs become expenses during the
current period without becoming part of
inventory
• Product costs are associated with goods
produced or purchased for resale
PERIOD COSTS
• Selling costs
– All costs associated with making the sale and
getting the product to the customer
• Administrative costs
– Executive, clerical, administrative (and so on)
costs associated with the general
management of the company
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PRODUCT COSTS: DIRECT MATERIALS (DM)

• Raw materials that become an integral
part of the finished product
• Costs of direct materials can be easily
traced to the finished product
PRODUCT COSTS: DIRECT LABOR (DL)

• Labor that can be physically traced to
individual units of products for sale
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PRODUCT COSTS: MANUFACTURING

OVERHEAD (MO)
• Indirect materials
– These goods end up in the final product, but it
doesn’t make sense, from a cost-benefit
perspective, to track the materials
• Indirect labor
– Labor used indirectly in the process of
producing goods
– Too costly to track cost of labor
• All other product costs
SUMMARY OF COST CLASSIFICATIONS
Costs
Product costs Period costs
General
Direct Direct
Manufacturing overhead Selling and
materials labor
admin.
Other Indirect Indirect

MO materials labor
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1/11/2017
Product cost allocation

Direct costs
(Direct material and direct labor)
Indirect costs
(Manufacturing overhead)
Overhead cost pool
Allocation base
Hammers Scepters
HOW DO WE ASSIGN MANUFACTURING

OVERHEAD TO PARTICULAR PRODUCTS?
• Cost allocation is the assignment of
indirect costs to cost objects / objectives
(e.g., products, product lines,
departments)
• We assign indirect costs in proportion to
the cost objects’ use of a particular
resource (the allocation base)
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ALLOCATION BASES
• Allocation base is the metric based on
which firms allocate overhead costs
• Characteristics
– Allocation base must be an activity or metric
that is common to all products
– Hopefully, the allocation base chosen actually
drives the overhead costs
– That is, hopefully the allocation base is a cost
driver (an activity or metric with which costs
vary)
ALLOCATION BASE EXAMPLES

Cost Allocation base
Machine maintenance Machine hours
Heating or cooling Cubic feet of space
Cleaning costs Square feet of factory
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WHY ALLOCATE OVERHEAD COSTS?

• A large portion of a company’s costs might
not relate directly to a product line
– Need estimates for financial reporting and
decision-making throughout the year
– Allocate costs across product lines to estimate
profitability
IN SUMMARY
• You understand what managerial
accounting is and why it matters to firms
and you
• From Ned’s, you now know about
– Cost behavior
– Break-even analysis
– Cost-volume-profit analysis
• From class, you now know all about
– Cost classifications
23
1/11/2017
It is not the answer that enlightens, but the

question.
~Eugéne Ionesco
24

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AC415

Wednesday 11 January 2017

● Put income statement in percentage of sales

● Thisimplicitly assumes that other line items vary

(Dollars in millions) 2001 2002

Note that Net Sales, COSG, and SG&A decreased with

Proportional Variable Cost

Variable Total Cost

● Separate Cost of Goods Sold (COGS) and Selling General

Five steps outlined below

● Only imperfect estimate

Caterpillar 2001 2002 Change

Revenue 20,450 20,152 - 298

Cost of Goods Sold 14,752 14,709 - 43

Gross Margin 5,698 5,443

SG&A 2,567 2,531 - 36

Operating Profit 3,131 2,912

COGS: 14% = (43/298). SG&A: 12% = (36/298)

Separate Fixed and Variable Costs

● What were sales?

● How much of COGS was variable/fixed?

● How much of SG&A was variable/fixed?

Caterpillar 2002 Caterpillar 2002 2003

Revenue 20,152 Revenue 20,152 22,763

COGS 14,709 Variable

Gross Margin 5,443 Contribution

SG&A 2,531 Fixed

Operating Profit 2,912 Operating Profit

3: Remainder is Fixed Costs

Caterpillar 2002 Caterpillar 2002 2003

Revenue 20,152 Revenue 20,152 22,763

COGS 14,709 Variable

Gross Margin 5,443 Contribution

SG&A 2,531 Fixed

Operating Profit 2,912 Operating Profit

Caterpillar 2002 Caterpillar 2002 2003

Revenue 20,152 Revenue 20,152 22,763

COGS 14,709 Variable

SG&A 2,531 Fixed 12,001 12,001

GAAP Financial Accounting

Caterpillar 2002 Caterpillar 2002 2003

SG&A 2,531 Fixed 12,001 12,001

● Uses Contribution Margin to analyze fixed and variable

● How much revenues do we need to:

● What is our “safety margin” measured in revenues

Break-Even (BE) Analysis

Fixed Costs (FC)

(Total) Contrib. margin

● What is the break-even revenues for Caterpillar in 2003?

= $1 revenues - $.14 (COGS) - $.12 (SG&A)

– Total Fixed Cost = 11,888 + 113 = $12,001

– What was the actual safety margin in 2002?

Based on Caterpillar, Inc. 2011

Separate Fixed and Variable Costs

Caterpillar 2011 (partial) Income Statement

(Dollars in millions) 2010 2011

Note that Net Sales, COSG, and SG&A increased with

Caterpillar 2010 2011 Change

Revenue 39,867 57,392

COGS: %. SG&A: %.