As the Feature Story indicates, to manage any size business you must understand how costs respond to changes in sales volume and the effect of costs and revenues on profits. A prerequisite to understanding cost‐volume‐profit (CVP) relationships is knowledge of how costs behave. In this chapter, we first explain the considerations involved in cost behavior analysis. Then, we discuss and illustrate CVP analysis.
Don’t Worry—Just Get Big
It wasn’t that Jeff Bezos didn’t have a good job. He was a vice president at a Wall Street firm. But, he quit his job, moved to Seattle, and started an online retailer, which he named Amazon.com. Like any good entrepreneur, Jeff strove to keep his initial investment small. Operations were run out of his garage. And, to avoid the need for a warehouse, he took orders for books and had them shipped from other distributors’ warehouses.
By its fourth month, Amazon was selling 100 books a day. In its first full year, it had $15.7 million in sales. The next year, sales increased eightfold. Two years later, sales were $1.6 billion.
Although its sales growth was impressive, Amazon’s ability to lose money was equally amazing. One analyst nicknamed it Amazon.bomb, while another, predicting its demise, called it Amazon.toast. Why was it losing money? The company used every available dollar to reinvest in itself. It built massive warehouses and bought increasingly sophisticated (and expensive) computers and equipment to improve its distribution system. This desire to grow as fast as possible was captured in a T‐shirt slogan at its company picnic, which read “Eat another hot dog, get big fast.” This buying binge was increasing the company’s fixed costs at a rate that exceeded its sales growth. Skeptics predicted that Amazon would soon run out of cash. It didn’t.
In the fourth quarter of 2010 (only 15 years after its world headquarters was located in a garage), Amazon reported quarterly revenues of $12.95 billion and quarterly income of $416 million. But, even as it announced record profits, its share price fell by 9%. Why? Because although the company was predicting that its sales revenue in the next quarter would increase by at least 28%, it predicted that its operating profit would fall by at least 2% and perhaps by as much as 34%. The company made no apologies. It explained that it was in the process of expanding from 39 distribution centers to 52. As Amazon’s finance chief noted, “You’re not as productive on those assets for some time. I’m very pleased with the investments we’re making and we’ve shown over our history that we’ve been able to make great returns on the capital we invest in.” In other words, eat another hot dog.
Sources: Christine Frey and John Cook, “How Amazon.com Survived, Thrived and Turned a Profit,” Seattle Post (January 28, 2008); and Stu Woo, “Sticker Shock Over Amazon Growth,” WallStreet Journal Online (January 28, 2011).
LEARNING OBJECTIVE 1
Explain variable, fixed, and mixed costs and the relevant range.
Cost behavior analysis is the study of how specific costs respond to changes in the level of business activity. As you might expect, some costs change, and others remain the same. For example, for an airline company such as Southwest or United, the longer the flight, the higher the fuel costs. On the other hand, Massachusetts General Hospital’s costs to staff the emergency room on any given night are relatively constant regardless of the number of patients treated. A knowledge of cost behavior helps management plan operations and decide between alternative courses of action. Cost behavior analysis applies to all types of entities.
The starting point in cost behavior analysis is measuring the key business activities. Activity levels may be expressed in terms of sales dollars (in a retail company), miles driven (in a trucking company), room occupancy (in a hotel), or dance classes taught (by a dance studio). Many companies use more than one measurement base. A manufacturer, for example, may use direct labor hours or units of output for manufacturing costs, and sales revenue or units sold for selling expenses.
For an activity level to be useful in cost behavior analysis, changes in the level or volume of activity should be correlated with changes in costs. The activity level selected is referred to as the activity (or volume) index. The activity index identifies the activity that causes changes in the behavior of costs. With an appropriate activity index, companies can classify the behavior of costs in response to changes in activity levels into three categories: variable, fixed, or mixed.
Variable costs are costs that vary in total directly and proportionately with changes in the activity level. If the level increases 10%, total variable costs will increase 10%. If the level of activity decreases by 25%, variable costs will decrease 25%. Examples of variable costs include direct materials and direct labor for a manufacturer; cost of goods sold, sales commissions, and freight‐out for a merchandiser; and gasoline in airline and trucking companies. A variable cost may also be defined as a cost that remains the same per unit at every level of activity.
To illustrate the behavior of a variable cost, assume that Damon Company manufactures tablet computers that contain $10 cameras. The activity index is the number of tablet computers produced. As Damon manufactures each tablet, the total cost of cameras used increases by $10. As part (a) of Illustration 18-1 shows, total cost of the cameras will be $20,000 if Damon produces 2,000 tablets, and $100,000 when it produces 10,000 tablets. We also can see that a variable cost remains the same per unit as the level of activity changes. As part (b) of Illustration 18-1 shows, the unit cost of $10 for the cameras is the same whether Damon produces 2,000 or 10,000 tablets.
ILLUSTRATION 18-1 Behavior of total and unit variable costs
Companies that rely heavily on labor to manufacture a product, such as Nike or Reebok, or to perform a service, such as Hilton or Marriott, are likely to have many variable costs. In contrast, companies that use a high proportion of machinery and equipment in producing revenue, such as AT&T or Duke Energy Co., may have few variable costs.
▼ HELPFUL HINT
Variable costs per unit remain constant at all levels of activity.
Fixed costs are costs that remain the same in total regardless of changes in the activity level. Examples include property taxes, insurance, rent, supervisory salaries, and depreciation on buildings and equipment. Because total fixed costs remain constant as activity changes, it follows that fixed costs per unit vary inversely with activity: As volume increases, unit cost declines, and vice versa.
To illustrate the behavior of fixed costs, assume that Damon Company leases its productive facilities at a cost of $10,000 per month. Total fixed costs of the facilities will remain constant at every level of activity, as part (a) of Illustration 18-2 shows. But, on a per unit basis, the cost of rent will decline as activity increases, as part (b) of Illustration 18-2 shows. At 2,000 units, the unit cost per tablet computer is $5 ($10,000÷2,000)$5 ($10,000÷2,000). When Damon produces 10,000 tablets, the unit cost of the rent is only $1 per tablet ($10,000÷10,000)($10,000÷10,000).
ILLUSTRATION 18-2 Behavior of total and unit fixed costs
The trend for many manufacturers is to have more fixed costs and fewer variable costs. This trend is the result of increased use of automation and less use of employee labor. As a result, depreciation and lease charges (fixed costs) increase, whereas direct labor costs (variable costs) decrease.
PEOPLE, PLANET, AND PROFIT INSIGHT
Gardens in the Sky
© Jani Bryson/iStockphoto
Because of population increases, the United Nations’ Food and Agriculture Organization estimates that food production will need to increase by 70% by 2050. Also, by 2050, roughly 70% of people will live in cities, which means more food needs to be hauled further to get it to the consumer. To address the lack of farmable land and reduce the cost of transporting produce, some companies, such as New York‐based BrightFarms, are building urban greenhouses.
This sounds great, but do the numbers work? Some variable costs would be reduced. For example, the use of pesticides, herbicides, fuel costs for shipping, and water would all drop. Soil erosion would be a non‐issue since plants would be grown hydroponically (in a solution of water and minerals), and land requirements would be reduced because of vertical structures. But, other costs would be higher. First, there is the cost of the building. Also, any multistory building would require artificial lighting for plants on lower floors.
Until these cost challenges can be overcome, it appears that these urban greenhouses may not break even. On the other hand, rooftop greenhouses on existing city structures already appear financially viable. For example, a 15,000 square‐foot rooftop greenhouse in Brooklyn already produces roughly 30 tons of vegetables per year for local residents.
Sources: “Vertical Farming: Does It Really Stack Up?” The Economist (December 9, 2010); and Jane Black, “BrightFarms Idea: Greenhouses That Cut Short the Path from Plant to Grocery Shelf,” The Washington Post (May 7, 2013).
What are some of the variable and fixed costs that are impacted by hydroponic farming? (Go to WileyPLUS for this answer and additional questions.)
In Illustration 18-1 part (a) (page 884), a straight line is drawn throughout the entire range of the activity index for total variable costs. In essence, the assumption is that the costs are linear. If a relationship is linear (that is, straight‐line), then changes in the activity index will result in a direct, proportional change in the variable cost. For example, if the activity level doubles, the cost doubles.
It is now necessary to ask: Is the straight‐line relationship realistic? In most business situations, a straight‐line relationship does not exist for variable costs throughout the entire range of possible activity. At abnormally low levels of activity, it may be impossible to be cost‐efficient. Small‐scale operations may not allow the company to obtain quantity discounts for raw materials or to use specialized labor. In contrast, at abnormally high levels of activity, labor costs may increase sharply because of overtime pay. Also, at high activity levels, materials costs may jump significantly because of excess spoilage caused by worker fatigue.
As a result, in the real world, the relationship between the behavior of a variable cost and changes in the activity level is often curvilinear, as shown in part (a) of Illustration 18-3. In the curved sections of the line, a change in the activity index will not result in a direct, proportional change in the variable cost. That is, a doubling of the activity index will not result in an exact doubling of the variable cost. The variable cost may more than double, or it may be less than double.
ILLUSTRATION 18-3 Nonlinear behavior of variable and fixed costs
Total fixed costs also do not have a straight‐line relationship over the entire range of activity. Some fixed costs will not change. But it is possible for management to change other fixed costs. For example, in some instances, salaried employees (fixed) are replaced with freelance workers (variable). Illustration 18-3, part (b), shows an example of the behavior of total fixed costs through all potential levels of activity.
▼ HELPFUL HINT
Fixed costs that may be changeable include research, such as new product development, and management training programs.
For most companies, operating at almost zero or at 100% capacity is the exception rather than the rule. Instead, companies often operate over a somewhat narrower range, such as 40–80% of capacity. The range over which a company expects to operate during a year is called the relevant range of the activity index. Within the relevant range, as both diagrams in Illustration 18-4 show, a straight‐line relationship generally exists for both variable and fixed costs.