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CHAPTER 5

Cost-Volume-Profit
ASSIGNMENT CLASSIFICATION TABLE
Study Objectives

Questions

Brief
Exercises

1.

Distinguish between
variable and fixed costs.

1, 2, 3, 6

1, 2, 3, 4,
5, 6

2.

Explain the significance


of the relevant range.

4, 5

3.

Explain the concept of


mixed costs.

6, 7, 8

1, 3, 4, 5

1, 3, 4,
5, 6

4.

List the five components of


cost-volume-profit analysis.

5.

Indicate what contribution


margin is and how it can
be expressed.

10, 11, 17

6, 7

8, 9, 10, 11, 1A, 2A, 3A,


12, 13
4A, 5A

1B, 2B, 3B,


4B, 5B

6.

Identify the three ways to


determine the break-even
point.

12, 13, 14

8, 9

8, 9, 10, 11, 1A, 2A, 3A,


12, 13,14,
4A, 5A
16

1B, 2B, 3B,


4B, 5B

7.

Give the formulas for


determining sales required
to earn target net income.

16

10, 12

14, 15

2A, 5A

2B, 5B

8.

Define margin of safety,


and give the formulas
for computing it.

15

11

16

2A, 4A, 5A

2B, 4B, 5B

Exercises

A
Problems

B
Problems

1A

1B

1A

1B

5-1

ASSIGNMENT CHARACTERISTICS TABLE


Problem
Number

Description

Difficulty
Level

Time
Allotted (min.)

1A

Determine variable and fixed costs, compute break-even


point, prepare a CVP graph, and determine net income.

Simple

2030

2A

Prepare a CVP income statement, compute break-even


point, contribution margin ratio, margin of safety ratio,
and sales for target net income.

Moderate

3040

3A

Compute break-even point under alternative courses


of action.

Simple

2030

4A

Compute break-even point and margin of safety ratio,


and prepare CVP income statement before and after
changes in business environment.

Moderate

2030

5A

Compute break-even point and margin of safety ratio,


and prepare a CVP income statement before and after
changes in business environment.

Moderate

2030

1B

Determine variable and fixed costs, compute break-even


point, prepare a CVP graph, and determine net income.

Simple

2030

2B

Prepare a CVP income statement, compute break-even


point, contribution margin ratio, margin of safety ratio,
and sales for target net income.

Moderate

3040

3B

Compute break-even point under alternative courses


of action.

Simple

2030

4B

Compute break-even point and margin of safety ratio,


and prepare CVP income statement before and after
changes in business environment.

Moderate

2030

5B

Compute break-even point and margin of safety ratio, and


prepare a CVP income statement before and after changes
in business environment.

Moderate

2030

5-2

5-3

Define margin of safety, and give


the formulas for computing it.

* 8.

Broadening Your Perspective

Give the formulas for determining


sales required to earn target net
income.

* 5.

* 7.

Indicate what contribution margin


is and how it can be expressed.

* 4.

Identify the three ways to determine


the break-even point.

List the five components of


cost-volume-profit analysis.

* 3.

* 6.

Explain the concept of mixed costs. E5-4

E5-7

Explain the significance of the


relevant range.

* 2.

E5-4

Distinguish between variable and


fixed costs.

E5-1

Real-World Focus Decision Making


Exploring the Web Across the
Organization

E5-16
P5-2A

P5-4B
P5-5B

P5-5B

Managerial Analysis
Ethics Case
All About You

P5-4A
P5-5A

P5-5A
P5-5B

E5-12 P5-2A
E5-14 P5-2B
E5-15
Q5-16
BE5-10
BE5-12
Q5-15
BE5-11

P5-3A
P5-4A
P5-3B
P5-4B
P5-5A
E5-16
P5-1A
P5-2A
P5-1B
P5-2B
E5-10
E5-11
E5-12
E5-13
E5-14
Q5-13
BE5-8
BE5-9
E5-8
E5-9

P5-2B

P5-1B

P5-3A
P5-3B
P5-4A
P5-5A
P5-4B
P5-5B

BE5-3
E5-3
P5-1A

Evaluation

BE5-6
P5-1A
P5-2A
P5-1B
P5-2B

E5-5
E5-6

Synthesis

E5-10
E5-11
E5-12
E5-13

Q5-11
Q5-17
BE5-6
BE5-7
E5-8
E5-9

Q5-8
BE5-4
BE5-5

BE5-2

E5-2

Analysis
E5-3
E5-6
P5-1A
P5-1B

Application

BE5-1 E5-5
E5-1
E5-2

Communication

Q5-12
Q5-14

Q5-10

Q5-9

Q5-6
Q5-7
BE5-1

Q5-4
Q5-5

Q5-1
Q5-2
Q5-3
Q5-6

Knowledge Comprehension

* 1.

Study Objective

Correlation Chart between Blooms Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOMS TAXONOMY TABLE

STUDY OBJECTIVES
1.

DISTINGUISH BETWEEN VARIABLE AND FIXED


COSTS.

2.

EXPLAIN THE SIGNIFICANCE OF THE RELEVANT


RANGE.

3.

EXPLAIN THE CONCEPT OF MIXED COSTS.

4.

LIST THE FIVE COMPONENTS OF COST-VOLUMEPROFIT ANALYSIS.

5.

INDICATE WHAT CONTRIBUTION MARGIN IS AND


HOW IT CAN BE EXPRESSED.

6.

IDENTIFY THE THREE WAYS TO DETERMINE THE


BREAK-EVEN POINT.

7.

GIVE THE FORMULAS FOR DETERMINING SALES


REQUIRED TO EARN TARGET NET INCOME.

8.

DEFINE MARGIN OF SAFETY, AND GIVE THE FORMULAS FOR COMPUTING IT.

5-4

CHAPTER REVIEW
Cost Behavior Analysis
1.

Cost behavior analysis is the study of how specific costs respond to changes in the level of
business activity. A knowledge of cost behavior helps management plan operations and decide
between alternative courses of action.

2.

The activity index identifies the activity that causes changes in the behavior of costs; examples
include direct labor hours, sales dollars, and units of output. Once an appropriate activity index is
chosen, costs can be classified as variable, fixed or mixed.

Variable and Fixed Costs


3.

(S.O. 1) Variable costs are costs that vary in total directly and proportionately with changes in
the activity level. Examples of variable costs include direct materials and direct labor, cost of
goods sold, sales commissions, and freight-out. A variable cost may also be defined as a cost that
remains the same per unit at every level of activity.

4.

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. Fixed
costs per unit vary inversely with activity; as volume increases, unit cost declines and vice versa.

Relevant Range
5.

(S.O. 2) The range over which a company expects to operate during the year is called the
relevant range. Within the relevant range a straight-line relationship exists for both variable
and fixed costs.

Mixed Costs
6.

(S.O. 3) Mixed costs are costs that contain both a variable element and a fixed element; they
increase in total as the activity level increases, but not proportionately. For purposes of CVP
analysis, mixed costs must be classified into their fixed and variable elements.

7.

The high-low method uses the total costs incurred at the high and low levels of activity. The
difference in costs represents variable costs, since only the variable cost element can change as
activity levels change.

8.

The steps in computing fixed and variable costs under the high-low method are:
a. Determine variable cost per unit from the following formula:
Change in
Total Costs
b.

High minus Low


Activity Level

Variable Cost
per Unit

Determine the fixed cost by subtracting the total variable cost at either the high or the low
activity level from the total cost at that activity level.

Cost-Volume-Profit Analysis
9.

(S.O. 4) Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and
volume on a companys profits. It is a critical factor in such management decisions as profit
planning, setting selling prices, determining product mix, and maximizing use of production
facilities.
5-5

10.

CVP analysis considers the interrelationships among the following components: (a) volume or
level of activity, (b) unit selling prices, (c) variable cost per unit, (d) total fixed costs, and (e) sales
mix.

Basic CVP Components


11.

The following assumptions underlie each CVP analysis:


a. The behavior of both costs and revenues is linear throughout the relevant range of the
activity index.
b. All costs can be classified as either variable or fixed with reasonable accuracy.
c. Changes in activity are the only factors that affect costs.
d. All units produced are sold.
e. When more than one type of product is sold, the sales mix will remain constant. That is, the
percentage that each product represents of total sales will stay the same.

Contribution Margin
12.

(S.O. 5) Contribution margin is the amount of revenue remaining after deducting variable costs.
The formula for contribution margin per unit is:
Unit Selling
Price

13.

Unit Variable
Costs

Contribution
Margin per Unit

Contribution margin per unit indicates the amount available to cover fixed costs and contribute to
income. The formula for the contribution margin ratio is:
Contribution
Margin Per Unit

Unit Selling
Price

Contribution
Margin Ratio

The ratio indicates the portion of each sales dollar that is available to apply to fixed costs and to
contribute to income.
Break-Even Analysis
14.

(S.O. 6) The break-even point is the level of activity at which total revenue equals total costs
(both fixed and variable). Knowledge of the break-even point is useful to management when it
decides whether to introduce new product lines, change sales prices on established products, or
enter new market areas.

15.

A common equation used for CVP analysis is as follows:


Sales = Variable Costs + Fixed Costs + Net Income

16.

Under the contribution margin technique, the break-even point can be computed by using
either the contribution margin per unit or the contribution margin ratio.

17.

The formula, using unit contribution margin, is:


Fixed
Costs

Contribution
Margin per Unit

5-6

Break-even
Point in Units

18.

The formula using the contribution margin is:


Fixed
Costs

19.

Contribution
Margin Ratio

Break-even
Point in Dollars

A chart (or graph) can also be used as an effective means to determine and illustrate the breakeven point. A cost-volume-profit (CVP) graph is as follows:
Dollars (000)

Sales Line

900
Total Cost Line

800
700
600
Break-even Point

Variable Costs

500
400
300

Fixed Cost Line

200
100
0

Fixed Costs
200 400 600 800 1000 1200 1400 1600 1800
Units of Sales

Target Net Income


20.

(S.O. 7) Target net income is the income objective for individual product lines. The follow-ing
equation is used to determine target net income sales:
Required Sales = Variable Costs + Fixed Costs + Target Net Income

Margin of Safety
21.

(S.O. 8) Margin of safety is the difference between actual or expected sales and sales at the
break-even point.
a. The formula for stating the margin of safety in dollars is:
Actual (Expected)

Sales

b.

Break-even
Sales

Margin of Safety
in Dollars

The formula for determining the margin of safety ratio is:


Margin of Safety
in Dollars

Actual (Expected)
=
Sales

Margin of
Safety Ratio

The higher the dollars or the percentage, the greater the margin of safety.
5-7

LECTURE OUTLINE
A.

Cost Behavior Analysis.


1. Cost behavior analysis is the study of how specific costs respond to
changes in the level of business activity.
2. 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 into three categories: variable, fixed, or
mixed.

TEACHING TIP

Use ILLUSTRATION 5-1 to define and graphically illustrate variable and fixed
cost classifications. Emphasize total cost behavior with changes in activity levels,
then demonstrate unit cost behavior with activity level changes. Point out that
for internal analysis of operations by management, having costs classified into
variable and fixed classifications facilitates CVP analysis.
3. Variable costs are costs that vary in total directly and proportionately
with changes in the activity level. A variable cost remains the same per
unit at every level of activity.
4. Fixed costs are costs that remain the same in total regardless of changes
in the activity level.
a.

Because total fixed costs remain constant as activity changes, it


follows that fixed costs per unit vary inversely with activity.

b.

Examples of fixed costs include property taxes, insurance, rent,


supervisory salaries, and depreciation on buildings and equipment.

5-8

5. The relevant range is the range of activity over which a company expects
to operate during a year. It is important in CVP analysis because the
behavior of costs is assumed to be linear (straight-line) throughout the
relevant range. Although the linear relationship may not be completely
realistic, the linear assumption produces useful data for CVP analysis as
long as the level of activity remains within the relevant range.
6. Mixed costs are costs that contain both a variable element and a fixed
element. Mixed costs change in total but not proportionately with changes
in the activity level.
a.

For purposes of CVP analysis, mixed costs must be classified into


their fixed and variable elements. One method that management
may use to classify these costs is the high-low method.

TEACHING TIP

Use ILLUSTRATION 5-2 to define and graphically illustrate the mixed costs
classification. Point out that for CVP analysis, the variable and fixed elements of
a mixed cost should be separated using a method such as the high-low method.
b.

B.

The high-low method uses the total costs incurred at the high and
low levels of activity. The difference in costs between the high and
low levels represents variable costs, since only the variable cost
element can change as activity levels change. Fixed costs are
determined by subtracting the total variable cost at either the high
or low activity level from the total cost at that activity level.

Cost-Volume-Profit Analysis.
1. Cost-volume-profit (CVP) analysis is the study of the effects of changes
in costs and volume on a companys profits. CVP analysis is important in
profit planning. It is useful in setting selling prices, determining product
mix, and maximizing use of production facilities.

5-9

TEACHING TIP

ILLUSTRATION 5-3 lists the basic components and assumptions that underlie
CVP analysis.
2. CVP analysis considers the interrelationships among the following
components:
a.

Volume or level of activity.

b.

Unit selling prices.

c.

Variable cost per unit.

d.

Total fixed costs.

e.

Sales mix.

3. The following assumptions underlie each CVP analysis:


a.

The behavior of both costs and revenues is linear throughout the


relevant range of the activity index.

b.

Costs can be classified accurately as either variable or fixed.

c.

Changes in activity are the only factors that affect costs.

d.

All units produced are sold.

e.

When more than one type of product is sold, the sales mix will
remain constant (the percentage that each product represents of
total sales will stay the same).

4. Contribution margin is the amount of revenue remaining after deducting


variable costs. It can be expressed as a per unit amount or as a ratio.

5-10

TEACHING TIP

Use ILLUSTRATION 5-4 to demonstrate the calculation of the contribution margin


on a unit basis and as a ratio. Emphasize the importance of the contribution margin
in CVP analysis.

C.

a.

Contribution Margin per Unit = Unit Selling Price Unit Variable


Costs.

b.

Contribution Margin Ratio = Contribution Margin per Unit Unit


Selling Price.

Break-even Analysis.
1. At the break-even point, the company will realize no income but will
suffer no loss.
2. Knowledge of the break-even point is useful to management when it
decides whether to introduce new product lines, change sales prices on
established products, or enter new market areas.
3. The break-even point can be:
a.

Computed from a mathematical equation: Break-even Point in


Dollars = Total Variable Costs + Total Fixed Costs. The break-even
point in units can be computed by using unit selling prices and unit
variable costs.

TEACHING TIP

ILLUSTRATION 5-5 provides an example of break-even analysis calculated by


the equation approach. The break-even point can be stated in terms of units or
sales dollars.
5-11

b.

Computed by using contribution margin: Break-even Point in Units =


Fixed Costs Contribution Margin per Unit. Break-even Point in
Dollars = Fixed Costs Contribution Margin Ratio.

TEACHING TIP

ILLUSTRATION 5-6 provides an example of computing the break-even point in


dollars and units using the contribution margin approach.
c.

Derived from a CVP graph at the intersection of the total-cost line


and the total-sales line.

TEACHING TIP

ILLUSTRATION 5-7 provides an example of determining the break-even point in


dollars and units by using a CVP graph. Point out that the equation approach
(Illustration 5-5), the contribution margin technique (Illustration 5-6), and the CVP
graph all provide the same answer and are alternative approaches to CVP
analysis.
4. The income objective set by management is called target net income. To
meet target net income, required sales must be determined.
a.

Mathematical equation: Required Sales = Variable Costs + Fixed


Costs + Target Net Income. Required sales may be expressed in
either sales units or sales dollars.

b.

Contribution margin technique: Fixed Costs + Target Net Income


Contribution Margin Ratio = Required Sales in Dollars.

c.

Graphic presentation: In the profit area of the CVP graph, the distance
between the sales line and the total cost line at any point equals net
income. A company can find required sales by analyzing the differences between the two lines until the desired net income is found.
5-12

TEACHING TIP

ILLUSTRATION 5-8 provides an example of calculating target net income using


the mathematical equation approach, contribution margin technique, and the CVP
graph (see Illustration 5-7 at 14,000 units of activity).
5. Margin of safety is the difference between actual or expected sales and
sales at the break-even point. The margin of safety can be expressed in
dollars or as a ratio.
a.

Margin of Safety in Dollars = Actual (Expected) Sales Break-even


Sales.

b.

Margin of Safety Ratio = Margin of Safety in Dollars Actual


(Expected) Sales.

5-13

20 MINUTE QUIZ
Circle the correct answer.
True/False
1.

The range over which a company is expected to operate is called the relevant range of
the activity index.
True

2.

A mixed cost contains both selling and administrative cost elements.


True

3.

False

In a CVP income statement, contribution margin is reported in the body of the statement.
True

10.

False

If the unit contribution margin is $300 and fixed costs are $240,000 then the break-even
point in units would be 800 units.
True

9.

False

Sales mix is the percentage that each product represents of total sales.
True

8.

False

The contribution margin is the amount of revenue remaining after deducting fixed costs.
True

7.

False

If revenue = $80 and variable cost = 40% of revenue, then contribution margin = $48.
True

6.

False

If a salesperson incurs $2,000 of expenses in servicing two customers and $4,000 of


expenses in servicing four customers, the fixed costs are $1,000.
True

5.

False

Variable costs are costs that remain the same per unit at every level of activity.
True

4.

False

False

Margin of safety is the difference between actual sales and contribution margin.
True

False

5-14

Multiple Choice
1.

Which of the following is a false statement regarding assumptions of CVP analysis?


a. Total fixed costs remain constant over the relevant range.
b. Unit selling prices are constant.
c. Changes in volume or level of activity increase variable costs per unit.
d. All units produced are sold.

2.

Mixed costs may be separated into fixed costs and variable costs by using
a. the relevant range method.
b. the high-low method.
c. the contribution margin method.
d. all of the above.

3.

If the unit selling price is $500, the unit variable cost is $300, and the total monthly fixed
costs are $300,000, then the contribution margin ratio is
a. 30%.
b. 40%.
c. 50%.
d. 60%.

4.

If activity level increases 25% and a specific cost increases from $40,000 to $50,000, this
cost would be classified as a
a. variable cost.
b. mixed cost.
c. fixed cost.
d. none of the above.

5.

If total fixed costs are $900,000 and variable costs as a percentage of unit selling price
are 40%, then the break-even point in dollars is
a. $1,500,000.
b. $360,000.
c. $2,250,000.
d. not determinable with the information given.

5-15

ANSWERS TO QUIZ
True/False
1.
2.
3.
4.
5.

True
False
True
False
True

6.
7.
8.
9.
10.

False
True
True
True
False

Multiple Choice
1.
2.
3.
4.
5.

c.
b.
b.
a.
a.

5-16

ILLUSTRATION 5-1
COST CLASSIFICATIONSVARIABLE AND FIXED COSTS

VARIABLE COST

TOTAL COST BEHAVIOR

Cost

Costs that vary in total


directly and proportionately
with changes in activity
levels.
Activity

UNIT COST BEHAVIOR: Variable cost per unit remains constant for
all activity levels.
FIXED COST

TOTAL COST BEHAVIOR

Cost

Costs that remain the


same in total regardless of
changes in activity levels.

Activity

UNIT COST BEHAVIOR: Fixed cost per unit varies inversely with
changes in activity levels.
Note: Cost behavior assumptions are valid only in the relevant range.

5-17

ILLUSTRATION 5-2
COST CLASSIFICATIONMIXED COSTS

MIXED COST

TOTAL COST BEHAVIOR

Cost

Costs that contain both


variable and fixed elements,
and increase in total but
not proportionately with
changes in activity levels.
Activity

EXAMPLE
High
Change
in
activity
level

5,000 hours
Low

Jan.
Feb.
Mar.
Apr.
May
June

Machine
Hours
5,000
8,000
4,000
6,000
3,000
6,500

Power
Costs
$ 800
1,100
700
$500
900
600
950

Change
in costs

1. Determine variable cost per unit:


Change in
Total Cost
$500

2. Determine fixed cost:

High Low
Activity Levels
5,000

Variable Cost
per Unit
$.10 per hour

Activity Level
High
Low
$1,100
$600

Total cost
Less: Variable cost
8,000 $.10 =
800
3,000 $.10 =
300
Total fixed cost
$ 300
$300
Power costs are $300 per month plus $.10 per hour.
5-18

ILLUSTRATION 5-3
BASIC COMPONENTS AND ASSUMPTIONS THAT
UNDERLIE CVP ANALYSIS
INTERRELATIONSHIPS AMONG THE BASIC COMPONENTS

1. Volume or level of activity.


2.

Unit selling prices.

3.

Variable cost per unit.

4.

Total fixed costs.

5.

Sales mix.

ASSUMPTIONS FOR CVP ANALYSIS

1. The behavior of both costs and revenues is linear throughout


the relevant range of the activity index.
2. All costs can be classified accurately as either variable or fixed.
3. Changes in activity are the only factors that affect costs.
4. All units produced are sold.
5. When more than one type of product is sold, the sales mix will
remain constant.

5-19

ILLUSTRATION 5-4
CONTRIBUTION MARGIN
CONTRIBUTION MARGIN: REVENUE REMAINING AFTER
DEDUCTING VARIABLE COSTS

Example:
Selling price
Variable costs
Contribution margin

Per
Unit

$25
15
$10

100%
60%
40%

CONTRIBUTION MARGIN PER UNIT

Unit Selling
Price

$25

Unit Variable
Costs

$15

Contribution
Margin Per Unit
$10

CONTRIBUTION MARGIN RATIO

Contribution
Margin Per Unit
$10

Unit Selling
Price
$25

5-20

Contribution
Margin Ratio
40%

ILLUSTRATION 5-5
BREAK-EVEN ANALYSISEQUATION APPROACH

EXAMPLE:

Per
Unit
%
$25 100%
15
60%
$10
40%
$100,000

Selling price
Variable costs
Contribution margin
Fixed costs

Break-even point in dollars:


Let X = sales dollars at break-even point
X = .60 X + $100,000
.40 X = $100,000
X = $250,000
Break-even point in units:
Let X = number of units to sell to break-even
$25 X = $15 X + $100,000
$10 X = $100,000
X = 10,000 units
Proof:
Sales
Variable costs
Contribution margin
Fixed costs
Net income

$250,000 (10,000 units $25)


150,000 (10,000 units $15)
100,000 (10,000 units $10)
100,000
$
0

5-21

ILLUSTRATION 5-6
BREAK-EVEN ANALYSISCONTRIBUTION
MARGIN TECHNIQUE

EXAMPLE:

Per
Unit
%
$25 100%
60%
15
40%
$10
$100,000

Selling price
Variable costs
Contribution margin
Fixed costs

Break-even point in dollars:

Fixed
Costs

Contribution
Margin Ratio

$100,000

.40

Break-even Point
in Dollars
$250,000

Break-even point in units:

Fixed
Costs
$100,000

Contribution
Margin per Unit
$10

5-22

Break-even Point
in Units
10,000 units

ILLUSTRATION 5-7
CVP GRAPH

Sales
Line

450
400
Profit
Area
350

Dollars (000)

300

Break-even
Point

250
200
150
Loss
Area

Variable
Costs

Fixed
Cost
Line

100

Fixed
Costs

50
0

Total
Cost
Line

2,000

6,000

10,000
14,000
Units of Sales

5-23

18,000

ILLUSTRATION 5-8
TARGET NET INCOME

EXAMPLE: Target net income $40,000


Per
Unit
%
$25 100%
Selling price
15
60%
Variable costs
$10
40%
Contribution margin
Fixed costs
$100,000
EQUATION APPROACH
Required sales in units:
Let X = unit sales for target net income of $40,000
$25 X = $15 X + $100,000 + $40,000
$10 X = $140,000
X = 14,000 units
Required sales in dollars:
Let X = sales dollars for target net income of $40,000
X = .60 X + $100,000 + $40,000
.40 X = $140,000
X = $350,000
CONTRIBUTION MARGIN TECHNIQUE
Required sales in units:

Fixed Costs +
Target Income
$140,000

Contribution
Margin per Unit
$10

Required Sales
in Units
14,000 units

Required Sales
in Dollars
$350,000

Required sales in dollars:

Fixed Costs +
Target Income
$140,000

Contribution
Margin Ratio
.40
5-24