Cost Terms, Concepts and Classifications: Chapter Two

Cost Terms, Concepts and
Classifications
Chapter Two
McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

2-2
Learning Objective 1
Identify and give examples

of each of the three basic
manufacturing cost
categories.

2-3
Manufacturing Costs
Direct Direct Manufacturing

Materials Labor Overhead
The Product

2-4
Direct Materials
Raw materials that become an integral part of the

product and that can be conveniently traced
directly to it.
Example: A radio installed in an automobile

2-5
Direct Labor
Those labor costs that can be easily traced to

individual units of product.
Example: Wages paid to automobile assembly workers

2-6
Manufacturing Overhead
Manufacturing costs that cannot be traced directly

to specific units produced.
Examples: Indirect labor and indirect materials
Wages paid to employees Materials used to support

who are not directly the production process.
involved in production
work. Examples: lubricants and
Examples: maintenance cleaning supplies used in the
workers, janitors and automobile assembly plant.
security guards.

2-7
Non-manufacturing Costs
Selling Administrative
Costs Costs
Costs necessary to get All executive,

the order and deliver organizational, and
the product. clerical costs.

2-8
Distinguish between
product costs and period
costs and give examples
of each.

2-9
Product Costs Versus Period Costs
Product costs include Period costs include all

direct materials, direct selling costs and
labor, and administrative costs.
manufacturing
overhead.
Inventory Cost of Good Sold Expense
Sale
Balance Income Income

Sheet Statement Statement
2-10
Quick Check 
Which of the following costs would be considered a

period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.

2-11
Quick Check 
Which of the following costs would be considered a

period rather than a product cost in a manufacturing
company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.

2-12
Classifications of Costs
Manufacturing costs are often

classified as follows:
Direct Direct Manufacturing
Material Labor Overhead
Prime Conversion
Cost Cost

2-13
Comparing Merchandising and
Manufacturing Activities
Merchandisers . . . Manufacturers . . .
 Buy finished goods.  Buy raw materials.
 Sell finished goods.  Produce and sell
finished goods.
MegaLoMart

2-14
Balance Sheet
Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash
 Receivables  Receivables
 Prepaid Expenses
 Inventories
 Merchandise
Inventory • Raw Materials
• Work in Process
• Finished Goods

2-15
Balance Sheet
Merchandiser Manufacturer
Current assets Current Assets
 Cash  Cash
 Receivables  Receivables
Materials waiting to
 Prepaid Expenses be processed.
Partially complete  Inventories
 Merchandise
products – some
Inventory • Raw Materials
material, labor, or • Work in Process
overhead has been • Finished Goods
added.
Completed products
awaiting sale.
2-16
Prepare an income
statement including
calculation of the cost of
goods sold.

2-17
The Income Statement
Cost of goods sold for manufacturers differs only

slightly from cost of goods sold for merchandisers.
Merchandising Company Manufacturing Company
Cost of goods sold:

Cost of goods sold:
Beg. merchandise Beg. finished
inventory $ 14,200 goods inv. $ 14,200
+ Purchases 234,150 + Cost of goods
Goods available manufactured 234,150
for sale $ 248,350 Goods available
- Ending for sale $248,350
merchandise - Ending
inventory (12,100) finished goods
= Cost of goods inventory (12,100)
sold $ 236,250 = Cost of goods
sold $236,250

2-18
Basic Equation for Inventory Accounts
Withdrawals
Beginning Additions Ending
balance + to inventory = balance + from
inventory

2-19
Quick Check 
If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
B. $ 800.
C. $1,200.
D. $ 200.

2-20
Quick Check 
If your inventory balance at the beginning of the

month was $1,000, you bought $100 during the
month, and sold $300 during the month, what would
be the balance at the end of the month?
A. $1,000.
$1,000 + $100 = $1,100
B. $ 800. $1,100 - $300 = $800
C. $1,200.
D. $ 200.

2-21
Prepare a schedule of cost

of goods manufactured.

2-22
Schedule of Cost of Goods Manufactured
Calculates the cost of raw

material, direct labor and
manufacturing overhead
used in production.
Calculates the manufacturing

costs associated with goods
that were finished during the
period.

2-23
Product Cost Flows
Manufacturing Work
Raw Materials Costs In Process
Beginning raw Direct materials

materials inventory
+ Raw materials
purchased
= Raw materials
available for use
in production
– Ending raw materials
inventory
= Raw materials used
As items are removed from raw
in production materials inventory and placed into
the production process, they are
called direct materials.

2-24
Product Cost Flows
Manufacturing Work
Conversion
Beginning raw Direct materials
materials inventory + Direct labor
costs are costs
+ Raw materials + Mfg. overhead incurred to
purchased = Total manufacturing convert the
= Raw materials costs
direct material
available for use
in production into a finished
– Ending raw materials product.
inventory
in production

2-25
Product Cost Flows
Manufacturing Work
Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials
inventory All manufacturing costs incurred
= Raw materials used during the period are added to the
in production
beginning balance of work in
process.

2-26
Product Cost Flows
Manufacturing Work
Beginning raw Direct materials Beginning work in

materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory
Costs associated with the goods that process inventory
= Raw materials used = Cost of goods
areincompleted
production
during the period are manufactured
transferred to finished goods
inventory.

2-27
Product Cost Flows
Work
In Process Finished Goods
Beginning work in Beginning finished

process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold

2-28
Manufacturing Cost Flows
Balance Sheet Income

Costs Inventories Statement
Expenses
Material Purchases Raw Materials
Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold
Selling and Period Costs Selling and

Administrative Administrative
2-29
Quick Check 
Beginning raw materials inventory was $32,000.

During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the cost of direct material used?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000

2-30
Quick Check 
Beginning raw materials inventory was $32,000.

During the month, $276,000 of raw material was
purchased. A count at the end of the month
revealed that $28,000 of raw material was still
present. What is the costBeg.
of direct material used?
raw materials $ 32,000
A. $276,000 + Raw materials
purchased 276,000
B. $272,000 = Raw materials available
for use in production $ 308,000
C. $280,000 – Ending raw materials
D. $ 2,000 inventory 28,000
in production $ 280,000

2-31
Quick Check 
Direct materials used in production totaled

$280,000. Direct labor was $375,000 and
factory overhead was $180,000. What were
total manufacturing costs incurred for the
month?
A. $555,000
B. $835,000
C. $655,000
D. Cannot be determined.

2-32
Quick Check 
Direct materials used in production totaled

$280,000. Direct labor was $375,000 and
factory overhead was $180,000.
Direct Materials What were
$ 280,000
total manufacturing+ costs incurred for the
Direct Labor 375,000
+ Mfg. Overhead 180,000
month? = Mfg. Costs Incurred
A. $555,000 for the Month $ 835,000
B. $835,000
C. $655,000

2-33
Quick Check 
Beginning work in process was $125,000.

Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work
in process inventory at the end of the
month. What was the cost of goods
manufactured during the month?
A. $1,160,000
B. $ 910,000
C. $ 760,000
2-34
Quick Check 
Beginning work in process was $125,000.

Manufacturing costs incurred for the month
were $835,000. There were $200,000 of
partially finished goods remaining in work
in process inventory at the end of the $ 125,000
Beginning work in
process inventory
month. What was the +cost of goods
Mfg. costs incurred
for the period 835,000
manufactured during the month?
= Total work in process
A. $1,160,000 – Ending
during the period
work in
$ 960,000
B. $ 910,000 = Costprocess inventory

of goods
200,000
C. $ 760,000 manufactured $ 760,000
2-35
Quick Check 
Beginning finished goods inventory was

$130,000. The cost of goods manufactured
for the month was $760,000. And the ending
finished goods inventory was $150,000.
What was the cost of goods sold for the
month?
A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000.
2-36
Quick Check 
Beginning finished goods inventory was

$130,000. The cost of goods manufactured
for the month was $760,000. And the ending
finished goods inventory was $150,000.
What was the cost of goods sold for the
month?
A. $ 20,000. $130,000 + $760,000 = $890,000
B. $740,000. $890,000 - $150,000 = $740,000
C. $780,000.
D. $760,000.
2-37
Understand the
differences between
variable costs and fixed
costs.

2-38
Cost Classifications for Predicting Cost
Behavior
How a cost will react to

changes in the level of
activity within the
relevant range.
 Total variable costs
change when activity
changes.
 Total fixed costs remain
unchanged when activity
changes.

2-39
Variable Cost
Your total long distance telephone bill is based

on how many minutes you talk.
Total Long Distance
Telephone Bill
Minutes Talked
2-40
Variable Cost Per Unit
The cost per long distance minute talked is

constant. For example, 10 cents per minute.
Telephone Charge
Per Minute
Minutes Talked
2-41
Fixed Cost
Your monthly basic telephone bill probably

does not change when you make more local
calls.
Telephone Bill
Monthly Basic
Number of Local Calls

2-42
Fixed Cost Per Unit
The average fixed cost per local call decreases

as more local calls are made.
Monthly Basic Telephone

Bill per Local Call
2-43
Cost Classifications for Predicting Cost
Behavior
Behavior of Cost (within the relevant range)

Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Average fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

2-44
Quick Check 
Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

2-45
Quick Check 
Which of the following costs would be variable with

respect to the number of cones sold at a Baskins &
Robbins shop? (There may be more than one
correct answer.)
A. The cost of lighting the store.
B. The wages of the store manager.
C. The cost of ice cream.
D. The cost of napkins for customers.

2-46
Understand the
differences between direct
and indirect costs.

2-47
Assigning Costs to Cost Objects
Direct costs Indirect costs

• Costs that can be • Costs that cannot be
easily and conveniently easily and conveniently
traced to a unit of traced to a unit of
product or other cost product or other cost
object. object.
• Examples: direct • Example: manufacturing
material and direct labor overhead

2-48
Define and give examples

of cost classifications used
in making decisions:
differential costs,
opportunity costs, and
sunk costs.

2-49
Cost Classifications for Decision Making
• Every decision involves a choice between at

least two alternatives.
• Only those costs and benefits that differ

between alternatives are relevant in a decision.
All other costs and benefits can and should be
ignored.

2-50
Differential Cost and Revenue
Costs and revenues that differ among

alternatives.
Example: You have a job paying $1,500 per month in

your hometown. You have a job offer in a neighboring
city that pays $2,000 per month. The commuting cost
to the city is $300 per month.
Differential revenue is:

$2,000 – $1,500 = $500
Differential cost is:

$300
2-51
Opportunity Cost
The potential benefit

that is given up when
one alternative is
selected over another.
Example: If you were
not attending college,
you could be earning
$15,000 per year.
Your opportunity cost
of attending college for
one year is $15,000.
2-52
Sunk Costs
Sunk costs have already been incurred and

cannot be changed now or in the future.
They should be ignored when making
decisions.
Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the $10,000 cost.

2-53
Quick Check 
Suppose you are trying to decide whether to drive

or take the train to Portland to attend a concert. You
have ample cash to do either, but you don’t want to
waste money needlessly. Is the cost of the train
ticket relevant in this decision? In other words,
should the cost of the train ticket affect the decision
of whether you drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.

2-54
Quick Check 

waste money needlessly. Is the cost of the train
ticket relevant in this decision? In other words,
should the cost of the train ticket affect the decision
of whether you drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.

2-55
Quick Check 

waste money needlessly. Is the annual cost of
licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.

2-56
Quick Check 

waste money needlessly. Is the annual cost of
licensing your car relevant in this decision?
A. Yes, the licensing cost is relevant.
B. No, the licensing cost is not relevant.

2-57
Quick Check 
Suppose that your car could be sold now for

$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

2-58
Quick Check 
Suppose that your car could be sold now for

$5,000. Is this a sunk cost?
A. Yes, it is a sunk cost.
B. No, it is not a sunk cost.

2-59
Summary of the Types of Cost
Classifications
• Financial reporting
• Predicting cost behavior
• Assigning costs to cost objects
• Decision making

Further Classification of Labor
Costs
Appendix 2A

2-61
(Appendix 2A)
Properly account for labor
costs associated with idle
time, overtime, and fringe
benefits.

2-62
Idle Time
Machine Material
Breakdowns Shortages
Power
Failures
The labor costs incurred

during idle time are ordinarily
treated as manufacturing
overhead.
2-63
Overtime
The overtime premiums for all factory

workers are usually considered to be part
of manufacturing overhead.

2-64
Labor Fringe Benefits
Fringe benefits include employer paid

costs for insurance programs, retirement
plans, supplemental unemployment
programs, Social Security, Medicare,
workers’ compensation and
unemployment taxes.
Some companies Other companies treat

include all of these fringe benefit
costs in expenses of direct
manufacturing laborers as additional
overhead. direct labor costs.
Cost of Quality
Appendix 2B

2-66
(Appendix 2B)
Identify the four types of
quality costs and explain
how they interact.

2-67
Quality of Conformance
When the overwhelming majority of

products produced conform to design
specifications and are free from
defects.

2-68
Prevention and Appraisal Costs
Support activities
Prevention whose purpose is to
Costs reduce the number of
defects
Incurred to identify
defective products
Appraisal Costs before the products are
shipped

2-69
Internal and External Failure Costs
Incurred as a result of
Internal Failure
identifying defects
Costs before they are shipped
Incurred as a result of
External Failure defective products
Costs being delivered to
customers

2-70
Examples of Quality Costs
Appraisal Costs
Prevention Costs
• Testing & inspecting
• Quality training
incoming materials
• Quality circles
• Final product testing
• Statistical process
• Depreciation of testing
control activities
equipment
Internal Failure Costs External Failure Costs

• Cost of field servicing &
• Scrap
handling complaints
• Spoilage
• Warranty repairs
• Rework
• Lost sales

2-71
Distribution of Quality Costs
When quality of conformance is low, total

quality cost is high and consists mostly of
internal and external failure.
Total quality costs drop rapidly as the quality

of conformance increases.
Companies reduce their total quality costs by

focusing their efforts on prevention and
appraisal because the cost savings from
reduced defects usually overwhelm the
costs of additional prevention and
appraisal.
Total quality costs are minimized when the

quality of conformance is slightly less
than 100%.
2-72
(Appendix 2B)
Prepare and interpret a
quality cost report.

2-73 Quality Cost Report
For Years 1 and 2
Year 2 Year 1
Amount Percent* Amount Percent*
Prevention costs:
Systems development $ 400,000 0.80% $ 270,000 0.54%
Quality training 210,000 0.42% 130,000 0.26%
Supervision of prevention activities 70,000 0.14% 40,000 0.08%
Quality improvement 320,000 0.64% 210,000 0.42%
Total prevention cost 1,000,000 2.00% 650,000 1.30%
Appraisal costs: Quality cost

Inspection 600,000 1.20% 560,000 1.12%
Reliability testing 580,000 1.16% 420,000 0.84% reports provide
Supervision of testing and inspection 120,000 0.24% 80,000 0.16%
Depreciation of test equipment 200,000 0.40% 140,000 0.28% an estimate of
Total appraisal cost 1,500,000 3.00% 1,200,000 2.40%
the financial
Internal failure costs:
Net cost of scrap 900,000 1.80% 750,000 1.50%
consequences
Rework labor and overhead
Downtime due to defects in quality
1,430,000
170,000
2.86%
0.34%
810,000
100,000
1.62%
0.20%
of the
Disposal of defective products 500,000 1.00% 340,000 0.68% company’s
Total internal failure cost 3,000,000 6.00% 2,000,000 4.00%
current defect
External failure costs:
Warranty repairs 400,000 0.80% 900,000 1.80% rate.
Warranty replacements 870,000 1.74% 2,300,000 4.60%
Allowances 130,000 0.26% 630,000 1.26%
Cost of field servicing 600,000 1.20% 1,320,000 2.64%
Total external failure cost 2,000,000 4.00% 5,150,000 10.30%
Total quality cost $ 7,500,000 15.00% $ 9,000,000 18.00%
* AsMcGraw-Hill/Irwin
a percentage of total sales. In each year sales totaled $50,000,000. Copyright © 2008, The McGraw-Hill Companies, Inc.
2-74
Quality Cost Reports in Graphic Form
$10 20
9
Quality 18
Quality Cost as a Percentage of Sales

8
reports 16
Quality Cost (in millions)
7
External External
can also 14
External External
6 Failure Failure be 12 Failure Failure
5 prepared 10
4 Internal
Failure
in 8 Internal
Failure
3 Internal
Failure
graphic 6 Internal
Failure
2
Appraisal form. 4
Appraisal
Appraisal Appraisal
1 2
Prevention Prevention Prevention Prevention
0 0
1 2 1 2
Year Year
2-75
Uses of Quality Cost Information
Help managers see the

financial significance of
defects.
Help managers identify

the relative importance
of the quality problems.
Help managers see
whether their quality
costs are poorly
distributed.
2-76
Limitations of Quality Cost Information
Simply measuring quality

cost problems does not
solve quality problems.
Results usually lag

behind quality
improvement programs.
The most important

quality cost, lost sales, is
often omitted from
quality cost reports.
2-77
ISO 9000 Standards
ISO 9000 standards have become

international measures of quality.
To become ISO 9000 certified, a
company must demonstrate:
1. A quality control system is in use, and the
system clearly defines an expected level of
quality.
2. The system is fully operational and is
backed up with detailed documentation of
quality control procedures.
3. The intended level of quality is being
achieved on a sustained basis.

2-78
End of Chapter 2

Cost Behavior:
Analysis and Use
Chapter Five

5-2
Understand how fixed and

variable costs behave and
how to use them to predict
costs.

5-3
Types of Cost Behavior Patterns
Recall the summary of our cost behavior

discussion from an earlier chapter.
Summary of Variable and Fixed Cost Behavior
Variable Total variable cost is Variable cost per unit remains

proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.

5-4
The Activity Base
Units
Machine
produce
hours
d
A measure of what
causes the
incurrence of a
variable cost
Miles Labor
driven hours

5-5
True Variable Cost Example
A variable cost is a cost whose total dollar amount

varies in direct proportion to changes in the activity
level. Your total long distance telephone bill is
based on how many minutes you talk.
Total Long Distance
Telephone Bill
Minutes Talked
5-6


relevant range.

5-7
Variable Cost Per Unit Example
A variable cost remains constant if expressed on

a per unit basis. The cost per minute talked is
constant. For example, 10 cents per minute.
Telephone Charge
Per Minute
Minutes Talked
5-8
Extent of Variable Costs
The proportion of variable costs differs across

organizations. For example . . .
A public utility with
large investments in A manufacturing company
equipment will tend will often have many
to have fewer variable costs.
variable costs.
A merchandising company
A service company
usually will have a high
will normally have a high
proportion of variable costs,
proportion of variable costs.
like cost of sales.
5-9
Examples of Variable Costs
1. Merchandising companies – cost of goods sold.

2. Manufacturing companies – direct materials,
direct labor, and variable overhead.
3. Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs,
such as invoicing.
4. Service companies – supplies, travel, and
clerical.

5-10
True Variable Cost
Direct materials is a true or proportionately variable

cost because the amount used during a period will
vary in direct proportion to the level of production
activity.
Cost
Volume
5-11
Step-Variable Costs
A resource that is obtainable only in large chunks (such

as maintenance workers) and whose costs increase or
decrease only in response to fairly wide changes in
activity is known as a step-variable cost.
Cost
Volume
5-12
Step-Variable Costs
Small changes in the level of production are

not likely to have any effect on the number of
maintenance workers employed.
Cost
Volume
5-13
Step-Variable Costs
Only fairly wide changes in the activity level will

cause a change in the number of maintenance
workers employed
Cost
Volume
5-14
The Linearity Assumption and the Relevant Range
Economist’s A straight line

closely
Curvilinear Cost approximates a
Function curvilinear
variable cost
Relevant line within the
Total Cost
relevant range.
Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Activity
5-15
Let’s look at fixed cost behavior on the next

screens.

relevant range.

5-16
Total Fixed Cost Example
A fixed cost is a cost whose total dollar amount remains

constant as the activity level changes. Your monthly
basic telephone bill is probably fixed and does not
change when you make more local calls.
Monthly Basic
Telephone Bill

5-17


relevant range.

5-18
Fixed Cost Per Unit Example
Average fixed costs per unit decrease as the activity

level increases. The fixed cost per local call
decreases as more local calls are made.
Monthly Basic Telephone

Bill per Local Call

5-19
Types of Fixed Costs
Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced short-term by current
in the short term. managerial decisions
Examples Examples
Depreciation on Advertising and
Equipment and Research and
Real Estate Taxes Development
5-20
The Trend Toward Fixed Costs
The trend in many industries is toward

greater fixed costs relative to variable costs.
As machines take over Knowledge workers
many mundane tasks tend to be salaried,
previously performed highly-trained and
by humans, difficult to replace. The
“knowledge workers” cost to compensate
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles. rather than variable.

5-21
Is Labor a Variable or a Fixed Cost?
The behavior of wage and salary costs can

differ across countries, depending on labor
regulations, labor contracts, and custom.
In France, Germany, China, and Japan, management has

little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.
In the United States and the United Kingdom, management

has greater latitude. Labor costs are more variable in nature.

5-22
Fixed Costs and Relevant Range
90
Thousands of Dollars
Total cost doesn’t

Rent Cost in
Relevant change for a wide

60 range of activity,
Range and then jumps to
a new higher cost
for the next higher
30 range of activity.
0
0 1,000 2,000 3,000
Rented Area (Square Feet)

5-23
The relevant range of activity for a fixed cost

is the range of activity over which the graph
of the cost is flat.
Example: Office space is
available at a rental rate of
$30,000 per year in
increments of 1,000 square
feet. As the business grows,
more space is rented,
increasing the total cost.

5-24
Step-variable costs
can be adjusted
How does this more quickly and . . .
type of fixed cost The width of the
differ from a step- activity steps is
much wider for the
variable cost? fixed cost.

5-25
Quick Check 
Which of the following statements about cost

behavior are true?
1. Fixed costs per unit vary with the level of
activity.
2. Variable costs per unit are constant within the
relevant range.
3. Total fixed costs are constant within the
relevant range.
4. Total variable costs are constant within the
relevant range.

5-26
Quick Check 
Which of the following statements about cost

behavior are true?
1. Fixed costs per unit vary with the level of
activity.
2. Variable costs per unit are constant within the
relevant range.
3. Total fixed costs are constant within the
relevant range.
4. Total variable costs are constant within the
relevant range.

5-27
Mixed Costs
A mixed cost has both fixed and variable

components. Consider the example of utility cost.
Y
Total Utility Cost
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
5-28
Mixed Costs
The total mixed cost line can be expressed

as an equation: Y = a + bX
Where: Y = the total mixed cost

a = the total fixed cost (the
Y vertical intercept of the line)
b = the variable cost per unit of
Total Utility Cost
activity (the slope of the line)

X = the level of activity
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
5-29
Mixed Costs Example
If your fixed monthly utility charge is $40, your

variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours,
what is the amount of your utility bill?
Y = a + bX
Y = $40 + ($0.03 × 2,000)
Y = $100
5-30
Analysis of Mixed Costs
Account Analysis and the Engineering Approach
Each account is classified as either

variable or fixed based on the analyst’s
knowledge of how the account behaves.
Cost estimates are based on an

evaluation of production methods, and
material, labor and overhead
requirements.

5-31
Use a scattergraph plot to

diagnose cost behavior.

5-32
The Scattergraph Method
Plot the data points on a graph

(total cost vs. activity).
Y
20
Maintenance Cost
1,000’s of Dollars
* * * ** *
**
10 * *
0 X
0 1 2 3 4
Patient-days in 1,000’s

5-33
Draw a line through the data points with about an

equal numbers of points above and below the line.
Y
20
Maintenance Cost
* * * ** *
**
10 * *
0 X
0 1 2 3 4

5-34
Use one data point to estimate the total level of activity

and the total cost.
Y Total maintenance cost = $11,000
20
Maintenance Cost
* * * ** *
**
10 * *
Intercept = Fixed cost: $10,000
0 X
0 1 2 3 4
Patient days = 800
5-35
Make a quick estimate of variable cost per unit and

determine the cost equation.
Total maintenance at 800 patients $ 11,000

Less: Fixed cost 10,000
Estimated total variable cost for 800 patients $ 1,000
$1,000
Variable cost per unit = = $1.25/patient-day
800
Y = $10,000 + $1.25X
Total maintenance cost Number of patient days

5-36
Analyze a mixed cost

using the high-low
method.

5-37
The High-Low Method
Assume the following hours of maintenance work and

the total maintenance costs for six months.

5-38
The High-Low Method
The variable cost

per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400
= $8.00/hour
300

5-39
The High-Low Method
Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($8/hour × 800 hours)
Total Fixed Cost = $9,800 – $6,400
Total Fixed Cost = $3,400
5-40
The High-Low Method
The Cost Equation for Maintenance

Y = $3,400 + $8.00X

5-41
Quick Check 
Sales salaries and commissions are $10,000 when

80,000 units are sold, and $14,000 when 120,000
units are sold. Using the high-low method, what is
the variable portion of sales salaries and
commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit

5-42
Quick Check 

the variable portion of sales salaries and
commission?
Units Cost
a. $0.08 per unit High level 120,000 $ 14,000
b. $0.10 per unit Low level 80,000 10,000
c. $0.12 per unit Change 40,000 $ 4,000
d. $0.125 per unit $4,000 ÷ 40,000 units

= $0.10 per unit

5-43
Quick Check 

the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000

5-44
Quick Check 

the fixed portion of sales salaries and commissions?
a. $ 2,000 Total cost = Total fixed cost +
Total variable cost
b. $ 4,000
$14,000 = Total fixed cost +
c. $10,000 ($0.10 × 120,000 units)
d. $12,000 Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000

5-45
Least-Squares Regression Method
A method used to analyze mixed costs if a

scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of the

data points to estimate
the fixed and variable
cost components of a
mixed cost.
The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.

5-46
• Software can be used to fit

a regression line through
the data points.
• The cost analysis objective
is the same: Y = a + bX
Least-squares regression also provides a statistic,

called the R2, which is a measure of the goodness
of fit of the regression line to the data points.

5-47
R2 is the percentage of the variation in total cost

explained by the activity.
Y
20
* ** *
Total Cost
* * **
10 * *2
R varies from 0% to 100%, and
the higher the percentage the better.
0 X
0 1 2 3 4
Activity
5-48
Comparing Results From the Three Methods
The three methods just discussed provide

slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method
uses differing amounts of the data points to
provide estimates.
Least-squares regression provides the most
accurate estimate because it uses all the data
points.

5-49
Prepare an income
statement using the
contribution format.

5-50
The Contribution Format
Let’s put our

knowledge of cost
behavior to work by
preparing a
contribution format
income statement.

5-51
Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000
The contribution margin format emphasizes

cost behavior. Contribution margin covers fixed
costs and provides for income.
5-52
Uses of the Contribution Format
The contribution income statement format is used

as an internal planning and decision making tool.
We will use this approach for:
1. Cost-volume-profit analysis (Chapter 6).
2. Budgeting (Chapter 9).
3. Segmented reporting of profit data (Chapter 12).
4. Special decisions such as pricing and make-or-
buy analysis (Chapter 13).

5-53
Used primarily for Used primarily by

external reporting. management.

Least Squares Regression
Using Microsoft Excel
Appendix 5A

5-55
Analyze a mixed cost

using the least-squares
regression method.

5-56
Simple Regression Analysis Example
Matrix, Inc. wants to

know its average
fixed cost and
variable cost per unit.
Using the data to the
right, let’s see how to
do a regression using
Microsoft Excel.

5-57
Simple Regression Using Excel
You will need three pieces of

information from your
regression analysis:
1. Estimated Variable Cost per
Unit (line slope)
2. Estimated Fixed Costs (line
intercept)
3. Goodness of fit, or R2
To get these three pieces

information we will need to
use three different Excel
functions.
LINEST, INTERCEPT, & RSQ

5-58
Place your cursor in

cell F4 and press the
= key. Click on the
pull down menu and
scroll down to “More
Functions . . .”

5-59
Scroll down to the

“Statistical”,
functions. Now
scroll down the
statistical
functions until you
highlight
“SLOPE”

5-60
1. In the Known_y’s box, enter C4:C19 for the range.

2. In the Known_x’s box, enter D4:D19 for the range.

5-61
Here is the
estimate of the
slope of the line.
1. In the Known_y’s box, enter, C4:C19 for the range.

2. In the Known_x’s box, enter, D4:D19 for the range.

5-62
With your cursor in

cell F5, press the =
key and go to the pull
down menu for
special functions.
Select Statistical and
scroll down to
highlight the
INTERCEPT function.

5-63
Here is the
estimate of the
fixed costs.


5-64
Finally, we will
determine the
“goodness of
fit”, or R2, by
using the RSQ
function.

5-65
Here is the
estimate of R2.


5-66
End of Chapter 5

Cost-Volume-Profit
Relationships
Chapter Six

6-2
Explain how changes in

activity affect contribution
margin and net operating
income.

6-3
Basics of Cost-Volume-Profit Analysis
Contribution Margin (CM) is the amount

remaining from sales revenue after variable
expenses have been deducted.
6-4
Basics of Cost-Volume-Profit Analysis
CM is used first to cover fixed

expenses. Any remaining CM
contributes to net operating income.
6-5
The Contribution Approach
Sales, variable expenses, and contribution margin can

also be expressed on a per unit basis. If Racing sells
an additional bicycle, $200 additional CM will be
generated to cover fixed expenses and profit.

6-6
Each month, Racing must generate at least

$80,000 in total CM to break even.

6-7
If Racing sells 400 units in a month, it will be

operating at the break-even point.

6-8
If Racing sells one more bike (401 bikes), net

operating income will increase by $200.

6-9
We do not need to prepare an income statement

to estimate profits at a particular sales volume.
Simply multiply the number of units sold above
break-even by the contribution margin per unit.
If Racing sells
430 bikes, its
net income will
be $6,000.

6-10
Prepare and interpret a

cost-volume-profit (CVP)
graph.

6-11
CVP Relationships in Graphic Form
The relationship among revenue, cost, profit and

volume can be expressed graphically by preparing
a CVP graph. Racing developed contribution
margin income statements at 300, 400, and 500
units sold. We will use this information to prepare
the CVP graph.
Income Income Income
300 units 400 units 500 units
Sales $ 150,000 $ 200,000 $ 250,000
Less: variable expenses 90,000 120,000 150,000
Contribution margin $ 60,000 $ 80,000 $ 100,000
Less: fixed expenses 80,000 80,000 80,000
Net operating income $ (20,000) $ - $ 20,000

6-12
CVP Graph
450,000
400,000
350,000
300,000
250,000
200,000
In a CVP graph, unit volume is
150,000
usually represented on the
100,000
horizontal (X) axis and dollars on
50,000
the vertical (Y) axis.
-
- 100 200 300 400 500 600 700 800
Units

6-13
CVP Graph
450,000
400,000
350,000
300,000
250,000
200,000
150,000 Fixed Expenses

100,000
50,000
-
- 100 200 300 400 500 600 700 800
Units

6-14
CVP Graph
450,000
400,000
350,000
300,000
250,000
Total Expenses
200,000

100,000
50,000
-
- 100 200 300 400 500 600 700 800
Units

6-15
CVP Graph
450,000
400,000
350,000 Total Sales

300,000
250,000
Total Expenses
200,000

100,000
50,000
-
- 100 200 300 400 500 600 700 800
Units

6-16
CVP Graph
450,000
400,000
Break-even point
(400 units or $200,000 in sales)
350,000
300,000
250,000
200,000
150,000
100,000
50,000
-
- 100 200 300 400 500 600 700 800
Units

6-17
Use the contribution

margin ratio (CM ratio) to
compute changes in
contribution margin and
net operating income
resulting from changes in
sales volume.

6-18
Contribution Margin Ratio
The contribution margin ratio is:

Total CM
CM Ratio =
Total sales
For Racing Bicycle Company the ratio is:
$80,000
= 40%
$200,000
Each $1.00 increase in sales results in a
total contribution margin increase of 40¢.

6-19
Or, in terms of units, the contribution margin ratio is:

Unit CM
CM Ratio =
Unit selling price
For Racing Bicycle Company the ratio is:
$200 = 40%
$500

6-20
400 Bikes 500 Bikes

Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
A $50,000 increase in sales revenue

results in a $20,000 increase in CM.
($50,000 × 40% = $20,000)

6-21
Quick Check 
Coffee Klatch is an espresso stand in a downtown

office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense
per cup is $0.36. The average fixed expense per
month is $1,300. 2,100 cups are sold each month
on average. What is the CM Ratio for Coffee
Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139

6-22
Quick Check 

on average. What is the CM Ratio for Coffee
Klatch? Unit contribution margin
CM Ratio =
a. 1.319 Unit selling price
b. 0.758 ($1.49-$0.36)
=
c. 0.242 $1.49
d. 4.139 $1.13
= = 0.758
$1.49
6-23
Show the effects on

contribution margin of
changes in variable costs,
fixed costs, selling price,
and volume.

6-24
Changes in Fixed Costs and Sales Volume
What is the profit impact if Racing can

increase unit sales from 500 to 540
by increasing the monthly advertising
budget by $10,000?

6-25

$80,000 + $10,000 advertising = $90,000
Sales increased by $20,000, but net operating

income decreased by $2,000.
6-26
The Shortcut Solution

Increase in CM (40 units X $200) $ 8,000
Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)

6-27
Change in Variable Costs and Sales Volume
What is the profit impact if Racing can

use higher quality raw materials, thus
increasing variable costs per unit by $10,
to generate an increase in unit sales
from 500 to 580?

6-28
Change in Variable Costs and Sales Volume
580 units × $310 variable cost/unit = $179,800
Sales increase by $40,000, and net operating income

McGraw-Hill/Irwin
increases by $10,200.
Copyright © 2008, The McGraw-Hill Companies, Inc.
6-29
Change in Fixed Cost, Sales Price and Volume
What is the profit impact if Racing (1) cuts

its selling price $20 per unit, (2) increases
its advertising budget by $15,000 per
month, and (3) increases sales from 500
to 650 units per month?

6-30
Change in Fixed Cost, Sales Price and Volume
Sales increase by $62,000, fixed costs increase by

$15,000, and net operating income increases by $2,000.
6-31
Change in Variable Cost, Fixed Cost and Sales Volume
What is the profit impact if Racing (1) pays

a $15 sales commission per bike sold
instead of paying salespersons flat salaries
that currently total $6,000 per month, and
(2) increases unit sales from 500 to 575
bikes?

6-32
Change in Variable Cost, Fixed Cost and Sales Volume
Sales increase by $37,500, variable costs increase by

$31,125, but fixed expenses decrease by $6,000.
6-33
Change in Regular Sales Price
If Racing has an opportunity to sell 150

bikes to a wholesaler without disturbing
sales to other customers or fixed
expenses, what price would it quote to the
wholesaler if it wants to increase monthly
profits by $3,000?

6-34
Change in Regular Sales Price
$ 3,000 ÷ 150 bikes = $ 20 per bike

Variable cost per bike = 300 per bike
Selling price required = $ 320 per bike
150 bikes × $320 per bike = $ 48,000

Total variable costs = 45,000
Increase in net income = $ 3,000

6-35
Compute the break-even

point in unit sales and
sales dollars.

6-36
Break-Even Analysis
Break-even analysis can be

approached in two ways:
1. Equation method
2. Contribution margin method

6-37
Equation Method
Profits = (Sales – Variable expenses) – Fixed expenses
OR
Sales = Variable expenses + Fixed expenses + Profits
At the break-even point

profits equal zero

6-38
Break-Even Analysis
Here is the information from Racing Bicycle Company:
Total Per Unit Percent

Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000

6-39
Equation Method
We calculate the break-even point as follows:

$500Q = $300Q + $80,000 + $0
Where:
Q = Number of bikes sold
$500 = Unit selling price
$300 = Unit variable expense
$80,000 = Total fixed expense

6-40
Equation Method
We calculate the break-even point as follows:

$500Q = $300Q + $80,000 + $0

$200Q = $80,000
Q = $80,000 ÷ $200 per bike
Q = 400 bikes

6-41
Equation Method
The equation can be modified to calculate

the break-even point in sales dollars.
X = 0.60X + $80,000 + $0
Where:
X = Total sales dollars
0.60 = Variable expenses as a % of sales
$80,000 = Total fixed expenses

6-42
Equation Method
The equation can be modified to calculate

the break-even point in sales dollars.
X = 0.60X + $80,000 + $0
0.40X = $80,000
X = $80,000 ÷ 0.40
X = $200,000

6-43
Contribution Margin Method
The contribution margin method has two

key equations.
Break-even point Fixed expenses

=
in units sold CM per unit
Break-even point in Fixed expenses

total sales dollars = CM ratio

6-44
Contribution Margin Method
Let’s use the contribution margin method

to calculate the break-even point in total
sales dollars at Racing.
Break-even point in Fixed expenses
total sales dollars = CM ratio
$80,000
= $200,000 break-even sales
40%

6-45
Quick Check 

office building. The average selling price of a cup
of coffee is $1.49 and the average variable
expense per cup is $0.36. The average fixed
expense per month is $1,300. 2,100 cups are sold
each month on average. What is the break-even
sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups

6-46
Quick Check 

office building. The average selling price of a cup
of coffee is $1.49 and the average variable
Fixed expenses
expense per cupBreak-even =
is $0.36. The average
CM perfixed
Unit
expense per month is $1,300. 2,100 cups are sold
$1,300
each month on average. = What is the break-even
$1.49/cup - $0.36/cup
sales in units?
$1,300
a. 872 cups =
$1.13/cup
b. 3,611 cups
= 1,150 cups
c. 1,200 cups
d. 1,150 cups

6-47
Quick Check 

on average. What is the break-even sales in
dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129

6-48
Quick Check 

on average. What is the break-even sales in
dollars?
a. $1,300 Break-even Fixed expenses
=
b. $1,715 sales CM Ratio
$1,300
c. $1,788 =
0.758
d. $3,129
= $1,715
6-49
Determine the level of

sales needed to achieve a
desired target profit.

6-50
Target Profit Analysis
The equation and contribution margin methods

can be used to determine the sales volume
needed to achieve a target profit.
Suppose Racing Bicycle Company wants

to know how many bikes must be sold
to earn a profit of $100,000.

6-51
The CVP Equation Method
$500Q = $300Q + $80,000 + $100,000
$200Q = $180,000
Q = 900 bikes

6-52
The Contribution Margin Approach
The contribution margin method can be

used to determine that 900 bikes must be
sold to earn the target profit of $100,000.
Unit sales to attain Fixed expenses + Target profit
=
the target profit CM per unit
$80,000 + $100,000
= 900 bikes
$200/bike

6-53
Quick Check 

month is $1,300. How many cups of coffee would
have to be sold to attain target profits of $2,500 per
month?
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups

6-54
Quick Check 
Unit sales
Fixed expenses + Target profit
to attain =
Coffee Klatch is an espresso stand Unit
in aCM
downtown
target profit
office building. The average selling
$1,300 price of a cup of
+ $2,500
coffee is $1.49 and the= average variable expense
$1.49 - $0.36
month is $1,300. How $3,800cups of coffee would
many
=
$1.13
have to be sold to attain target profits of $2,500 per
month? = 3,363 cups
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups

6-55
Compute the margin of

safety and explain its
significance.

6-56
The Margin of Safety
The margin of safety is the excess of

budgeted (or actual) sales over the
break-even volume of sales.
Margin of safety = Total sales - Break-even sales
Let’s look at Racing Bicycle Company and

determine the margin of safety.

6-57
If we assume that Racing Bicycle Company has actual

sales of $250,000, given that we have already
determined the break-even sales to be $200,000,
the margin of safety is $50,000 as shown.
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000

6-58
The margin of safety can be expressed as

20% of sales.
($50,000 ÷ $250,000)
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000

6-59
The margin of safety can be expressed in

terms of the number of units sold. The
margin of safety at Racing is $50,000, and
each bike sells for $500.
Margin of $50,000
= = 100 bikes
Safety in units $500

6-60
Quick Check 

on average. What is the margin of safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

6-61
Quick Check 
CoffeeMargin
Klatchofissafety
an espresso
= Total stand
sales –inBreak-even
a downtownsales
office building. The average cups –
= 2,100selling price of cups
1,150 a cup of
coffee is $1.49 and the=average
950 cupsvariable expense
per cup is $0.36. The averageor
fixed expense per
month is Margin
$1,300.of2,100 cups are
safety 950 sold
cupseach month
on average.percentage = 2,100
What is the margin of cups = 45%
safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

6-62
Cost Structure and Profit Stability
Cost structure refers to the relative proportion

of fixed and variable costs in an organization.
Managers often have some latitude in
determining their organization’s cost structure.

6-63
Cost Structure and Profit Stability
There are advantages and disadvantages to high

fixed cost (or low variable cost) and low fixed
cost (or high variable cost) structures.
An advantage of a high fixed
cost structure is that income
will be higher in good years
compared to companies A disadvantage of a high fixed
with lower proportion of cost structure is that income
fixed costs. will be lower in bad years
compared to companies
with lower proportion of
fixed costs.
6-64
Compute the degree of

operating leverage at a
particular level of sales
and explain how it can be
used to predict changes in
net operating income.

6-65
Operating Leverage
A measure of how sensitive net operating

income is to percentage changes in sales.
Degree of Contribution margin

=
operating leverage Net operating income

6-66
Operating Leverage
At Racing, the degree of operating leverage is 5.

Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000
$100,000
= 5
$20,000
6-67
Operating Leverage
With an operating leverage of 5, if Racing

increases its sales by 10%, net operating
income would increase by 50%.
Percent increase in sales 10%

Degree of operating leverage × 5
Percent increase in profits 50%
Here’s the verification!

6-68
Operating Leverage
Actual sales Increased

(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Less fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,000
10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.
6-69
Quick Check 
Coffee Klatch is an espresso stand in a

downtown office building. The average
selling price of a cup of coffee is $1.49 and
the average variable expense per cup is
$0.36. The average fixed expense per month
is $1,300. 2,100 cups are sold each month
on average. What is the operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
6-70
Quick Check 
Actual sales
Coffee Klatch is an espresso stand in a 2,100 cups
downtown office building.
Sales The average $ 3,129
selling price of a cupLess:
of coffee isexpenses
Variable $1.49 and 756
the average variableContribution
expense margin
per cup is 2,373
Less: Fixed expenses 1,300
$0.36. The average fixed expense per month
is $1,300. 2,100 cups are sold each month
on average. What is the operating leverage?
a. 2.21 Operating Contribution margin
b. 0.45 leverage = Net operating income
c. 0.34 $2,373
= $1,073 = 2.21
d. 2.92
6-71
Quick Check 
At Coffee Klatch the average selling price of a cup of

coffee is $1.49, the average variable expense per cup
is $0.36, the average fixed expense per month is
$1,300 and an average of 2,100 cups are sold each
month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%

6-72
Quick Check 
At Coffee Klatch the average selling price of a cup of

coffee is $1.49, the average variable expense per cup
is $0.36, the average fixed expense per month is
$1,300 and an average of 2,100 cups are sold each
month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
Percent increase in sales 20.0%
b. 20.0%
× Degree of operating leverage 2.21
c. 22.1% Percent increase in profit 44.20%
d. 44.2%

6-73
Verify Increase in Profit
Actual Increased
sales sales
2,100 cups 2,520 cups
Sales $ 3,129 $ 3,755
Less: Variable expenses 756 907
Less: Fixed expenses 1,300 1,300
Net operating income $ 1,073 $ 1,548
% change in sales 20.0%
% change in net operating income 44.2%

6-74
Structuring Sales Commissions
Companies generally compensate

salespeople by paying them either a
commission based on sales or a salary plus a
sales commission. Commissions based on
sales dollars can lead to lower profits in a
company.
Let’s look at an example.

6-75
Pipeline Unlimited produces two types of surfboards,

the XR7 and the Turbo. The XR7 sells for $100 and
generates a contribution margin per unit of $25. The
Turbo sells for $150 and earns a contribution margin
per unit of $18.
The sales force at Pipeline Unlimited is

compensated based on sales commissions.

6-76
If you were on the sales force at Pipeline, you would

push hard to sell the Turbo even though the XR7
earns a higher contribution margin per unit.
To eliminate this type of conflict, commissions can

be based on contribution margin rather than on
selling price alone.

6-77
Compute the break-even

point for a multiproduct
company and explain the
effects of shifts in the
sales mix on contribution
margin and the break-
even point.

6-78
The Concept of Sales Mix
• Sales mix is the relative proportion in which a

company’s products are sold.
• Different products have different selling prices,
cost structures, and contribution margins.
Let’s assume Racing Bicycle Company sells

bikes and carts and that the sales mix between
the two products remains the same.

6-79
Multi-product break-even analysis

Racing Bicycle Co. provides the following information:
$265,000
= 48.2% (rounded)
$550,000
6-80
Multi-product break-even analysis

Break-even Fixed expenses
sales = CM Ratio
$170,000
=
48.2%
= $352,697

6-81
Key Assumptions of CVP Analysis
Selling price is constant.

Costs are linear.
In multiproduct companies, the sales mix is
constant.
In manufacturing companies, inventories do
not change (units produced = units sold).

6-82
End of Chapter 6

Variable Costing:
A Tool for Management
Chapter Seven

7-2
Explain how variable

costing differs from
absorption costing and
compute unit product
costs under each method.

7-3
Overview of Absorption
and Variable Costing
Absorption Variable
Costing Costing
Direct Materials
Product
Product Direct Labor
Costs
Costs Variable Manufacturing Overhead
Fixed Manufacturing Overhead

Period
Period Variable Selling and Administrative Expenses
Costs
Costs Fixed Selling and Administrative Expenses

7-4
Quick Check 
Which method will produce the highest values for

work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends. . .

7-5
Quick Check 
Which method will produce the highest values for

work in process and finished goods inventories?
a. Absorption costing.
b. Variable costing.
c. They produce the same values for these
inventories.
d. It depends. . .

7-6
Unit Cost Computations
Harvey Company produces a single product

with the following information available:

7-7
Unit product cost is determined as follows:
Under absorption costing, selling and

administrative expenses are
always treated as period expenses and
deducted from revenue as incurred.
7-8
Prepare income
statements using both
variable and absorption
costing.

7-9
Income Comparison of
Absorption and Variable Costing
Let’s assume the following additional

information for Harvey Company.
 20,000 units were sold during the year at a price of
$30 each.
 There were no units in beginning inventory.
Now, let’s compute net operating

income using both absorption
and variable costing.
7-10
Absorption Costing

7-11
Variable Costing
Variable
manufacturing
Variable Costing
costs only.
Sales (20,000 × $30) $ 600,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (25,000 × $10) 250,000
manufacturing
Goods available for sale 250,000
Less ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 200,000
expensed.
Variable selling & administrative
expenses (20,000 × $3) 60,000 260,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000

7-12
Reconcile variable costing

and absorption costing net
operating incomes and
explain why the two
amounts differ.

7-13
Comparing the Two Methods

7-14
We can reconcile the difference between

absorption and variable income as follows:
Variable costing net operating income $ 90,000

Add: Fixed mfg. overhead costs
deferred in inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 120,000
Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
7-15
Extended Comparisons of Income Data
Harvey Company Year Two

7-16
Since there was no change in the variable costs

per unit, total fixed costs, or the number of
units produced, the unit costs remain unchanged.
7-17
Absorption Costing
Absorption Costing
Sales (30,000 × $30) $ 900,000
Less cost of goods sold:
Beg. inventory (5,000 × $16) $ 80,000
Add COGM (25,000 × $16) 400,000
Less ending inventory - 480,000
Gross margin 420,000
Less selling & admin. exp.
Variable (30,000 × $3) $ 90,000
Fixed 100,000 190,000
These are the 25,000 units

produced in the current period.
7-18
Variable Costing
Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.

7-19
We can reconcile the difference between

absorption and variable income as follows:
Variable costing net operating income $ 260,000

Deduct: Fixed manufacturing overhead
costs released from inventory
(5,000 units × $6 per unit) 30,000
Absorption costing net operating income $ 230,000
Fixed mfg. Overhead $150,000

= = $6.00 per unit
Units produced 25,000 units
7-20

7-21
Summary of Key Insights

7-22
Effect of Changes in Production
on Net Operating Income
Let’s revise the Harvey Company example.
In the previous example,

25,000 units were produced each year,
but sales increased from 20,000 units in year
one to 30,000 units in year two.
In this revised example,

production will differ each year while
sales will remain constant.
7-23
Harvey Company Year One

7-24
Unit Cost Computations for Year One
Since the number of units produced increased

in this example, while the fixed manufacturing overhead
remained the same, the absorption unit cost is less.
7-25
Absorption Costing: Year One

7-26
Variable Costing: Year One
Variable
manufacturing
Variable Costing
costs only.
Sales (25,000 × $30) $ 750,000
Less variable expenses:
Beginning inventory $ -
All fixed
Add COGM (30,000 × $10) 300,000
manufacturing
Less ending inventory (5,000 × $10) 50,000
overhead is
Variable cost of goods sold 250,000
expensed.
Variable selling & administrative
expenses (25,000 × $3) 75,000 325,000
Less fixed expenses:
Manufacturing overhead $ 150,000
Selling & administrative expenses 100,000 250,000

7-27
Harvey Company Year Two

7-28
Unit Cost Computations for Year Two
Since the number of units produced decreased in the

second year, while the fixed manufacturing overhead
remained the same, the absorption unit cost is now higher.
7-29
Absorption Costing: Year Two
Absorption Costing
Sales (25,000 × $30) $ 750,000
Less cost of goods sold:
Beg. inventory (5,000 × $15) $ 75,000
Add COGM (20,000 × $17.50) 350,000
Less ending inventory - 425,000
Gross margin 325,000
Less selling & admin. exp.
Variable (25,000 × $3) $ 75,000
Fixed 100,000 175,000
These are the 20,000 units produced in the current

period at the higher unit cost of $17.50 each.
7-30
Variable Costing: Year Two

Variable
manufacturing
costs only.
All fixed
manufacturing
overhead is
expensed.

7-31
Conclusions
 Net operating income is not affected by changes in
production using variable costing.
 Net operating income is affected by changes in production
using absorption costing even though the number of units
sold is the same each year.
7-32
Understand the
advantages and
disadvantages of both
variable and absorption
costing.

7-33
Impact on the Manager
Opponents of absorption costing argue that

shifting fixed manufacturing overhead costs
between periods can lead to faulty decisions.
These opponents argue that variable costing income

statements are easier to understand because net operating
income is only affected by changes in unit sales. This
produces net operating income figures that are
more consistent with managers’ expectations.

7-34
CVP Analysis, Decision Making
and Absorption costing
Absorption costing does not support CVP

analysis because it essentially treats fixed
manufacturing overhead as a variable cost by
assigning a per unit amount of the fixed
overhead to each unit of production.
Treating fixed manufacturing overhead as a
variable cost can:
• Lead to faulty pricing decisions and keep-or-drop
decisions.
• Produce positive net operating income even
when the number of units sold is less than the
breakeven point.
7-35
External Reporting and Income Taxes
To conform to
GAAP requirements,
absorption costing must be used for
external financial reports in the
United States. Under the Tax
Reform Act of 1986,
absorption costing must be
used when filing income
Since top executives
tax returns.
are usually evaluated based on
external reports to shareholders,
they may feel that decisions
should be based on
absorption cost income.
7-36
Advantages of Variable Costing
and the Contribution Approach
Consistent with
CVP analysis.
Management finds Net operating income
it more useful. is closer to
net cash flow.
Consistent with standard
costs and flexible budgeting.
Advantages
Easier to estimate profitability
of products and segments.
Impact of fixed
costs on profits Profit is not affected by
emphasized. changes in inventories.
7-37
Variable versus Absorption Costing
Fixed manufacturing
costs must be assigned Fixed manufacturing
to products to properly costs are capacity costs
match revenues and and will be incurred
costs. even if nothing is
produced.
Absorption Variable
Costing Costing
7-38
Variable Costing and the
Theory of Constraints (TOC)
Companies involved in TOC use a form of variable

costing. However, one difference of the TOC approach
is that it treats direct labor as a fixed cost for three
reasons:
 Many companies have a commitment to guarantee
workers a minimum number of paid hours.
 Direct labor is usually not the constraint.
 TOC emphasizes the role direct laborers play in driving
continuous improvement. Since layoffs often devastate
morale, managers involved in TOC are extremely
reluctant to lay off employees.

7-39
Impact of JIT Inventory Methods
In a JIT inventory system . . .
Production
tends to equal
sales . . .
So, the difference between variable and

absorption income tends to disappear.
7-40
End of Chapter 7

5-1
Used primarily for Used primarily by

external reporting. management.

5-2
Additional slide
-While a traditional income statement works by

separating product costs (those incurred in the process
of manufacturing a product) from period costs (those
incurred in the process of selling products, as opposed
to making them), the contribution margin income
statement separates variable costs from fixed costs.
-In a contribution margin income statement, variable

selling and administrative periods costs are grouped
with variable product costs to arrive at the contribution
margin.

5-3
Additional slide
-A traditional income statement uses absorption or full

costing, where both variable and fixed manufacturing
costs are included when calculating the cost of goods
sold. The contribution margin income statement, by
contrast, uses variable costing, which means fixed
manufacturing costs are assigned to overhead costs
and therefore not included in product costs.
-Companies are generally required to present traditional

income statements for external reporting purposes.

5-4
Additional slide
-Contribution margin income statements, by contrast,
are often presented to managers and stakeholders to
analyze the performance of individual products or
product categories.
-Companies can benefit from contribution margin

income statements because they can provide more
detail as to the costs and resources needed to produce
a given product or unit of a product.
-While both income statements ultimately serve the

purpose of showing whether a company is profitable or
not over a certain period of time, the contribution
margin income statement can offer additional insight as
how to that net profit or loss came to be.

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Cost Terms, Concepts and

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Identify and give examples

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Direct Direct Manufacturing

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Raw materials that become an integral part of the

Example: A radio installed in an automobile

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Those labor costs that can be easily traced to

Example: Wages paid to automobile assembly workers

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Manufacturing costs that cannot be traced directly

Examples: Indirect labor and indirect materials

Wages paid to employees Materials used to support

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Costs necessary to get All executive,

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Product Costs Versus Period Costs

Product costs include Period costs include all

Inventory Cost of Good Sold Expense

Balance Income Income

Which of the following costs would be considered a

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Which of the following costs would be considered a

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Manufacturing costs are often

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The Income Statement

Cost of goods sold for manufacturers differs only

Merchandising Company Manufacturing Company

Cost of goods sold:

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Basic Equation for Inventory Accounts

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If your inventory balance at the beginning of the

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If your inventory balance at the beginning of the

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Prepare a schedule of cost

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Schedule of Cost of Goods Manufactured

Calculates the cost of raw

Calculates the manufacturing

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Product Cost Flows

Beginning raw Direct materials

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Product Cost Flows

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Product Cost Flows

Beginning raw Direct materials Beginning work in

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Product Cost Flows

Beginning raw Direct materials Beginning work in

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Product Cost Flows

Beginning work in Beginning finished

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