Chapter 22

Distinguish between Variable and Fixed Costs

I. Cost Behavior Analysis
a. The study of how specific costs respond to changes in the level
of business activity
b. Some costs change others remain the same
c. Helps management plan operations and decide between
alternative courses of actions
d. Applies to all types of businesses and entities
II. Activity Index
a. For an activity level to be useful changes in the level or volume
of activity should be correlated with changes in costs
b. The activity level selected is called the activity or volume index
c. The activity index
i. Identifies the activity that causes changes in the
behavior of costs
ii. Allows costs to be classified according to their response
to changes in activity as either variable costs, fixed
costs, or mixed costs
III. Behavior of Total and Unit Variable Costs
a. Variable Costs: are costs that vary in total directly and
proportionately with changes in the activity level. A variable
cost may also be defines as a cost that remains the same per
unit at every level of activity. Damon Company manufactures
radios that contain a $10 digital clock.
b. The activity index is the number of radios produced. As each
radio is manufactured the total cost of the clocks increases by
$10

IV. Behavior of Total and Unit Fixed Costs

a. Fixed Costs: costs that remain the same in total regardless of
changes in the activity level. Since fixed costs remain constant
in total as activity changes, fixed costs per unit vary inversely
with activity
b. Damon Company leases all of 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.
 Explain the Significance of the Relevant Range
I. Nonlinear Behavior of Variable and Fixed Costs
a. A straight-line relationship doesn’t usually exist for variable costs
throughout the entire range of activity
b. In the real world the relationship between variable cost behavior and
changes in the activity level is often curvilinear as shown in part a.
the behavior of total fixed costs through all levels of activity is shown
in part b

II. Linear Behavior Within Relevant Range

a. Relevant range of the activity index is the range over which a
company expects to operate during an yr. Within this range a
straight-line relationship normally exists for both fixed and variable
costs.

Explain the Concept of Mixed Costs

I. Behavior of a Mixed Cost
a. Mixed costs contain both variable and fixed cost elements
b. Mixed (semi variable) costs change in total but not proportionately
with changes in the activity level
c. Local rental terms for a 17-foot U haul truck including insurance, are
$50 per day plus $0.50 per mile. The per diem charge is a fixed cost
with respect to miles driven, while the mileage charge is s variable
cost. The graphic presentation of the rental cost for a one day rental is
as follows

II. Classification of Costs

a. Sidney corporation reports the following total costs at two levels of
production. Classify as a variable fixed or mixed
Cost 5,000 units 10,000 units Classification
Property taxes $4,200 $4,200 Fixed
Direct labor wages 12,000 24,000 Variable
Production supervision 2,000 3,000 Mixed
Electricity 800 950 Mixed
 III. Formula for Variable Cost per Unit using High-Low Method
a. In CVP analysis: its assumed that mixed costs must be classified into
their variable and fixed components
b. The high-low method: uses the total costs incurred at the high and low
levels of activity
c. The steps in calculating fixed and variable costs under this method are
as follows:
Step 1: determine variable cost per unit from the following formula
Change in total costs ÷ high minus low activity levels = variable cost per unit

IV. Assumed Maintenance Costs and Mileage Data

a. Assume that Metro Transit Company had the maintenance costs and
mileage data for its fleet of buses over a 4 month period as shown below
Month Miles driven Total cost Month Miles driven Total cost
January 20,000 30,000 March 35,000 $49,000
February 40,000 48,000 April 50,000 63,000

The difference in maintenance costs is $33,000 ($63,000 - $30,000) and the difference
in miles is 30,000 (50,000-20,000)
Therefore variable cost per unit for metro transit company is $1.10 ($33,000÷30,000)

V. High-Low Method Computation of Fixed Costs

Step 2: determine the fixed cost by subtracting the total variable cost at
either the high or low activity level from the total cost at that activity
level
For Metro Transit Company, the calculations are as follows
Activity Level
High Low
Total cost $63,000 $30,000
Less: variable costs
50,000x$1.10 55,000
20,000 x $1.10 22,000
Total fixed costs $8,000 $8,000

List the Five Components of Cost-Volume-Profit analysis

I. CVP Analysis
a. Cost-Volume-Profit (CVP) Analysis: is the study of the effects of
changes of costs and volume on a company profits
b. Cost-volume-profit (CVP) analysis is important in profit planning
c. Its also critical factor in management decisions
II. Components of CVP Analysis
a. The following assumptions underlie each CVP analysis:
i. The behavior of both costs and revenues in linear throughout
the relevant range of activity index
ii. All costs can be classified as either variable or fixed with
reasonable accuracy
iii. Changes in activity are the only factors that affect costs
iv. All units produced are sold
 v. When more than one type of product is sold the sales mix will
remain constant. Sales mix complicates CVP analysis because
different products will have different cost relationships
b. Volume or level of activity, unit selling prices, variable cost, total fixed
cost, and sales mix
i. When these assumption are invalid the results of CVP analysis
may be inaccurate
III. CVP Income Statement
a. A statement for internal use
b. Classifies costs and expenses as fixed or variable
c. Reports contribution margin in the body of the statement
i. Contribution margin: amount of revenue remaining after
deducting variable costs
d. Reports the same net income as a traditional income statement
IV. Assumed Selling Price and Cost Data for Vargo Video
a. In CVP analysis applications the term cost includes manufacturing
costs plus selling and administrative expenses
b. Relevant data for the high end, progressive scan DVD
players/recorders made by Vargo video company are as follows
Unit Selling Price $500
Unit Variable Costs $300
Total monthly fixed costs $200,000
V. Formula for and Computation of Contribution Margin
a. Contribution margin: is one of the key relationships in CVP analysis
and is the amount of revenue remaining after deducting variable costs
b. Vargo Video Company sells 1,000 DVDs in one month sale are $500,00
(1,00 x $500) and variable costs are $300,000 (1,000 x$300)
c. Thus CM is $200,000 computed as follows
Sales – variable costs = contribution margin
$500,000 – 300,000= 200,000
VI. Formula for Contribution Margin Per Unit
a. The contribution margin is then available to cover fixed costs and to
contribute income for the company
b. The formula for contribution margin per unit is show below
Unit selling price – unit available costs = contribution margin per unit
500- 300= 200
at Vargo Video Company the contribution margin per unit is 200(550-
300)
VII. CVP Income Statement- CM Effect
 VIII. Formula for Contribution Margin Ratio
a. Some managers prefer to use a contribution margin ratio
b. The formula for contribution margin ratio is shown here
Contribution margin per unit ÷unit selling price=contribution margin
ratio
200 ÷ 500 = 40%

at Vargo Video Company the contribution margin ratio is 40%

(200÷500)
Identify the Three Ways to Determine the Break-Even Point
I. Break Even Equation
a. Break Even Equation is a key relationship in CVP analysis and is the level of
activity at which total revenues equal total costs both fixed and variable. This
level of activity is called the break even point
b. The break even point can be
i. Computed from a mathematical equation
ii. Computed by using contribution margin
iii. Derived from a cost-volume-profit CVP graph
c. A common equation used for CVP analysis is:
Variable costs + fixed costs + net income = sales
II. Computation of Break Even Point in Units
a. Break point in units: can be calculated directly from a mathematical equation by
using unit selling prices and unit variable costs
Variable costs + fixed costs + net income = sales
300Q 200,000 0 500Q

$200Q= $200,000
Q= 1,000 units
Where
Q= sales volume in units
$500 = selling price
$300 = variable cost per unit
$200,000 = total fixed costs

III. Formula for Break Even Point in Dollars Using Contribution Margin Ratio
a. When the contribution margin ratio is used the formula to calculate the break
even point in dollars is:
Fixed costs ÷ contribution = break even point in dollars
200,000 ÷ 40%= 500,000
since Vargo Video Company’s contribution margin ratio is 40% the break even
point in dollars is calculated to be : 500,000 (200,000÷40%)
IV. Graphic Presentation
a. An effective way to find the break even point is to prepare a break
even graph
 b. The graph is referred to as a cost volume profit CVP graph since it
shows costs, volume, and profits
c. To construct a graph
i. Plot the total sales like starting at the zero activity level
ii. Plot the total fixed cost by horizontal line
iii. Plot the total cost line. This start at the fixed cost line at 0 activity
iv. Determine the break even point from the intersection of the total
cost line and the total sales line
V. CVP Graph
a. In the graph below sales volume is recorded along the horizontal axis. The
axis needs to extend to the maximum level of expected sales both total
revenues (sales) and total costs (fixed plus variable) are recorded on the
vertical axis

Give the formulas for Determining Sales Required to Earn Target Net Income
I. Formula for required sales to meet target net income
a. By adding an amount for target net income to the break-even
equation we obtain the formula below for determining
required sales.
b. Required sales may be expressed either in sales dollars or sales
units
Variable costs + fixed costs + target net income = required sales

II. Formula for required sales in units Using Contribution Margin Per Unit
a. The formula using the contribution margin per unit is
Fixed costs + target net income = required sales in units
Contribution margin per unit
The computation for Vargo Video is:
(200,000 + 120,000)/200 = 1,600 units

III. Formula for required sales in Dollars Using Contribution Margin Ratio
Fixed costs + target net income = required sales in dollars
Contribution margin ratio
The computation for Vargo Video is
320,000/40% = 800,000

IV. Formula for Margin of Safety in Dollars

a. The margin of safety is another relationship that may be
calculated in CVP analysis
b. It is the difference between actual or expected sales and sales
at the break event point
c. It may be expressed in dollars or as a ratio
d. The formula for determining the margin of safety in dollars is
shown below
Actual (expected) sales – break even sales = margin of safety in dollars
Given that Vargo Video Company’s actual (expected) sales are 750,000 the margin of safety
in dollars is calculated to be: 250,000 (750,000 – 500,00)
Describe the Essential Features of a Cost Volume Profit Income statement
I. Basic CVP Income Statement