Chapter 3

Introduction to Cost Behavior

and Cost-Volume Relationships

Course: Management Accounting

 Objectives
1. Explain how cost drivers affect cost behavior
2. Show how changes in cost-driver activity levels affect
variable and fixed costs
3. Calculate break-even sales volume in total dollars and
total units
4. Create a cost-volume-profit graph and understand the
assumptions behind it
5. Calculate sales volume in total dollars and total units to
reach a target profit
6. Calculate contribution margin and gross margin
7. Sales mix analysis
8. Compute cost-volume-profit relationships on an after-tax
basis
9. Understand how cost behavior and cost-volume-profit
analysis are used by managers

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 Cost Behavior

What is cost behavior?

It is how costs are related to, and

affected by, the activities of an
organization.

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 Cost Drivers

What are cost drivers?

Output measures of resources and

activities are called cost drivers.

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 Cost Drivers

Research and development - Example

Costs: Cost drivers:

 Salaries of sales personnel  Number of new product
costs of market surveys proposals

 Salaries of product and  Complexity of proposed

process engineers products

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 Cost Drivers

Design of products, services, and processes - Example

Costs Cost drivers

 Salaries of product and  Number of engineering
process engineers hours
 Cost of computer-aided  Number of distinct parts
design equipment used to per product
develop prototype of
product for testing

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 Cost Drivers

Production - Example

Costs: Cost drivers:

 Labor wages  Labor hours
 Supervisory salaries  No. of people supervised
 Maintenance wages  No. of mechanic hours
 Depreciation  No. of machine hours
 Energy  Kilowatt hours

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 Cost Drivers

Marketing - Example

Costs: Cost drivers:

 Cost of advertisements  Number
Numberofofadvertisements
advertisements
 Salaries of marketing  Sales dollars
personnel, travel costs,
entertainment costs

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 Cost Drivers

Distribution - Example

Costs Cost drivers

 Wages of shipping personnel  Labor hours
 Transportation costs  Weight of items delivered
including depreciation of
vehicles and fuel

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 Cost Drivers

Customer service - Example

Costs Cost drivers

 Salaries of service  Hours spent servicing
personnel products
 Costs of supplies, travel  Number of service calls

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 Cost Drivers

How well the accountant does at identifying

the most appropriate cost drivers determines
how well managers understand cost behavior
and how well costs are controlled.

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 Comparison of
Variable and Fixed Costs

A variable cost is a cost that changes in direct

proportion to changes in the cost driver.
Ex: COGS & Sales revenue

A fixed cost is not immediately affected

by changes in the cost driver.
Ex: Office rental costs

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 Rules of Thumb

Think of fixed costs as a total.

Total fixed costs remain unchanged
regardless of changes in cost-driver activity

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 Rules of Thumb

Think of variable costs on a per-unit basis.

The per-unit variable cost remains

unchanged regardless of changes in the
cost-driver activity

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 Cost Behavior of Variable and Fixed
If cost-driver level Increases (or Decreases)
Type of cost Total cost Cost per Unit (*)
Fixed costs No change Decrease (Increase)
Variable costs Increase (Decrease) No change
(*) Per unit of activity volume, for example, product units,
passenger-miles, sales dollars

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 Relevant Range

• This rule of thumb holds true only

within reasonable limits.
• The relevant range is the limit of
cost-driver activity within which a
specific relationship between costs
and the cost driver is valid.

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 Relevant Range
Fixed Costs ($)

16,000 –

12,000 –
Relevant Range
8,000 –

4,000

–
–

–
0 500 1,000 1,500 2,000 2,500
Volume in Units
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 Cost-Volume-Profit
Analysis (CVP)

What is cost-volume-profit analysis?

It is the study of the effects of output

volume on revenue (sales), expenses
(costs), and profit.

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 CVP Example

Saigon’s Coffee Shop

Per Unit Percentage
Selling price $5 100%
Variable cost $3 60%
Difference $2 40%
Total monthly fixed costs: $15,000
Rent 5,000
Labor 7,500
Other 2,500
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 Break-Even Point

The break-even point is the level of

sales at which revenue equals
expenses/costs and profit is zero.

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 Margin of Safety

• The margin of safety shows how far sales

can fall below the planned level before
losses occur.
Planned unit sales
–
Break-even unit sales
=
Margin of safety

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 Break-Even Point
Techniques

There are two basic techniques for

computing break-even point:
1. Contribution margin (CM)
2. Equation

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 Contribution Margin Technique

Break-even in units:

Per Unit Percentage

Selling price $5 100%
Variable cost (VC) $3 60%
Contribution (CM) $2 40%
$15,000 ÷ $2 = 7,500 units

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 Contribution Margin Technique

Break-even in dollars:

7,500 units × $5 = $37,500

or
$15,000 ÷ 40% = $37,500

Note: 40% is the percentage of CM/Sales

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 Equation Technique

Profit equals zero at the break-even point

Revenue (sales)
– Variable cost (VC)

– Fixed cost (FC)

= Zero profit (break-even point)

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 Equation Technique

Let Q = number of units to be sold to break even

$5Q – $3Q – $15,000 = 0

$2Q = $15,000
Q = $15,000 ÷ $2
Q = 7,500 units

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 Equation Technique

Let S = sales in dollars needed to break even

S – 60%S – $15,000 = 0
40%S = $15,000
S = $15,000 ÷ 40%
S = $37,500

Note: 60% is the percentage of VC/Sales

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 Cost-Volume-Profit Graph
Q Sales VC FC TC Profit
0 0 0 15,000 15,000 (15,000)
1,500 7,500 4,500 15,000 19,500 (12,000)
3,000 15,000 9,000 15,000 24,000 (9,000)
4,500 22,500 13,500 15,000 28,500 (6,000)
6,000 30,000 18,000 15,000 33,000 (3,000)
7,500 37,500 22,500 15,000 37,500 -
9,000 45,000 27,000 15,000 42,000 3,000
10,500 52,500 31,500 15,000 46,500 6,000
12,000 60,000 36,000 15,000 51,000 9,000
BEP at 7,500 units
or $37,500

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 Cost-Volume-Profit Graph

BEP at 7,500 units

or $37,500

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 Target Profit

Managers can also use CVP analysis to

determine the total sales, in units and
dollars, needed to reach a target profit

Target sales volume FC + Target profit

=
in units CM per unit

Target sales volume FC + Target profit

=
in dollars % CM

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 Target Profit (cont.)

How many units for sales to reach

a target profit of $9,000?

Target sales $15,000 + $9,000

= = 12,000 units
volume in units $2

Target sales $15,000 + $9,000

= = $60,000
volume in dollars 40%

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 Target Profit (cont.)

How many units for sales to reach

a target profit of $9,000?

Target sales $15,000 $9,000

= + = 12,000 units
volume in units $2 $2

BEP at
7,500 units
2,500 units is the extra
volume needed to
reach the target profit

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 Target Profit (cont.)

How many units for sales to reach

a target profit of $9,000?

Target sales $15,000 $9,000

= + = $60,000
volume in dollars 40% 40%

BEP at
$37,500
$22,500 is the extra
volume needed to
reach the target profit

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 Operating Leverage (OL)

• The use of fixed operating costs as

opposed to variable operating costs.
• In high leveraged companies, small
changes in sales volume result in large
changes in profit.
• Companies with less leverage are not
affected as much by changes in sales
volume.

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 Degree of Operating
Leverage (DOL)

Operating leverage : by using fixed

operating costs, a small change in sales
is magnified into a larger change in
operating income (EBIT).

This “multiplier effect” is called the

degree of operating leverage (DOL).

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35 Management Accounting
 Degree of Operating Leverage
from Sales Level

DOL = % change in EBIT

% change in sales

Change in EBIT
= EBIT
Change in sales
Sales
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 Degree of Operating Leverage
from Sales Level
If we have the data, we can use this
formula:

DOLs = Sales - Variable Costs

EBIT

DOLs = Q (P – VC)
Q (P – VC) – FC
Where,
Q: Quantity; P: Price; VC: Variable cost per unit; FC: Fixed cost

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 Degree of Operating Leverage
from Sales Level

In briefly:

Contribution margin
DOL =
EBIT

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 What does this tell us?

If DOL = 2, then a 1% increase in

sales will result in a 2% increase
in operating income (EBIT).

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 An example for DOL
Saigon’s Coffee Shop
Data:
Price $5
Variable cost per unit $3
Fixed cost $15,000
Income statement Planned New Change
Quantity (unit) 10,000 11,000 10%
Sales 50,000 55,000
Variable costs 30,000 33,000
Contribution margin 20,000 22,000
Fixed costs 15,000 15,000
EBIT 5,000 7,000 40%
DOL [$20,000/$5,000] 4
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 Gross Margin and Contribution Margin

Gross margin (also called gross profit) is the

difference between sales and cost of goods sold.

Contribution margin (CM) is the difference

between sales and variable costs.

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 Gross Margin and Contribution Margin
Comparing two format of income statement

Financial Management
accounting accounting
Sales Sales
(-) Cost of good sold (-) Variable cost
(=) Gross margin (=) Contribution margin
(-) Operating costs (-) Fixed cost
(=) EBIT (=) EBIT

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 Sales mix analysis
 Sales mix is the relative proportions or
combinations of quantities of products that
comprise total sales.

 If the proportions of the mix change, the

cost-volume-profit relationships also change.

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 Sales mix analysis (cont.)
Ex: Small Petrol Station SPS is selling two products.
Products Gasoline (G) Diesel (D)
Sales in units (ton) 100 25
Price per unit 30 20
Variable per unit 28 16
Contribution margin per unit 2 4
Total fixed cost 120
Income statement Gasoline (G) Diesel (D) Total
Sales 3,000 500 3,500
Variable costs 2,800 400 3,200
Contribution margins 200 100 300
Fixed cost 120
Profit 180

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 Sales mix analysis (cont.)
 Let D = number of units of Diesel to break even, and
 4D = number of units of Gasoline to break even

Break-even point for a constant sales mix of 4 units of G

for every unit of D.
Sales – Variable costs – Fixed costs = Zero Profit
[$30(4D) + $20(D)] – [$28(4D) + $16(D)] – $120 = 0
120D + 20D – 112D – 16D – 120 = 0
12D = 120
D = 10 units
G = 4D = 40 units
10D + 40G = 50 total units (D + G).
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 Sales mix analysis (cont.)
 If the SPS station sells only Diesel:
Fixed cost
Break-even point =
Contribution per unit
120
Break-even point = = 30 Diesel units
4

 If the SPS station sells only Gasoline:

Fixed cost
Break-even point =
Contribution per unit
120
Break-even point = = 60 Gasoline units
2
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 Sales mix analysis (cont.)

 Suppose total sales were equal to the budget

of 125 units.
 However, SPS sold only 15 Diesel and 110
Gasoline.
 What is profit?

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 Sales mix analysis (cont.)
Products Gasoline (G) Diesel (D)
Sales in units (ton) 110 15
Price per unit 30 20
Variable per unit 28 16
Contribution margin per unit 2 4
Total fixed cost 120
Income statement Gasoline (G) Diesel (D) Total
Sales 3,300 300 3,600
Variable costs 3,080 240 3,320
Contribution margins 220 60 280
Fixed cost 120
Profit 160
Profit was reduced (from 180 - 160) because Diesel, a product with high
Contribution margin per unit ($4/unit), decreased in sales structure.

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 Sales mix analysis (cont.)

 Suppose total sales were equal to the budget

of 125 units.
 However, SPS sold only 45 Diesel and 80
Gasoline.
 What is profit?

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 Sales mix analysis (cont.)
Products Gasoline (G) Diesel (D)
Sales in units (ton) 80 45
Price per unit 30 20
Variable per unit 28 16
Contribution margin per unit 2 4
Total fixed cost 120
Income statement Gasoline (G) Diesel (D) Total
Sales 2,400 900 3,300
Variable costs 2,240 720 2,960
Contribution margins 160 180 340
Fixed cost 120
Profit 220
Profit was increased (from 180 - 220) because Diesel, a product with high
Contribution margin per unit ($4/unit), increased in sales structure.

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 Target Net Income and Income Taxes
Management of Saigon’s Coffee Shop
would like to earn an after-tax income of
$4,000; the tax rate is 20%; What is the
Target operating income (TOI)/EBIT?
TOI
= Target net income ÷ (1 - tax rate)
= $4,000 ÷ (1 - 20%)
= $5,000

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 Target Net Income and Income Taxes
How many units must to sell?
Sales - VC - FC = Target net income ÷ (1-tax rate)

For Saigon’s Coffee Shop:

$5Q - $3Q - $15,000 = $4,000 ÷ (1 - 20%)
 $2Q = $5,000 + $15,000
 Q = $20,000 ÷ $2
We have, Q = 10,000 units

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 Target Net Income and Income Taxes
Saigon’s Coffee Shop Income Statement
Sales (10,000 x $5) 50,000
Variable costs (10,000 x $3) 30,000
Contribution margin (10,000 x $2) 20,000
Fixed costs 15,000
Operating income/EBIT 5,000
Income Tax 20% 1,000
Net income 4,000

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 An example for cost structure
Basic conditions
Income
Company A Company B
statement
Amount % Amount %
Sales 100,000 100% 100,000 100%
Variable cost 40,000 40% 80,000 80%
Contribution 60,000 60% 20,000 20%
Fixed costs 50,000 10,000
Profits 10,000 10,000

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 An example for cost structure (cont.)

Increase in sales: 30%

Income
Company A Company B
statement
Amount % Amount %
Sales 130,000 100% 130,000 100%
Variable cost 52,000 40% 104,000 80%
Contribution 78,000 60% 26,000 20%
Fixed costs 50,000 10,000
Profits 28,000 16,000

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 An example for cost structure (cont.)

Decrease in sales: -30%

Income
Company A Company B
statement
Amount % Amount %
Sales 70,000 100% 70,000 100%
Variable cost 28,000 40% 56,000 80%
Contribution 42,000 60% 14,000 20%
Fixed costs 50,000 10,000
Profits (8,000) 4,000

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 An example for cost structure (cont.)
Average over 2016-2020 PETROLIMEX COMECO
Sales 195,562 4,663
VC 186,973 95.6% 4,516 96.8%
CM 8,589 4.4% 147 3.2%
FC 3,624 32
EBIT 4,964 115
OL 1.73 1.28
BEP in dollars 82,525 1,010
% BEP in dollars/Sales 42% 22%
% FC/TC 2% 1%

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 An example for cost structure (cont.)

Average over 2016-2020 VNM MASAN-MCH

Sales 66,588 100% 20,246 100%
VC 49,113 74% 14,138 70%
CM 17,475 26% 6,108 30%
FC 3,073 1,889
EBIT 14,402 4,219
OL 1.21 1.45
BEP in dollars 11,708 6,261
% BEP in dollars/Sales 18% 31%
% FC/TC 6% 12%

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 An example for cost structure (cont.)

Average over 2016-2020 Vietnam Airlines VietJet Air

Sales 97,154 100% 43,496 100%
VC 87,099 90% 38,008 87%
CM 10,055 10% 5,488 13%
FC 8,746 586
EBIT 1,310 4,902
OL 8 1.12
BEP in dollars 84,500 4,641
% BEP in dollars/Sales 87% 11%
% FC/TC 9% 2%

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 An example for cost structure (cont.)

Average over 2016-2019 DHG TRAPHACO

Sales 3,906 100% 1,844 100%
VC 2,779 71% 1,293 70%
CM 1,127 29% 552 30%
FC 398 270
EBIT 729 282
OL 1.55 1.96
BEP in dollars 1,380 903
% BEP in dollars/Sales 35% 49%
% FC/TC 13% 17%

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 An example for cost structure (cont.)

Average over 2016-19 NAM VIET VINH HOAN HUNG HAU

Sales 3,593 100% 8,148 100% 1,031 100%
VC 2,997 83% 6,778 83% 938 91%
CM 596 17% 1,370 17% 93 9%
FC 137 304 36
EBIT 459 1,066 57
OL 1.30 1.29 1.62
BEP in dollars 826 1,807 396
% BEP in dollars/Sales 23% 22% 38%
% FC/TC 4.4% 4.3% 3.7%

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 An example for cost structure (cont.)

Average over 2016-2019 FICO VICEM

Sales 5,277 100% 8,415 100%
VC 4,586 87% 6,365 76%
CM 691 13% 2,050 24%
FC 382 908
EBIT 309 1,142
OL 2.2 1.8
BEP in dollars 2,916 3,728
% BEP in dollars/Sales 55% 44%
% FC/TC 8% 12%

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How is Cost Behavior and Cost-volume-profit
analysis are used by managers?

Understanding cost behavior is vital to

the manager’s decision-making role,
because one of the main goals of
management accounting is controlling
costs.

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