Chapter 2

Copyright © 2014 Pearson Education 2-1
Chapter 2
Introduction to Cost Behavior

and Cost-Volume-Profit
Relationships

Chapter 2 Learning Objectives
When you have finished studying this chapter,

you should be able to:
1. Explain how cost drivers affect cost behavior
2. Show how changes in cost-driver levels
affect variable and fixed costs.
3. Explain step- and mixed-cost behavior.
4. Measure and mathematically express cost
functions and use them to predict costs.
5. Measure and mathematically express cost
functions and use Copyright
them to predict costs.
© 2014 Pearson Education 2-3
Chapter 2 Learning Objectives
6. Create a cost-volume-profit (CVP) graph and

understand the assumptions behind it.
7. Calculate break-even sales volume in total
dollars and total units.
8. Calculate sales volume in total dollars and
total units to reach a target profit and the
safety margin.
9. Differentiate between contribution margin
and gross margin.

Learning
Objective 1
Cost Drivers and Cost Behavior
Cost behavior is how the activities of an

organization affect its costs.
Cost drivers are measures of activities that

require the use of resources and thereby
cause costs.
An organization has many cost drivers

across the various activities of its value
chain.
Learning
Objective 2 Variable and Fixed Cost Behavior
A variable cost A fixed cost

changes in direct Not affected by
proportion to changes Changes in the
in the cost-driver level. cost-driver level.
Think of variable costs Think of fixed costs

on a per-unit basis on a total-cost basis.
Per-unit variable cost Total fixed costs

remains unchanged remain unchanged
regardless of changes regardless of changes
in the cost-driver. in the cost-driver.
A variable cost A fixed cost

Cost Behavior of Variable and Fixed

Learning Step- and Mixed-Cost
Objective 3
Behavior Patterns
Step cost Mixed Cost
A cost that changes A cost that contains
abruptly (suddenly) elements of both
over different intervals fixed- and variable-
of activity because the cost behavior.
resources and their
costs come in
indivisible chunks.

Learning
Objective 4 Cost Functions
Managers will use cost functions often as a
planning and control tool. Cost functions are used
to:
1.Plan and control the activities of an organization,
which require useful and accurate estimates of
future fixed and variable costs.
2.Understand relationships between costs and
their cost drivers to allow managers in all types of
organizations in making decisions.
Cost measurement involves estimating or

predicting costs as a function of appropriate cost
drivers.
Copyright © 2014 Pearson Education 2 - 10

Steps of Estimating Costs
1. Measuring cost behavior as a function of

appropriate cost drivers.
2. Use these cost functions to estimate future

costs at expected levels of cost-driver activity.

Cost Function Equation
Let:
Y = Total cost
a = Fixed cost
b = Variable cost per unit
X = Cost-driver activity in number of units
The mixed-cost function is called a linear-cost function.
Mixed-cost function:
Y=a+bX
Y = $10,000 + $5.00X

Learning
Objective 5 Methods of Measuring Cost Functions
1. Engineering analysis
2. Account analysis
3. High-low analysis
4. Visual-fit analysis
5. Least-squares regression analysis

High-Low Method
Plot historical data points on a graph.
Focus on the highest- and lowest-activity points.
High month: April

Maintenance cost: $47,000
Number of patient-days: 4,900
Low month: September

Maintenance cost: $17,000
Number of patient-days: 1,200

High-Low Method Example
The point at which the line intersects the Y axis is

the intercept, F, or estimate of Fixed Costs, and the
slope of the line measures the variable cost.
What is the unit variable cost (b)?

Using algebra to solve for variable and fixed costs.
Variable costs = Change in costs ( Y)

change in activity ( X)
b = ($47,000 – $17,000) ÷ (4,900 – 1,200)

= $30,000 ÷ 3,700 = $8.1081

What is the fixed cost (a)?
a = Total mixed cost – total variable cost

At high : a = $47,000 - ($8.1081× 4,900 patient-days)
= $47,000 – $39,730
= $7,270 a month
At low: a = $17,000 = ($8.1081× 1,200 patient-days)

= $17,000 – $9,730
= $7,270 a month
Cost function measured by high-low method:

Y = $7,270 per month + ($8.1081 × patient-days)

Comprehensive Problem (1)
ABC Company produces and sells a single product with a price
of LE. 50 per unit. The following estimated annual cost data
have been prepared for the upper and lower levels of the
firm's relevant range of activity:
Lower Level Upper Level
Production (Units) 5,000 7,500
Direct Materials LE 50,000 LE 75,000
Direct Labor 40,000 60,000
Indirect Labor 21,000 28,500
Supplies 20,000 30,000
Depreciation 12,000 12,000
Selling Expenses 87,000 117,000
General and Administrative Expenses 30,000 37,500
1. Classify each individual element of cost according to its

behavior pattern, (fixed, variable, or mixed), and explain
why you made each classification.
2. Prepare the total cost function.
Answer of Problem (1)
1.
➢ Direct Materials:
Lower Level: 50,000/5,000= LE 10/ Unit
Upper Level: 75,000/7,500= LE 10/ Unit
So Direct Materials is a variable cost, Where Y= 10X
➢ Direct Labor:
So Direct Materials is a variable cost, Where Y= 8X
➢ Indirect Labor: is mixed cost

b= Unit Variable cost = Change in costs ( Y)
Change in activity ( X)
= (28,500-21,000)
(7,500 – 5,000)
= LE 3
a = Total Fixed Costs= Total mixed cost – total variable cost
At high: a= 28,500 - (3 × 7,500)= 28,500 – 22,500 =LE 6,000
Y = 6,000 + 3 X
➢ Supplies:
So, Supplies Cost is a variable cost, Where Y= 4X
➢ Depreciation:
Lower Level: LE 12,000
Upper Level: LE 12,000
So, Depreciation is a fixed cost, Where Y= 12,000
➢ Selling expenses is mixed cost

= (117,000 – 87,000)
(7,500 – 5,000)
= LE 12
At Lower: a= 87,000 - (12 × 5,000)= 87,000 – 60,000
=LE 27,000
Y = 27,000 + 12 X

➢ General and Administrative expenses is mixed cost
= (37,500 – 30,000)
(7,500 – 5,000)
= LE 3
At Upper: a= 37,500 - (3 × 7,500)= 37,500 – 22,500
=LE 15,000
Y = 15,000 + 3 X
2. For the company as a whole:

Unit Variable Cost= 10+ 8+ 3+ 4 + 12+ 3= LE 40
Total Fixed Cost= 6,000 +12,000 + 27,000 + 15,000
= LE 60,000
Y= 60,000 + 40 X

Learning Cost-volume-profit (CVP)
Objective 6
analysis
➢ Managers try to evaluate the effects of
changes in volume of goods or services
produced.
➢ Managers might be interested in upward
changes such as increased sales expected
from increases in promotion or advertising.
➢ Managers might be interested in downward
changes such as decreased sales expected
due to a new competitor entering the
market or due to a decline in economic
conditions.
➢ Managers are always interested in the
relationship between volume and revenue
(sales), expenses (costs), and net income
(net profit).
this is called
Cost-Volume-Profit (CVP) Analysis

CVP Scenario
Per Unit % of Sales
Selling price (SP) $1.50 100%
Variable cost/ unit 1.20 80
SP – VC $0.30 20%
Monthly fixed expenses:

Rent $3,000
Wages and Salaries 13,500
Other fixed expenses 1,500
Total F. expenses/month $18,000

Cost-Volume-Profit Graph

Learning
Objective 7 Break-Even Point
The break-even point is the level of sales

at which revenue equals expenses and net
income is zero.
Sales
- Variable expenses
- Fixed expenses
Zero net income
(break-even point)

Contribution Margin Method
CM / Unit CM % %
Selling price $1.50 Selling price 100
Variable costs 1.20 Variable costs 80
CM $ .30 CM 20
BEP in units = $18,000 fixed costs ÷ $.30

= 60,000 units

Contribution Margin Method
BEP in $ =$18,000 fixed costs ÷ 20% (CM %)

= $90,000

Equation Method
Let Q = number of units

to be sold to break even.
Variable Fixed
Sales – Expenses – Expenses = net income
$1.50Q – $1.20Q – $18,000 = 0
$0.30Q = $18,000
Q = $18,000 ÷ $.30
Q = 60,000 Units
Equation Method
Let S = sales in dollars

needed to break even.
S – 0.80S – $18,000 = 0
0.20S = $18,000
S = $18,000 ÷ 0.20
S = $90,000

Shortcut formulas:
BEP in units= fixed expenses

unit CM
= $18,000 = 60,000 Units

0.30
BEP in Sales = fixed expenses

CM ratio
= $18,000 = $90,000
20%

Learning
Objective 8 Target Net Profit
Managers use CVP analysis

to determine the total sales,
in units and dollars, needed
to reach a target net profit.
Target sales $1,440 per month

– variable expenses is the minimum
– fixed expenses acceptable
target net income net income.

Target Net Profit
Target sales volume in units =

(Fixed expenses + Target net income)÷ CM / unit
Selling price $1.50

Variable costs 1.20
CM / unit $ 0.30
($18,000 + $1,440) ÷ $0.30 = 64,800 units

Target Net Profit
Contribution margin ratio %

Selling price 100
Variable costs 80
Contribution margin 20
Target sales volume in dollars =

Fixed expenses + target net income
CM ratio
Sales volume in dollars = 18,000 + $1,440
0.20
= $97,200
Margin of Safety
Margin of safety = planned unit sales- BEP
How far can sales fall

below the planned level before losses occur?

Learning Contribution Margin
Objective 9 and Gross Margin

Problem 2

Required:
1. Calculate quarterly BEP in units and in

Dollars.
2. Calculate Safety margin in units for
the first quarter of the year.
3. Prepare income statement for the first
Quarter of the year to calculate Gross
Margin.

Degree of Operating Leverage
➢The effect of operating leverage on the

variability of profit is captured by degree of
operating leverage: the ratio of contribution
margin to profit, defined at a specific volume
of sales.
➢The degree of operating leverage at a
specific volume describes how a percentage
change in sales will translate into a
percentage change in profit.

Example:
Assume that we have two firms, Firm A and

Firm B. Firm A has fixed costs of $14,000 and
variable cost per unit of $0.10. Firm B has
fixed costs of only $2,000 but variable costs of
$.25 per unit. Both firms has a selling price of
$.30 per unit. The sales level of both firms is
80,000 units.
Calculate the expected operating income of

firms A and B if sales level is going to increase
to 90,000 units.

Answer
Firm A Firm B
Production (Units) 80,000 80,000
Unit Selling Price LE 0.30 LE 0.30
Unit Variable Cost 0.10 0.25
Total Revenues 24,000 24,000
(-) Total Variable costs 8,000 20,000
Total Contribution Margin (CM) 16,000 4,000
(-) Total Fixed Costs 14,000 2,000
Operating Income (OI) 2,000 2,000
Degree of Operating Leverage(CM/OI) 8 2

When sales volume increase from 80,000 units
to 90,000 units, this means that sales increase
by 12.5% {(90,000-80,000)/80,000}
Firm A Firm B
Degree of Operating Leverage(CM/OI) 8 2
* % of increase in sales volume 12.5% 12.5%
= % of increase in Operating Income 100% 25%
New Operating income (Old OI+ 4,000• 2,500••
Increase in OI)
•2,000 + 2000*100%
••2,000 + 2000* 25%

Answer the following questions:
The degree of operating leverage for a firm equals the ratio of

______ to ________:
A) fixed costs; variable costs
B) variable costs; fixed costs
C) fixed costs: operating profit
D) contribution margin; net income
The degree of operating leverage for Geesling Company is

8.0 at 80,000 units of sales. At 80,000 units of sales, the net
profit is $10,000. If the sales volume increases to 90,000 units
what is the net profit?
A) $12,000
B) $20,000
C) $22,222
D) $80,000

The following information is available for Company MN:
Sales $1,000,000
Variable Selling Expenses 22,000
Fixed Selling Expenses 33,000
Variable Administrative Expenses 30,000
Fixed Administrative Expenses 10,000
Variable Cost of Goods Sold 400,000
Fixed Cost of Goods Sold 100,000
If sales increase to $1,500,000, what is operating income?

A) $405,000
B) $500,000
C) $548,000
D) $679,000

Sales Mix

Assignment


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Copyright © 2014 Pearson Education 2-1

Introduction to Cost Behavior

Copyright © 2014 Pearson Education 2-2

When you have finished studying this chapter,

6. Create a cost-volume-profit (CVP) graph and

Copyright © 2014 Pearson Education 2-4

Cost behavior is how the activities of an

Cost drivers are measures of activities that

An organization has many cost drivers

A variable cost A fixed cost

Think of variable costs Think of fixed costs

Per-unit variable cost Total fixed costs

Copyright © 2014 Pearson Education 2-7

Copyright © 2014 Pearson Education 2-8

Copyright © 2014 Pearson Education 2-9

Cost measurement involves estimating or

Copyright © 2014 Pearson Education 2 - 10

1. Measuring cost behavior as a function of

2. Use these cost functions to estimate future

Copyright © 2014 Pearson Education 2 - 11

The mixed-cost function is called a linear-cost function.

Copyright © 2014 Pearson Education 2 - 12

Copyright © 2014 Pearson Education 2 - 13

Plot historical data points on a graph.

Focus on the highest- and lowest-activity points.

High month: April

Low month: September

Copyright © 2014 Pearson Education 2 - 14

The point at which the line intersects the Y axis is

What is the unit variable cost (b)?

Variable costs = Change in costs ( Y)

b = ($47,000 – $17,000) ÷ (4,900 – 1,200)

Copyright © 2014 Pearson Education 2 - 16

What is the fixed cost (a)?

a = Total mixed cost – total variable cost

At low: a = $17,000 = ($8.1081× 1,200 patient-days)

Cost function measured by high-low method:

Copyright © 2014 Pearson Education 2 - 17

1. Classify each individual element of cost according to its

➢ Indirect Labor: is mixed cost

➢ Selling expenses is mixed cost

Copyright © 2014 Pearson Education 2 - 23

2. For the company as a whole:

Copyright © 2014 Pearson Education 2 - 24

Copyright © 2014 Pearson Education 2 - 26

Monthly fixed expenses:

Copyright © 2014 Pearson Education 2 - 27

Copyright © 2014 Pearson Education 2 - 28

The break-even point is the level of sales

Copyright © 2014 Pearson Education 2 - 31

BEP in units = $18,000 fixed costs ÷ $.30

Copyright © 2014 Pearson Education 2 - 32

BEP in $ =$18,000 fixed costs ÷ 20% (CM %)

Copyright © 2014 Pearson Education 2 - 33

Let Q = number of units

Let S = sales in dollars

Copyright © 2014 Pearson Education 2 - 35

BEP in units= fixed expenses

= $18,000 = 60,000 Units

BEP in Sales = fixed expenses

Copyright © 2014 Pearson Education 2 - 36

Managers use CVP analysis

Target sales $1,440 per month

Copyright © 2014 Pearson Education 2 - 37