Chapter 4 Cost Behavior and Analysis.1

Cost Behavior and Analysis
Chapter 4/5
© 2015 McGraw-Hill Education (Asia)

Learning Objective 1
Understand how fixed and

variable costs behave and
how to use them to predict
costs.
© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 1

Types of Cost Behavior Patterns – Variable
A variable cost is a cost whose total dollar
amount varies in direct proportion to changes
in the activity level.
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
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.

The Activity Base (also called a cost driver)
Units Machine
produced hours
A measure of what
causes the
incurrence of a
variable cost
Miles Labor
driven hours

True Variable Cost – An Example
As an example of an activity base, consider

overage charges on a cell phone bill. The activity
base is the number of minutes used above the
allowed minutes in the calling plan.
Charges on Cell
Total Overage
Phone Bill
Minutes Talked
Types of Cost Behavior Patterns – Variable
Variable costs remain constant if expressed on

a per unit basis.


Total fixed cost remains the
relevant range.

Variable Cost Per Unit – An Example
Referring to the cell phone example, the cost per
overage minute is constant, for example 45 cents per
overage minute.
Overage Charge
Per Minute
Minutes Talked

Extent of Variable Costs
The proportion of variable costs differs across organizations.
For example . . .
A public utility like Florida A manufacturing company
Power and Light, like Black and Decker
with large investments in will often have many
equipment, will tend to have variable costs.
fewer variable costs.
Some service companies A merchandising company

have high variable costs, like Wal-Mart
while other service usually has a high
companies have high proportion of variable costs,
fixed costs. like cost of sales.

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.

True Variable Costs
The amount of a true variable cost used during the
period varies in direct proportion to the activity level.
The overage charge on a cell phone bill was one
example of a true variable cost.
Direct material is
Cost
another example
of a cost that
behaves in a true
variable pattern.
Volume

Step-Variable Costs
A step-variable cost is a resource that is obtainable only
in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.
Cost
Volume
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
Step-Variable Costs
Only fairly wide changes

in the activity level will
cause a change in the
number of maintenance
Cost
workers employed.
Volume

Types of Cost Behavior Patterns – Fixed
A fixed cost is a cost whose total dollar amount
remains constant as the activity level changes.


Total fixed costs remain the
relevant range.

Total Fixed Cost – An Example
For example, your cell phone bill probably includes a
fixed amount related to the total minutes allowed in
your calling plan. The amount does not change when
you use more or less allowed minutes.
Cell Phone Bill
Monthly Basic
Number of Minutes Used

within Monthly Plan
Types of Cost Behavior Patterns – Fixed
Average fixed costs per unit decrease as the
activity level increases.

Total fixed costs remain the
same even when the activity Average fixed costs per unit
Fixed level changes within the decrease as the activity
relevant range. level increases.

Fixed Cost Per Unit Example
For example, the fixed cost per minute used
decreases as more allowed minutes are used.
Cost Per Cell Phone Call
Number of Minutes Used

within Monthly Plan

Types of Fixed Costs
Committed Discretionary
Long-term, cannot be May be altered in the
significantly reduced in short-term by current
the short term. managerial decisions
Examples Examples
Depreciation on Buildings Advertising and
and Equipment and Real Research and
Estate Taxes Development
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 of compensating
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles. rather than variable.

Fixed Costs and the Relevant Range
90
Rent Cost in Thousands
The relevant range

Relevant of activity for a fixed
of Dollars
60 cost is the range of

Range activity over which
the graph of the
cost is flat.
30
0
0 1,000 2,000 3,000
Rented Area (Square Feet)

For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.
Fixed costs would increase

in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.

Step-variable costs
can be adjusted more
How does this quickly as conditions
step-function change and . . .
pattern differ from a The width of the activity
step-variable cost? steps is much wider for
the fixed cost.

Mixed Costs (also called semivariable costs)
A mixed cost contains both variable and fixed

elements. Consider the example of utility cost.
Y
Total Utility Cost
Variable
Cost per KW
X Fixed Monthly
Activity (Kilowatt Hours) Utility Charge

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

Mixed Costs – An 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
Analysis of Mixed Costs
Account Analysis and the Engineering Approach
High-Low Method
The least squares regression method

The High-Low Method
Analyze a mixed cost

using the high-low
method.

The High-Low Method – An Example
Assume the following hours of maintenance work
and the total maintenance costs for six months.

The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400
= $6.00/hour
400

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700
The Cost Equation for Maintenance

Y = $4,700 + $6.00X
The High-Low Method – An Example (Book)
Production cost in 6 months which fall within the
relevant rage of 6,000 units
Month Units Produced Total Cost
January 2,300 228,075
February 3,000 240,000
March 2,500 233,125
April 3,600 320,050
May 5,000 431,250
June 4,200 375,000
Highest 5,000 431,250

Lowest 2,300 228,075
2,700 203,175

Month Units Produced Total Cost The variable cost
January 2,300 228,075 per hour of
February 3,000 240,000
March 2,500 233,125 maintenance is
April 3,600 320,050 equal to the change
May 5,000 431,250
June 4,200 375,000
in cost divided by
the change in hours.
Highest 5,000 431,250
Lowest 2,300 228,075
Unit Variable Cost = P203,175
2,700 203,175
2,700
Unit Variable Cost = 75.25

Fixed Cost (Using Highest)
Total Cost 431,250
Variable Cost (P75.25 x 5,000) 376,250
Fixed Cost 55,000
Fixed Cost (Using Low est)

Total Cost 228,075
Variable Cost (P75.25 x 2,300) 173,075
Fixed Cost 55,000
Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = P431,250 – (P75.25/unit × 5,000 units
Total Fixed Cost = P431,250 – P376,250
Total Fixed Cost = P55,000

Fixed Cost (Using Highest)
Total Cost 431,250
Variable Cost (P75.25 x 5,000) 376,250
Fixed Cost 55,000
Fixed Cost (Using Low est)

Total Cost 228,075
Variable Cost (P75.25 x 2,300) 173,075
Fixed Cost 55,000
Cost Equation: y = P55,000 + P75.25x

Analyze a mixed cost
using the least-squares
regression method.

Simple Regression Analysis – An 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.

Simple Regression Using Excel – An Example
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 Excel functions.
SLOPE, INTERCEPT, and RSQ

Place your cursor in

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

Scroll down to the

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

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.

Here is the
estimate of the
slope of the line.


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.

Here is the
estimate of the
fixed costs.


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

Here is the
estimate of R2.


Quick Check 
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.

Quick Check 
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary inversely with the level
of activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.

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

Quick Check 
units are sold. Using the high-low method, what is the
variable portion of sales salaries and commission?
a. $0.08 per unit
Units Cost
b. $0.10 per unit High level 120,000 $ 14,000
c. $0.12 per unit Low level 80,000 10,000
d. $0.125 per unit Change 40,000 $ 4,000
$4,000 ÷ 40,000 units

= $0.10 per unit

Quick Check 
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000

Quick Check 
units are sold. Using the high-low method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000 Total cost = Total fixed cost +
b. $ 4,000 Total variable cost
c. $10,000 $14,000 = Total fixed cost +

($0.10 × 120,000 units)
d. $12,000
Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000

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.

 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.

R2 is the percentage of the variation in the dependent
variable (total cost) that is explained by variation in the
independent variable (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
Comparing Results From the two Methods
The 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.

Cost Volume Profit (CVP) Analysis
Management utilizes CVP Analysis to examine the
relationships and to predict the probable effects of
changes among certain elements affecting an entity’s
profit:
(1) Selling prices
(2) Sales volume
(3) Unit variable cost
(4) Total fixed cost
(5) Mix of products sold

Cost Volume Profit (CVP) Analysis
Functional Income statement used in

Financial Accounting
M&M INC.
Income Statement
For the year ended December 31, 2019
Sales ₱ 944,250
Less: Cost of Goods Sold 717,500
Gross Profit ₱ 226,750
Less: Operating Expenses
Selling Expenses ₱ 85,000
General and Administrative Expenses 107,000 192000
Net Operating Income ₱ 34,750
*Earnings before interest and taxes (EBIT)

The Contribution Format
Let’s put our

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

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.
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 to:
1. determine excess of revenues over all variable costs
(production or selling and administrative costs)
2. The excess is the amount available to cover fixed
expenses and then to provide profits for the period

Used primarily for Used primarily by

external reporting. management.

Break-even Analysis
© 2015 McGraw-Hill Education (Asia)

Learning Objective 1
Explain how changes in

activity affect contribution
margin and net operating
income.

Basics of Cost-Volume-Profit Analysis
The contribution income statement is helpful to managers
in judging the impact on profits of changes in selling price,
cost, or volume. The emphasis is on cost behavior.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles) $ 250,000
Less: Variable expenses 150,000
Contribution margin 100,000
Less: Fixed expenses 80,000
Contribution Margin (CM) is the amount remaining from

sales revenue after variable expenses have been deducted.
64
Basics of Cost-Volume-Profit Analysis

Sales (500 bicycles) $ 250,000
Less: Variable expenses 150,000
CM is used first to cover fixed expenses. Any

remaining CM contributes to net operating income.
65
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.
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500
Less: Variable expenses 150,000 300
Contribution margin 100,000 $ 200

Each month, RBC must generate at least
$80,000 in total contribution margin to break-even
(which is the level of sales at which profit is zero).
Total Per Unit
Sales (500 bicycles) $ 250,000 $ 500

If RBC sells 400 units in a month, it will be
operating at the break-even point.
Total Per Unit
Sales (400 bicycles) $ 200,000 $ 500
Net operating income $ -

If RBC sells one more bike (401 bikes), net
operating income will increase by $200.

Total Per Unit
Sales (401 bicycles) $ 200,500 $ 500
Net operating income $ 200

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
operating income
will be $6,000.
70
CVP Relationships in Graphic Form
The relationships among revenue, cost, profit and volume
can be expressed graphically by preparing a CVP graph.
Racing Bicycle developed contribution margin income
statements at 0, 200, 400, and 600 units sold. We will
use this information to prepare the CVP graph.
Units Sold
0 200 400 600
Sales $ - $ 100,000 $ 200,000 $ 300,000
Total variable expenses - 60,000 120,000 180,000
Contribution margin - 40,000 80,000 120,000
Fixed expenses 80,000 80,000 80,000 80,000
Net operating income (loss) $ (80,000) $ (40,000) $ - $ 40,000

Preparing the CVP Graph
$350,000
$300,000
$250,000
$200,000
$150,000
$100,000
In a CVP graph, unit volume is usually
$50,000
represented on the horizontal (X) axis
and dollars on the vertical (Y) axis.
$0
0 100 200 300 400 500 600
Units
72
$350,000

Draw a line parallel to the volume axis
$300,000
to represent total fixed expenses.
$250,000
$200,000
Fixed expenses
$150,000
$100,000
$50,000
$0
0 100 200 300 400 500 600
Units
73
$350,000 
Choose some sales volume, say 400 units, and plot the point representing
total expenses
$300,000
(fixed and variable). Draw a line through the data point
back to where the fixed expenses line intersects the dollar axis.
$250,000
$200,000
Total expenses
Fixed expenses
$150,000
$100,000
$50,000
$0
0 100 200 300 400 500 600
Units

74
$350,000 
Choose some sales volume, say 400 units, and plot the point representing
total sales.
$300,000
Draw a line through the data point back to the point of origin.
$250,000
$200,000
Sales
Total expenses
$150,000 Fixed expenses
$100,000
$50,000
$0
0 100 200 300 400 500 600
Units
75
$350,000 Break-even point
(400 units or $200,000 in sales) Profit Area
$300,000
$250,000
$200,000
Sales
Total expenses
$150,000 Fixed expenses
$100,000
$50,000
$0
0 100 200 300 400 500 600
Loss Area
Units
76
Break-even Analysis
Use the contribution margin
ratio (CM ratio) to compute
changes in contribution
margin and net operating
income resulting from
changes in sales volume.

Contribution Margin Ratio (CM Ratio)
The CM ratio is calculated by dividing the total
contribution margin by total sales.
Total Per Unit CM Ratio
Sales (500 bicycles) $ 250,000 $ 500 100%
Less: Variable expenses 150,000 300 60%
Contribution margin 100,000 $ 200 40%
$100,000 ÷ $250,000 = 40%

Page 54 Textbook
78
The contribution margin ratio at Racing Bicycle is:
CM per unit $200

CM Ratio = = = 40%
SP per unit $500
The CM ratio can also be calculated by

dividing the contribution margin per unit by
the selling price per unit.

If Racing Bicycle increases sales by $50,000, contribution
margin will increase by $20,000 ($50,000 × 40%).
Here is the proof:
400 Units 500 Units
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)

80
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

Quick Check 
What is the CM Ratio for Coffee Klatch?
a. 1.319 Unit contribution margin
CM Ratio =
b. 0.758 Unit selling price
c. 0.242 ($1.49-$0.36)
=
d. 4.139 $1.49
$1.13
= = 0.758
$1.49
82
Show the effects on
contribution margin of
changes in variable costs,
fixed costs, selling price,
and volume.

The Variable Expense Ratio
The variable expense ratio is the ratio of variable
expenses to sales. It can be computed by dividing the
total variable expenses by the total sales, or in a single
product analysis, it can be computed by dividing the
variable expenses per unit by the unit selling price.
Sales (500 bicycles) $ 250,000 $ 500 100%

84
Changes in Fixed Costs and Sales Volume
What is the profit impact if Racing

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

$80,000 + $10,000 advertising = $90,000
500 units 540 units

Sales $ 250,000 $ 270,000
Less: Variable expenses 150,000 162,000
Less: Fixed expenses 80,000 90,000
Net operating income $ 20,000 $ 18,000
Sales increased by $20,000, but net operating

income decreased by $2,000.

86
A shortcut solution using incremental
analysis
Increase in CM (40 units X $200) $ 8,000
Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)

Change in Variable Costs and Sales Volume
What is the profit impact if Racing

Bicycle 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?

88
Change in Variable Costs and Sales Volume
580 units × $310 variable cost/unit = $179,800
500 units 580 units

Sales $ 250,000 $ 290,000
Sales increase by $40,000, and net operating income

increases by $10,200.

89
Change in Fixed Cost, Sales Price
and Volume
What is the profit impact if RBC: (1) cuts its

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

90
Change in Fixed Cost, Sales Price
and Volume
650 units × $480 = $312,000
500 units 650 units

Sales $ 250,000 $ 312,000
Sales increase by $62,000, fixed costs increase by

$15,000, and net operating income increases by $2,000.

91
Change in Variable Cost, Fixed Cost
and Sales Volume
What is the profit impact if RBC: (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?

92
Change in Variable Cost, Fixed Cost
and Sales Volume
575 units × $315 = $181,125
500 units 575 units
Sales $ 250,000 $ 287,500
Sales increase by $37,500, fixed expenses decrease by

$6,000. Net operating income increases by $12,375.

93
Determine the break-even point. (BEP)
- The point where total revenue will equal total

costs or simply the level of sales at which
profit is zero.
- The concept suggests that a company must
sell beyond certain sales level (break-even
point) to generate point.

Break-even Analysis
Let’s use the RBC information to complete the
break-even analysis.
Sales (500 bicycles) $ 250,000 $ 500 100%

95
Break-even in Unit Sales:
Formula Method
Let’s apply the formula method to solve for

the break-even point.
Unit sales to Fixed expenses

=
break even CM per unit
$80,000
Unit sales =
$200
Unit sales = 400

Break-even in Dollar Sales:
Formula Method
Now, let’s use the formula method to calculate the

dollar sales at the break-even point.
Dollar sales to Fixed expenses

=
break even CM ratio
$80,000
Dollar sales =
40%
Dollar sales = $200,000

97
Quick Check 
What is the break-even sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129

98
Quick Check 
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 dollars?
a. $1,300 Break-even Fixed expenses
b. $1,715 =
sales $ CM Ratio
c. $1,788 $1,300
=
(1.49-0.36)/1.49
d. $3,129
= $1,715

99
Quick Check 
What is the break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
100
Quick Check 
Fixed expenses
What is the break-even sales in units?
Break-even = CM per Unit
a. 872 cups
$1,300
b. 3,611 cups =
$1.49/cup - $0.36/cup
c. 1,200 cups
$1,300
d. 1,150 cups =
$1.13/cup
= 1,150 cups
101
Determine the level of
sales needed to attain a
target profit.
Target Profit Analysis:
The Formula Method for the Quantity required
The formula uses the following equation.
Unit sales to attain Target profit + Fixed expenses

=
the target profit CM per unit
The Formula Method for the Quantity required
Suppose Racing Bicycle Company wants to
know how many bikes must be sold to earn
a profit of P100,000.
Unit sales to attain Target profit + Fixed expenses
=
the target profit CM per unit
P100,000 + P80,000
Unit sales =
$200
Unit sales = 900
Formula Method for the Sales $ required
We can calculate the dollar sales needed to
attain a target profit (net operating profit) of
P100,000 at Racing Bicycle.
Dollar sales to attain Target profit + Fixed expenses
=
the target profit CM ratio
P100,000 + P80,000
Dollar sales =
40%
Dollar sales = P450,000
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.
Use the formula method to determine 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
106
Quick Check 
$0.36. The Unit salesfixed expense per month is $1,300.
average Target profit + Fixed expenses
to attain
Use the formula method= to determineUnit
howCMmany cups of
target
coffee would profit
have to be sold to attain target profits of
$2,500 per month. $2,500 + $1,300
= $1.49 - $0.36
a. 3,363 cups
b. 2,212 cups $3,800
=
c. 1,150 cups $1.13
d. 4,200 cups = 3,363 cups
107
Quick Check 
Use the formula method to determine the sales dollars
that must be generated to attain target profits of $2,500
per month.
a. $2,550
b. $5,011
c. $8,458
d. $10,555
108
Quick Check 
Use the formula method
Sales $ to determine the sales dollars
Target profit + Fixed expenses
that must be to
generated
attain = to attain target profits of $2,500
CM ratio
per month. target profit
a. $2,550 $2,500 + $1,300
=
b. $5,011 ($1.49 – 0.36) ÷ $1.49
c. $8,458 $3,800
=
d. $10,555 0.758
= $5,011
109
Compute the margin of
safety and explain its
significance.
The Margin of Safety in Dollars
If we assume that RBC 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
111
The Margin of Safety Percentage
RBC’s margin of safety can be expressed as 20% of sales.

Difference in Sales/Actual Sales ($50,000 ÷ $250,000) or
Actual Net Operating Income/Actual Contribution Margin
($20,000/$100,000) = 20%
The company can afford a decline in sales by $50,000
without incurring a loss
Break-even *
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
* Budgeted Sales
112
The Margin of Safety Percentage
RBC’s margin of safety can be expressed as 20% of sales.

Difference in Sales/Actual Sales ($50,000 ÷ $250,000) or
Actual Net Operating Income/Actual Contribution Margin
($20,000/$100,000) = 20%
The company can afford a decline in sales by $50,000
without incurring a loss
Break-even *
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
* Budgeted Sales
113
The Margin of Safety
The margin of safety can be expressed in terms of

the number of units sold. The margin of safety at
RBC is $50,000, and each bike sells for $500;
hence, RBC’s margin of safety is 100 bikes.
Margin of $50,000
= = 100 bikes
Safety in units $500
114
Quick Check 
What is the margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
115
Quick Check 
What is the margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
Margin of safety = Total sales – Break-even sales
d. 2,100 cups = 2,100 cups – 1,150 cups
= 950 cups
116
Breakeven Calculation
RBC’s margin of safety = 20% of sales
Actual sales
500 units
Sales $ 250,000
Less: variable expenses 150,000
Less: fixed expenses 80,000
Break-even sales of RBC = 1 – 20% = 80% of sales

= $250,000 x 80%
= $200,000
= Break-even Sales on slide 75
117
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.
Operating Leverage
Operating leverage is a measure of how sensitive net

operating income is to percentage changes in sales.
It is a measure, at any given level of sales, of how a
percentage change in sales volume will affect profits.
Contributi on Margin
DOL Degree of Operating Leverage 
Net Operating Income * *
** Profit Before Tax is a commonly used alternative to Net Operating
Income in the degree of operating leverage calculation
119
Operating Leverage
To illustrate, let’s revisit the contribution income statement
for RBC.
Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Less: fixed expenses 80,000
Net income $ 20,000
Degree of
Operating $100,000
= $20,000 = 5
Leverage
120
Operating Leverage
With an operating leverage of 5, if RBC
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!
121
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
10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in

income from $20,000 to $30,000.
122
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
123
Quick Check 
Coffee Klatch is an espresso stand in a Actual sales
2,100 cups
downtown office building. The average selling
Sales $ 3,129
price of a cup of coffeeLess:
is $1.49 and the average756
Variable expenses
variable expense per cup is $0.36.
Contribution The average2,373
margin
fixed expense per month isFixed
Less: $1,300. 2,100 cups1,300
expenses
are sold each month on Netaverage.
operating What
incomeis the
$ 1,073
operating leverage?
a. 2.21
b. 0.45 Operating Contribution margin
c. 0.34 leverage = Net operating income
d. 2.92 $2,373
= $1,073 = 2.21
124
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%
125
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%
126
Verify Increase in Profit
Actual Increased
sales sales
2,100 cups 2,520 cups
Sales $ 3,129 $ 3,755
Less: Variable expenses 756 907
% change in sales 20.0%
% change in net operating income 44.2%
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.
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.
 When a company sells more than one product,
break-even analysis becomes more complex as
the following example illustrates.
Let’s assume Racing Bicycle Company sells

bikes and carts and that the sales mix between
the two products remains the same.
Multi-Product Breakeven Analysis
(The BE% Method)
RBC’s Bikes and Carts sales and profit data are as follows:
Bicycle Carts Total
Sales $ 250,000 $ 300,000 $ 550,000
Variable expenses 150,000 135,000 285,000
Contribution margin 100,000 165,000 265,000
Fixed expenses 170,000
Contributi on Margin 1
Sales $ 250,000 $300,000 DOL  
x Net Operating Income MoS%
Net Operating Income
BE% = 64.15%  MoS% 
Contributi on Margin
Breakeven sales $160,375 $192,450 95,000
 MoS%   35.85%
265,000
Total break-even sales = $352,825  MoS%  1  BE%
 BE%  1  MoS%  1  35.85  64.15%
(The BE% Method)
Bicycle Carts Total
Sales $ 160,375 100% $ 192,450 100% $ 352,825 100.0%
Variable expenses 96,225 60% 86,603 45% 182,828 51.8%
Contribution margin 64,150 40% 105,847 55% 169,997 48.2%

Net operating income Rounding error $ (3)
(The CM Ratio Method)
Bikes comprise 45% of RBC’s total sales revenue and the
carts comprise the remaining 55%. RBC provides the
following information:
Bicycle Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100.0%
Contribution margin 100,000 40.0% 165,000 55% 265,000 48.2%
Sales mix $ 250,000 45% $ 300,000 55% $ 550,000 100%
$265,000 = 48.2% (rounded)

$550,000
(The CM Ratio Method)
Dollar sales to Fixed expenses
=
break even CM ratio
Dollar sales to $170,000

= = $352,697
break even 48.2%
Bicycle Carts Total

Sales $ 158,714 100% $ 193,983 100% $ 352,697 100.0%
Contribution margin 63,485 40% 106,691 55% 170,176 48.2%
Net operating income Rounding error $ 176
Sales Mix $ 158,714 45% $ 193,983 55% $ 352,697 100.0%
Compare the Breakeven Results calculated
by the BE% and CM ratio methods
Rounding difference
Bicycle Carts Total from the breakeven
Breakeven Sales Mix
The BE% method $ 160,375 45% $ 192,450 55% $ 352,825 100% $ 3
The CM ratio method $ 158,714 45% $ 193,983 55% $ 352,697 100% $ 176
Using different methods to calculate the

break-even points will result in slightly different
answers due to rounding differences at
different points of the calculations. In this
example, the BE% seems to provide a better
estimation.
End of Chapter 4/5
135

Chapter 4 Cost Behavior and Analysis.1

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Cost Behavior and Analysis

© 2015 McGraw-Hill Education (Asia)

Understand how fixed and

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 1

Variable Total variable cost is Variable cost per unit remains

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 2

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 3

As an example of an activity base, consider

Variable costs remain constant if expressed on

Summary of Variable and Fixed Cost Behavior

Variable Total variable cost is Variable cost per unit remains

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 5

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 6

Some service companies A merchandising company

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 7

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 8

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 9

Small changes in the level of production are not

Only fairly wide changes

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 12

Summary of Variable and Fixed Cost Behavior

Variable Total variable cost is Variable cost per unit remains

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 13

Number of Minutes Used

Cost In Total Per Unit

Variable Total variable cost is Variable cost per unit remains

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 15

Cost Per Cell Phone Call

Number of Minutes Used

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 16

The trend in many industries is toward greater

As machines take over Knowledge workers

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 18

The relevant range

60 cost is the range of

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 19

Fixed costs would increase

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 20

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 21

A mixed cost contains both variable and fixed

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 22

Where: Y = The total mixed cost.

activity (the slope of the line).

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 23

If your fixed monthly utility charge is $40, your

Account Analysis and the Engineering Approach

The least squares regression method

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 25

Analyze a mixed cost

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 26

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 27

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 28

Total Fixed Cost = Total Cost – Total Variable Cost

The Cost Equation for Maintenance

Highest 5,000 431,250

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 31

© 2015 McGraw-Hill Education Garrison, Noreen, Brewer, Cheng & Yuen 32

Fixed Cost (Using Low est)

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = P431,250 – P376,250

Total Fixed Cost = P55,000

Fixed Cost (Using Low est)

Cost Equation: y = P55,000 + P75.25x