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Chapter 4

Cost-Volume-Profit Analysis
Revenues

Costs

Presentation Outline
I.

Common Cost Behavior Patterns


II. Cost Estimation Methods
III. The Relevant Range
IV. Cost-Volume Profit Analysis
V. Degree of Operating Leverage
VI. Excel and Regression Analysis

I. Common Cost Behavior Patterns


A. Variable Costs
B. Fixed Costs
C. Discretionary versus Committed
Fixed Costs
D. Mixed Costs
E. Step Costs

A. Variable Costs
Although variable cost per unit remain
constant, total variable cost increases
and decreases in proportion to
changes in the activity level.
$

Variable cost
in total

Level of Activity

B. Fixed Cost in Total


Although fixed cost per unit decreases with
increases in activity levels, total fixed cost is not
affected by changes in the activity level within the
relevant range (i.e., total fixed cost remains
constant even if the activity level changes.

Total fixed
cost

Level of Activity

C. Discretionary versus Committed Fixed Costs


Committed Fixed Costs
Examples include rent,
depreciation,
insurance. Two key
factors are:
1. Long term in nature
2. Cant be reduced to
zero even for short
periods of time without
seriously impairing the
organization.

Discretionary Fixed
Costs
Arise from annual
decisions by
management to spend
in certain fixed cost
areas (i.e., advertising,
research and
development,
maintenance).

D. Mixed Cost
A mixed cost has both a variable and
a fixed component.
$

Total cost line

Variable
component
Fixed
component
Level of Activity

E. Step Costs
Step costs are those costs that are fixed for a
range of volume but increase to a higher level
when the upper bound of the range is exceeded.
At that point the costs again remain fixed until
another upper bound is exceeded.
$

Level of Activity

II. Cost Estimation Methods


A. High-Low Method
1.

The Variable Cost Element


2. The Fixed Cost Element

B. Scattergraphs
1.

Outliers

C. Regression Analysis

A. The High-Low Method

The high-low method determines the fixed and


variable portions of a mixed cost by using
only the highest and lowest levels of activity
and related costs within the relevant range.

1. The Variable Cost Element


$

Total Cost
Line

Variable Cost

Fixed Cost
Activity Level
The variable cost element b is computed as follows:
b = (Cost at high activity level) (Cost at low activity level)
(High activity level) (Low activity level)

2. The Fixed Cost Element


Variable cost
per unit

y=a+bx
Total cost

Fixed
cost

Number of units
of activity

The fixed portion of a


mixed cost is found by
subtracting total
variable cost from total
cost (high or low level).

See Illustration on Page 120

C o s t o f R e c e iv in g
R e p o rt

B. Scattergraph
Scattergraph
250
200
150
100
50
0
-

50

100

150

Number of Shipments Received

A scattergraph is a graph that plots all known


activity observations and the associated costs.
A regression line is the line of best fit which is
the least squares regression line. In a
scattergraph, the line is estimated.

1. Outliers
Outliers are abnormal
or
nonrepresentative
observations within
a data set that may
be inadvertently
used in the
application of the
high-low method.

C. Regression Analysis
Regression analysis is a statistical
technique that analyzes the association
between dependent and independent
variables.
An independent variable is a variable
that, when changed, will cause
consistent and observable changes in
the dependent variable.

1. Illustration Using Microsoft Excel

Cost of Receiving
Report

Least Squares Regression


y = 1.2369x + 54.657

250
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150
100
50
0
-

50

100

Number of Shipments Received

150

2. Simple Regression v. Multiple Regression


Simple Regression
Only one
independent
variable is used to
predict the
dependent
variable.

Multiple Regression
Two or more
independent
variables are used
to predict the
dependent
variable.

y=a+bx

y = a + b1x1 + b2x2

III. The Relevant Range


The assumed range of activity is referred to a
the relevant range, which reflects the
companys normal operating range. The
relevant range is the range over which
cost behavior assumptions are valid.
A. The Relevant Range and Total Variable
Cost
B. The Relevant Range and Total Fixed Cost

A. The Relevant Range and Total Variable Cost


Although total variable cost increases when
activity increases, the rate is only constant
within the relevant range.
$

Relevant
range

Level of Activity

Total
variable cost

B. The Relevant Range and Total Fixed Cost


Total fixed cost can behave in a step-cost
manner when outside the relevant range..
$

Relevant
range

Level of Activity

Total fixed
cost

IV. Cost-Volume-Profit Analysis


A. Contribution Margin Concepts
B. The Profit Equation
C. Contribution Margin Method
D. Multiproduct Analysis
E. Constraints
F. Cost-Volume-Profit Assumptions
G. Margin of Safety

A. Contribution Margin Concepts


Sales Variable
Expenses =
Contribution
Margin
Contributes
toward covering
fixed expenses
and then toward
providing a profit.

May be computed
per unit or in total
(see page 235).
Contribution
margin ratio is the
contribution
margin divided by
sales (see page
240)

B. The Profit Equation


Total
Variable
+
Sales =
costs

Unit selling
x=
price

Fixed
costs

Target pretax
+
profit

Unit variable
Fixed
Target pretax
x + costs +
cost
profit

Note: x = Number of units sold


Solve for x to determine units that must be sold to reach a certain
target pretax profit. Target pretax profit equals zero to compute
breakeven.

C. Contribution Margin Method


Unit Sales Needed to Reach a Target Pretax Profit
Fixed costs + Target pretax profit
Unit contribution margin

Target
units

Sales Dollars Needed to Reach a Target Pretax Profit


Fixed costs + Target pretax profit
Contribution margin ratio

Target
sales $

Target pretax profit equals zero to compute breakeven.

D. Multiproduct Analysis
Contribution Margin Approach (See
example on pages 127-128)
Contribution Margin Ratio
Approach (See example on pages
128-131)

E. Constraints
When there are constraints on how
many items can be provided, the
focus shifts from the contribution
margin per unit to the contribution
margin per unit of constraint. See
illustration on page 135.

F. Cost-Volume-Profit
Assumptions
Selling price remains constant
Cost can be accurately separated
into fixed and variable components
Variable and fixed cost behavior
assumptions hold
Sales mix is constant

G. Margin of Safety

Actual unit sales


- Breakeven unit sales
= Margin of Safety in
Units

How much can


sales drop
before we
incur a loss?

Actual sales dollars


- Breakeven sales dollars
= Margin of Safety in
Dollars

V. Degree of Operating Leverage


Operating leverage is a measure of the mix
of variable and fixed costs in a firm.
Degree of
operating
leverage

Total contribution margin


Pretax profit

The degree of operating leverage can be used to predict the impact


on profit before tax of a given percentage increase in sales. For
example, if the degree of operating leverage is 2.5 and there is a
10% increase in sales, then pretax profit should increase by 25%.

VI. Excel and Regression


Analysis

An Illustration of
Regression Analysis
Using Microsoft
Excel

Dependent variable

Independent variable

Prediction
equation

Variable
Cost per
Unit

y = $3,998.25 + 2.09x
Fixed Cost

Number
of Units

Slope of regression line

$3,998.25

Fixed
Cost

Coefficient of Correlation

The multiple R (called the coefficient of correlation) is a


measure of the proximity of the data points to the regression
line. In addition, the sign of the statistic (+ or -) tells us the
direction of the correlation. In this case, there is a positive
correlation between the number of pizzas produced
(independent variable) and the total overhead costs
(dependent variable). A coefficient of correlation may range
from zero (no relationship, to 1 (perfect relationship).

A coefficient of correlation of 1 would indicate that


all data observations fall on the regression line.

Coefficient of Determination

The R Square (often represented R 2 and called the coefficient


of determination) is a measure of goodness of fit (how well
the regression line fits the data). R 2 can be interpreted as
the proportion of variation in the dependent variable
(overhead costs) that is explained by changes in the
dependent variable (the number of pizzas). The R 2 may range
from zero to one. An R2 of less than one indicates that other
independent variable might have an impact on the dependent
variable.

Summary
Cost behavior
Separating mixed costs
The relevant range
Target net profit and breakeven
analysis
Degree of operating leverage