Financial and Managerial

Accounting

Wild, Shaw, and Chiappetta

Fourth Edition
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 18

Cost Behavior and

Cost-Volume-Profit
Analysis
 Conceptual Learning
Objectives

C1: Describe different types of cost

behavior in relation to production and
sales volume.
C2: Describe several applications of cost-
volume-profit analysis.

18-3
Analytical Learning Objectives

A1: Compute the contribution margin and

describe what it reveals about a
company’s cost structure.
A2: Analyze changes in sales using the
degree of operating leverage.

18-4
 Procedural Learning
Objectives
P1: Determine cost estimates using the
scatter diagram, high-low, and
regression methods of estimating costs.
P2: Compute the break-even point for a
single product company.
P3: Graph costs and sales for a single
product company.
P4: Compute the break-even point for a
multiproduct company.

18-5
C2 Questions Addressed by
Cost-Volume-Profit Analysis
CVP
CVPanalysis
analysisis isused
usedtotoanswer
answerquestions
questions
such
suchas:as:
 What

What sales
salesvolume
volumeis isneeded
neededto to earn
earn aa
target
targetincome?
income?
 What

What isisthe
thechange
changein inincome
incomeifif selling
selling
prices
pricesdecline
declineand
andsales
salesvolume
volume
increases?
increases?
 How

How much
muchdoes doesincome
incomeincrease
increaseififwe we
install
installaanew
newmachine
machineto toreduce
reducelabor
labor
costs?
costs?
 What

What isisthe
theincome
incomeeffect
effectifif we
wechange
changethethe
sales
salesmix
mixof ofour
our products
productsor orservices?
services?
18-6
C1

Total Fixed Cost

Total fixed costs remain unchanged
when activity changes.
Telephone Bill
Monthly Basic

Your monthly basic

telephone bill probably
does not change when
Number of Local Calls you make more local calls.
18-7
C1

Fixed Cost Per Unit

Fixed costs per unit decline
as activity increases.

Monthly Basic Telephone

Bill per Local Call
Your average cost per
local call decreases as
more local calls are made.
Number of Local Calls
18-8
C1

Total Variable Cost

Total variable costs change
when activity changes.
Total Long Distance
Telephone Bill

Your total long distance

telephone bill is based
on how many minutes
Minutes Talked you talk.
18-9
C1

Variable Cost Per Unit

Variable costs per unit do not change
as activity increases.

Telephone Charge
The cost per long distance Per Minute
minute talked is constant.
For example, 7
cents per minute. Minutes Talked
18-10
C1

Cost Behavior Summary

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Changes as activity level Remains the same over wide

Variable
changes. ranges of activity.
Remains the same even Dereases as activity level
Fixed
when activity level changes. increases.

18-11
C1

Mixed Costs
Mixed costs contain a fixed portion
that is incurred even when the
facility is unused, and a variable
portion that increases with usage.

Example: monthly electric utility

charge
 Fixed service fee
 Variable charge per
kilowatt hour used
18-12
C1

Step-Wise Costs

Total cost remains

constant within a
narrow range of
activity.

Cost
Activity

18-13
P1 Identifying and Measuring
Cost Behavior

The objective
is to classify
all costs as
either fixed or
variable.

18-14
P1

Scatter Diagram
Δin cost
Unit Variable Cost = Slope =
Δin units

20
1,000’s of Dollars

* ** * Vertical
Total Cost in

* * distance
** is the
10 * * change
in cost.
Horizontal distance is
the change in activity.
0
0 1 2 3 4
Activity, 1,000’s of Units Produced
18-15
P1

The High-Low Method

The following relationships between units
produced and costs are observed:
Units Cost
High activity level 67,500 $ 29,000
Low activity level 17,500 20,500
Change 50,000 $ 8,500

Using these two levels of activity, compute:

 the variable cost per unit.
 the total fixed cost.
18-16
P1

The High-Low Method

Units Cost
High activity level 67,500 $ 29,000
Low activity level 17,500 20,500
Change 50,000 $ 8,500

Δin cost $8,500

 Unit variable cost = Δin units = $50,000 = $0.17 /unit

 Fixed cost = Total cost – Total variable cost

Fixed cost = $29,000 – ($0.17 per unit × $67,500)
Fixed cost = $29,000 – $11,475 = $17,525
18-17
P1

Least-Squares Regression
Least-squares regression is usually covered
in advanced cost accounting courses. It is
commonly used with spreadsheet
programs or calculators.

The objective of the cost

analysis remains the
same: determination of
total fixed cost and the
variable unit cost.
18-18
P2 Computing The
Break-Even Point

The break-even point (expressed in

units of product or dollars of sales) is
the sales level at which a company
earns neither a profit nor incurs a
loss.

18-19
A1 Computing The
Break-Even Point

Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

Contribution
Contribution margin
margin is
is amount
amount by
by which
which revenue
revenue
exceeds
exceeds the
the variable
variable costs
costs of
of producing
producing the
the revenue.
revenue.
18-20
A1 Understanding the
Contribution Margin
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

How much contribution margin must this company

have to cover its fixed costs (break even)?
Answer: $24,000
18-21
P2 Computing The
Break-Even Point
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

How many units must this company sell to cover its

fixed costs (break even)?
Answer: $24,000 ÷ $30 per unit = 800 units
18-22
P2 Computing The
Break-Even Point
We have just seen one of the basic CVP
relationships – the break-even
computation.
Fixed costs
Break-even point in units =
Contribution margin per unit

Unit sales price less unit variable cost

($30 in previous example)

18-23
P2 Computing The
Break-Even Point
The break-even formula may also be
expressed in sales dollars.

Fixed costs
Break-even point in dollars =
Contribution margin ratio

Unit contribution margin

Unit sales price

18-24
P3

Preparing a CVP Chart

 Plot total fixed costs on the vertical axis.
Costs and Revenue
in Dollars

Total fixed costs

Total costs

 Draw the total cost line with a slope

equal to the unit variable cost.

Volume in Units
18-25
P3

Preparing a CVP Chart

 Starting at the origin, draw the sales line Sales
with a slope equal to the unit sales price.
Costs and Revenue
in Dollars

Total fixed costs

Total costs

Break-even
Point

Volume in Units 18-26

C1

Assumptions of CVP Analysis

 A limited range of activity called the relevant
range, where CVP relationships are linear.
 Unit selling price remains constant.
 Unit variable costs remain constant.
 Total fixed costs remain constant.
 Production = sales (no inventory changes).

18-27
C2 Computing Income
from Expected Sales

Income
Income (pretax)
(pretax) == Sales
Sales –– Variable
Variable costs
costs –– Fixed
Fixed
costs
costs

18-28
C2 Computing Sales for a
Target Income

Break-even
Break-even formulas
formulas may
may be
be
adjusted
adjusted to
to show
show the
the sales
sales volume
volume
needed
needed to
to earn
earn any
any amount
amount of
of
income.
income.
Fixed costs + Target income
Unit sales =
Contribution margin per unit

Fixed costs + Target income

Dollar sales =
Contribution margin ratio
18-29
C2 Computing Sales (Dollars) for a
Target Net Income

Target
Target net
net income
income is
is income
income after
after
income
income tax.
tax. But
But we
we can
can use
use target
target
income
income before
before tax
tax in
in our
our
calculations.
calculations.
Fixed + Target income
costs before tax
Dollar sales =
Contribution margin ratio

18-30
C2 Computing Sales (Dollars) for a
Target Net Income
To convert target net income to
before-tax income, use the following
formula:
Target net income
Before-tax income =
1 - tax rate

18-31
C2 Computing the
Margin of Safety
Margin of safety is the amount by which
sales can drop before the company
incurs a loss.
Margin of safety may be expressed as a
percentage of expected sales.

Margin of safety Expected sales - Break-even sales

=
percentage Expected sales

18-32
C2

Sensitivity Analysis
The
The basic
basic CVP
CVP relationships
relationships may
may be
be
used
used to
to analyze
analyze aa number
number of
of
situations
situations such
such as
as changing
changing sales
sales
price,
price, changing
changing variable
variable cost,
cost, or
or
changing
changing fixed
fixed cost.
cost.

Continue

18-33
P4 Computing Multiproduct
Break-Even Point
The CVP formulas may be modified for use when a
company sells more than one product.
 The unit contribution margin is replaced with the

contribution margin for a composite unit.

 A composite unit is composed of specific

numbers of each product in proportion to the

product sales mix.
 Sales mix is the ratio of the volumes of the

various products.

18-34
P4 Computing Multiproduct
Break-Even Point

The resulting break-even formula

for composite unit sales is:

Break-even point Fixed costs

= Contribution margin
in composite units
per composite unit

18-35
A2

Operating Leverage
AA measure
measure ofof the
the extent
extent to
to which
which fixed
fixed
costs
costs are
are being
being used
used in
in an
an organization.
organization.

AA measure
measure of
of how
how aa percentage
percentage change
change in
in
sales
sales will
will affect
affect profits.
profits.
Contribution margin
= Degree of operating leverage
Pretax income

18-36
End of Chapter 18

18-37