1

Chapter 21:

Cost behavior & cost-volume-

profit analysis
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Learning Objectives
After studying this chapter, you should be able to:
[1] Distinguish between variable and fixed costs.
[2] Explain the significance of the relevant range.
[3] Explain the concept of mixed costs.
[4] List the five components of cost-volume-profit analysis.
[5] Indicate what contribution margin is and how it can be expressed.
[6] Identify the three ways to determine the break-even point.
[7] Give the formulas for determining sales required to earn target net income.
[8] Define margin of safety, and give the formulas for computing it.

[9] Explain the term sales mix and its effects on break-even sales.

[10] Understand how operating leverage affects profitability.

Cost Behavior Analysis
Cost Behavior Analysis is the study of how specific costs
respond to changes in the level of business activity.

 Some costs change; others remain the same.

 Helps management plan operations and decide between

alternative courses of action.

 Applies to all types of businesses and entities.

 Starting point is measuring key business activities.

Cost Behavior Analysis
Cost Behavior Analysis is the study of how specific costs
respond to changes in the level of business activity.

 Activity levels may be expressed in terms of:

► Sales dollars (in a retail company)
► Miles driven (in a trucking company)
► Room occupancy (in a hotel)
► Dance classes taught (by a dance studio)

 Many companies use more than one measurement base.

Cost Behavior Analysis
Cost Behavior Analysis is the study of how specific costs
respond to changes in the level of business activity.

 Changes in the level or volume of activity should be

correlated with changes in costs.
 Activity level selected is called activity or volume index.
 Activity index:
► Identifies the activity that causes changes in the behavior of
costs.
► Allows costs to be classified as variable, fixed, or mixed.
Cost Behavior Analysis
Variable Costs
 Costs that vary in total directly and proportionately with
changes in the activity level.
► Example: If the activity level increases 10 percent, total
variable costs increase 10 percent.

► Example: If the activity level decreases by 25 percent,

total variable costs decrease by 25 percent.

 Variable costs remain the same per unit at every level of

activity.
Cost Behavior Analysis
Illustration: Damon Company manufactures tablet computers
that contain a $10 camera. The activity index is the number of
tablets produced. As Damon
manufactures each tablet, the total
cost of the camera increases by $10.
As part (a) shows, total cost of the
cameras will be $20,000 if Damon
produces 2,000 tablets, and $100,000
when it produces 10,000 tablets. We
also can see that a variable cost
remains the same per unit as the level
of activity changes.
Cost Behavior Analysis
Illustration: Damon Company manufactures tablet computers
that contain a $10 camera. The activity index is the number of
tablets produced. As Damon
manufactures each tablet, the total
cost of the camera increases by $10.
As part (b) shows, the unit cost of $10
for the camera is the same whether
Damon produces 2,000 or 10,000
tablets.
 9

Cost Behavior Analysis

Variable Costs
 10

Cost Behavior Analysis

Fixed Costs
 Costs that remain the same in total regardless of changes
in the activity level.
 Per unit cost varies inversely with activity: As volume
increases, unit cost declines, and vice versa
 Examples:
► Rent
► Depreciation on buildings and equipment
Cost Behavior Analysis
Illustration: Damon Company leases its productive facilities at a
cost of $10,000 per month. Total fixed costs of the
facilities will remain constant at every
level of activity, as part (a) shows.
Cost Behavior Analysis
Illustration: Damon Company leases its productive facilities at a
cost of $10,000 per month. Total fixed costs of the
facilities will remain constant at every
level of activity. But, on a per unit
basis, the cost of rent will decline as
activity increases, as part (b) shows.
At 2,000 units, the unit cost per tablet
computer is $5 ($10,000 ÷ 2,000).
When Damon produces 10,000
tablets, the unit cost is only $1
($10,000 ÷ 10,000).
 13

Cost Behavior Analysis

Fixed Costs
 14

Cost Behavior Analysis

Review Question
Variable costs are costs that:

a. Vary in total directly and proportionately with changes

in the activity level.

b. Remain the same per unit at every activity level.

c. Neither of the above.

d. Both (a) and (b) above.

Cost Behavior Analysis
Mixed Costs
 Costs that have both a variable cost element and a
fixed cost element.
 Change in total
but not
proportionately
with changes in
activity level.
 16

Helena Company, reports the following total costs at two levels

of production.

Classify each cost as variable, fixed, or mixed.

Variable
Fixed
Mixed
Cost Behavior Analysis
High-Low Method
 Mixed costs must be classified into their fixed and variable
elements.

 High-Low Method uses the total costs incurred at both the

high and the low levels of activity to classify mixed costs.

 The difference in costs between the high and low levels

represents variable costs, since only variable costs
change as activity levels change.
Cost Behavior Analysis
High-Low Method
STEP 1: Determine variable cost per unit using the
following formula:
Cost Behavior Analysis
High-Low Method
Illustration: Metro Transit Company has the following
maintenance costs and mileage data for its fleet of buses over
a 6-month period.

Change in Costs (63,000 - 30,000) $33,000 $1.10

= cost per
High minus Low (50,000 - 20,000) 30,000
unit
Cost Behavior Analysis
High-Low Method
STEP 2: Determine the fixed cost by subtracting the total
variable cost at either the high or the low activity level from the
total cost at that level.
Cost Behavior Analysis
High-Low Method
Maintenance costs are therefore $8,000 per month plus $1.10
per mile. This is represented by the following formula:

Maintenance costs = Fixed costs + ($1.10 x Miles driven)

Example: At 45,000 miles, estimated maintenance costs would

be:
Fixed
Variable $ 8,000
($1.10 x 45,000)

49,500
$57,500
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Byrnes Company accumulates the following data concerning a

mixed cost, using units produced as the activity level.

(a) Compute the variable and fixed cost elements using the high-
low method.
(b) Estimate the total cost if the company produces 6,000 units.
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(a) Compute the variable and fixed cost elements using the high-
low method.

Variable cost: ($14,740 - $11,100) / (9,800 - 7,000) = $1.30 per unit

Fixed cost: $14,740 - $12,740 ($1.30 x 9,800 units) = $2,000
or $11,100 - $9,100 ($1.30 x 7,000) = $2,000
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(b) Estimate the total cost if the company produces 6,000 units.

Total cost (6,000 units): $2,000 + $7,800 ($1.30 x 6,000) = $9,800

Cost-Volume-Profit Analysis
Cost-volume-profit (CVP) analysis is the study of the effects of
changes of costs and volume on a company’s profits.
 Important in profit planning

 Critical factor in management decisions as

► Setting selling prices,

► Determining product mix, and

► Maximizing use of production facilities.

Cost-Volume-Profit Analysis
Basic Components
Cost-Volume-Profit Analysis
Basic Components - Assumptions
 Behavior of both costs and revenues is linear throughout
the relevant range of the activity index.

 All costs can be classified as either variable or fixed with

reasonable accuracy.

 Changes in activity are the only factors that affect costs.

 All units produced are sold.

 When more than one type of product is sold, the sales

mix will remain constant.
Cost-Volume-Profit Analysis
CVP Income Statement
 A statement for internal use.
 Classifies costs and expenses as fixed or variable.
 Reports contribution margin in the body of the statement.
► Contribution margin – amount of revenue remaining after
deducting variable costs.

 Reports the same net income as a traditional income

statement.
Cost-Volume-Profit Analysis
CVP Income Statement
Illustration: Vargo Video produces a high-definition digital
camcorder with 15x optical zoom and a wide-screen, high-
resolution LCD monitor. Relevant data for the camcorders sold by
this company in June 2014 are as follows.
Cost-Volume-Profit Analysis
CVP Income Statement
Illustration: The CVP income statement for Vargo Video
therefore would be reported as follows.
Cost-Volume-Profit Analysis
Contribution Margin per Unit
 Contribution margin is available to cover fixed costs and to
contribute to income.
 Formula for contribution margin per unit and the
computation for Vargo Video are:
Cost-Volume-Profit Analysis
Contribution Margin per Unit
Vargo’s CVP income statement assuming a zero net income.
Cost-Volume-Profit Analysis
Contribution Margin per Unit
Assume that Vargo sold one more camcorder, for a total of 1,001
camcorders sold.
Cost-Volume-Profit Analysis
Contribution Margin Ratio
 Shows the percentage of each sales dollar available to apply
toward fixed costs and profits.
 Formula for contribution margin ratio and the computation
for Vargo Video are:
Cost-Volume-Profit Analysis
Contribution Margin Ratio
Assume current sales are $500,000, what is the effect of a
$100,000 (200-unit) increase in sales?
Cost-Volume-Profit Analysis
Contribution Margin Ratio
Assume Vargo Video’s current sales are $500,000 and it wants to
know the effect of a $100,000 (200-unit) increase in sales.
 37

Cost-Volume-Profit Analysis
Review Question
Contribution margin:

a. Is revenue remaining after deducting variable costs.

b. May be expressed as contribution margin per unit.

c. Is selling price less cost of goods sold.

d. Both (a) and (b) above.

Cost-Volume-Profit Analysis
Break-Even Analysis
 Process of finding the break-even point level of activity at
which total revenues equal total costs (both fixed and
variable).
 Can be computed or derived
► from a mathematical equation,
► by using contribution margin, or
► from a cost-volume profit (CVP) graph.
 Expressed either in sales units or in sales dollars.
Break-Even Analysis
Mathematical Equation
Break-even occurs where total sales equal variable costs plus
fixed costs; i.e., net income is zero

Computation
of break-even
point in units.
Break-Even Analysis
Contribution Margin Technique
 At the break-even point, contribution margin must equal
total fixed costs

(CM = total revenues – variable costs)

 Break-even point can be computed using either contribution
margin per unit or contribution margin ratio.
Break-Even Analysis
Contribution Margin Technique
 When the BEP in units is desired, contribution margin per
unit is used in the following formula which shows the
computation for Vargo Video:
Break-Even Analysis
Contribution Margin Technique
 When the BEP in dollars is desired, contribution margin
ratio is used in the following formula which shows the
computation for Vargo Video:
Break-Even Analysis
Graphic
Presentation
Because this graph
also shows costs,
volume, and profits,
it is referred to as a
cost-volume-profit
(CVP) graph.
 44

Break-Even Analysis
Review Question
Gossen Company is planning to sell 200,000 pliers for $4 per
unit. The contribution margin ratio is 25%. If Gossen will
break even at this level of sales, what are the fixed costs?
a. $100,000.

b. $160,000.

c. $200,000.

d. $300,000.
 45

Lombardi Company has a unit selling price of $400, variable

costs per unit of $240, and fixed costs of $180,000. Compute
the break-even point in units using (a) a mathematical
equation and (b) contribution margin per unit.

Variable Fixed Net

Sales - - =
Costs Costs Income

$400Q - $240Q - $180,000 = 0

$160Q - $180,000
Q = 1,125 units
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Lombardi Company has a unit selling price of $400, variable

costs per unit of $240, and fixed costs of $180,000. Compute
the break-even point in units using (a) a mathematical
equation and (b) contribution margin per unit.

Fixed Contribution Break-Even

÷ =
Costs Margin per Unit Point in Units

$180,000 ÷ $160 = 1,125 units

Cost-Volume-Profit Analysis
Target Net Income
 Level of sales necessary to achieve a specified income.
 Can be determined from each of the approaches used to
determine break-even sales/units:
► from a mathematical equation,
► by using contribution margin, or

► from a cost-volume profit (CVP) graph.

 Expressed either in sales units or in sales dollars.

Cost-Volume-Profit Analysis
Target Net Income
Sales necessary to achieve a specified level of income.

Mathematical Equation
Formula for required sales to meet target net income.
Target Net Income
Mathematical Equation
Using the formula for the break-even point, simply include the
desired net income as a factor.
Target Net Income
Contribution Margin Technique
To determine the required sales in units for Vargo Video:
Target Net Income
Contribution Margin Technique
To determine the required sales in dollars for Vargo Video:
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Review Question

The mathematical equation for computing required sales

to obtain target net income is:
Required sales =
a. Variable costs + Target net income.
b. Variable costs + Fixed costs + Target net income.
c. Fixed costs + Target net income.
d. No correct answer is given.
Cost-Volume-Profit Analysis
Margin of Safety
 Difference between actual or expected sales and sales at the
break-even point.
 Measures the “cushion” that management has if expected
sales fail to materialize.
 May be expressed in dollars or as a ratio.
 Assuming actual/expected sales are $750,000:
Cost-Volume-Profit Analysis
Margin of Safety
 Computed by dividing the margin of safety in dollars by the
actual or expected sales.
 Assuming actual/expected sales are $750,000:

 The higher the dollars or percentage, the greater the margin of

safety.
 55

Cost-Volume-Profit Analysis
Review Question
Marshall Company had actual sales of $600,000 when break-
even sales were $420,000. What is the margin of safety ratio?

a. 25%.
b. 30%.
c. 33 1/3%.
d. 45%.
 5656

Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
following:

(a)break-even point in dollars using the contribution margin

(CM) ratio;

(b)the margin of safety assuming actual sales are $1,382,400;

and

(c) the sales dollars required to earn net income of $410,000.

 57

Compute: (a) break-even point in dollars using the

contribution margin (CM) ratio.
Unit selling price $56
Unit variable costs - 42
Contribution margin per unit 14
Unit selling price 56
Contribution margin ratio 25%

Fixed costs $320,000

Contribution margin ratio 25%
Break-even sales in dollars $1,280,000
 58

Compute: (b) the margin of safety assuming actual sales are

$1,382,400.

Actual (Expected) sales $ 1,382,400

Break-even sales - 1,280,000
Margin of safety in dollars 102,400
Actual (Expected) sales 1,382,400
Margin of safety ratio 7.4%
 59

Compute: (c) the sales dollars required to earn net income

of $410,000.

Fixed costs $ 320,000

Target net income + 410,000
730,000
Contribution margin ratio 25%
Required sales in dollars $2,920,000
 60

Comprehensive

Mabo Company makes calculators that sell for $20 each. For
the coming year, management expects fixed costs to total
$220,000 and variable costs to be $9 per unit. Compute:

a) Break-even point in dollars

b) Margin of safety percentage assuming actual sales are

$500,000.

c) Sales required in dollars to earn net income of $165,000.

 61

Comprehensive

Mabo Company makes calculators that sell for $20 each. For
the coming year, management expects fixed costs to total
$220,000 and variable costs to be $9 per unit.
Compute break-even point in dollars

Contribution margin per unit = $20 - $9 = $11

Contribution margin ratio = $11 / $20 = 55%

Break-even point in dollars = $220,000 / 55%

= $400,000
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Comprehensive

Mabo Company makes calculators that sell for $20 each. For
the coming year, management expects fixed costs to total
$220,000 and variable costs to be $9 per unit. Compute the
margin of safety percentage assuming actual sales are
$500,000.
$500,000 - $400,000
Margin of safety = = 20%
$500,000
 63

Comprehensive

Mabo Company makes calculators that sell for $20 each. For
the coming year, management expects fixed costs to total
$220,000 and variable costs to be $9 per unit. Compute the
sales required in dollars to earn net income of $165,000.

$20Q = $9Q + $220,000 + $165,000

$11Q = $385,000

Q = 35,000 units

35,000 units x $20 = $700,000 required sales

Sales Mix
Break-Even Sales in Units

 Sales mix is the relative percentage in which a company

sells its products.
 If a company’s unit sales are 80% printers and 20%
computers, its sales mix is 80% to 20%.
 Sales mix is important because different products often
have very different contribution margins.
Sales Mix
Break-Even Sales in Units
Companies can compute break-even sales for a mix of two or more
products by determining the weighted-average unit contribution
margin of all the products.

Illustration: Vargo Video sells not only camcorders but TV sets as

well. Vargo sells its two products in the following amounts: 1,500
camcorders and 500 TVs. The sales mix, expressed as a function of
total units sold, is as follows.
Sales Mix
Break-Even Sales in Units
Additional information related to Vargo Video.
Sales Mix
Break-Even Sales in Units
First, determine the weighted-average contribution margin.
Sales Mix
Break-Even Sales in Units
Second, use the weighted-average unit contribution margin to
compute the break-even point in units
Sales Mix
Break-Even Sales in Units
 With a break-even point of 1,000 units, Vargo must sell:
► 750 Camcorders (1,000 units x 75%)
► 250 TVs (1,000 units x 25%)

 At this level, the total contribution margin will equal the fixed
costs of $275,000.
Sales Mix
Break-Even Sales in Dollars
 Works well if the company has many products.
 Calculates break-even point in terms of sales dollars for
► divisions or
► product lines,
► NOT individual products.
Sales Mix
Break-Even Sales in Dollars
Illustration: Kale Garden Supply Company has two divisions.
Sales Mix
Break-Even Sales in Dollars
First, determine the weighted-average contribution margin.

Second, calculate
break-even point in
dollars.
Sales Mix
Break-Even Sales in Dollars
 With break-even sales of $937,500 and a sales mix of 20%
to 80%, Kale must sell:

► $187,500 from the Indoor Plant division

► $750,000 from the Outdoor Plant division

 If the sales mix becomes 50% to 50%, the weighted average

contribution margin ratio changes to 35%, resulting in a lower
break-even point of $857,143.
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Sales Mix
Review Question
Net income will be:

a. Greater if more higher-contribution margin units are sold

than lower-contribution margin units.

b. Greater is more lower-contribution margin units are sold

than higher-contribution margin units.

c. Equal as song as total sales remain equal, regardless of

which products are sold.

d. Unaffected by changes in the mix of products sold.

Cost Structure and Operating
Leverage
Cost Structure is the relative proportion of fixed versus
variable costs that a company incurs.
 May have a significant effect on profitability.

 Company must carefully choose its cost structure.

Cost Structure and Operating
Leverage
Illustration: Vargo Video and one of its competitors, New Wave
Company, both make camcorders. Vargo Video uses a traditional,
labor-intensive manufacturing process. New Wave Company has
invested in a completely automated system. The factory employees
are involved only in setting up, adjusting, and maintaining the
machinery.

CVP
income
statements
 Cost Structure and Operating
Leverage
Effect on Contribution Margin Ratio

First let’s look

at the
contribution
margin ratios.
Cost Structure and Operating
Leverage
Effect on Contribution Margin Ratio

 New Wave contributes 80 cents to net income for each dollar

of increased sales while Vargo only contributes 40 cents.
 New Wave’s cost structure which relies on fixed costs is more
sensitive to changes in sales.
Cost Structure and Operating
Leverage
Effect on Break-Even Point
Calculate the break-even point.

 New Wave needs to generate $150,000 more in sales than

Vargo to break-even.
 Because of the greater break-even sales required, New Wave is
a riskier company than Vargo.
Cost Structure and Operating
Leverage
Effect on Margin of Safety
Computation of margin of safety ratio

 The difference in ratios reflects the difference in risk between

New Wave and Vargo.
 Vargo can sustain a 38% decline in sales before operating at a loss
versus only a 19% decline for New Wave.
Cost Structure and Operating
Leverage
Operating Leverage
 Extent that net income reacts to a given change in sales.

 Higher fixed costs relative to variable costs cause a company

to have higher operating leverage.

 When sales revenues are increasing, high operating leverage

means that profits will increase rapidly.

 When sales revenues are declining, too much operating

leverage can have devastating consequences.
Cost Structure and Operating
Leverage
Degree of Operating Leverage
 Provides a measure of a company’s earnings volatility.
 Computed by dividing total contribution margin by net income.

New Wave’s earnings would go up (or down) by about two times

(5.33 ÷ 2.67 = 1.99) as much as Vargo’s with an equal increase in
sales.
 83

Cost Structure and Operating

Leverage
Review Question
The degree of operating leverage:

a. Can be computed by dividing total contribution margin

by net income.

b. Provides a measure of the company’s earnings

volatility.

c. Affects a company’s break-even point.

d. All of the above.

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Homework
• PR 21-1A
• PR 21-2A