Chapter 5

Break Even Analysis and Leverage

 Cost Behavior Analysis
 Cost behavior analysis is the study of how specific costs
respond to changes in the level of activity within a
company.
 The starting point in cost behavior analysis is measuring the
key activities in the company’s business.
 Activity levels may be expressed in terms of
– sales dollars (retail company),
– miles driven (trucking company),
– room occupancy (hotel), or
– number of dance classes taught (dance studio).
 Cost Behavior Analysis
 For an activity level to be useful in cost
behavior analysis, there should be correlation
between changes in the level or volume of
activity and changes in the costs.
 The activity level selected is referred to as the
activity (or volume) index.
 The activity index identifies the activity that
causes changes in the behavior of costs.
 Study Objective 1

Distinguish between variable and

fixed costs.
 Variable Costs
Variable costs are costs that vary in total
directly and proportionately with changes in the
activity level.

A variable cost may also be defined as a cost

that remains the same per unit at every level
of activity.
 Variable Costs
 Damon Company manufactures radios that contain a $10 digital
clock. The activity index is the number of radios produced. As
each radio is manufactured, the total cost of the clocks increases
by $10. (a) (b)
Total Variable Costs Unit Variable Costs
(Digital Clocks) (Digital Clocks)

$100 $25

Cost (per unit)

20
Cost (000)

80
60 15

40 10

20 5

0 0
0 2 4 6 8 10 0 2 4 6 8 10
Illustration 5-1 Radios produced in (000) Radios produced in (000)
 Fixed Costs
Fixed costs are costs that remain the same in
total regardless of changes in the activity level.

Since fixed costs remain constant in total as

activity changes, fixed costs per unit vary
inversely with activity. As volume increases,
unit cost declines and vice versa.
 Fixed Costs
 Damon Company leases all of 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.
(a) (b)
Total Fixed Costs Fixed Costs Per Unit
(Rent Expense) (Rent Expense)

$25 $5

Cost (per unit)

Cost (000)

20 4
15 3
10 2
5 1
0 0
0 2 4 6 8 10 0 2 4 6 8 10
Radios produced in (000) Radios produced in (000)
Illustration 5-2
 Study Objective 2

Explain the meaning and

importance of the relevant range.
 Nonlinear Behavior of
Variable and Fixed Costs
In the previous two slides, the assumption was made that total variable costs
and total fixed costs were linear, and straight lines were used to represent
both types of costs. A straight-line relationship does not usually exist for
variable costs throughout the entire range of activity.
In the real world, the
(a) (b)
relationship between variable
Total Variable Costs Total Fixed Costs
cost behavior and changes in Curvilinear Nonlinear
the activity level is often
curvilinear, as shown in part
(a) on the right. The
behavior of total fixed costs
Cost ($)

Cost ($)
through all levels of activity
is shown in part (b).

0 20 40 60 80 100 0 20 40 60 80 100
Illustration 5-3 Activity level (%) Activity level (%)
 Linear Behavior Within
Relevant Range
Operating at zero or at 100% capacity is the exception for most
companies. Companies usually operate over a narrower range – such
as 40-80% of capacity. The relevant range of the activity index is the
range over which a company expects to operate during a year.
(a) (b)
Within this range, as Total Variable Costs Total Fixed Costs
Curvilinear Nonlinear
shown in both
diagrams to the right, a Relevant
Range
Relevant
Range
straight-line
Cost ($)

Cost ($)
relationship normally
exists for both fixed
and variable costs.
0 20 40 60 80 100 0 20 40 60 80 100
Illustration 5-4 Activity level (%) Activity level (%)
 Study Objective 4

State the five components of cost-

volume-profit analysis.
 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.
 CVP analysis involves a consideration of the
interrelationships among the following components:
– Volume or activity level
– Unit selling price
– Variable cost per unit
– Total fixed costs
– Sales mix
 CVP Assumptions
The following assumptions underlie each CVP application:
When these assumptions are not valid, the results of CVP analysis
may be inaccurate.
1 The behavior of both costs and revenues is linear throughout the
relevant range of the activity index.
2 All costs can be classified as either variable or fixed with
reasonable accuracy.
3 Changes in activity are the only factors that affect costs.
4 All units produced are sold.
5 When more than one type of product is sold, total sales will be in
a constant sales mix.
 CVP Analysis
In CVP analysis applications, the term cost includes
manufacturing costs plus selling and administrative expenses.

 We will use Vargo Video Company as an example.

Relevant data for the VCRs made by this company are as
follows:

Unit selling price $500

Unit variable costs $300
Total monthly fixed costs $200,000

Illustration 5-10
 Study Objective 5

Indicate the meaning of contribution

margin and the ways it may be
expressed.
 Contribution Margin
One of the key relationships in CVP analysis is contribution
margin (CM). Contribution margin is the amount of
revenue remaining after deducting variable costs. The
CM is then available to cover fixed costs and to contribute
income for the company.
 For example, assume that Vargo Video sells 1,000 VCRs in
one month, sales are $500,000 (1,000 x $500) and variable
costs are $300,000 (1,000 x $300). Thus, contribution margin
is $200,000, computed as follows: Illustration 5-11

Contribution
Sales
- Variable Costs = Margin

$500,000 - $300,000 = $200,000

 Unit Contribution Margin
Views differ as to the best way to express contribution
margin (CM). Some favor a per unit basis.
 At Vargo Video, the contribution margin per unit is $200.

Illustration 5-12

Unit Variable Contribution

Unit Selling Price
- Cost = Margin per Unit

$500 - $300 = $200

 CM per unit indicates that for every VCR sold, Vargo Video will have $200
to cover fixed costs and contribute to income.
 Contribution Margin Ratio
Others prefer to use a contribution margin ratio.
 At Vargo Video, the contribution margin ratio is 40%.
Illustration 5-13

Contribution Contribution
Margin per Unit  Unit Selling Price = Margin Ratio

$200  $500 = 40%

 The CM ratio means that 40 cents of each sales dollar ($1 x 40%) is
available to apply to fixed costs and to contribute to income.
 Study Objective 6

Identify the three ways that the break-

even point may be determined.
 Break-Even Analysis
 The second key relationship in CVP analysis
is the break-even point, which is the level of
activity where total revenues equals total
costs, both fixed and variable.
 Since no income is involved when the break-
even point is the objective, the analysis is
often referred to as break-even analysis.
 Break-Even Analysis
 The break-even point can be:
– Computed from a mathematical equation.
– Computed by using contribution margin.
– Derived from a CVP graph.
 The break-even point can be expressed in
either sales dollars or sales units.
 Break-Even Analysis:
Mathematical Equation
In its simplest form, the equation for break-
even sales is:

Break-even Sales = Variable Costs + Fixed Costs

Illustration 5-14
 Break-Even Analysis:
Mathematical Equation for Dollars
The break-even point in dollars is found by expressing
variable costs as a percentage of unit selling price.

 For Vargo Video, the percentage is 60% ($300  $500). Sales must be $500,000 for Vargo
Video to break even. The computation to determine sales dollars at the break-even point is:

X = .60X + $200,000
.40X = $200,000
X = $500,000
where:
X = sales dollars at the break-even point
.60 = variable costs as a percentage of unit selling price
$200,000 = total fixed costs
Illustration 5-15
 Break-Even Analysis:
Mathematical Equation for Units
The break-even point in units can be computed
directly from the mathematical equation by using
unit selling prices and unit variable costs. Vargo
must sell 1,000 units to break even. The
computation is:
$500X = $300X + $200,000
$200X = $200,000
X = 1,000 units
where:
X = sales volume
$500 = unit selling price
$300 = variable cost per unit
$200,000 = total fixed costs
Illustration 5-16
 Break-Even Analysis:
Mathematical Equation Proof

The accuracy of the previous computations can be

proved as follows:

Sales (1,000 x $500) $500,000

Total costs:
Variable (1,000 x $300) $300,000
Fixed 200,000 500,000
Net Income $ -0-

Illustration 5-16
 Break-Even Analysis:
CM Technique for Units
Because we know that CM equals total revenues less variable costs, it follows that at the break-
even point, contribution margin must equal total fixed costs.
When the CM per unit is used, the formula to compute break-even point in units is shown below:

 Once again, the CM per unit for Vargo Video is $200.

Contribution Break-even Point

Fixed Costs
 Margin per Unit = in Units

$200,000  $200 = 1,000

 Break-Even Analysis:
CM Technique for Dollars
When the CM ratio is used, the formula to compute
break-even point in dollars is shown below:

 Again, the CM ratio for Vargo Video is 40%.

Contribution Break-even Point

Fixed Costs
 Margin Ratio = in Dollars

$200,000  40% = $500,000

 Study Objective 7

Define Cash Break-Even Point,

Operating Leverage
 Cash Break-Even Point

If the firm has a minimum of available cash or the

opportunity cost of holding excess cash is high,
management may want to know the volume of sales
that will cover all cash expenses during a period

CASH BREAK-EVEN POINT

 Cash Break-Even Point

Not all fixed operating costs involve cash payments.

For example, depreciation expenses are noncash
charges. To find the cash break-even point is lower
than the usual break-even point. The formula is

Cash Break-Even = Fixed Cost – Depreciation

CM per unit
 Cash Break-Even Point
Example: The Wayne Company manufactures and
sells doors to home builders. The doors are sold for
Php25 each. Variable costs are Php15 per door and
fixed operating costs total Php50,000 including the
depreciation in the amount of Php2,000
Cash Break-Even = Fixed Cost – Depreciation
CM per unit

Cash Break-Even = Php50,000 – 2,000

Php25 – 15
= 4,800 doors
 Operating Leverage
Operating Leverage is a measure of operating risk and
arises from fixed operating costs. A simple indication
of operating leverage is the effect that a change in
sales has on earnings. The formula is

Operating Leverage = % changes in EBIT

at given level of sales (x) % changes in sales

Operating Leverage = (SP – VC/unit) X

at given level of sales (x) (SP – VC/unit) X - FC
 Operating Leverage
Operating Leverage is a measure of operating risk and
arises from fixed operating costs. A simple indication
of operating leverage is the effect that a change in
sales has on earnings. The formula is

Where:
EBIT = earnings before interest and taxes
 Operating Leverage
Example: From previous example, assume that the
Wayne Company is currently selling 6,000 doors
per year
Operating Leverage = (SP – VC/unit) X
at given level of sales (x) (SP – VC/unit) X - FC
Operating Leverage = (P25 – 15)(6,000)
at given level of sales (x) (P25 – 15) 6,000 – 50,000
Operating Leverage = 6
Which means if sales increase by 10%, the company can expect its net income to increase by six
times that amount, or 60%
 Financial Leverage
Financial Leverage is a measure of financial risk and
arises from financial risk and arises from fixed
financial costs.One way to measure financial leverage
is to determine how to earnings per share are
affected by a change in EBIT(for operating
income)
Financial Leverage = % change in EPS
at given level of sales (x)% change in EBIT

Financing Leverage = (SP – VC/unit) X - FC

at given level of sales (x) (SP – VC/unit) X – FC - IC
 Financial Leverage
Financial Leverage is a measure of financial risk and
arises from financial risk and arises from fixed
financial costs.One way to measure financial leverage
is to determine how to earnings per share are
affected by a change in EBIT(for operating
income)
Financing Leverage = (SP – VC/unit) X - FC
at given level of sales (x) (SP – VC/unit) X – FC - IC
Where EPS is earnings per share, IC is fixed finance
charges, (i.e, interest expense or preferred stock
dividends)
 Financial Leverage
Financial Leverage is a measure of financial risk and
arises from financial risk and arises from fixed
financial costs.One way to measure financial leverage
is to determine how to earnings per share are
affected by a change in EBIT(for operating
income)
Where EPS is earnings per share, IC is fixed finance
charges, (i.e, interest expense or preferred stock
dividends)
Preferred stock dividend must be adjusted for taxes
i.e. Preferred Stock Dividend / (1 – t)
 Financial Leverage
Example: Using the data in previous example, the
Wayne Company has total financial charges of
Php2,000, half in interest expense and half in
preferred stock dividend. The corporate tax rate is
40%. What is their financial leverage? First,

IC = Php1,000 + Php1,000
(1 – 0.40)
IC = Php1,000 + 1,667 = Php2,667
 Financial Leverage
Example: Using the data in previous example, the
Wayne Company has total financial charges of
Php2,000, half in interest expense and half in
preferred stock dividend. The corporate tax rate is
40%. What is their financial leverage? First,

Financial Leverage = (P – V) X – FC
(P – V) X – FC - IC

(25 – 15)(6,000) – 50,000

(25 – 15)(6,000) – 50,000 – 2,667
 Financial Leverage
Example: Using the data in previous example, the
Wayne Company has total financial charges of
Php2,000, half in interest expense and half in
preferred stock dividend. The corporate tax rate is
40%. What is their financial leverage? First,

(25 – 15)(6,000) – 50,000

(25 – 15)(6,000) – 50,000 – 2,667
Financial Leverage = 1.36
Which means that if EBIT increases by 10%, Wayne can
expect its EPS to increase by 1.36% or 1.36%
 Total Leverage
Total Leverage is a measure of total risk. The way to
measure total leverage is to determine how EPS is
affected by change in sales.

Total Leverage at a given level of sales =

% change in EPS
% change in Sales

Total Leverage at a given level of sales =

Operating leverage x Financial Leverage
 Total Leverage
Total Leverage is a measure of total risk. The way to
measure total leverage is to determine how EPS is
affected by change in sales.

Total Leverage at a given level of sales =

Operating leverage x Financial Leverage

Total Leverage at a given level of sales =

6 x 1.36 = 8.16
 Exercises
Break-Even and Cash Break-Even Points: The following price and
cost data are given for firms A, B and C.
A B C
Selling Price per unit Php25 Php12 Php15
Variable Cost per unit 10 6 5
Fixed Operating Costs P30,000 P24,000 P100,000
Depreciation 5,000 4,000 20,000

Calculate:
a.Break Even Point in units
b.Cash Break Even Point in units
c.Rank these firms in terms of their risk
 Exercises
Operating and Financial Leverage: John Tripper Soft Drinks Inc,.
Sells 500,000 bottles of soft drinks a year. Each bottle produced has a
variable cost of P0.25 & sells for P0.45. Fixed operating costs are
P50,000. The company has current interest charges of P6,000 &
preferred dividends of P2,400. Tax Rate is 40%.

Calculate:
a.Degree of Operating Leverage, Financial Leverage and Total
Leverage
b.Do part (a) at the 750,000 bottle sales level