Managerial Accounting

Managerial Accounting
Introduction to Cost Behavior and Cost-Volume-Profit Relationships
Chapter 2
Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2-1

Chapter 2
Introduction to Cost Behavior

and Cost-Volume-Profit
Relationships

Chapter 2 Learning Objectives
When you have finished studying this chapter, you

should be able to:
1. Explain how cost drivers affect cost behavior.
2. Show how changes in cost-driver levels affect

variable and fixed costs.
3. Explain step- and mixed-cost behavior.
4. Create a cost-volume-profit (CVP) graph and

understand the assumptions behind it.
5. Calculate break-even sales volume in total dollars

and total units.
Chapter 2 Learning Objectives
6. Calculate sales volume in total dollars and total

units to reach a target profit.
7. Differentiate between contribution margin and

gross margin.
8. Explain the effects of sales mix on profits

(Appendix 2A).
9. Compute cost-volume-profit (CVP) relationships on

an after-tax basis (Appendix 2B).

Cost Drivers and Cost Behavior
Cost drivers are measures

of activities that require
the use of resources
and thereby cause costs.
Cost behavior is how the

activities of an
organization affect its costs.

Learning
Objective 1
Cost Drivers and Cost Behavior

Value Chain Functions, Costs, and Cost Drivers
Value Chain Function Example Cost Drivers

And Resource Costs
Research and development
• Salaries of sales personnel Number of new product proposals
costs of market surveys
• Salaries of product and process Complexity of proposed products
engineers
Design of products, services, and

processes
• Salaries of product and process Number of engineering hours
engineers
• Cost of computer-aided design Number of distinct parts per
equipment used to develop product
prototype of product for testing


and Resource Costs
Production
• Labor wages Labor hours
• Supervisory salaries Number of people supervised
• Maintenance wages Number of mechanic hours
• Depreciation of plant and machinery, Number of machine hours
supplies
• Energy cost Kilowatt hours
Marketing
• Cost of advertisements Number of advertisements
• Salaries of marketing personnel, Sales dollars
travel costs, entertainment costs


And Resource Costs
Distribution
• Wages of shipping personnel Labor hours
• Transportation costs including Weight of items delivered
depreciation of vehicles and fuel
Customer service
• Salaries of service personnel Hours spent servicing products
• Costs of supplies, travel Number of service calls
Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 10

Learning
Objective 2 Variable and Fixed Cost Behavior
A variable cost A fixed cost is

changes in direct not immediately
proportion to changes affected by changes
in the cost-driver level. in the cost-driver level.
Think of variable Think of fixed costs

costs on a per-unit basis. on a total-cost basis.
The per-unit variable

Total fixed costs remain
cost remains unchanged
unchanged regardless of
regardless of changes in
changes in the cost-driver.
the cost-driver.

Cost Behavior of Variable and Fixed

Cost Behavior: Further Considerations
Cost behavior depends on the decision

context, the circumstances surrounding
the decision for which the cost will be
used.
Cost behavior also depends on

management decisions—management
choices determine cost behavior.

Relevant Range
The relevant range is the limit

of cost-driver activity level within which a
specific relationship between costs
and the cost driver is valid.
Even within the relevant range, a fixed

cost remains fixed only over a given
period of time—usually the budget period.

Fixed Costs and Relevant Range

Learning Step- and Mixed-Cost
Objective 3
Behavior Patterns
Step cost:
Mixed Cost:
A cost that changes
abruptly at different A cost that contains
intervals of activity elements of both
because the resources fixed- and variable-
and their costs come cost behavior
in indivisible chunks.

Step-Cost Behavior
Step cost treated as a fixed cost Step cost treated as a variable cost

Learning Cost-volume-profit (CVP)
Objective 4
analysis
Managers trying to evaluate the effects of

changes in volume of goods or services produced
might be interested in upward changes such as
increased sales expected from increases in
promotion or advertising.
AND
Managers might be interested in downward
changes such as decreased sales expected due to
a new competitor entering the market or due to a
decline in economic conditions.

CVP Scenario
Cost-volume-profit (CVP) analysis is the study of the
effects of output volume on revenue (sales), expenses
(costs), and net income (net profit).
Per Unit Percentage of

Sales
Selling price $1.50 100%
Variable cost of each item 1.20 80
Selling price less variable cost $ .30 20%
Monthly fixed expenses:

Rent $3,000
Wages for replenishing and
servicing 13,500
Other fixed expenses 1,500
Total fixed expenses per month $18,000

Cost-Volume-Profit Graph
$150,000 A
Net Income
138,000 Sales C
120,000 Net Income Area
Dollars
D
90,000 Variable
Total Break-Even Point Expenses
60,000 Expenses 60,000 units
Net Loss
30,000 or $90,000
Area
18,000 B
Fixed Expenses
0 10 20 30 40 50 60 70 80 90 100
Units (thousands)

Learning
Objective 5 Break-Even Point
The break-even point is the level of sales at which

revenue equals expenses and net income is zero.
Sales
- Variable expenses
- Fixed expenses
Zero net income (break-even point)

Contribution Margin Method
Contribution margin Contribution margin ratio

Per Unit Per Unit %
Selling price $1.50 Selling price 100
Variable costs 1.20 Variable costs 80
Contribution margin $ .30 Contribution margin 20
$18,000 fixed costs ÷ $.30 =

60,000 units (break even)

Contribution Margin Method
60,000 units × $1.50 (Sales Price) = $90,000

in sales to break even
$18,000 fixed costs

÷ 20% (contribution-margin percentage)
= $90,000 of sales to break even

Equation Method
Let N = number of units

to be sold to break even.
Variable Fixed
Sales – Expenses – Expenses = net income
$1.50N – $1.20N – $18,000 = 0
$.30N = $18,000
N = $18,000 ÷ $.30
N = 60,000 Units

Equation Method
Let S = sales in dollars

needed to break even.
S – .80S – $18,000 = 0
.20S = $18,000
S = $18,000 ÷ .20
S = $90,000
Shortcut formulas:
Break-even = fixed expenses = $18,000 = 60,000
volume in units unit contribution margin .30
Break-even = fixed expenses = $18,000 = $90,000

volume in sales contribution margin ratio .2

Learning
Objective 6 Target Net Profit
Managers use CVP analysis

to determine the total sales,
in units and dollars, needed
to reach a target net profit.
Target sales $1,440 per month

– variable expenses is the minimum
– fixed expenses acceptable
target net income net income.

Target Net Profit
Target sales volume in units =

(Fixed expenses + Target net income)
÷ Contribution margin per unit
Selling price $1.50

Variable costs 1.20
Contribution margin per unit $ .30
($18,000 + $1,440) ÷ $.30 = 64,800 units
Target sales dollars = sales price X sales volume in units

Target sales dollars = $1.50 X 64,800 units = $97,200.

Target Net Profit
Contribution margin ratio

Per Unit %
Selling price 100
Variable costs 80
Contribution margin 20
Target sales volume in dollars =

Fixed expenses + target net income
contribution margin ratio
Sales volume in dollars =
18,000 + $1,440 = $97,200
.20
Nonprofit Application
Suppose a city has a $100,000

lump-sum budget appropriation
to conduct a counseling program.
Variable costs per prescription

are $400 per patient per day.
Fixed costs are $60,000 in the

relevant range of 50 to 150 patients.

If the city spends the entire budget

appropriation, how many patients
can it serve in a year?
Variable + Fixed
Sales = expenses + expenses
$100,000 = $400N + $60,000
$400N = $100,000 – $60,000
N = $40,000 ÷ $400
N = 100 patients

If the city cuts the total budget appropriation by

10%, how many patients can it serve in a year?
Budget after 10% Cut

$100,000 X (1 - .1) = $90,000
Variable + Fixed
Sales = expenses + expenses
$90,000 = $400N + $60,000
$400N = $90,000 – $60,000
N = $30,000 ÷ $400
N = 75 patients
Operating Leverage
Operating leverage measures the sensitivity

of the firm’s operating income (or EBIT) to
fluctuations in sales
Margin of safety = planned unit sales –

break-even sales. How far can sales fall
below the planned level before losses occur?

Operating Leverage
Low leveraged firms have lower fixed costs

and higher variable costs.
Changes in sales volume will have a
smaller effect on net income.
Where :
% change in EBIT = (EBITt1 – EBITt)/ EBITt
% change in sales = (Salest1 – Salest) / Salest
Thus % change in EBIT

= OL x % change in sales
Operating Leverage Example
If a company has an operating leverage (OL)
of 6, then what is the change in EBIT if sales
increase by 5%?
% change in EBIT = OL x % change in sales

= 6 x 5% = 30%
Thus, if the firm increases sales by 5%,

EBIT will increase by 30%
The greater the firm’s degree of operating

leverage, the more the profits will vary
in response to change in sales



Learning Contribution Margin
Objective 7 and Gross Margin

Contribution Margin
and Gross Margin
Sales price – Cost of goods sold = Gross margin
Sales price - all variable expenses =

Contribution margin
Per Unit
Selling price $1.50
Variable costs (acquisition cost) 1.20
Contribution margin and
gross margin are equal $ .30

Contribution Margin and Gross Margin
Suppose the firm paid a commission of $.12 per unit sold.
Contribution Gross
Margin Margin
Per Unit Per Unit
Sales $1.50 $1.50
Acquisition cost of unit sold 1.20 1.20
Variable commission .12
Total variable expense $1.32
Contribution margin .18
Gross margin $.30
Learning Appendix 2A
Objective 8
Sales Mix Analysis
Sales mix is the relative proportions or

combinations of quantities of products
that comprise total sales.
If the proportions of the mix change,

the cost-volume-profit relationships
also change.

Sales Mix Analysis
Ramos Company Example
Wallets Key Cases
(W) (K) Total
Sales in units 300,000 75,000 375,000

Sales @ $8 and $5 $2,400,000 $375,000 $2,775,000
Variable expenses
@ $7 and $3 2,100,000 225,000 2,325,000
Contribution margins
@ $1 and $2 $ 300,000 $150,000 $ 450,000
Fixed expenses 180,000
Net income $ 270,000

Sales Mix Analysis
Let K = number of units of K to break even, and
4K = number of units of W to break even.
Break-even point for a constant sales mix of 4 units of W

for every unit of K.
sales – variable – fixed = zero net income
expense expenses
[$8(4K) + $5(K)] – [$7(4K) + $3(K)] – $180,000 = 0

32K + 5K - 28K - 3K - 180,000 = 0
6K = 180,000
K = 30,000
W = 4K = 120,000
30,000K + 120,000W = 150,000 total units (K + W).

Sales Mix Analysis
If the company sells only key cases:

break-even point = fixed expenses
contribution margin per unit
= $180,000
$2
= 90,000 key cases
If the company sells only wallets:

break-even point = fixed expenses
contribution margin per unit
= $180,000
$1
= 180,000 wallets

Sales Mix Analysis
Suppose total sales

were equal to the
budget of 375,000 units.
However, Ramos sold

only 50,000 key cases
And 325,000 wallets.
What is net income?

Sales Mix Analysis
Ramos Company Example

Wallets Key Cases
(W) (K) Total
Sales in units 325,000 50,000 375,000

Sales @ $8 and $5 $ 2,600,000 $250,000 $2,850,000
Variable expenses
@ $7 and $3 2,275,000 150,000 2,425,000
Contribution margins
@ $1 and $2 $ 325,000 $100,000 $ 425,000
Fixed expenses 180,000
Net income $ 245,000

Learning
Objective 9 Impact of Income Taxes
Income taxes do not affect the break-even point.

There is no income tax at a level of zero income.
Income taxes affect the calculation of the volume

required to achieve a specified after-tax target
profit.
Suppose that a company earns $1,440 before

Taxes and pays income tax at a rate of 40%.

Impact of Income Taxes
Suppose the target net income after taxes was $864
Target income before taxes = Target after-tax net income

1 – tax rate
Target income before taxes = $ 864 = $1,440

1 – 0.40

Target sales - Variable expenses - Fixed expenses

= Target after-tax net income ÷ (1 – tax rate)
$1.50N - $1.20N - $18,000 = $864 ÷ (1 – 0.40)

$.30N = $18,000 + ($864/.6)
$.18N = $10,800 + $864 = $11,664
N = $11,664/$.18
N = 64,800 units

Suppose target net income after taxes was $1,440
$1.50N - $1.20N - $18,000 = $1,440 ÷ (1 – 0.40)

$.30N = $18,000 + ($1,440/.6)
$.18N = $10,800 + $1,440 = $12,240
N = $12,240/$.18
N = 68,000 units

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Introduction to Cost Behavior and Cost-Volume-Profit Relationships

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2-1

Introduction to Cost Behavior

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2-3

When you have finished studying this chapter, you

1. Explain how cost drivers affect cost behavior.

2. Show how changes in cost-driver levels affect

3. Explain step- and mixed-cost behavior.

4. Create a cost-volume-profit (CVP) graph and

5. Calculate break-even sales volume in total dollars

6. Calculate sales volume in total dollars and total

7. Differentiate between contribution margin and

8. Explain the effects of sales mix on profits

9. Compute cost-volume-profit (CVP) relationships on

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2-5

Cost drivers are measures

Cost behavior is how the

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2-6

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2-7

Value Chain Function Example Cost Drivers

Design of products, services, and

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2-8

Value Chain Function Example Cost Drivers

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2-9

Value Chain Function Example Cost Drivers

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 10

A variable cost A fixed cost is

Think of variable Think of fixed costs

The per-unit variable

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 11

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 12

Cost behavior depends on the decision

Cost behavior also depends on

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 13

The relevant range is the limit

Even within the relevant range, a fixed

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 14

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 15

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 16

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 17

Managers trying to evaluate the effects of

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 18

Per Unit Percentage of

Monthly fixed expenses:

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 19

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 20

The break-even point is the level of sales at which

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 21

Contribution margin Contribution margin ratio

$18,000 fixed costs ÷ $.30 =

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 22

60,000 units × $1.50 (Sales Price) = $90,000

$18,000 fixed costs

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 23

Let N = number of units

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 24

Let S = sales in dollars

Break-even = fixed expenses = $18,000 = $90,000

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 25

Managers use CVP analysis

Target sales $1,440 per month

Copyright © 2014 Pearson Education, Inc. publishing as Prentice Hall 2 - 26

Target sales volume in units =