Chapter 2.

Introduction to Cost
Behavior and Cost-Volume-
.

Profit Relationships
.

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.
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.
9. Compute cost-volume-profit (CVP) relationships on an after-tax basis
 DEFINITION

• cost behavior is :
How the activities of an organization affect its costs.

• cost-volume-profit (CVP) analysis is :

The study of the effects of output volume on revenue
(sales), expenses (costs), and net income (net profit).
Identifying Activities, Resources, Costs, and
Cost Drivers
• cost driver
A measure of activities that requires the use of resources and thereby cause costs.
• Different types of costs behave in different ways. Consider the costs of making the 737-MAX—
Boeing’s newest version of the most popular single-aisle airplane ever produced.
• To predict costs for decision making and to control costs on a day-to-day basis, Boeing managers
identify :
● key activities performed,
● resources used in performing these activities,
● costs of the resources used, and
● cost drivers , measures of activities that require the use of resources and thereby cause costs.

• Exhibit 2-1 shows how activities link resources and their costs with the output of products or
services.
Exhibit 2-2
Examples of Value-Chain Functions, Resource Costs, and Cost Drivers
• Exhibit 2-2 lists examples of resource costs and potential cost drivers for activities in each of the value-chain
functions. How well we identify the most appropriate cost drivers determines how well managers understand
cost behavior and how well managers can control costs.

• Variable-Cost and Fixed-Cost Behavior

variable cost
A cost that changes in direct proportion to changes in the cost-driver level.
fixed cost
A cost that is not affected by changes in the cost-driver level.
• Accountants classify costs as variable or fixed depending on whether the cost changes with respect to a
particular cost driver. A variable cost changes in direct proportion to changes in thecost driver. In contrast,
changes in the cost driver do not affect a fixed cost . Suppose the cost driver is units of goods or services
produced. A 10% increase in units produced would result in a 10% increase in variable costs. However, the
fixed costs would remain unchanged.
Example for Variable Cost and Fixed Cost
• Consider an example of variable costs for Watkins Products , the 140-year-old health food company. If
atkins pays its sales personnel a 20% straight commission on sales, the total cost of sales commissions to
Watkins is 20% of sales dollars—a variable cost with respect to sales revenues. Or suppose Long Lake Bait
Shop buys bags of fish bait from a supplier for $2 each. The total cost of fish bait is $2 times the number of
bags purchased—a variable cost with respect to units (number of bags) purchased.
Notice that variable costs do not change per unit of the cost driver, but the total variable costs change in
direct proportion to the cost-driver activity.

• Now consider an example of a fixed cost. Suppose Sony rents a factory for $500,000 per year to produce
DVD players. The number of DVD players produced does not affect the total fixed cost of $500,000. The unit
cost of rent applicable to each DVD player, however, does depend on the total number of DVD players
produced. If Sony produces 50,000 DVD players, the unit cost will be $500,000 , 50,000 = $10. If Sony
produces 100,000 DVD players, the unit cost will be $500,000 , 100,000 = $5. Therefore, while the fixed cost
per-unit of the cost-driver becomes progressively smaller as the volume increases, the total fixed cost does
not change with volume.
• Pay special attention to the fact that the terms “variable” or “fixed” describe the behavior of the total dollar
cost, not the per-unit cost, which has the opposite behavior. Total variable costs increase as the cost driver
increases but variable costs per unit remain constant. Total fixed costs remain constant as cost driver activity
increases but fixed costs per unit decrease.
• Exhibit 2-3: Cost Behavior of Fixed and Variable Costs

• To plan and control costs, managers focus on the activities required to make, sell, and deliver
• products or services and the resources needed to support these activities.
 Exhibit 2-4: Receiving Activity and Resources Used

Consider the behavior of just two of these resource costs, equipment and fuel costs, ignoring
other resource costs such as labor and supplies. Suppose equipment costs of $45,000 are fixed
and do not vary with increases or decreases in the number of parts received, while fuel cost is a
variable cost that increases or decreases by $.80 with each part received. Exhibit 2-4 shows how
these resource costs relate to the receiving activity.
 Exhibit 2-5: Total Fuel and Equipment Lease Costs

Exhibit 2-5 illustrates the relationship between the receiving activity and resource costs.
The equipment costs represent the total fixed lease cost of $45,000. The fuel costs are variable at $0.80 per part
received. We can use the descriptions of cost behavior in Exhibits 2-4 and 2-5 to find total fuel and equipment cost at
any other level of receiving activity. For example, the total equipment and fuel costs of receiving 30,000 parts is
$45,000 + (30,000 * $.80) = $69,000. Similarly, the total cost of receiving 27,500 parts is $45,000 + (27,500 * $.80)
= $67,000. Notice how we used the respective costs in these calculations. We used the total cost of $45,000
for the fixed equipment lease cost and the unit cost of $.80 for variable fuel cost.
Exhibit 2-5 : (continued)
Cost Behavior: Further Considerations
• For a variety of reasons, cost behavior cannot always be accurately described as simply variable or fixed.
Cost behavior depends on the decision context , the circumstances surrounding the decision for which the
cost will be used, as illustrated by examples in the discussion that follows. Further, cost behavior also
depends on management decisions—management choices determine cost behavior.
• Complicating Factors for Fixed and Variable Costs
In this section, we illustrate and explain some of the factors that complicate cost behavior for fixed and
variable costs.
• FIXED COSTS Although we described fixed costs as unchanging regardless of changes in the cost driver,
this description holds true only within limits. For example, rent costs for a production building are generally
fixed within a limited range of activity but may rise if activity increases enough to require additional rental
space or may decline if activity decreases so much that it allows the company to rent less space. The relevant
range is the limits of the cost-driver level within which a specific relationship between costs and the cost
driver is valid.
• VARIABLE COSTS The idea of a relevant range is obviously important for fixed costs, but a corresponding
issue may also arise for variable costs. For example, if GE obtains volume discounts for purchasing larger
quantities of input materials such as glass and tungsten, the materials cost per case for the GE lightbulb plant
would be lower, and the slope of the variable cost function would be lower, at higher levels of production.
Exhibit 2-6 : Fixed Costs and Relevant Range
• The top figure shows a refined analysis that reflects all the complexities described previously. The
bottom figure shows a simplified analysis that focuses only on the cost in the relevant range,
ignoring the issue of cost behavior outside the relevant range. Within the relevant range
highlighted in yellow, the refined and simplified analyses coincide. However, the refined
description at the top of Exhibit 2-6 explicitly shows the rental costs at the levels of activity
outside the relevant range. The simplified description at the bottom of the exhibit shows only the
rental costs for the relevant range and uses a dashed line outside the relevant range to remind
the user that the graphed cost is outside the limits of the relevant range.
• decision context
The circumstances surrounding the decision for which the cost will be used.
• relevant range
The limits of the cost-driver level within which a specific relationship between costs and the cost
driver is valid.
• As a decision maker, it is essential to recognize when your decision will move outside the relevant range. In
that case, it is essential that you obtain the information included in the refined analysis, showing how costs
behave outside the relevant range.
Step- and Mixed-Cost Behavior Patterns
• Some costs are neither purely fixed nor purely variable. For example, two types of costs that combine
characteristics of both fixed- and variable-cost behavior are step costs and mixed costs.
• step cost
A cost that changes abruptly at different intervals of activity because the resources and their costs come in
indivisible chunks
• Exhibit 2-7: Step-Cost Behavior
• mixed cost
A cost that contains elements of both fixed- and variable-cost behavior.
• The fixed-cost element is unchanged over the relevant range of activity levels while the variable-cost element
of the mixed cost varies proportionately with cost-driver activity. You might think of the fixed cost element as
the cost of creating the capacity to operate and the variable cost element as the additional cost of actually
using that capacity.
• For example, the cost of providing diagnostic imaging services at the Mayo Clinic is a mixed cost. There is a
substantial fixed cost of having expensive imaging equipment available and ready for use. There is also a
variable cost associated with actual use of the equipment, such as the costs of power, technicians to operate
the equipment, and physicians to interpret the results.
• As another example, the cost of running an evening dinner cruise on the Seine River in Paris is a mixed cost.
There is a fixed cost of having the boat and crew available to travel along the river. There is also a variable
cost of having service staff, food, and beverages to match the number of passengers on the cruise.
• Effect of Time Horizon and Magnitude on Cost Behavior
Whether costs behave as fixed or variable often depends on the time frame affected by a decision
and on the magnitude of the change in cost-driver activity. For long time spans or large changes in
activity level, more costs behave as variable. For short time spans or small changes in activity level,
more costs behave as fixed. The preceding discussion of step costs shows how cashier wage costs
can be variable in large magnitude decisions about staffing but fixed in small magnitude decisions.
 Cost-Volume-Profit Analysis
• The study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit).
• For the remainder of this chapter, we consider only decisions where costs are fixed, variable, or mixed. The
models developed assume the fixed cost components of cost do not change with the cost driver and the
variable cost components change in direct proportion to a single cost driver. These models serve as useful
starting points in decisions where the assumptions do not hold exactly but are reasonable approximations. For
example, the models apply to step costs where the decision spans a large enough number of steps and the
steps in the cost function are proportional to the cost driver so that the steps can be reasonably approximated
as a variable cost.
• CVP Scenario
• Amy Winston, the manager of food services for one of Boeing’s plants, is trying to decide whether to rent a
line of snack vending machines. Although individual snack items have various acquisition costs and selling
prices, Winston has decided that an average selling price of $1.50 per unit and an average acquisition cost of
$1.20 per unit will suffice for purposes of this analysis. She predicts the following revenue and expense
relationships:
Graphing the CVP Relationship
• the following procedure for constructing the graph, visualize the revenues and costs that correspond to the
points and lines you are plotting.
• 1. Draw the axes. The horizontal axis is sales volume and the vertical axis is dollars of cost and revenue.
• 2. Plot revenue. Select a convenient value at the upper end of the relevant range for sales volume, say,
100,000 units, and plot point A for total sales dollars at that volume: 100,000 * $1.50 = $150,000. Draw the
revenue line from the origin (the point corresponding to $0 and 0 units) to point A.
• 3. Plot fixed costs. Draw the horizontal line showing the $18,000 fixed portion of cost. The point where the
horizontal fixed cost line intersects the vertical axis is point B.
• 4. Plot fixed costs plus variable costs. Determine the variable portion of cost at the volume you used to plot
point A: 100,000 units * $1.20 = $120,000. Plot point C, the fixed plus variable costs for 100,000 units,
$18,000 + $120,000 = $138,000. Then draw a line between this point and point B, the fixed plus variable
costs for 0 units, $18,000 + $0 = $18,000. This line shows the total cost (fixed cost plus variable cost) at
volumes between 0 and 100,000 units.
• 5. Locate the break-even point —the volume of sales at which revenue equals total cost and therefore
income is zero. Graphically, this is the point at 60,000 units where the sales revenue line and the total cost
line cross. At 60,000 units, total revenue (60,000 * $1.50 = $90,000) is equal to total cost ([60,000 * $1.20] +
$18,000 = $90,000). On the graph, the breakeven point is labeled point D.
• CVP analysis is sometimes also referred to as break-even analysis. However, this term is misleading. Why?
Because CVP analysis reveals more than just the break-even point. At any volume of activity, the vertical
distance between the revenue line and the total cost line represents the profit or loss at that volume.
Exhibit 2-8: Cost-Volume-Profit (CVP) Graph
• It is important to remember that CVP analysis is based on a set of important assumptions.
• Some of these assumptions follow:
• 1. We can classify costs into variable and fixed categories. The variable costs vary in direct proportion
to activity level. Fixed costs do not change with activity level.
• 2. We expect no change in costs due to changes in efficiency or productivity.
• 3. The behavior of revenues and costs is linear over the relevant range. This means that selling prices
per unit and variable costs per unit do not change with the level of sales. Note that almost all break-
even graphs show revenue and cost lines extending back to the verticalaxis as shown in Exhibit 2-8 .
As illustrated by the earlier discussion of Exhibits 2-6 and
• 2-7 , this approach is misleading in cases where the relevant range does not extend all the way back to
zero volume.
• 4. In multiproduct companies, the sales mix remains constant. The sales mix is the relative
proportions or combinations of quantities of different products that constitute total sales.
• 5. The inventory level does not change significantly during the period. That is, the number of
• units sold equals the number of units produced.
 Computing the Break-Even Point

To express the break-even point in terms of dollar sales rather than number of units, multiply
the number of units (60,000) by the selling price per unit ($1.50) to find the break-even point in
terms of dollar sales, $90,000.
• CONTRIBUTION-MARGIN METHOD The general equation can also be reformulated in terms of the
unit contribution margin or marginal income per unit that every unit sold generates, which is the unit
sales price minus the variable cost per unit. For the vending machine snack items, the unit contribution
margin is $.30:

• When do we reach the break-even point? When we sell enough units to generate a total contribution margin
(total number of units sold * unit contribution margin) that is sufficient to cover the total fixed costs. Think
about the contribution margin of the snack items. Each unit sold generates extra revenue of $1.50 and extra
cost of $1.20. Fixed costs are unaffected. If we sell zero units, we incur a loss equal to the fixed cost of
$18,000. Each additional unit sold reduces the loss by $.30 until sales reach the break-even point. After that
point, each unit sold adds (or contributes) $.30 to profit.
• To find the break-even number of units, divide the fixed costs of $18,000 by the unit contribution margin of
$.30. The number of units that we must sell to break even is $18,000, $.30 = 60,000 units. The sales revenue
at the break-even point is 60,000 units * $1.50 per unit, or $90,000.
• Instead of using per unit variable costs and contribution margins, it is sometimes more convenient to use
percentages. The variable cost percentage and the contribution margin percentage can be computed using
either total or per unit costs:
Note that the contribution-margin percentage = 100% - variable cost percentage. We can also express these
percentages as ratios, the variable-cost ratio and contribution-margin ratio, which are simply the percentages
multiplied by 100. Now let’s solve for break-even sales dollars in our vending machine example without
computing the unit break-even point by using the contribution-margin ratio or percentage:
• unit contribution margin (marginal income per unit)
The sales price per unit minus the variable cost per unit
• total contribution margin
Total number of units sold times the unit contribution margin.
• variable-cost percentage
Total variable costs divided by total sales.
• contribution-margin percentage
Total contribution margin divided by sales or 100% minus the variable cost percentage.
• variable-cost ratio
Variable cost percentage expressed as a ratio.
• contribution-margin ratio
Contribution margin percentage expressed as a ratio.
contribution margin
A term used for either total contribution margin, unit contribution margin, or contribution margin
percentage
• RELATIONSHIP BETWEEN THE TWO METHODS The contribution-margin method is a specific
• version of the general equation method. Look at the last three lines in the two solutions given
• for equation 1. They read

Should you use the general equation method or the contribution-margin method? Use whichever
is easier for you to understand or apply to a particular case. Both yield the same results, so the
choice is a matter of personal preference.
Effects of Changes in Fixed Expenses or Contribution Margin
In addition to determining profit at various volume levels, we can use CVP to examine the effects
of changes in fixed costs, variables costs, or selling prices.
• CHANGES IN UNIT CONTRIBUTION MARGIN Companies can also reduce their break-even points by
increasing their unit contribution margins, by either increasing unit sales prices or decreasing unit variable
costs, or both.
• For example, assume the fixed costs for the vending machine example remain at $18,000.
• (1) If Winston increases the selling price from $1.50 to $1.60 per unit and the original variable costs per unit
are unchanged at $1.20 per unit, find the monthly break-even point in number of units and in dollar sales. (2)
If Winston reduces variable costs per unit by $.10 per unit and the selling price remains unchanged at $1.50
per unit, find the monthly break-even point in number of units and in dollar sales.
 Additional Uses of CVP Analysis
• Margin of Safety
• CVP analysis can help managers assess risk. One measure of risk is the margin of safety . The margin of
safety measures how far sales can fall before losses occur and is the difference between the level of planned
sales and the break-even point. The margin of safety can be defined in either units or dollars:
margin of safety in units = planned unit sales - break@even unit sales
margin of safety in dollars = planned dollar sales - break@even dollar sales
• For example, if Amy Winston in our vending machine example predicts sales volume of 80,000 units or
$120,000, the margin of safety in units is 20,000 units and the margin of safety in dollars is $30,000:
margin of safety in units = 80,000 units - 60,000 units = 20,000 units
margin of safety in dollars = $120,000 - $90,000 = $30,000
• The larger the margin of safety, the less likely it is that volume will fall to the point where the company has
an operating loss, that is, below the break-even point. Conversely, a smaller margin of safety indicates greater
risk of incurring a loss.
• Operating Leverage
• In addition to weighing the varied effects of changes in fixed and variable costs, managers need to consider the firm’s
cost structure —the combination of variable- and fixedcost resources used to carry out the organization’s activities.
• There is typically a tradeoff between variable and fixed costs in choosing a cost structure. Lower variable costs are
often achieved by incurring higher fixed costs. For example, highly-automated factories with high fixed overhead
costs typically have lower variable labor costs compared to less automated factories. Firms with higher fixed costs
and lower variable costs are said to have greater operating leverage —the sensitivity of a firm’s profit to changes in
volume of sales. Inhighly leveraged companies with lower variable costs, small changes in sales volume result in
large changes in net income. In companies with less leverage and higher variable costs, changes in sales volume have
a smaller effect on income.

• cost structure
• The combination of variableand fixed-cost resources used to carry out the organization’s activities.
• operating leverage
• The sensitivity of a firm’s profit to changes in volume of sales.
degree of operating leverage
The ratio of contribution margin to profit, defined at a specific volume of sales

Exhibit 2-11
High Versus Low Operating Leverage
Contribution Margin and Gross Margin
• gross margin (gross profit)
The excess of sales over the total cost of goods sold.
• cost of goods sold
The cost of the merchandise that a company acquires or produces and sells
• Compare the gross margin with the contribution margin:
gross margin = sales price - cost of goods sold
contribution margin = sales price - all variable expenses
• Exhibit 2-12 shows costs divided on two different dimensions. As shown at the bottom of the exhibit, the
gross margin uses the division on the production or acquisition cost versus selling and administrative cost
dimension, and the contribution margin uses the division based on the variable-cost versus fixed-cost
dimension.
• In our vending-machine illustration, the contribution margin and the gross margin are identical because the
cost of goods sold is the only variable cost:
• Now, suppose the firm had to pay a commission of $.12 per unit sold:
END