John Wiley & Sons, Inc.

2005
Prepared by
Dan R. Ward
Suzanne P. Ward
University of Louisiana at Lafayette
Managerial Accounting
Weygandt Kieso Kimmel
CHAPTER 5
COST-VOLUME-PROFIT
CHAPTER 5
COST VOLUME - PROFIT
Study Objectives
ODistinguish between variable and fixed costs.
OExplain the significance of the relevant range.
OExplain the concept of mixed costs.
OList the five components of cost-volume-profit
analysis.
OIndicate what contribution margin is and how it
can be expressed.


Study Objectives: Continued
OIdentify the three ways to determine the break-
even point.
OGive the formulas for determining sales
required to earn target net income.
ODefine margin of safety, and give the formulas
for computing it.


COST BEHAVIOR ANALYSIS
Definition: 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 make
decisions
Applies to all types of businesses and entities

COST BEHAVIOR ANALYSIS
Continued
Starting point is measuring key business
activities
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)
COST BEHAVIOR ANALYSIS
Continued
Many companies use more
than one measurement base

For an activity level
to be useful:
Changes in the level or volume of activity should be
correlated with changes in cost


COST BEHAVIOR ANALYSIS
Continued
The activity level selected is called
the activity (or volume) index
Identifies the activity that causes
changes in the behavior of costs
Allows costs to be classified
according to their response to
changes in activity as:
Variable Costs
Fixed Costs
Mixed Costs

COST BEHAVIOR ANALYSIS
VARIABLE COSTS
Study Objective 1
Costs that vary in total directly and proportionately
with changes in the activity level

If the activity level increases 10 percent, total
variable costs increase 10 percent

If the activity level decreases by 25 percent, total
variable costs will decrease by 25 percent

COST BEHAVIOR ANALYSIS
VARIABLE COSTS - Continued
Variable costs also remain constant per unit at
every level of activity

Examples of variable costs include
Direct material and direct labor for a manufacturer
Sales commissions for a merchandiser
Gasoline in airlines and trucking companies

COST BEHAVIOR ANALYSIS
VARIABLE COSTS - Continued
Example
Damon Company manufactures radios that
contain a $10 clock
Activity index is the number of radios produced
For each radio produced, the total cost of the
clocks increases by $10
If 2,000 radios are made, the total cost of the clocks
is $20,000 (2,000 X $10)
If 10,000 radios are made, the total cost of the
clocks is $100,000 (10,000 X $10)
COST BEHAVIOR ANALYSIS
VARIABLE COSTS - Continued
Example: Continued

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 decline, and vice versa
Examples include
Property taxes
Insurance
Rent
Depreciation on buildings and equipment

COST BEHAVIOR ANALYSIS
FIXED COSTS - Continued
Example
Damon Company leases its productive facilities
for $10,000 per month
Total fixed costs of the facilities remain constant
at all levels of activity - $10,000 per month
On a per unit basis, the cost of rent decreases as
activity increases and vice versa
At 2,000 radios, the unit cost is $5 ($10,000 2,000
units)
At 10,000 radios, the unit cost is $1 ($10,000
10,000 units)
COST BEHAVIOR ANALYSIS
FIXED COSTS - Continued
Example: Continued
COST BEHAVIOR ANALYSIS
RELEVANT RANGE
Study Objective 2
Throughout the range of possible levels of activity,
a straight-line relationship usually does not exist for
either variable costs or fixed costs
The relationship between variable costs and changes in
activity level is often curvilinear
For fixed costs, the relationship is nonlinear some
fixed costs will not change over the entire range of
activities, others may
COST BEHAVIOR ANALYSIS
RELEVANT RANGE - Continued
COST BEHAVIOR ANALYSIS
RELEVANT RANGE - Continued
Defined as the range of activity over which a
company expects to operate during a year
Within this range, a straight-line relationship
usually exists for both variable and fixed costs










COST BEHAVIOR ANALYSIS
MIXED COSTS
Study Objective 3
Costs that have
both a variable cost
element and a fixed
cost element
Sometimes called
semivariable cost
Change in total but
not proportionately
with changes in
activity level

COST BEHAVIOR ANALYSIS
MIXED COSTS High-Low Method
Mixed costs must be classified into their fixed and
variable elements
One approach to separate the costs is called the
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
MIXED COSTS High-Low Method - Continued
Steps in Method
STEP 1: Determine variable cost per unit using the
following formula:




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

=
Change in
Total Costs
High minus Low
Activity Level
Variable Cost
per Unit
COST BEHAVIOR ANALYSIS
MIXED COSTS High-Low Method - Continued
Example
Data for Metro Transit Company
for the last 4-month period:






High Level of Activity: April $63,000 50,000 miles
Low Level of Activity: January 30,000 20,000 miles
Difference $33,000 30,000 miles

Step 1: Using the formula, variable costs per unit are
$33,000 30,000 = $1.10 variable cost per mile
Month
January
February
Miles Driven
20,000
40,000
Total Cost
$30,000
$48,000
Month
March
April
Miles Driven
35,000
50,000
Total Cost
$49,000
$63,000
COST BEHAVIOR ANALYSIS
MIXED COSTS High-Low Method - Continued
Example: Continued
Step 2: Subtract total variable costs at either the high or low
activity level from the total cost at that same level









Total Cost
Less: Variable costs
(50,000 x $1.10)
(20,000 x $1.10)
Total fixed costs
High
$63,000

55,000

$ 8,000
Low
$30,000

22,000
$ 8,000
Activity Level
COST BEHAVIOR ANALYSIS
MIXED COSTS High-Low Method - Continued
Example: Continued

Maintenance costs: $8,000 per month plus $1.10 per mile

To determine maintenance costs at a particular activity level:
Omultiply the activity level times the variable cost per unit
Othen add that total to the fixed cost

EXAMPLE: If the activity level is 45,000 miles, the estimated
maintenance costs would be $8,000 fixed and $49,500
variable ($1.10 X 45,000 miles) for a total of $57,500.

Lets Review
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


Lets Review
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-VOLUME-PROFIT
ANALYSIS
Study Objective 4

Study of the effects of changes of costs and
volume on a companys profits
A critical factor in management decisions
Important in profit planning
COST-VOLUME-PROFIT
ANALYSIS

Considers the interrelationships among the five
components of CVP analysis:

ASSUMPTIONS UNDERLYING
CVP ANALYSIS
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

CVP INCOME STATEMENT
Study Objective 5
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

CVP INCOME STATEMENT

Example
Vargo Video Company produces DVD players.
Relevant data for June 2005:
Unit selling price of DVD player $500
Unit variable costs $300
Total monthly fixed costs $200,000
Units sold 1,600






CVP INCOME STATEMENT
Contribution Margin Per Unit
Contribution margin is available to cover fixed costs
and to contribute to income
Formula for contribution margin per unit:



Example: Computation for Vargo Video
=
Unit Selling Price Unit Variable
Costs
Contribution
Margin per Unit
=
Unit Selling Price
$500
Unit Variable
Costs $300
Contribution
Margin per Unit
$200
CVP INCOME STATEMENT
Contribution Margin Ratio
Shows the percentage of each sales dollar available
to apply toward fixed costs and profits




Example: Computation for Vargo Video


=
Contribution
Margin Ratio
Unit Selling Price
Contribution
Margin per Unit
=
Contribution
Margin Ratio
40%
Unit Selling Price
$500
Contribution
Margin per Unit
S200
CVP INCOME STATEMENT
Contribution Margin Ratio - Example
Ratio helps to determine the effect of changes in sales on net income
BREAK-EVEN ANALYSIS
Study Objective 6
Process of finding the break-even point
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
from a cost-volume-profit (CVP) graph
Expressed either in sales units or in sales dollars
BREAK-EVEN ANALYSIS
Mathematical Equation
Variable Costs
$300 Q
Fixed Costs
$200,000
Net Income
$0
Sales
$500 Q
= + +
Example using the Vargo Video data:








Where:
Q = sales volume; $500 = selling price; $300 = variable cost per unit; $200,000 total fixed costs
To find sales dollars required to break-even:
1000 units X $500 = $500,000 (break-even sales dollars)


$200 Q $200,000
Q 1000 units
=
=
BREAK-EVEN ANALYSIS
Contribution Margin Technique
At the break-even point, contribution margin must equal
total fixed costs (CM = total revenues variable costs)
The break-even point can be computed using either
contribution margin per unit or contribution margin ratio
When the break even point in units is desired, contribution margin
per unit is used in the following formula



When the break even point in dollars is desired, contribution
margin ratio is used in the following formula


=
Fixed Costs
Break-even Point
in Units
Contribution
Margin per Unit
=
Fixed Costs
Break-even Point
in Dollars
Contribution
Margin Ratio
BREAK-EVEN ANALYSIS
Contribution Margin Technique
Example using Vargo Video data:

= Fixed Costs
$200,000
Break-even Point
in Units
1,000 units
Contribution
Margin per Unit
$200
= Fixed Costs
$200,000
Break-even Point
in Dollars
$500,000
Contribution
Margin per Unit
40%
BREAK-EVEN ANALYSIS
Graphic Presentation
A cost-volume-profit (CVP) graph shows costs,
volume, and profits
Used to visually find the break-even point
To construct a CVP graph,
Plot the total revenue line
starting at the zero activity level
Plot the total fixed cost
by a horizontal line
Plot the total cost line.
(Starts at the fixed cost line
at zero activity)
Determine the break-even point from the intersection of
the total cost line and the total revenue line
BREAK-EVEN ANALYSIS
CVP Graph for Vargo Video
BREAK-EVEN ANALYSIS
Target Net Income
Study Objective 7
Level of sales necessary
to achieve a specified
income
Can be determined
from each of the
approaches used to
determine break-even
sales/units
May be expressed either
in sales dollars or sales
units
BREAK-EVEN ANALYSIS
Target Net Income - Example
Using the Contribution Margin Approach
and the Vargo Video Data:
Formula for required sales in units:




Formula for required sales in dollars
=
Contribution
Margin Ratio
40%
Fixed Costs + Target
Net Income
$200,000 + $120,000
Required Sales in
Dollars
$800,000
=
Contribution
Margin Per Unit
$200
Fixed Costs + Target
Net Income
$200,000 + $120,000
Required Sales
in Units
1,600 units
Lets Review
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


Lets Review
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


BREAK-EVEN ANALYSIS
Margin of Safety
Difference between actual or expected sales and sales
at the break-even point
May be expressed in dollars or as a ratio
Example -
To determine the margin of safety in dollars for Vargo Video
assuming that actual (expected) sales are $750,000:







=
Margin of Safety
in Dollars
$250,000
Break-even
Sales
$500,000
Actual (Expected)
Sales
S750,000
BREAK-EVEN ANALYSIS
Margin of Safety Ratio
Study Objective 8
Computed by dividing the margin of safety in dollars
by the actual or expected sales (using Vargo Video data)




Results indicate that Vargo Videos sales could fall
by 33 percent before it would be operating at a loss.
The higher the dollars or the percentage, the greater
the margin of safety.

=
Margin of Safety
Ratio
33%
Actual (Expected)
Sales
$750,000
Margin of Safety
in Dollars
$250,000
Summary of Study Objectives
O Distinguish between variable and fixed costs.
Variable costs:
Costs that vary in total directly and proportionately with changes
in the activity index, but remain constant on a per unit basis
Fixed costs:
Costs that remain the same in total regardless of changes in the
activity index, but, on a per unit basis, vary inversely with
changes in the activity index
O Explain the significance of the relevant range.
Relevant range
Range of activity within which the company expects to operate
Cost behavior assumed to be linear through this range

Summary of Study Objectives
O Explain the concept of mixed costs.
Contains both a variable cost and a fixed cost component
For CVP analysis, must be divided into its fixed and variable
amounts
One method used to classify these costs is the high-low method
O List the five components of CVP analysis.
O Volume or level of activity
O Unit selling price
O Variable cost per unit
O Total fixed costs
O Sales mix
Summary of Study Objectives

O Indicate what contribution margin is and
how it can be expressed.
Contribution margin is the excess of revenue
over all variable costs
Can be expressed either as a per unit amount
or as a ratio
O Identify the three ways to determine the
break-even point.
O Using a mathematical equation
O The contribution margin technique
O From a CVP graph

Summary of Study Objectives
O Give the formulas for determining sales required to earn
target net income.
General formula:
Required sales = Variable costs + Fixed costs + Target Net Income
Other formulas:
Required sales in units = (Fixed costs + Target Net Income)
Contribution margin per unit
and
Required sales in dollars = (Fixed costs + Target Net Income)
Contribution margin ratio
O Define the margin of safety and give the formulas for
computing it.
Excess of actual or expected sales over sales at break-even
Formulas:
Actual (expected) sales Break-even sales = Margin of safety in dollars
and
Margin of safety in dollars Actual (expected) sales = Margin of safety
ratio



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