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- 1. Copyright © 2014 Pearson Education 2 - 1
Introduction to Cost Behavior
and Cost-Volume-Profit
Relationships
Chapter 2
- 2. Copyright © 2014 Pearson Education 2 - 2
Variable and Fixed Cost Behavior
A variable cost
changes in direct
proportion to changes
in the cost-driver level.
A fixed cost is
not immediately
affected by changes
in the cost-driver level.
Think of variable
costs on a per-unit basis.
The per-unit variable
cost remains unchanged
regardless of changes in
the cost-driver.
Think of fixed costs
on a total-cost basis.
Total fixed costs remain
unchanged regardless of
changes in the cost-driver.
Learning
Objective 2
- 4. Copyright © 2014 Pearson Education 2 - 4
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.
- 5. Copyright © 2014 Pearson Education 2 - 5
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.
- 7. Copyright © 2014 Pearson Education 2 - 7
Step- and Mixed-Cost
Behavior Patterns
Learning
Objective 3
Mixed Cost:
A cost that contains
elements of both
fixed- and variable-
cost behavior
Step cost:
A cost that changes
abruptly at different
intervals of activity
because the resources
and their costs come in
indivisible chunks.
- 8. Copyright © 2014 Pearson Education 2 - 8
Step-Cost Behavior
Step cost treated as a fixed cost Step cost treated as a variable cost
- 9. Copyright © 2014 Pearson Education 2 - 9
Cost-volume-profit (CVP)
analysis
Learning
Objective 4
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.
- 10. Copyright © 2014 Pearson Education 2 - 10
CVP Scenario
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 (CVP) analysis is the study of the
effects of output volume on revenue (sales), expenses
(costs), and net income (net profit).
- 11. Copyright © 2014 Pearson Education 2 - 11
Cost-Volume-Profit Graph
18,000
30,000
90,000
120,000
138,000
$150,000
0 10 20 30 40 50 60 70 80 90 100
Units (thousands)
Dollars
60,000
Total
Expenses
Sales
Net Income Area
Break-Even Point
60,000 units
or $90,000
Net Loss
Area
A
C
D
B
Fixed Expenses
Variable
Expenses
Net Income
- 12. Copyright © 2014 Pearson Education 2 - 12
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)
Learning
Objective 5
- 13. Copyright © 2014 Pearson Education 2 - 13
Contribution Margin Method
$18,000 fixed costs ÷ $.30 =
60,000 units (break even)
Contribution margin
Per Unit
Selling price $1.50
Variable costs 1.20
Contribution margin$ .30
Contribution margin ratio
Per Unit %
Selling price 100
Variable costs 80
Contribution margin 20
- 14. Copyright © 2014 Pearson Education 2 - 14
Contribution Margin Method
$18,000 fixed costs
÷ 20% (contribution-margin percentage)
= $90,000 of sales to break even
60,000 units × $1.50 (Sales Price) = $90,000
in sales to break even
- 15. Copyright © 2014 Pearson Education 2 - 15
Equation Method
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
Let N = number of units
to be sold to break even.
- 16. Copyright © 2014 Pearson Education 2 - 16
Equation Method
S – .80S – $18,000 = 0
.20S = $18,000
S = $18,000 ÷ .20
S = $90,000
Let S = sales in dollars
needed to break even.
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
- 17. Copyright © 2014 Pearson Education 2 - 17
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
– variable expenses
– fixed expenses
target net income
$1,440 per month
is the minimum
acceptable
net income.
Learning
Objective 6
- 18. Copyright © 2014 Pearson Education 2 - 18
Target sales volume in units =
(Fixed expenses + Target net income)
÷ Contribution margin per unit
($18,000 + $1,440) ÷ $.30 = 64,800 units
Target Net Profit
Selling price $1.50
Variable costs 1.20
Contribution margin per unit $ .30
Target sales dollars = sales price X sales volume in units
Target sales dollars = $1.50 X 64,800 units = $97,200.
- 19. Copyright © 2014 Pearson Education 2 - 19
Sales volume in dollars =
18,000 + $1,440 = $97,200
.20
Target Net Profit
Target sales volume in dollars =
Fixed expenses + target net income
contribution margin ratio
Contribution margin ratio
Per Unit %
Selling price 100
Variable costs 80
Contribution margin 20
- 20. Copyright © 2014 Pearson Education 2 - 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.
- 21. Copyright © 2014 Pearson Education 2 - 21
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
Nonprofit Application
- 22. Copyright © 2014 Pearson Education 2 - 22
Nonprofit Application
If the city cuts the total budget appropriation by
10%, how many patients can it serve in a year?
Variable + Fixed
Sales = expenses + expenses
$90,000 = $400N + $60,000
$400N = $90,000 – $60,000
N = $30,000 ÷ $400
N = 75 patients
Budget after 10% Cut
$100,000 X (1 - .1) = $90,000
- 23. Copyright © 2014 Pearson Education 2 - 23
Operating Leverage
Margin of safety = planned unit sales –
break-even sales. How far can sales fall
below the planned level before losses occur?
Low leveraged firms have lower fixed costs
and higher variable costs.
Changes in sales volume will have a
smaller effect on net income.
- 24. Copyright © 2014 Pearson Education 2 - 24
Operating Leverage
Operating leverage:
a firm’s ratio of fixed costs to variable costs.
Highly leveraged firms have high fixed costs
and low variable costs. A small change in sales
volume = a large change in net income.
- 25. Copyright © 2014 Pearson Education 2 - 25
Contribution Margin
and Gross Margin
Learning
Objective 7
- 26. Copyright © 2014 Pearson Education 2 - 26
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
- 27. Copyright © 2014 Pearson Education 2 - 27
Contribution Margin and Gross Margin
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
Suppose the firm paid a commission of $.12 per unit sold.
- 28. Copyright © 2014 Pearson Education 2 - 28
Appendix 2A
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.
Learning
Objective 8
- 29. Copyright © 2014 Pearson Education 2 - 29
Sales Mix Analysis
Ramos Company Example
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
Wallets
(W)
Key Cases
(K) Total
- 30. Copyright © 2014 Pearson Education 2 - 30
Sales Mix Analysis
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).
Let K = number of units of K to break even, and
4K = number of units of W to break even.
- 31. Copyright © 2014 Pearson Education 2 - 31
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
- 32. Copyright © 2014 Pearson Education 2 - 32
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?
- 33. Copyright © 2014 Pearson Education 2 - 33
Sales Mix Analysis
Ramos Company Example
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
Wallets
(W)
Key Cases
(K) Total