Managerial Accounting

Wild and Shaw

2010 Edition
McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All

Chapter 5
Cost Behavior and
Cost-Volume-Profit
Analysis

Conceptual Learning
Objectives
C1: Describe different types of cost
behavior in relation to production and
sales volume.
C2: Identify assumptions in cost-volume
profit analysis and explain their
impact.
C3: Describe several applications of
cost-volume-profit analysis.
5-3

Analytical Learning Objectives

A1: Compare the scatter diagram, highlow, and regression methods of
estimating costs.
A2: Compute contribution margin and
describe what it reveals about a
companys cost structure.
A3: Analyze changes in sales using the
degree of operating leverage.
5-4

Procedural Learning
Objectives
P1: Determine cost estimates using three
different methods.
P2: Compute the break-even point for a
single product company.
P3: Graph costs and sales for a single
product company.
P4: Compute break-even point for a
multiproduct company.
5-5

C2

Questions Addressed by
Cost-Volume-Profit Analysis

CVP
CVPanalysis
analysisis
is used
used to
to answer
answerquestions
questions
such
suchas:
as:

What
Whatsales
salesvolume
volumeis
isneeded
neededto
toearn
earnaa
target
targetincome?
income?

What
Whatis
isthe
thechange
changein
in income
incomeifif selling
selling
prices
pricesdecline
declineand
and sales
salesvolume
volume
increases?
increases?

How
How much
muchdoes
doesincome
incomeincrease
increaseififwe
we
install
install aanew
new machine
machineto
to reduce
reducelabor
labor
costs?
costs?

What
Whatis
isthe
theincome
incomeeffect
effectififwe
wechange
changethe
the
sales
salesmix
mixof
ofour
our products
productsor
or services?
services?
5-6

C1

Total Fixed Cost

Monthly Basic
Telephone Bill

Total fixed costs remain unchanged

when activity changes.

Number of Local Calls

Your monthly basic

telephone bill probably
does not change when
you make more local calls.
5-7

C1

Fixed Cost Per Unit

Your average cost per

local call decreases as
more local calls are made.

Monthly Basic Telephone

Bill per Local Call

Fixed costs per unit decline

as activity increases.

Number of Local Calls

5-8

C1

Total Variable Cost

Total Long Distance

Telephone Bill

Total variable costs change

when activity changes.

Minutes Talked

Your total long distance

telephone bill is based
on how many minutes
you talk.
5-9

C1

Variable Cost Per Unit

The cost per long distance

minute talked is constant.
For example, 7
cents per minute.

Per Minute
Telephone Charge

Variable costs per unit do not change

as activity increases.

Minutes Talked
5-10

C1

Cost Behavior Summary

Summary of Variable and Fixed Cost Behavior
Cost

In Total

Per Unit

Variable

Changes as activity level

changes.

Remains the same over wide

ranges of activity.

Fixed

Remains the same even

when activity level changes.

Dereases as activity level

increases.

5-11

C1

Mixed Costs
Mixed costs contain a fixed portion
that is incurred even when the
facility is unused, and a variable
portion that increases with usage.
Example: monthly electric utility
charge

Fixed service fee

Variable charge per

kilowatt hour used
5-12

C1

Step-Wise Costs

Cost

Total cost remains

constant within a
narrow range of
activity.

Activity
5-13

P1

Identifying and Measuring

Cost Behavior

The objective
is to classify
all costs as
either fixed or
variable.
5-14

P1

Scatter Diagram

Total Cost in
1,000s of Dollars

Unit Variable Cost = Slope =

20

10

* *
* *

in cost
in units

* ** *
**

Horizontal distance is
the change in activity.

Vertical
distance
is the
change
in cost.

0
1
2
3
4
Activity, 1,000s of Units Produced
5-15

P1

The High-Low Method

The following relationships between units produced
and costs are observed:

Using these two levels of activity, compute:

the variable cost per unit.
the total fixed cost.
5-16

P1

The High-Low Method

Unit variable cost = in cost = $8,500 = $0.17 /unit

$50,000
in units
Fixed cost = Total cost Total variable cost
Fixed cost = $29,000 ($0.17 per unit $67,500)
Fixed cost = $29,000 $11,475 = $17,525
5-17

P1

Least-Squares Regression
Least-squares regression is usually covered
in advanced cost accounting courses. It is
commonly used with spreadsheet
programs or calculators.
The objective of the cost
analysis remains the
same: determination of
total fixed cost and the
variable unit cost.
5-18

P2

Computing Break-Even Point

The break-even point (expressed in
units of product or dollars of sales) is
the sales level at which a company
earns neither a profit nor incurs a
loss.

5-19

P2

Computing Break-Even Point

Contribution
Contribution margin
margin is
is amount
amount by
by which
which revenue
revenue
exceeds
exceeds the
the variable
variable costs
costs of
of producing
producing the
the revenue.
revenue.
5-20

P2

Computing Break-Even Point

How much contribution margin must this company

have to cover its fixed costs (break even)?
Answer: $24,000
5-21

P2

Computing Break-Even Point

How many units must this company sell to cover its

fixed costs (break even)?
Answer: $24,000 $30 per unit = 800 units
5-22

P2

Computing Break-Even Point

We have just seen one of the basic CVP
relationships the break-even
computation.

Fixed costs
Break-even point in units =
Contribution margin per unit

Unit sales price less unit variable cost

($30 in previous example)

5-23

P2

Computing Break-Even Point

The break-even formula may also be
expressed in sales dollars.
Fixed costs
Break-even point in dollars =
Contribution margin ratio

Unit contribution margin

Unit sales price

5-24

P3

Preparing a CVP Chart

Costs and Revenue
in Dollars

Plot total fixed costs on the vertical axis.

Total fixed costs

Total costs

Draw the total cost line with a slope

equal to the unit variable cost.

Volume in Units
5-25

P3

Preparing a CVP Chart

Starting at the origin, draw the sales line

Sales

Costs and Revenue

in Dollars

with a slope equal to the unit sales price.

Total fixed costs

Total costs
Break-even
Point
Volume in Units
5-26

C2

Assumptions of CVP Analysis

A limited range of activity called the relevant

range, where CVP relationships are linear.
Unit selling price remains constant.

Unit variable costs remain constant.

Total fixed costs remain constant.

Production = sales (no inventory changes).

5-27

C3

Computing Income
from Expected Sales
Income
Income (pretax)
(pretax) == Sales
Sales Variable
Variable costs
costs Fixed
Fixed
costs
costs

5-28

C3

Computing Sales for a Target

Income
Break-even
Break-even formulas
formulas may
may be
be
adjusted
adjusted to
to show
show the
the sales
sales volume
volume
needed
needed to
to earn
earn any
any amount
amount of
of
income.
income.
Unit sales =

Fixed costs + Target income

Contribution margin per unit

Fixed costs + Target income

Dollar sales =
Contribution margin ratio
5-29

C3

Computing Sales (Dollars) for a

Target Net Income
Target
Target net
net income
income is
is income
income after
after
income
income tax.
tax. But
But we
we can
can use
use target
target
income
income before
before tax
tax in
in our
our
calculations.
calculations.
Dollar sales =

Fixed + Target income

costs
before tax
Contribution margin ratio

5-30

C3

Computing Sales (Dollars) for a

Target Net Income
To convert target net income to beforetax income, use the following
formula:
Target net income
Before-tax income =
1 - tax rate

5-31

C3

Computing the Margin of

Safety
Margin of safety is the amount by which
sales can drop before the company
incurs a loss.
Margin of safety may be expressed as a
percentage of expected sales.
Margin of safety
percentage

Expected sales - Break-even sales

Expected sales

5-32

C3

Sensitivity Analysis
The
The basic
basic CVP
CVP relationships
relationships may
may be
be
used
used to
to analyze
analyze aa number
number of
of
situations
situations such
such as
as changing
changing sales
sales
price,
price, changing
changing variable
variable cost,
cost, or
or
changing
changing fixed
fixed cost.
cost.

Continue
5-33

P4

Computing Multiproduct
Break-Even Point

The CVP formulas may be modified for use when a

company sells more than one product.
The unit contribution margin is replaced with the
contribution margin for a composite unit.
A composite unit is composed of specific
numbers of each product in proportion to the
product sales mix.
Sales mix is the ratio of the volumes of the
various products.
5-34

P4

Computing Multiproduct
Break-Even Point
The resulting break-even formula
for composite unit sales is:
Break-even point
in composite units

Fixed costs
Contribution margin
per composite unit

5-35

A3

Operating Leverage
AA measure
measure of
of the
the extent
extent to
to which
which fixed
fixed
costs
costs are
are being
being used
used in
in an
an organization.
organization.
AA measure
measure of
of how
how aa percentage
percentage change
change in
in
sales
sales will
will affect
affect profits.
profits.
Contribution margin
Pretax income

= Degree of operating leverage

5-36

End of Chapter 5

5-37