CHAPTER 5 COSTVOLUMEPROFIT COST BEHAVIOR ANALYSIS

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CHAPTER 5 COST-VOLUME-PROFIT 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

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COST BEHAVIOR ANALYSISContinued

• 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)

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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

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COST BEHAVIOR ANALYSISContinued

• 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

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COST BEHAVIOR ANALYSISVARIABLE COSTS

• 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

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COST BEHAVIOR ANALYSISVARIABLE 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

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COST BEHAVIOR ANALYSISVARIABLE 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)

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COST BEHAVIOR ANALYSIS VARIABLE COSTS -
Continued

• Example Continued

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COST BEHAVIOR ANALYSISFIXED 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

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COST BEHAVIOR ANALYSISFIXED 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)

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COST BEHAVIOR ANALYSISFIXED COSTS - Continued

• Example Continued

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COST BEHAVIOR ANALYSISRELEVANT RANGE

• 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

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COST BEHAVIOR ANALYSISRELEVANT RANGE - Continued
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COST BEHAVIOR ANALYSISRELEVANT 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

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COST BEHAVIOR ANALYSISMIXED COSTS

• 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

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COST BEHAVIOR ANALYSISMIXED 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

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COST BEHAVIOR ANALYSISMIXED 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

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COST BEHAVIOR ANALYSISMIXED 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

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COST BEHAVIOR ANALYSISMIXED 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

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COST BEHAVIOR ANALYSISMIXED 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
• multiply the activity level times the variable
  cost per unit
• then 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.

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Lets Review

• Variable costs are costs that
• Vary in total directly and proportionately with
  changes in the activity level
• Remain the same per unit at every activity level
• Neither of the above
• Both (a) and (b) above

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Lets Review

• Variable costs are costs that
• Vary in total directly and proportionately with
  changes in the activity level
• Remain the same per unit at every activity level
• Neither of the above
• Both (a) and (b) above

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COST-VOLUME-PROFIT ANALYSISStudy 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

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COST-VOLUME-PROFIT ANALYSIS

• Considers the interrelationships among the five
  components of CVP analysis

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ASSUMPTIONS UNDERLYINGCVP 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

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CVP INCOME STATEMENT

• 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

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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

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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

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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

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CVP INCOME STATEMENT Contribution Margin Ratio -
Example

• Ratio helps to determine the effect of changes in
  sales on net income

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BREAK-EVEN ANALYSIS

• 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

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BREAK-EVEN ANALYSIS Mathematical Equation

• 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)

Sales 500 Q




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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

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BREAK-EVEN ANALYSIS Contribution Margin Technique

• Example using Vargo Video data

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BREAK-EVEN ANALYSISGraphic 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

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BREAK-EVEN ANALYSIS CVP Graph for Vargo Video
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BREAK-EVEN ANALYSIS Target Net Income

• 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

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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

Required Sales in Units 1,600 units
Required Sales in Dollars 800,000
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Lets Review

• Contribution margin
• Is revenue remaining after deducting variable
  costs
• May be expressed as contribution margin per unit
• Is selling price less cost of goods sold
• Both (a) and (b) above

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Lets Review

• Contribution margin
• Is revenue remaining after deducting variable
  costs
• May be expressed as contribution margin per unit
• Is selling price less cost of goods sold
• Both (a) and (b) above

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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

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BREAK-EVEN ANALYSIS Margin of Safety Ratio

• 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.

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Summary of Study Objectives

• 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
• 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

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Summary of Study Objectives

• 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
• List the five components of CVP analysis.
• Volume or level of activity
• Unit selling price
• Variable cost per unit
• Total fixed costs
• Sales mix

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Summary of Study Objectives

• 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
• Identify the three ways to determine the
  break-even point.
• Using a mathematical equation
• The contribution margin technique
• From a CVP graph

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Summary of Study Objectives

• 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
• 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