Cost Behavior and Cost-Volume-Profit Analysis

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Cost Behavior and Cost-Volume-Profit Analysis
Student Version
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Classify costs as variable costs, fixed costs, or
mixed costs.
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Variable Costs
Variable costs are costs that vary in proportion
to changes in the level of activity.
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Jason Sound Inc.
Jason Sound Inc. produces stereo systems. The
parts for the stereo system are purchased from
suppliers for 10 per unit (a variable cost) and
assembled by Jason Sound Inc.
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For Model JS-12, the direct materials for the
relevant range of 5,000 to 30,000 units of
production are shown below.
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Fixed Costs
Fixed costs are costs that remain the same in
total dollar amount as the activity base changes.
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Minton Inc.
Minton Inc. manufactures, bottles, and
distributes perfume. The production supervisor is
Jane Sovissi. She is paid 75,000 per year. The
plant produces from 50,000 to 300,000 bottles of
La Fleur Perfume.
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Fixed Versus Variable Cost of Jane Sovissis
Salary per Bottle of Perfume
Salary per Bottle of Perfume Produced
Number of Bottles of Perfume Produced
Total Salary for Jane Sovissi
50,000 bottles 75,000 1.500 100,000 75,000
0.750 150,000 75,000 0.500 200,000 75,000 0.3
75 250,000 75,000 0.300 300,000 75,000 0.250
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Mixed Costs
Mixed costs (sometimes called semivariable or
semifixed costs) have characteristics of both a
variable and a fixed cost. Over one range of
activity, the total mixed cost may remain the
same. Over another range of activity, the mixed
cost may change in proportion to changes in level
of activity.
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Simpson Inc.
Simpson Inc. manufactures sails, using rented
equipment. The rental charges are 15,000 per
year, plus 1 for each machine hour used over
10,000 hours.
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High-Low Method
The high-low method is a cost estimation method
that may be used for separating mixed costs into
their fixed and variable components.
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Estimating Variable Cost Using High-Low
Production Total (Units) Cost
Fill in the formula for difference in cost.
June 1,000 45,550 July 1,500 52,000 August 2,100
61,500 September 1,800 57,500 October 750 41,250
61,500
41,250
Difference in Total cost
20,250
Variable Cost per Unit
Difference in Production
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Estimating Variable Cost Using High-Low
Production Total (Units) Cost
Then, fill in the formula for difference in
production.
June 1,000 45,550 July 1,500 52,000 August 2,100
61,500 September 1,800 57,500 October 750 41,250
2,100
750
1,350
Difference in total cost
20,250
Variable Cost per Unit
Difference in Production
1,350
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Estimating Variable Cost Using High-Low
Production Total (Units) Cost
June 1,000 45,550 July 1,500 52,000 August 2,100
61,500 September 1,800 57,500 October 750 41,250
Variable cost per unit is 15
20,250
15
Variable Cost per Unit
1,350
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Estimating Fixed Cost Using High-Low
The first step in determining fixed cost is to
insert the variable cost of 15 into the
following formula
Total Cost (Variable Cost per Unit Units of
Production) Fixed Cost
Total Cost (15 Units of Production) Fixed
Cost
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Production Total (Units) Cost
Using the highest level of production, we insert
the total cost and units produced in the formula.
June 1,000 45,550 July 1,500 52,000 August 2,100
61,500 September 1,800 57,500 October 750 41,250
Total Cost (Variable Cost per Unit Units of
Production) Fixed Cost
61,500
Total cost (15 Units of Production) Fixed
Cost
2,100 units)
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61,500 (15 2,100 units) Fixed cost
61,500 31,500 Fixed cost 61,500 31,500
Fixed cost 30,000 Fixed cost
If the lowest level had been chosen, the results
of the formula would provide the same fixed cost
of 30,000.
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With fixed costs and variable costs estimated at
30,000 and 15 per unit, a formula is in place
to estimate production at any level. If the
company is expected to produce 950 units in
November, the estimated total overhead would be
calculated as follows
Total Cost (Variable Cost per Unit Units of
Production) Fixed cost
Total Cost 15 (950) 30,000
Total Cost 44,250
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Compute the contribution margin, the contribution
margin ratio, and the unit contribution margin.
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Cost-Volume-Profit Relationships
Cost-volume-profit analysis is the examination of
the relationships among selling prices, sales and
production volume, costs, expenses, and profits.
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Contribution Margin
The contribution margin is the excess of sales
revenues over variable costs. It is especially
useful because it provides insight into the
profit potential of a company.
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Contribution Margin Ratio (in dollars)
The contribution margin ratio is most useful when
the increase or decrease in sales volume is
measured in sales dollars. In this case, the
following formula is used to determine change in
income from operations.
Change in Sales Dollars Contribution Margin
Ratio
Change in Income from Operations

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Contribution Margin Ratio
100 60
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Using Contribution Margin per Unit as a Shortcut
Lambert Inc.s sales could be increased by 15,000
units from 50,000 to 65,000 units. Lamberts
income from operations would increase by 120,000
(15,000 8) as shown below.
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Determine the break-even point and sales
necessary to achieve a target profit.
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Baker Corporations fixed costs are estimated to
be 90,000. The unit contribution margin is
calculated as follows
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The break-even point (in units) is calculated
using the following equation
Break-Even Sales (units) 9,000 units
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The break-even point (in dollars) is calculated
using the following equation
Break-Even Sales (dollars) 225,000
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Park Co. is evaluating a proposal to pay an
additional 2 commission on sales to its
salespeople (a variable cost) as an incentive to
increase sales. Fixed costs are estimated at
840,000. The unit contribution margin before the
additional 2 commission is determined below.
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Without additional 2 commission
With additional 2 commission
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Target Profit
The sales volume required to earn a target profit
is determined by modifying the break-even
equation.
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Units Required for Target Profit
Fixed costs are estimated at 200,000, and the
desired profit is 100,000. Unit contribution
margin is 30.
Unit selling price 75 Unit variable cost
45 Unit contribution margin 30
200,000
100,000
30
Sales (units) 10,000 units
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Target Profit
Unit Contribution Margin Unit Selling Price
Contribution Margin Ratio
750,000
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Using a cost-volume-profit chart and a
profit-volume chart, determine the break-even
point and sales necessary to achieve a target
profit.
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The cost-volume-profit chart in Slides 36 to 48
is based on Exhibit 5. Exhibit 5 was constructed
using the following data
Unit selling price 50 Unit variable cost
30 Unit contribution margin 20 Total fixed
costs 100,000
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Cost-Volume-Profit Chart
500 450 400 350 300 250 200 150 100 50
Sales and Costs (in thousands)
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)
Volume is shown on the horizontal axis.
(continued)
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Using maximum sales of 500,000 and knowing that
each unit sells for 50, we can find the values
of the two axis. Where the horizontal sales and
costs line intersects the vertical 10,000 unit of
sales line is Point A in Slide 38.
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Cost-Volume-Profit Chart (continued)
Point A
500 450 400 350 300 250 200 150 100 50
Sales and Costs (in thousands)
1 2 3 4 5 6 7 8 9 10
0
Units of Sales (in thousands)
Point A could have been plotted at any sales
level because linearity is assumed.
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Cost-Volume-Profit Chart (continued)
Point A
500 450 400 350 300 250 200 150 100 50
Sales and Costs (in thousands)
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)
Beginning at zero on the left corner of the
graph, connect a straight line to the dot (Point
A).
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Cost-Volume-Profit Chart (continued)
500 450 400 350 300 250 200 150 100 50
Sales and Costs (in thousands)
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)
Fixed cost of 100,000 is a horizontal line.
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A point on the chart is needed to establish the
revenue line. An arbitrary sales amount is picked
of 10,000 units. At this sales level, the cost
should be 400,000, calculated as follows
(10,000 30) 100,000 400,000.
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Cost-Volume-Profit Chart (continued)
500 450 400 350 300 250 200 150 100 50
Sales and Costs (in thousands)
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)
A line is drawn between fixed cost (100,000) and
the point.
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The line would be the same if another point had
been picked. For example, assume that 8,000 units
had been chosen. At this sales level, the cost
should be 400,000 (8,000 30) 100,000
340,000.
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Cost-Volume-Profit Chart (continued)
500 450 400 350 300 250 200 150 100 50
Sales and Costs (in thousands)
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)
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Cost-Volume-Profit Chart (continued)
500 450 400 350 300 250 200 150 100 50
Sales and Costs (in thousands)
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)
Break-even is sales of 5,000 units or 250,000.
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Cost-Volume-Profit Chart (continued)
500 450 400 350 300 250 200 150 100 50
Operating Loss Area
Sales and Costs (in thousands)
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)
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Cost-Volume-Profit Chart (continued)
500 450 400 350 300 250 200 150 100 50
Sales and Costs (in thousands)
Operating Profit Area
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (in thousands)
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Cost-Volume-Profit Chart (concluded)
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Revised Cost-Volume-Profit Chart
Break-even in sales would be reduced from
250,000 to 200,000 (5,000 to 4,000 in units).
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The maximum operating loss is equal to the fixed
costs of 100,000. Assuming that the maximum unit
sales within the relevant range is 10,000 units,
the maximum operating profit is 100,000,
computed as follows
Sales (10,000 units 50) 500,000 Variable
costs (10,000 units 30) 300,000
Contribution margin (10,000 units
20) 200,000 Fixed costs 100,000 Operating
profit 100,000
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Compute the break-even point for a company
selling more than one product, the operating
leverage, and the margin of safety.
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Cascade Company Example
Cascade Company sold 8,000 units of Product A and
2,000 units of Product B during the past year.
Cascade Companys fixed costs are 200,000. Other
relevant data are as follows
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It is useful to think of the individual products
as components of one overall enterprise product.
For Cascade Company, the overall enterprise
product is called E.
Unit selling price of E (90 0.8) (140
0.2) 100 Unit variable cost of E (70 0.8)
(95 0.2) 75 Unit contribution
margin of E 25
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Break-Even Point of 8,000 Units of E
Fixed Costs Unit Contribution Margin
Break-Even Sales (units)
Break-Even Sales (units) 8,000 units
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Operating Leverage Example

Jones Inc. Wilson Inc.
Sales 400,000 400,000 Variable costs 300,000
300,000 Contribution margin 100,000 100,000 Fix
ed costs 80,000 50,000 Income from
operations 20,000 50,000 Operating
leverage ? ?
Both companies have the same contribution margin.
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Operating Leverage Example

Jones Inc. Wilson Inc.
Sales 400,000 400,000 Variable costs 300,000
300,000 Contribution margin 100,000 100,000 Fix
ed costs 80,000 50,000 Income from
operations 20,000 50,000 Operating
leverage ? ?
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Contribution Margin Income from Operations
100,000
Jones Inc.
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20,000
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Operating Leverage Example

Jones Inc. Wilson Inc.
Sales 400,000 400,000 Variable costs 300,000
300,000 Contribution margin 100,000 100,000 Fix
ed costs 80,000 50,000 Income from
operations 20,000 50,000 Operating
leverage ? ?
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Contribution Margin Income from Operations
100,000
Wilson Inc.
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50,000
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Margin of Safety
The margin of safety indicates the possible
decrease in sales that may occur before an
operating loss results.
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