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Chapter 20 - Cost-Volume-Profit Analysis
Financial and Managerial Accounting, 17/e 20-1
20 COST-VOLUME-PROFIT ANALYSIS
Chapter Summary
The relationship between costs and revenue and the level of business activity is
the foundation of profit planning. We begin our presentation of cost-volume-profit
analysis with an introduction to cost behavior relationships. Fixed, variable and
semivariable cost functions are illustrated graphically and numerically. The distinction
between the behavior of total and unit costs is explained and graphically illustrated as
well.
With the various cost behavior patterns established, the chapter turns to the
development of the basic CVP model. This analysis is initially presented graphically.
Following discussion of the contribution margin concept the same results are established
numerically. The model is solved for target levels of operating income and the margin of
safety. A number of comparative static experiments illustrate the usefulness of the CVP
model in a realistic planning situation. This example is developed from the point of view
of managers of several different functional areas.
The chapter concludes with an examination of the significance of sales mix and
the high-low method of estimating fixed and variable components of mixed costs.
Learning Objectives
1. Explain how fixed, variable, and semivariable costs respond to changes in the volume
of business activity.
2. Explain how economies of scale can reduce unit costs.
3. Prepare a cost-volume-profit graph.
4. Compute contribution margin and explain its usefulness.
5. Determine the sales volume required to earn a desired level of operating income.
6. Use the contribution margin ratio to estimate the change in operating income caused
by a change in sales volume.
7. Use CVP relationships to evaluate a new marketing strategy.
8. Use CVP when a company sells multiple products.
9. Determine semivariable cost elements.
Chapter 20 - Cost-Volume-Profit Analysis
Brief topical outline
A Cost-volume relationships
1 Fixed costs (and fixed expenses)
2 Variable costs (and variable expenses)
3 Semivariable costs (and semivariable expenses) - see Case in Point
(page 883)
4 Cost-volume relationships: a graphic analysis
5 The behavior of per-unit costs - see Your Turn (page 886)
6 Economies of scale - see Case in Point (page 886)
7 Additional cost behavior patterns
B Cost behavior and operating income
1 Cost-volume-profit analysis: an illustration
2 Preparing and using a cost-volume-profit graph
3 Contribution margin: a key relationship
a Contribution margin ratio
4 How many units must we sell?
5 How many dollars in sales must we generate?
6 What is our margin of safety?
7 What change in operating income do we anticipate?
8 Business applications of CVP
a Director of advertising
b Plant manager - see Your Turn (page 894)
c Vice president of sales
9 Additional considerations in CVP
10 CVP analysis when a company sells many products
a Improving the "quality" of the sales mix
11 Determining semivariable cost elements: the high-low method
12 Assumptions underlying cost-volume-profit relationships
13 Summary of basic cost-volume-profit relationships – see Ethics, Fraud &
Corporate Governance (page 898)
C Concluding remarks
Topical coverage and suggested assignment
Homework Assignment
(To Be Completed Prior to Class)
Class
Meetings on
Chapter
Topical
Outline
Coverage
Discussion
Questions
Brief
Exercises
Exercises
Problems
Critical
Thinking
Cases
1
A
1, 3, 5
1, 2, 9
2
B
7, 8, 9
4, 5, 6
3, 4, 5
1
2
3
B – C
13, 14, 15
10
6, 11, 14
5
Chapter 20 - Cost-Volume-Profit Analysis
Financial and Managerial Accounting, 17/e 20-3
Comments and observations
Teaching objectives for Chapter 20
In this chapter, we explain the patterns of cost behavior and cost-volume-profit
relationships. In discussing cost behavior patterns and cost-volume-profit analysis, our
teaching objectives are to:
1 Explain the importance of understanding cost-volume-profit relationships in planning
and controlling business operations.
2 Define and provide examples of fixed costs, variable costs, and semivariable costs.
3 Contrast the behavior of a cost expressed on per-unit basis with that of the total cost.
4 Explain that cost behavior patterns (and cost-volume-profit analysis) serve only as
useful approximations. (As part of this discussion, explore other cost behavior
patterns and introduce the concept of the relevant volume range.)
5 Illustrate the preparation of a break-even graph, and explain its usefulness.
6 Define contribution margin, contribution margin ratio, and contribution margin
per unit. (Stress that these concepts form the cornerstone of cost-volume-profit
analysis, and also will be used extensively in later chapters.)
7 Show how contribution margin ratio and/or contribution margin per unit are used
to determine the sales volume necessary to earn a specified level of operating
income.
8 Illustrate the importance of sales mix and the relative contribution margin ratios of
different products.
9 Illustrate and explain the high-low method of determining the fixed and variable
components of a semivariable cost.
10 Review the assumptions underlying cost-volume-profit analysis.
11 Review the summary of basic cost-volume-profit relationships.
Chapter 20 - Cost-Volume-Profit Analysis
General comments
We find that the challenge in successfully presenting cost-volume-profit analysis is to get
students to understand the significance of contribution margin, rather than to commit
numerous formulas to memory. Memorizing formulas serves little purpose beyond the
next exam; an understanding of the concept of contribution margin, however, can serve
students well through a lifetime of managerial and personal financial decisions.
Contribution margin is merely that portion of revenue that "contributes" to
fixed costs and (after covering the fixed costs) to operating income. In short, all revenue
except for the contribution margin is consumed by the variable costs relating to the
revenue. Once students grasp the fact that only the contribution margin "contributes" to
covering fixed costs and to providing a profit, most of the formulas presented in this
chapter will "fall into place."
We recommend that in approaching any cost-volume-profit problem (homework
assignment or exam question), students jot down in the margin of the paper the
contribution margin ratio and contribution margin per unit. One of these
measurements is usually the key to solving the problem.
Supplemental Exercises
Group Exercise
Suppose a company faces two technologies for manufacturing its single product.
The first requires significantly higher fixed costs but much smaller unit variable costs
than does the second. Prepare a cost-volume-profit graph for each of the technologies.
Using the graphs, discuss the economic circumstances that would lead to a choice of one
technology over the other.
Internet Exercise
Research the Dell Computer website at http://www.dell.com/ and the Hewlett
Packard website at http://www.hewlettpackard.com/ to see how these corporations differ
in their approach to manufacturing and selling personal computers.
Chapter 20 - Cost-Volume-Profit Analysis
Financial and Managerial Accounting, 17/e 20-5
CHAPTER 20 NAME #
10-MINUTE QUIZ A SECTION
Information regarding a product manufactured and sold by Schiffman is shown below:
Maximum capacity with existing facilities 4,000 units
Total fixed costs per month ......................................................................... $50,000
Variable cost per unit ................................................................................... $42.00
Sales price per unit ....................................................................................... $56.00
1 Refer to the above data. The contribution margin ratio for this product is:
a 20%. c 30%.
b 25%. d 40%.
2 Refer to the above data. The number of units Schiffman must sell to break even is:
(rounded)
a 3,927. c 4,823.
b 3572. d 5,140.
3 Refer to the above data. The dollar sales volume necessary to produce monthly
operating income of $12,000 before taxes is:
a $188,000. c $288,000.
b $186,000. d $248,000.
Use the following data for questions 4 and 5.
The monthly high and low levels of units and total manufacturing overhead for Ratnere
Company are shown below:
Manufacturing
Units Overhead
Highest observed level .................................................... 117,000 $306,000
Lowest observed level .................................................... 81,000 234,000
4 Refer to the above data. The cost formula for Ratnere’s monthly overhead cost can
be expressed as:
a $2.65 average cost per unit.
b $1.75 average cost per unit.
c $24,000 fixed cost plus $1.00 per unit.
d $72,000 fixed cost + $2.00 per unit.
5 Refer to the above data. In a month in which 30,000 equivalent full units are
produced, Ratnere’s manufacturing overhead should be approximately:
a $52,500. c $ 132,000.
b $79,500. d $ 90,500.
Chapter 20 - Cost-Volume-Profit Analysis
CHAPTER 20 NAME #
10-MINUTE QUIZ B SECTION
1 Management predicts total sales for June to be $3,000,000, yielding a margin of
safety of $1,000,000 and a contribution margin ratio of 25%. Which of the
following amounts is not consistent with this information?
a Fixed costs, $500,000.
b Variable costs, $750,000.
c Operating income, $250,000.
d Break-even sales volume, $2,000,000.
Use the following data for questions 2 through 4.
The recent high and low levels of hours operated and monthly repair cost for heavy
equipment for Universal Mfg. are shown below:
Hours Operated Repair Cost
Highest observed level 24,000 $7,450
Lowest observed level .................................................... 21,500 6,700
2 Refer to the above data. Using the high-low method, compute the variable element
of repair cost per hour of operation for Universal’s equipment:
a $750 c $0.30.
b $3.33. d $0.34.
3 Refer to the above data. Using the high-low method, compute the fixed element of
Universal’s monthly repair cost:
a $150. c $6,300.
b $250. d $6,450.
4 Refer to the above data. The total estimated repair cost for a month in which
Universal operates equipment for 19,000 hours is:
a $5,950. c $6,450.
b $6,300. d $5,700.
5 Perkins Corporation manufactures two products; data are shown below:
Contribution Relative
Margin Ratio Sales Mix
Product A ........................................................................ 40% 40%
Product B......................................................................... 30% 60%
If Perkins’ monthly fixed costs average $425,000, what is its break-even point
expressed in sales dollars?
a $1,320,000. c $1,250,000.
b $1,400,000. d $990,000.
