Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
355
chapter
19(5)
Cost-Volume-Profit
Analysis
______________________________________________
OPENING COMMENTS
Cost-volume-profit analysis is conducted using both a formula-based mathematical approach and a
graphic approach. It is applied to single-product and multiple-product companies. The chapter concludes
with an appendix that discusses variable costing.
1. Classify costs as variable costs, fixed costs, or mixed costs.
2. Compute the contribution margin, the contribution margin ratio, and the unit contribution margin.
3. Determine the break-even point and sales necessary to achieve a target profit.
necessary to achieve a target profit.
5. Compute the break-even point for a company selling more than one product, the operating leverage,
and the margin of safety.
ADM: Describe and illustrate the use of cost-volume-profit analysis for decision making in a service
business.
KEY TERMS
activity bases (drivers)
break-even point
Chapter 19(5) Cost-Volume-Profit Analysis 356
contribution margin
contribution margin ratio
cost behavior
cost-volume-profit analysis
cost-volume-profit chart
fixed costs
high-low method
margin of safety
mixed costs
operating leverage
profit-volume chart
relevant range
sales mix
unit contribution margin
variable costing
variable costs
STUDENT FAQS
Why does variable cost per unit stay the same but total cost varies with the number of units you
produce?
How do you choose what activity base to use?
Why does fixed cost remain the same in total dollar amount but increase or decrease per unit as the
level of activity changes?
What do increases in fixed cost do to break-even analysis?
What do increases in variable cost do to break-even analysis?
OBJECTIVE 1
Classify costs as variable costs, fixed costs, or mixed costs.
SYNOPSIS
Cost behavior is the manner in which a cost changes as activity changes. Managers find this relationship
useful as it allows managers to predict profits as sales and production volume change. Activity bases are
the things that cause cost to change, and the range over which the changes are of interest is called the
relevant range. Costs are classified as variable, fixed, or mixed costs. Variable costs are those that change
directly in proportion to changes in production volume. Direct materials and direct labor are usually
variable costs. Variable costs have certain characteristics, such as the cost per unit remains the same and
total cost varies in proportion to the activity base. Exhibit 1 shows a graphical representation of variable
cost per unit and variable total cost. Fixed costs are those that remain the same in total over the relevant
range. Straight-line depreciation is an example of a fixed cost. Although total cost remains the same, fixed
cost per unit decreases as production increases. Mixed costs have characteristics of both a variable and
fixed cost. They are also called semivariable or semifixed costs. An example might be a rental car that has
a fixed component (charge per day) and also charges per mile driven. For purposes of analysis, mixed
Chapter 19(5) Cost-Volume-Profit Analysis 357
costs are usually separated into their fixed and variable components. The high-low method is a cost
estimation tool that is used to calculate mixed costs. To calculate, you must have several periods of
historical data, including units produced and total costs. Subtract the lowest levels of production from the
highest levels of production computed as: variable cost per unit = difference in total cost/difference in
units produced. The fixed cost is then estimated by subtracting the total variable costs from the total fixed
costs, as follows: fixed cost = total costs—(variable cost per unit × units produced). Mixed costs contain a
fixed component even if nothing is produced.
Key Terms and Definitions
Activity Base (Driver)—A measure of activity that is related to changes in cost. Used in
analyzing and classifying cost behavior. Activity bases are also used in the denominator in
calculating the predetermined factory overhead rate to assign overhead costs to cost objects.
Cost Behavior—The manner in which a cost changes in relation to its activity base (driver).
Fixed Costs—Costs that tend to remain the same in amount, regardless of variations in the level
of activity.
High-Low Method—A technique that uses the highest and lowest total costs as a basis for
estimating the variable cost per unit and the fixed cost component of a mixed cost.
Mixed Costs—Costs with both variable and fixed characteristics, sometimes called semivariable
or semifixed costs.
Relevant Range—The range of activity over which changes in cost are of interest to
management.
Variable Costing—The concept that considers the cost of products manufactured to be
composed only of those manufacturing costs that increase or decrease as the volume of
production rises or falls (direct materials, direct labor, and variable factory overhead).
Variable Costs—Costs that vary in total dollar amount as the level of activity changes.
Relevant Check Up Corner and Exhibits
Exhibit 1—Variable Cost Graphs
Exhibit 2—Variable Costs and Their Activity Bases
Exhibit 3—Fixed Cost Graphs
Exhibit 4—Fixed Costs and Their Activity Bases
Exhibit 5—Mixed Costs
Exhibit 6—Variable and Fixed Cost Behavior
Exhibit 7—Variable, Fixed, and Mixed Cost
Check Up Cornier 19(5)-1 – Cost Behavior
SUGGESTED APPROACH
Knowing how costs behave enables management to estimate costs when evaluating alternative operating
proposals. Begin your coverage of this objective by reviewing the definitions of variable, fixed, and
mixed costs. Be sure to point out the behavior of both total and unit costs. For example, variable costs are
illustrated in text Exhibit 1. When reviewing this illustration, stress that as the number of units produced
increases, the total direct materials cost increases but the unit cost remains constant.
Chapter 19(5) Cost-Volume-Profit Analysis 358
Fixed costs are shown in text Exhibit 3. This illustration compares the supervisor’s salary in a plant that
makes perfume to the number of perfume bottles produced. The total salary is constant at all production
levels. As a result, the per-unit cost decreases as production increases.
Mixed costs have both a fixed and a variable component. An example of a mixed cost is the price paid to
rent a moving van if that price includes a fixed fee plus a charge per mile (i.e., $50 plus $0.30 per mile).
In addition to understanding how costs behave, managers need to know what activities create costs. These
activities are called activity bases (or activity drivers). Ask your students to identify the activity base that
drives their textbook expenditures. (Answer: the number of courses taken)
GROUP LEARNING ACTIVITY—Variable, Fixed, and Mixed Costs
Divide your class into small groups. Ask them to list examples of fixed, variable, and mixed costs
incurred by a McDonald’s restaurant. Encourage them to list as many examples as they can. Also instruct
them to identify the activity base (driver) for each variable cost on their list.
Possible response: McDonald’s variable costs could include all the food and drinks, hourly labor, food
containers, and condiments. Fixed costs could include rent or mortgage, managers’ salaries, insurance,
and franchise fees. Mixed costs could include utilities, advertising, and maintenance costs.
DEMONSTRATION PROBLEM—High-Low Method
For most business analysis, mixed costs must be separated into their fixed and variable components. Use
the following problem to demonstrate the high-low method.
The power costs of Jones Manufacturing behave as a mixed cost. The activity that creates most of the
power costs is machine usage. Therefore, power costs will be analyzed in relation to machine hours.
Machine hours and power costs for the past six months are presented on Transparency Master (TM)
19(5)-1. Ask students to identify the highest and lowest levels of power usage (August and July
respectively). Next, ask them to compute the difference in machine hours and power costs and record
these numbers in their notes.
Once the high and low points have been identified, the variable portion of the cost is determined using the
following equation:
Difference in Total Cost
Variable Cost/Unit Difference in Machine Hours
$300
Variable Cost/Unit $0.05/hour
6,000 hours
The fixed portion can be determined using data from either the high or the low power-usage points and
the following equation:
Chapter 19(5) Cost-Volume-Profit Analysis 359
Total Cost = (Variable Cost/Unit No. of Units) + Fixed Costs
Chapter 19(5) Cost-Volume-Profit Analysis 360
Using data from July:
$1,900 = ($0.05/unit 14,000) + Fixed Costs
$1,900 – $700 = Fixed Costs
$1,200 = Fixed Costs
OBJECTIVE 2
Compute the contribution margin, the contribution margin ratio, and the unit contribution
margin.
SYNOPSIS
Cost-volume-profit analysis is useful for managerial decision making. The analysis may be used to
analyze the following: the effects of changes in selling price on profits, the effects of changes in costs of
profits, the effects of changes in volume on profits, how to set prices, how to select the mix of products to
sell, and how to choose marketing strategy. The contribution margin provides insights in to the profit
potential and is calculated as: contribution margin = sales—variable costs. The contribution margin can
also be expressed as a percentage; this ratio is calculated as: contribution margin ratio = contribution
margin/sales. This ratio is most useful when the increase or decrease in sales volume is measured in sales
dollars. The contribution margin can also be computed per unit as: unit contribution margin = sales price
per unit—variable cost per unit.
Key Terms and Definitions
Contribution Margin—Sales less variable costs and variable selling and administrative
expenses.
Contribution Margin Ratio—The percentage of each sales dollar that is available to cover the
fixed costs and provide an operating income.
Cost-Volume-Profit Analysis—The systematic examination of the relationships among selling
prices, volume of sales and production, costs, expenses, and profits.
Unit Contribution Margin—The dollars available from each unit of sales to cover fixed costs
and provide operating profits.
Relevant Check Up Corner and Exhibits
Exhibit 8—Contribution Margin Income Statement Format
Check Up Corner 19(5)-2) – Contribution Margin
SUGGESTED APPROACH
Give students the following formulas related to contribution margin (CM):
CM = Sales—Variable Costs
CM Ratio = CM/Sales
Chapter 19(5) Cost-Volume-Profit Analysis 361
Stress that contribution margin is the amount of funds left from a sale after the variable costs have been
paid. Contribution margin is used to pay the fixed costs of the business. Once all fixed costs have been
covered, any contribution margin left represents profit.
The contribution margin ratio tells what percent of each sales dollar is contribution margin. Once again, if
sales are above break-even, this percentage represents profit.
GROUP LEARNING ACTIVITY—Contribution Margin
Give your students the following sales and cost data for Van Buren Company. The total sales and cost
information is based on the sale of 20,000 units.
Total Per Unit
Sales $570,000 $28.50
Variable costs $387,600 $19.38
Fixed costs $140,000
Divide the class into small groups. Ask students to compute the total contribution margin, contribution
margin ratio, and unit contribution margin for this company. Also instruct them to compute the increase
in net income that will result from a $50,000 increase in sales and a 1,000-unit increase in sales.
The answers to this exercise are as follows:
1. Total contribution margin: $182,400
2. Contribution margin ratio: 32 percent
3. Unit contribution margin: $9.12
4. Increase in net income from $50,000 increase in sales: $50,000 32% = $16,000
5. Increase in net income from 1,000-unit increase in sales: 1,000 $9.12 = $9,120
OBJECTIVE 3
Determine the break-even point and sales necessary to achieve a target profit.
SYNOPSIS
of activity; however, unit variable costs may be affected by changes in the price of materials, labor, or
sales. An increase in unit variable costs increases the break-even point, and decreases in variable costs
decrease the break-even point. If the selling price changes, this also changes the break-even point in the
Chapter 19(5) Cost-Volume-Profit Analysis 362
© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
opposite direction. If the sales price increases, the break-even point decreases, and if the sales price
decreases, the break-even point increases. A summary of the effects is shown in Exhibit 13. By modifying
the break-even equation, a business can determine what sales are necessary to achieve a target profit. The
equation is: sales (units) = (fixed costs + target profit)/unit contribution margin.
Key Terms and Definitions
Break-Even Point—The level of business operations at which revenues and expired costs are
equal.
Relevant Check Up Corner and Exhibits
Exhibit 9—Break-Even Point
SUGGESTED APPROACH
Under this objective, the text presents formulas to calculate the break-even point in units and the unit
sales necessary to achieve a target profit. Use the following lecture notes to explain these formulas.
LECTURE NOTES—Break-Even Point and Target Profit
Fixed Costs + Target Profit
Sales (units) Unit Contribution Margin
formula can be derived as follows:
Sales Price (X) – Variable Cost (X) – Fixed Costs = Income from Operations
where: X = No. of units sold
also note: sales price and variable cost are per-unit amounts
