Financial and Managerial

Accounting

Wild, Shaw, and Chiappetta

Fourth Edition
McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 18

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: Describe several applications of cost-
volume-profit analysis.

18-3
Analytical Learning Objectives

A1: Compute the contribution margin and

describe what it reveals about a
company’s cost structure.
A2: Analyze changes in sales using the
degree of operating leverage.

18-4
 Procedural Learning
Objectives
P1: Determine cost estimates using the
scatter diagram, high-low, and
regression methods of estimating
costs.
P2: Compute the break-even point for a
single product company.
P3: Graph costs and sales for a single
product company.
P4: Compute the break-even point for a
multiproduct company.
18-5
C2 Questions Addressed by
Cost-Volume-Profit Analysis
CVP analysis is used to answer questions
such as:
 What sales volume is needed to earn a
target income?
 What is the change in income if selling
prices decline and sales volume
increases?
 How much does income increase if we
install a new machine to reduce labor
costs?
 What is the income effect if we change the
sales mix of our products or services?
18-6
C1

Total Fixed Cost

Total fixed costs remain unchanged
when activity changes.
Monthly Basic
Telephone Bill

Your monthly basic

telephone bill probably
does not change when
Number of Local Calls you make more local calls.
18-7
C1

Fixed Cost Per Unit

Fixed costs per unit decline
as activity increases.

Monthly Basic Telephone

Bill per Local Call
Your average cost per
local call decreases as
more local calls are made.
Number of Local Calls
18-8
C1

Total Variable Cost

Total variable costs change
when activity changes.
Total Long Distance
Telephone Bill

Your total long distance

telephone bill is based
on how many minutes
Minutes Talked you talk.
18-9
C1

Variable Cost Per Unit

Variable costs per unit do not change
as activity increases.

Telephone Charge
The cost per long distance Per Minute
minute talked is constant.
For example, 7
cents per minute. Minutes Talked
18-10
C1

Cost Behavior Summary

Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit

Changes as activity level Remains the same over wide

Variable
changes. ranges of activity.
Remains the same even Dereases as activity level
Fixed
when activity level changes. increases.

18-11
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
18-12
C1

Step-Wise Costs

Total cost remains

constant within a
narrow range of
activity.

Cost
Activity

18-13
P1 Identifying and Measuring
Cost Behavior

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

18-14
P1

Scatter Diagram
Δ in cost
Unit Variable Cost = Slope =
Δ in units
1,000’s of Dollars

20
* ** * Vertical
Total Cost in

* * distance
** is the
10 * * change
in cost.
Horizontal distance is
the change in activity.
0
0 1 2 3 4
Activity, 1,000’s of Units Produced
18-15
P1

The High-Low Method

The following relationships between units
produced and costs are observed:
Units Cost
High activity level 67,500 $ 29,000
Low activity level 17,500 20,500
Change 50,000 $ 8,500

Using these two levels of activity, compute:

 the variable cost per unit.
 the total fixed cost.
18-16
P1

The High-Low Method

Units Cost
High activity level 67,500 $ 29,000
Low activity level 17,500 20,500
Change 50,000 $ 8,500

Δ in cost $8,500
 Unit variable cost =
Δ
=
in units $50,000
= $0.17 /unit
 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
18-17
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.
18-18
P2 Computing The
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.

18-19
A1 Computing The
Break-Even Point

Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

Contribution margin is amount by which revenue

exceeds the variable costs of producing the revenue.

18-20
A1 Understanding the
Contribution Margin
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

How much contribution margin must this company

have to cover its fixed costs (break even)?
Answer: $24,000
18-21
P2 Computing The
Break-Even Point
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

How many units must this company sell to cover its

fixed costs (break even)?
Answer: $24,000 ÷ $30 per unit = 800 units
18-22
P2 Computing The
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)

18-23
P2 Computing The
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

18-24
P3

Preparing a CVP Chart

 Plot total fixed costs on the vertical axis.
Costs and Revenue
in Dollars

Total fixed costs

Total costs

 Draw the total cost line with a slope

equal to the unit variable cost.

Volume in Units
18-25
P3

Preparing a CVP Chart

 Starting at the origin, draw the sales line Sales
with a slope equal to the unit sales price.
Costs and Revenue
in Dollars

Total fixed costs

Total costs

Break-
even
Point

Volume in Units 18-26

C1

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).

18-27
C2 Computing Income
from Expected Sales

Income (pretax) = Sales – Variable costs – Fixed

costs

18-28
C2 Computing Sales for a
Target Income

Break-even formulas may be

adjusted to show the sales volume
needed to earn any amount of
income.
Fixed costs + Target income
Unit sales =
Contribution margin per unit

Fixed costs + Target income

Dollar sales =
Contribution margin ratio
18-29
C2 Computing Sales (Dollars) for a
Target Net Income

Target net income is income after

income tax. But we can use target
income before tax in our
calculations.
Fixed + Target income
costs before tax
Dollar sales =
Contribution margin ratio

18-30
C2 Computing Sales (Dollars) for a
Target Net Income
To convert target net income to
before-tax income, use the
following formula:
Target net income
Before-tax income =
1 - tax rate

18-31
C2 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 Expected sales - Break-even sales

=
percentage Expected sales

18-32
C2

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

Continue

18-33
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.

18-34
P4 Computing Multiproduct
Break-Even Point

The resulting break-even formula

for composite unit sales is:
Break-even point Fixed costs
= Contribution margin
in composite units
per composite unit

18-35
A2

Operating Leverage
A measure of the extent to which fixed
costs are being used in an organization.

A measure of how a percentage change in

sales will affect profits.

Contribution margin
= Degree of operating leverage
Pretax income

18-36
End of Chapter 18

18-37