Behavior of Costs and BEP

Analysis
Sessions 4-6

Behavior of Costs
Cost-volume relationships
Fixed and variable costs
Step-function costs

Relation of costs to volume

Higher volume causes higher costs
Variable costs = items of cost that
vary, in total, directly and
proportionately with volume
Fixed costs = non-variable costs =
items of cost that, in total, do not vary
with volume
Semivariable costs = semifixed costs
= partly variable costs = mixed costs
= costs that include a combination of
variable and fixed cost items

TC = TFC +(UVC*X)
TC = total cost;
TFC = total fixed cost (per time
period),
UVC = Unit variable cost (per unit
of volume),
X = volume
Equations for:[Illustration 16-1]
Variable cost line: TC = UVC*X
Fixed cost line: TC = TFC
Semivariable cost: TC = TFC +

Cost Relations
Average costs = total
cost/volume
Average cost behaves differently
than total cost
As volume goes up
Total fixed cost remains constant,
total variable costs goes up, per unit
variable costs stays the same, per
unit fixed cost goes down, per unit
total cost goes down
As volume increases without limit,
unit cost approaches variable unit cost

Limitations of C-V
Relations
A straight line approximates cost
behavior only within a certain range
of volume, the relevant range
When volume approaches zero,
management takes steps to reduce fixed
costs
When volume exceeds relevant
range, fixed costs increase

Limitations
Amount of variable costs depends
on the time period over which behavior
is estimated (the relevant time
period)
If the time period is one day, few costs
are variable
Over an extremely long time period, no
costs are fixed

Environmental assumptions must be

made.

Wage rates, fringe benefits, material prices,

technology changes

Problem 16-1
Categories of Costs

Solution
1. Cost of raw materials used by
students Variable Costs Graph
B
2. Depreciation of machinery and
equipment used Fixed Costs
Graph A
3. Cost of Blueprint and manuals
Semi Variable Costs[Step
Costs]-Graph D
4. Utilities and Maintenance- Semi

Sticky Costs
Generally considered variable but
fall less with decreases of
activity than they rise with
increases [Illustration 16-5]
Managers tend to increase
resources more quickly than they
decrease
Examples:
Sales commissions with minimum
guarantees
Managers slower to fire employees than

Step-function costs
Incurred when costs are added in
discrete chunks, e.g. a supervisor for
every 10 workers
Adding the chunk of costs increases
capacity
Height of a stair step (riser)
indicates cost of adding incremental
capacity
Step width (tread) shows how much
additional volume of activity can be
serviced by an additional increment of

Step function
If treads are narrow and risers
are low (i.e. steps are small), then steps
can be approximated by a variable
cost line
If it is believed within relevant time
period, cost will remain within relevant
range for a single stair step (tread),
then cost is appropriately treated as
a fixed cost for time period
Step functions are often hidden in C-V
diagrams as either variable or fixed
costs

Profit-graph

Add revenue line to C-V diagram

Assumes constant selling price
UP = unit price= selling price
TR = total revenue

Breakeven volume

TR = UP*X
TC = TFC + (UVC*X)
Breakeven: TR = TC
Substituting: UP*X = TFC +
(UVC*X)
X = TFC/(UP - UVC)

- Page no.469: Illustration

Contribution
Unit contribution = unit
contribution margin = marginal
income = unit selling price - variable
cost per unit = UP - UVC
I = total income = (UP - UVC) * X TFC
What is contribution:
[ Illustration 16-11]
First: contribution to cover fixed costs
Then: contribution toward profit

Break-even volume
In units = Fixed costs in Rs /unit
contribution in Rs
In revenue Rs = Fixed costs in Rs /
contribution percent
Contribution percent = contribution
margin percentage = contribution as a
percent of revenues = (UP - UVC)/ UP

Target Profit
Add to breakeven analysis to show
units or dollar of sales to achieve a
target (T) level of profit:
UP*X = TFC + (UVC*X) + T
X = (TFC+T)/(UP - UVC)

Cash versus accrual

profit-graphs
So far we have considered profit and
costs on an accrual basis
To look at a profit-graph on a cash
basis:
Major difference is depreciation (a
non-cash expense)
Also to be meaningful sales volume
should equal production volume

Profit-graph shows how to improve profit

performance:
[Illustration 16-3]

Increase selling price

Decrease variable cost
Decrease fixed cost
Increase volume

Margin of Safety
Excess of actual sales over BEP
sales in units or in Rs
For E-g: [200 less 160 units/ 200
units ]*100= 20%

Several Products
2 Options
1. BEP Product wise computation
2. Weighted Average Contribution
based BEP
Refer Exhibit 3 of Case 16-3 : Bill
French

Measures of volume
So far we have assumed a singleproduct
If multiple products, with different
cost structures, unlikely that units
would be a reliable measure of
activity
Possible common denominators
include: labor hours, labor dollars,
machine hours, homogeneous quantities
such as tons or barrels and sales value

Questions to consider in selecting a

volume measure
Input (resources used) or output
(goods or services produced)?
Money or non-monetary
quantities?

Input or output?
Input measures: resources used:
labor hours worked, labor cost,
machine hours, kilowatt hours of
electricity, pounds of material
Output measures: units or dollars
Manufacturing firms might use
input measures such as labor or
machine hours
Retail stores might use dollar sales

Money or non-monetary
quantities?
A non-monetary measure is not
affected by price changes and therefore
may have some advantages
If price changes affect all costs
equally, use of labor costs as an
activity measure implicitly allows for
price changes
Best volume measure should be
related to the activity that causes cost
The more items of cost that are
combined in the cost function the more
difficult it is to relate causality to a

Operating Leverage
Volum Fixed
e
Cost

Variable
Cost

Total
Cost

Revenue

Profit

200

400

200*6=1,2
00

1,600

200*8.5=
1,700

100

300

400

300*6=1,8
00

2,200

300*8.5=
2,550

350

Chang
e
50%
[+]

No
change

50%
change[+]

37.5%
change
[+]

50%
change[+]

250 %
change [+]

Operating Leverage
As production volume increases,
average per unit cost decreases
because the average fixed cost
decreases
= Change in profit / change in
volume
= 250% / 50% = 5 times
Leverage works both the ways

Other Influences of Costs

1. Changes in Input Prices
2. Rate of Volume Change
3. Direction of Change in Volume
4. Duration of Change in Volume
5. Prior Knowledge of the change
6. Productivity
7. Management Discretion
- Learning Curve [Appendix]

Case 16-1

Hospital Supply, Inc

Case 16-1

[1] BEP in units and sales value?

[2] Do you recommend a price
cut from $4,350 to $3,850?
What would be the impact on
monthly sales, costs and
income?
[3] What impact would accepting
the government contract have
on March Income?
[4] What is the minimum unit
price it should consider for

Case
16-1
[5] what is the minimum price that
would be acceptable in selling 200
units of an obsolete model?
[6] what in-house unit cost should
be used to compare with the
quotation received from the supplier?
Should the proposal be accepted for
a price [payment to the contractor]
of $2,475 per unit?
[7] What is the maximum purchase
price per unit that Hospital
Supply should be willing to pay the
outside contractor? Should the

Q-1:BEP in units and sales

value?
Total Fixed Costs = FC per unit times
normal volume = {660+770}*3000 =
$42,90,000
-Contribution margin per unit = SP-VC
= 4,350-2,070= $2,280
Therefore BEP in units = $ 42,90,000/2,280
= 1,882 units
BEP in sales = 42,90,000/ {2,280/4,350} =
$81,85,461= or 1,882*
$4,350=$81,86,700

2.Do you recommend a price cut from $4,350

to $3,850? What would be the impact on monthly
sales, costs and income?
Particulars

Before
Price
Reduction
[ in $]

After Price
Reduction [in
$]

Difference
[in $]

Selling Price

4,350

3,850

{500}

Quantity

3,000 units

3,500 units

500

Revenue

1,30,50,000 1,34,75,000

4,25,000

Variable
Manufacturing Costs

{53,85,000}

{62,82,500}

{8,97,500}

Variable Marketing
costs

{8,25,000}

{9,62,500}

{1,37,500}

Contribution margin 68,40,000

62,30,000

{6,10,000
}

Fixed manufacturing
costs

{19,80,000}

{19,80,000}

Fixed marketing costs

{23,10,000}

{23,10,000}

Recommendations-Q-2
The differential contribution margin
and differential income are the same
Lowering prices reduces income,
hence the company should not
reduce the price

Q-3: what impact would accepting

the government contract have on
Particula Without March
Regular Income?
Governm Total
Differenc
rs
{1}

Revenue
Less:
Variable
mfg
,,Mktg
costs
Contribu
tion
margin
Less:
Fixed mfg
cost

governm
ent
contract
[in$]
{2}

[in $]
{3}3500
units

ent
[in $]
{4}- 500
units

{5}
={3+4}

1,74,00,0
00

1,52,25,0 14,20,00
00
0

1,66,45,0
00

71,80,000 62,82,50
11,00,000 0

e
{2-5}

{7,55,000
}

8,97,500
71,80,000 -------------------------------9,62,500
1,37,500

9,62,500
91,20,00
0

19,80,000

79,80,0
00

5,22,500

85,02,50
0

{6,17,50
0}

19,80,000 ----------------

Recommendation
Accepting government order
reduces the profit amount

Q-4: what is the minimum unit price

Hospital Supply should consider for
accepting the foreign market order of
1000 units?

Using the BEP formulae

X units= TFC / {UR-UVC}
= 1000 units = 22,000 / {UR- 2,205}
1000[UR-2,205} = 22,000
1000 UR 22,05,000 = 22,000
1000 UR = 22,27,000
Therefore UR = 22,27,000/1000 =
2,227 $

Q-5:what is the minimum price that would

be acceptable in selling 200 units of an
obsolete model?
-The manufacturing costs are sunk
- Any price in excess of the differential costs
of selling the hoists will add to income
- Here the differential costs = $275 per
unit variable marketing costs= the
minimum price
- Under opportunity cost concept, the
price should exceed the sum of {a] the
differential marketing costs and {b} the
potential scrap proceeds

Q-6: what in-house unit cost should be used to compare

with the quotation received from the supplier? Should the
proposal be accepted for a price [payment to the contractor]
of $2,475 per unit?
Particulars

All Production
In-house [ in $ ]3,000 units

1000Units
contracted and
2000 units in
house
production [in $]

Total Revenue

1,30,50,000

1,30,50,000

Less:
Total variable
manufacturing costs
,, ,, Mktg costs

53,85,000
8,25,000

35,90,000
7,70,000

Total Contribution
Margin

68,40,000

86,90,000

Less: Total fixed mfg

costs
Total fixed mktg costs

19,80,000
23,10,000

13,86,000
23,10,000

Payment to contractor --------------------

Income Before Tax

49,94,000 - X

25,50,000

Q-6 : Solution
49,94,000 X = 25,50,000
Therefore X = 24,44,000 or
$ 2,444 per unit as the maximum
purchase price
- Therefore at $ 2,475 purchase price is
not acceptable ; it would decrease income
by $31,000 i.e
- {2,475-2,444} * 1000

Q.7: What is the maximum purchase price per unit that

Hospital Supply should be willing to pay the outside
contractor? Should the proposal be accepted for a price of $
2,475 per unit to the contractor?

Particula 3000
rs
regular
hoists
produce
d inhouse

Regular[
In]
[2000
units]

Regular
[out]
[1000
units]

Modified
[800
units]

Total

Revenue

87,00,00
0

43,50,00
0

39,60,00
0

1,70,10,
000

1,30,50,
000

Less:
v.mfg.cost 53,85,000 35,90,000 --------s
2,20,000
v.mkt.cost 8,25,000
5,50,000
s
Contribu
tion
margin

68,40,00
0

45,60,00
0

19,80,000 ----F.mfg.cost 23,10,000 ----s

24,20,000 60,10,000
12,10,000
4,40,000

41,30,00
0

11,00,00
0

97,90,00
0

--------

------

19,80,000
23,10,000

Q-7: Maximum payment

55,00,000 -X= 25,50,000
X = $ 29,50,000 OR $ 2,950 per unit
= maximum price
Now the proposal should be accepted
at a price of $2,475

Prestige Telephone
Company
Case 16-2

Questions..
1. Which expenses are variable with respect
to revenue hours? Which expenses are
fixed with respect to revenue hours?
2. For each expense that is not variable with
respect to revenue hours calculate the cost
per revenue hour
3. Create a contribution margin income
statement for Prestige Data Services.
Assume that intra-company usage is 205
hours. Assume commercial usage is at the
March level

Questions..

4. Assuming the intra-company demand for service

will average 205 hours per month, what level of
commercial revenue hours of computer use
would be necessary to break even each month
5. Estimate the effect on income of each of the
options as follows
- Increasing the price to commercial customers to
$1,000 per hour would reduce demand by 30%
- Reducing the price to commercial customers to
$600 per hour would increase demand by 30%
- Increased promotion would increase
revenue hours by up to 30%. Bradley is
unsure how much promotion this would take.
[ How much could be spent and still leave
Prestige Data Services with no reported loss each
month if commercial hours were increased 30%]
- 16 hours operations on weekdays and 8

Questions
6. Based on your analysis above, is
Prestige Data Services really a
problem to Prestige Telephone
Company? What should Rowe do
about Prestige Data Services?

Solution

Q-1:Which expenses are variable with

respect to revenue hours?
Expense

Amount [ in $]

Variable Expenses
Materials [Jan = 27.44; Feb=
27.63 & March = 28.58]
Power cost per hour [ based on
segregation into fixed and
variable using high-low method ]

28.58
4.70

Operations wages[ based on

segregation into fixed and
variable using high-low method ]

24

Total Variable Expenses per

hour

57.28

Q-1: Which expenses are fixed with respect to

revenueAmount
hours?
Expense
[ in $]
Non variable Expenses
Space
Custodial
Computer Lease
Computer Maintenance
Depreciation on computer
equipment and office equipment
and fixtures
Power cost [High-low
method]
Wages& Salaries [ NonVariable Expenses]
Operations [ High-low
method]
Systems development
Administration
Sales
Sales Promotion [ assumed as
programmed cost]
Corporate Services

8,000
1,240
95,000
5,400
26,180
106

21,600
12,000
9,000
11,200
8,000
15,400

Q-2: Cost per revenue hour

Expense

Non variable Expenses

Space
Custodial
Computer Lease
Computer Maintenance
Depreciation on computer
equipment and office equipment
and fixtures
Power Cost[ High Low Method]
Wages& Salaries [ NonVariable Expenses]
Operations
Systems development
Administration
Sales
Sales Promotion [ assumed as
programmed cost]
Corporate Services

Amount [ in $] Cost per

revenue hour
[ March]-361
8,000
1,240
95,000
5,400

22.16
3.43
263.16
14.96

26,180
106

72.52
0.29

21,600
12,000
9,000
11,200

59.83
33.24
24.93
31.03

8,000

22.17

15,400

42.66

Q-2: cost per revenue hour

Category

Cost per revenue hour[Based

on March= 361 hours]

Total Variable cost per revenue

hour

57.28

Total Non-variable expenses per

revenue hour

590.38

Total expenses per revenue

hour

647.66

Q-3: Contribution Margin Income

Statement [illustration]
Particulars

Amount [in INR]

Revenues
Less: Variable Costs
Variable mfg. costs
Variable non-mfg
costs

*****
***
***

Contribution
Margin
Less: Fixed Costs
Fixed mfg costs
Fixed non-mfg costs
Operating Income
before tax

Amount [in INR]

***
***

***
***

***
***

Contribution Income Statement of Prestige

Telephone Company[March Com.usage]
Particulars

Amount [in $]

Revenues
205*400 = 82,000
[at 205 intra company
and 138 commercial
138*800 = 1,10,400
usage]
Less: Variable
Costs
-Power cost
-Operations wages
- Material
Total Variable
costs
Contribution
Margin
Less: Fixed Costs

4.70* 343= 1,612

24*343= 8,232
28.58*343 = 9,803

Amount [in $]
1,92,400

1,612
8,232
9,803
19,647

1,72,753 [ per hour

= 503.65]
2,13,126

Q-4 : Assuming the intra-company demand

for service will average 205 hours per month,
what level of commercial revenue hours of
computer use would be necessary to break
even each month

BEP in hours for Commercial

demand
= {TFC-allowed costs after VC of Intra
company operations }/ Contribution
per hour
=2,13,126 - [82,000 {205
hours*57.28=11,743} ] / {80057.28}
= [2,13,126 70,257]/ 742.72
= 1,42,869/742.72 = 192.36 or 193

Q-5: Analyzing options

[a] increase in price to commercial
customers to $1,000 per hourexpected to reduce demand by 30%
from 138 hours in March 2004 to
97 hours [ 138*.70 = 96.6 hours]
- Contribution = 97 hours *[1,00057.28] = $91,444
- Present Contribution
= 138 hours * {800- 57.28} =
$1,02,496

Q-5: Analyzing options

[b] Reducing the price to commercial
customers to $600 per hour- expected
to increase demand by 30% to 179 hours
[ 138* 1.30 = 179.4 hours]
Present contribution = $1,02,496
Expected contribution from the proposal
= 179 hours * [$600-$ 57.28] = $ 97,147
Therefore price reduction decreases profit
by $ 5,349 per month

Q-5: Analyzing Options

[c] How much could be spent and still leave
Prestige Data Services with no loss when
commercial hours are increased by 30%?
30% increase in commercial hours lead to
179 hours per month
- Total contribution = 179 hours * [$800-$
57.28]
=$1,32,947 and the present contribution is at
$ 1,02,496 therefore $ 30,451 could be
spent without reducing income

Q5 [d] Reducing operations to 16 hrs on weekdays

and 8 hrs on saturdays with a 20% decrease in
comm.hrs

Present Contribution: $1,02,496

Revised Commercial Hours : 138 *0.8
= 110.4 = 111 hours
Contribution Per Hour at the existing
rate = 800- 57.28 $ = $ 742.72
Revised Contribution = 111*
$742.72= $ 82,442 . Lower than
the present contribution

Q-6: Based on your analysis above, is Prestige Data

Services really a problem to Prestige Telephone
Company? What should Rowe do about Prestige
Data Services?
Prestige Data Services
is not a problem to
Prestige Telephone Company because
1. Commercial revenue hours appear to be
increasing[ w/o increase in expenses ]
2. Additional sales promotion and acceptance
of the service increased utilization-increased
revenue- profits not losses
3. The promise behind the set up of Prestige
Data Services is being realized by Prestige
Telephone company- evident from the available
data
4. excess hours/ capacity need to be
converted into Commercial revenue hoursincreased profitability of the subsidiary and the
parent

Bill French

Case 16-3

Case 16-3 Bill French

Questions
1. Assumptions implicit in Bills
Calculations
2. BEP on various situations
3. Should the company alter the
product mix in favour of product
C? Does BEP help in this regard?
4. BEP of individual products? Why
the sum of individual BEP differ from
the aggregate?
5. What are the uses of BEP analysis?

Assumptions Implicit in Bills

calculations
Variability of the VC is constant
FC is fixed only in the relevant
range
Reasonable constant relationship
between production and sales
pattern
Constant Sales Mix
Constant Selling Price

Various
BEPs
Situation 1: Allowing for

10%
increase in VC ,increase in SP of C
& $60,000 per month increase in FC,
change in product mix but not
holding
any
dividend
or
retention requirements against
operations
Situation 2 : No allowance for 10%
increase in VC, no dividend
requirement, no earnings retention
goal but change in product mix,
increased FC and change in
selling price of product C

Particu
lars

Situation
1
ProdA ProdB
ProdB

ProdA

Last
Next
year
year

Last year

Next
year

ProdC ProdC
Last
Next year
year

Unit
capacit
y
Unit
achieve
d

6,00,00
0

4,00,0
00

4,00,000

4,00,000

5,00,000

9,50,000

Selling
price
per
unit[in$
]

10

10

2.40

4.80

Sales
60,00,0
revenue 00

40,00,0
00

36,00,000

36,00,00
0

12,00,00
0

45,60,000

VC per
unit[in
$]

7.50

8.25

3.75

4.125

1.50

1.65

FC[in $]

9,60,00

9,60,00

15,60,000

15,60,00

4,50,000

11,70,00

Situation 1
Particulars

Total
Last year

Total
Next year

Unit
capacity[uni
ts]

20,00,000

20,00,000

Unit
achieved

15,00,000

17,50,000

Selling price
per
unit[in$]Wgt.avg

7.20

6.95

Sales
revenue

1,08,00,00 1,21,60,000
0

VC per
unit[in $]wgt.avg

4.50

3.72

FC[in $]

29,70,000

36,90,000

PBT[in $]

10,80,000

19,52,500

[-]IT @50%

5,40,000

9,76,250

[-]Dividend

3,00,000

4,50,000

Situation 1-BEP
FC= $ 36,90,000
Contribution per unit = $3.23
BEP [in units] = $36,90,000/3.23 =
11,42,000 units
CMP = 3.23/ 6.95 = 0.4647
BEP in Revenue $=
$36,90,000/0.4647
= $ 79,40,000

Situation 2
Particulars

Total

Pdt A

Pdt B

Pdt C

Selling
price per
unit [in $]

6.95

10

4.80

Variable
Cost per
unit [in $]

3.39

7.5

3.75

1.5

Contributio 3.56
n per unit
[in $]

2.5

5.25

3.3

Units to be
sold next
year

4,00,000

4,00,000

9,50,000

10,00,000

21,00,000

31,35,000

17,50,000

Total
62,35,000
Contributio
n [in $]

Situation 2-BEP
FC= $ 36,90,000
Contribution per unit = $3.56
BEP [in units] = $36,90,000/3.56 =
10,36,500 units
CMP = 3.56/ 6.95 = 0.5122
BEP in Revenue $=
$36,90,000/0.5122
= $ 72,04,000

Situation 3 -BEP
Change in both VC & FC, Change in
Volume & Selling Price per unit
Coverage required: Fc of $ 36,90,000,
pre tax dividend of $ 6,00,000 and Pre tax
RE of $3,00,000= Total of $ 45,90,000
Unit Contribution = $ 3.23
BEP in units = 14,21,000
CMP = 0.4647
BEP in Revenue $ = $ 98,77,000

Summary
of
options
Particulars
FC [in $]
Contri BEP[uni CMP
bution
per
unit
[in $]

ts]

BE [in
revenue
$]

Situation 1

36,90,000

3.23

11,42,00 0.46
0
47

79,40,000

Situation 2

36,90,000

3.56

10,36,50 0.51
0
22

72,04,000

Situation 3

45,90,000

3.23

14,21,00 0.46
0
47

98,77,000

Pay Extra dividend,

no union increase,
increased FC & RE of
$1,50,000

48,90,000

3.56

13,74,00 0.512 95,47,000

0
2

Allow union increase,

pay no extra
dividend, increased FC
& RE of $1,50,000

45,90,000

3.23

14,21,00 0.464 98,77,000

0
7

Q3: Should the company alter

the existing product emphasis

CMP of Product A is 18%

while that of Product C is
66%
The per unit contribution [in
$] for Product A is $1.75
versus $ 3.15 for product C
Hence, the company should
alter the existing product
emphasis as it results in

Q 3: Amount to be invested for

additional C capacity
Product A contributes 56% of Product C
Contribution = 1.75/3.15=56%
Means that company can afford to gain in
C units only 44% of the number of A units
that it gives up
Amount of contribution available to pay for the
added capacity and to return a reasonable profit
i.e ROI
Here for instance for an addition of
1,00,000 units of Product C must not give an
additional FC of more than $ 3,15,000

Q 4 : BEP of individual products[ using

exhibit 3]

Particulars

Total

Pdt A

Pdt B

Pdt C

Selling
price per
unit [in $]

7.20

10

2.4

(-) VC per
unit [in $]

4.5

7.5

3.75

1.5

Contributio 2.7
n per unit
[in $]

2.5

5.25

0.9

Sales units

6,00,000

4,00,000

5,00,000

Total
40,50,000
Contributio
n [in $]

15,00,000

21,00,000

4,50,000

(-) FC [in $]

29,70,000

9,60,000

15,60,000

4,50,000

PBT

10,80,000

5,40,000

5,40,000

BEP in units

11,00,000

3,84,000

2,97,143

5,00,000

BEP in $

79,20,000

38,40,000

26,74,287

12,00,000

15,00,000

Q 4 : BEP of individual
products[ using exhibit 3]
Sum of Individual BEP units =
11,81,143 units
BEP units [total] = 11,00,000
Why there is a difference
between the two numbers?
- Both will be equal only when the
unit contribution is same for all
three products
- In such situation, product mix is
irrelevant

Q5: Uses of BEP analysis

What kind of decisions?
What kind of insights?
Short run alternatives choices vs
Long Run Alternative Choices?