CH 04

CHAPTER
CHAPTER 44
Cost-Volume-Profit Analysis
Purpose
Purpose of
of Budgeting
Budgeting
Planning
How many units of input do I need to
support a budgeted output?
Control
Are operations effective and efficient?
Decision making
How do we decide on a price, and
choose quantity given constraints?
Learning objective 1:
Identify common cost behavior patterns
Common
Common Cost
Cost Behavior
Behavior Patterns
Patterns
Variable Costs
Costs which change directly in
proportion to changes in quantity or
activity
Fixed Costs
Costs which do not change when
quantity or activity volume changes
Learning objective 1: Identify common cost behavior patterns
Common
Common Cost
Cost Behavior
Behavior Patterns
Patterns
Mixed Costs
Costs that have both variable and fixed
elements
Step Costs
Fixed for a range of output, but
increase when upper bound of range is
exceeded
Variable
Variable Costs
Costs
Costs that change in proportion to
changes in volume or activity
An automobile manufacturer will need
400 tires to make 100 cars, but 4,000
tires to make 1,000 cars
A bakery will need 2 eggs to make 1 cake
and 20 eggs to make 10 cakes
If activity increases by 10%, cost

increases by 10%
Variable
Variable Costs
Costs
A company has decided that direct labor
costs are 100% variable. Last month total
direct labor costs were $125,000 and total
direct labor hours worked were 10,000.
1. What is the direct labor cost per hour?
$125,000 / 10,000 hours = $12.50 per hour
2.Predict labor costs in a month when 12,000
labor hours are worked
$12.50 per hour 12,000 hours = $150,000
Variable
Variable Costs
Costs
Total Variable Cost = $91 Units produced

Fixed
Fixed Costs
Costs
Do not change in response to changes
in activity level
Typical fixed costs are depreciation,
supervisory salaries, and building
maintenance
Rent for a bakery will not double if
output increases from 100 to 200 cakes
Activity increases by 10%, costs

remain unchanged
Fixed
Fixed Costs
Costs
Total fixed cost = $94,000

Fixed
Fixed Costs
Costs
Discretionary Fixed Costs
Management can easily change
Advertising, research and development
Many companies cut back on these costs
when sales drop. This can be shortsighted.
Why?
Committed Fixed Costs

Cannot be easily changed
Rent, insurance
Fixed
Fixed Costs
Costs
LINK TO PRACTICE
Using Less Water but Paying Higher Rates!
1. What happens to cost per unit when fixed

costs remain the same but volume or
activity declines?
2.Can you think of another way to set rates
to make ratepayers less angry?
Mixed
Mixed Costs
Costs
Contain both variable and fixed cost
elements
Can separate mixed costs into variable
and fixed components
Salesperson with base salary (fixed) and
commission on sales (variable)
Base salary included with fixed costs
Commission included with variable costs
Mixed
Mixed Costs
Costs
Total cost = ($91 Units produced) + $94,000

Step
Step Costs
Costs
Fixed cost for a specific range
Increases to higher level when upper
bound of range is exceeded
Use correct cost when budgeting for a
particular relevant range
Company adds third production shift,

cost increase includes supervisory
salary
Step
Step Costs
Costs
Total step costs =

$94,000 for relevant range 0 3,000 units produced
$144,000 for relevant range 3,001 6,000 units
$194,000 for relevant range 6,001 9,000 units
Direct
Direct Labor
Labor
Q Is direct labor always a variable cost?
Are you willing to lay off workers when
production declines?
What if the decline is temporary?
What if the decline is permanent?
Does the degree of automation make a
difference in whether direct labor is fixed
or variable?
Cost
Cost Estimation
Estimation Methods
Methods
Account Analysis
-Classify costs into variable and fixed pools
Scattergraphs
-Can see cost relationships visually
High-Low Method
-Linear estimation connects high and low
volume observations
Regression Analysis
-Linear estimation is best fit to observed
values
Learning objective 2: Estimate the relation between cost and activity using account analysis and
the high-low method
Account
Account Analysis
Analysis
Most common approach
Requires professional judgment of
management
Management classifies costs as
fixed, variable, or mixed
Total variable costs divided by activity
equals variable cost per unit
Variable cost per unit and total fixed
costs can be used in cost equation
Learning objective 2: Estimate the relation between cost and activity using account analysis
and the high-low method
Account
Account Analysis
Analysis
Total cost = ($81.50 Variable cost per unit Units produced) +

$102,000 Fixed costs
Expected cost of 2,500 units = ($81.50 2,500) + $102,000 =
$305,750
Learning objective 2: Estimate the relation between cost and activity using account analysis
and the high-low method
Account
Account Analysis
Analysis
Learning objective 2: Estimate the relation between cost and activity using account analysis and the high-low method
Scattergraphs
Scattergraphs
Utilization of cost information from
previous periods
Weekly, monthly, or quarterly cost
reports
Plot the actual costs at the observed
activity levels
Look for relationship between cost and

activity, linear is ideal
Use relationship to predict future costs
Scattergraphs
Scattergraphs
Is there a relationship between units produced and

production costs? Describe the relationship.
High-Low
High-Low Method
Method
Utilization of cost information from
previous periods
Connect straight line from lowest
activity level to highest activity level
Slope of the line (change in cost divided by
change in activity) equals variable cost per
unit
Total cost at lowest or highest activity level
minus variable cost at that level equals
fixed cost
High-Low
High-Low Method
Method
Total cost
at high
activity
level
Total cost at
low activity
level
High-Low
High-Low Method
Method
High-Low
High-Low Method
Method
Regression Analysis
Statistical technique
Estimates the slope and intercept of
a cost equation
Finds the best straight line fit to the
observations
Typically statistical software

packages are utilized
Spreadsheet applications like Excel
typically include statistical operations
Regression Analysis
Regression Analysis
Input Y range are the costs. Input X range is the production.
Regression Analysis
The
The Relevant
Relevant Range
Range
Range of activity for which estimates
and predictions are expected to be
accurate
- Accuracy expected only for production
levels within range
Difficult to assess costs outside the

relevant range
Learning objective 3: Perform cost-volume profit analysis for single products
The
The Relevant
Relevant Range
Range
Cost-Volume-Profit
Analysis
The Profit Equation
Profit = SP(x) VC(x) TFC
Where:
x = Quantity of units produced and sold
SP = Selling price per unit
VC = Variable cost per unit
TFC = Total fixed cost
Fundamental to CVP analysis

Cost-Volume-Profit
Analysis
Break-Even Point
Number of units sold that allow the company to
neither earn a profit nor incur a loss
$0 = SP(x) VC(x) TFC
CodeConnect has the following cost

structure
Selling price $200.00 per unit
Variable cost $90.83 per unit
Total fixed cost $160,285
Find CodeConnects break-even point

Cost-Volume-Profit
Analysis
Break-Even Point
$0 = SP(x) VC(x) TFC
$0 = [$200.00 (x)] [$90.83(x)] $160,285
$0 = [($200.00 $90.83)(x)] $160,285
$0 = $109.17(x) $160,285
$109.17(x) = $160,285
x = $160,285 / $109.17
x = 1,468.21 units
Break-even point is 1,469 units (always round up)
Break-Even
Break-Even Point
Point
Gabbys Wedding Cakes creates elaborate

wedding cakes. Each cake sells for $500.
The variable cost of baking the cakes is $200
and the fixed cost per month is $6,000
1. Calculate the break-even point in units
$6,000 / ($500 - $200) = 20 cakes
2. How many cakes must be sold to earn a profit
of $9,000?
($9,000 + $6,000) / ($500 - $200) = 50 cakes
Margin
Margin of
of Safety
Safety
The margin of safety is the
difference between the expected
level of sales and break-even sales
If breakeven sales for Model DX375 is $293,600
and expected sales are $350,000, calculate the
margin of safety.
The margin of safety is:
$350,000 - $293,600 = $56,400.
3. At Winford Corp., the selling price per lawn mower is

$120, variable cost per lawn mower is $55. Fixed
costs are $130,000. Expected sales are 4,200 units.
The Margin of Safety is?
a. $264,000
b. $384,000
c. $143,000
d. $121,000
Answer a:
Expected sales =
4,200 units X $120 =
Break even sales = 2,000 units X $120 =
Margin of safety = $504,000 $240,000 =
$504,000
$240,000
$264,000
4. At Winford Corp., the selling price per lawn

mower is $120, variable cost per lawn mower
is $55. Fixed costs are $130,000. Expected
sales are 4,200 units. What is profit expected
to be?
$143,000
Answer here: _________________
Margin of safety in units = 4,200 2,000 = 2,200
2,200 units $65 unit CM = $143,000
Contribution
Contribution Margin
Difference between revenue and
variable costs
Contribution margin =
Total revenue minus total variable costs
Unit contribution margin =

Selling price minus variable cost per unit
- The unit contribution margin measures
the amount of incremental profit
generated by selling an additional unit
Contribution
Contribution Margin
Margin Ratio
Ratio
The contribution margin ratio measures
the amount of incremental profit
generated by an additional dollar of sales
Two methods to calculate the
contribution margin ratio
1. Contribution margin divided by sales
revenue (Sales TVC) / Sales
2. Unit contribution margin divided by
selling price (SP VC) / SP
Rhetorix, Inc. produces stereo speakers. The

selling price per pair of speakers is $800.
The variable cost of production is $300 and
the fixed cost per month is $50,000.
1. Calculate the unit contribution margin
associated with a pair of speakers
$800 $300 = $500
2.Calculate the contribution margin ratio for
Rhetorix associated with a pair of speakers
($800 $300) / $800 = 0.625
Contribution
Contribution Margin
Using the contribution margin and the
contribution margin ratio
SP = $200.00, VC = $90.83, CM = 200 90.83 = $109.17, TFC
= 160,285, profit = $40,000
Units to produce =
(Profit + TFC) / Unit contribution margin
($40,000 + $160,285) / 109.17 = 1,835 units
Sales required (in dollars) =

(Profit + TFC) / Contribution margin ratio
CM ratio = $109.17 / $200.00 = 0.5459
($40,000 + $160,285) / 0.5459 = $366,890
Rhetorix, Inc. produces stereo speakers. The

selling price per pair of speakers is $800. The
variable cost of production is $300 and the fixed
cost per month is $50,000.
1. If the company sells five more speakers than
planned, what is the expected effect on profit
of selling the additional speakers?
5 speakers $500 unit CM = $2,500 profit
2.If the company has sales that are $5,000
higher than expected, what is the expected
effect on profit?
$5,000 0.625 = $3,125
1. At Winford Corp., the selling price per

lawn mower is $120, variable cost per
lawn mower is $55. Fixed costs are
$130,000. Contribution Margin per unit is?
a. $65
b. $75
c. $175
d. $30
Answer a: $120 $55 = $65
2. At Winford Corp., the selling price per lawn

mower is $120, variable cost per lawn mower is
$55. Fixed costs are $130,000.
Break-Even Point in units is?
a. 1,000 units
b. 1,083 units
c. 2,000 units
d. None of these
Answer c: $130,000 / ($120 $55) = 2,000 units
Cost-Volume-Profit
Analysis
What If Analysis
Utilize profit equation to determine
impact of managerial decisions
Change in Fixed and Variable Costs
Change in Selling Price
Taxes in CVP Analysis

After tax profit =
[SP(x) VC(x) TFC](1 t)
Multiproduct
Multiproduct Analysis
Analysis
Contribution Margin Approach
Used if products are similar
Identify number of units needed to be
sold to break even
Calculate weighted average contribution margin
based on expected units sold and product mix
Assume product mix to calculate break-even point
and target profit
Multiproduct
Analysis
Rohr Watch Company
Selling price
Variable cost
Contribution margin
Units produced and sold
Weight
Model Model
A
B
$2,000 $3,000
800 1,200
$1,200 $1,800
4,000 2,000
Total
6,000
4,000 / 6,000
2,000 / 6,000
Weighted average contribution margin is

[(2 $1,200) + (1 $1,800)]/3 = $1,400
per unit
Break-even is $3,500,000 / $1,400 = 2,500 units
Break-even is 2,500 (4,000 / 6,000) = 1,667 Model A units
(Whole units.)
Break-even is 2,500 (2,000 / 6,000) = 834 Model B units
(Whole units.)
Learning objective 4: Perform cost-volume profit analysis for multiple products
Multiproduct
Analysis
Contribution Margin Ratio Approach
- Products are substantially different
Calculate total company contribution

margin ratio
Use total company contribution
margin ratio to compute required
sales in dollars
Multiproduct
Analysis
A company with 4 divisions has the following
information available:
Total sales$6,450,000
Total variable costs $4,706,000
Total direct fixed costs
$1,260,000
Total common fixed costs $1,120,000
1. Calculate total company contribution margin
($6,450,000 $4,706,000) / $6,450,000 = .2704
2.Calculate total company break-even sales in

dollars.
($1,260,000 + $1,120,000) / .2704 = $8,801,775
Assumptions
Assumptions in
in CVP
CVP Analysis
Analysis
Assumptions can affect the validity of
the analysis
1. Costs can be separated into fixed and
variable components
2. Total fixed cost and unit variable cost
do not change over the levels of interest
3. Multiproduct analysis assumes the
product mix does not change
Despite assumptions, CVP is useful

Operating
Operating Leverage
Leverage
Level of fixed versus variable costs
in a company
High level of fixed costs has a high
operating leverage
- Companies with high operating leverage
have large fluctuations in profit when
sales increase or decrease
Learning objective 5: Discuss the effect of operating leverage
Fixed
Fixed vs.
vs. Variable
Variable Costs
Costs
LINK TO PRACTICE
Fixed Costs Too HighMake Them Variable!
1. Can you think of any ways other than

incentive compensation and outsourcing to
turn fixed costs into variable costs?
2. Would you rather have fixed or variable costs
when revenues are increasing? When
revenues are decreasing?
Learning objective 5: Discuss the effect of operating leverage
Constraints
Constraints
Constraints on how many items can be
produced
- Shortage of space, equipment, or labor
Utilize contribution margin per unit to

analyze situations
- Calculate contribution margin per unit of
constraint
- Produce product with highest contribution
margin per unit of constraint
Linear programming can solve multiple

constraints
Learning objective 6: Use the cost per unit of the constraint to analyze situations involving a resource constraint
Constraints
Constraints
A company can produce Product A or
Product B using the same machinery. Only
1,000 machine hours are available
Product A has the higher contribution margin, but

Product B has the higher contribution margin per
machine hour
Learning objective 6: Use the cost per unit of the constraint to analyze situations involving a resource constraint
Copyright
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2010 John Wiley & Sons, Inc. All rights
reserved. Reproduction or translation of this work
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CHAPTER

Identify common cost behavior patterns

Learning objective 1: Identify common cost behavior patterns

Learning objective 1: Identify common cost behavior patterns

If activity increases by 10%, cost

Learning objective 1: Identify common cost behavior patterns

Total Variable Cost = $91 Units produced

Activity increases by 10%, costs

Total fixed cost = $94,000

Committed Fixed Costs

Learning objective 1: Identify common cost behavior patterns

1. What happens to cost per unit when fixed

Learning objective 1: Identify common cost behavior patterns

Total cost = ($91 Units produced) + $94,000

Company adds third production shift,

Total step costs =

Total cost = ($81.50 Variable cost per unit Units produced) +

Look for relationship between cost and

Is there a relationship between units produced and

Typically statistical software

Input Y range are the costs. Input X range is the production.

Difficult to assess costs outside the

Learning objective 3: Perform cost-volume profit analysis for single products

Learning objective 3: Perform cost-volume profit analysis for single products

Fundamental to CVP analysis

CodeConnect has the following cost

Find CodeConnects break-even point

Learning objective 3: Perform cost-volume profit analysis for single products

Learning objective 3: Perform cost-volume profit analysis for single products

Gabbys Wedding Cakes creates elaborate

Learning objective 3: Perform cost-volume profit analysis for single products

$350,000 - $293,600 = $56,400.

Learning objective 3: Perform cost-volume profit analysis for single products

3. At Winford Corp., the selling price per lawn mower is

Learning objective 3: Perform cost-volume profit analysis for single products

4. At Winford Corp., the selling price per lawn

Learning objective 3: Perform cost-volume profit analysis for single products

Unit contribution margin =

Learning objective 3: Perform cost-volume profit analysis for single products

Learning objective 3: Perform cost-volume profit analysis for single products

Rhetorix, Inc. produces stereo speakers. The

Sales required (in dollars) =

Rhetorix, Inc. produces stereo speakers. The

1. At Winford Corp., the selling price per

2. At Winford Corp., the selling price per lawn

Learning objective 3: Perform cost-volume profit analysis for single products

Taxes in CVP Analysis

Learning objective 3: Perform cost-volume profit analysis for single products

Learning objective 3: Perform cost-volume profit analysis for single products

Weighted average contribution margin is

Calculate total company contribution

Learning objective 4: Perform cost-volume profit analysis for multiple products

2.Calculate total company break-even sales in

Despite assumptions, CVP is useful

Learning objective 5: Discuss the effect of operating leverage

1. Can you think of any ways other than

Learning objective 5: Discuss the effect of operating leverage

Utilize contribution margin per unit to

Linear programming can solve multiple

Product A has the higher contribution margin, but

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