Chapter 20

Cost Behavior and Cost-

Volume-Profit Analysis
Accounting, 21st Edition
Warren Reeve Fess

© Copyright 2004 South-Western, a division

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 Objectives
Objectives
1. Classify costs by their behavior as variable
After
costs, fixed costs, studying
Afterorstudying this
this
mixed costs.
2. Compute thechapter, you
contribution
chapter, should
youmargin,
should the
contribution margin
be ratio,
able and
to: the unit
be able to:
contribution margin, and explain how they may
be useful to management.
3. Using the unit contribution margin, determine
the break-even point and the volume necessary
to achieve a target profit.
 Objectives
Objectives
4. Using a cost-volume profit chart and a profit-volume
chart, determine the break-even point and the
volume necessary to achieve a target profit.

5. Calculate the break-even point for a business

selling more than one product.
6. Compute the margin of safety and the
operating leverage, and explain how
managers use this concept.
7. List the assumptions underlying cost-volume-
profit analysis.
Cost
Cost Behavior
Behavior
 Variable
Variable Cost
Cost
Jason Inc. produces stereo sound systems
under the brand name of J-Sound. The parts
for the stereo are purchased from an outside
supplier for $10 per unit (a variable cost).
 Variable
Variable Cost
Cost
Total Variable Cost Graph

$300,000
$250,000
Total Costs

$200,000
$150,000
$100,000
$50,000
0 10 20 30
Units Produced
(in thousands)
 Variable
Variable Cost
Cost
Unit Variable Cost Graph

$20
Cost per Unit $15

$10
$5
0 10 20 30
Units Produced
(000)
 Variable
Variable Cost
Cost
$300,000 $20

Cost per Unit

Total Costs

$250,000 $15
$200,000 $10
$150,000 $5
$100,000 0 10 20 30
$50,000 Units Produced (000)
0 10 20 30
Units Produced (000)
Number of Direct Total Direct
Units Materials Materials
Produced Cost per Unit Cost

5,000 units $10 $ 50,000

10,000 10 l00,000
15,000 10 150,000
20,000 10 200,000
25,000 10 250,000
30,000 10 300,000
 Fixed
Fixed Costs
Costs
The production
supervisor for Minton
Inc.’s Los Angeles plant
is Jane Sovissi. She is
paid $75,000 per year.
The plant produces from La Fleur

50,000 to 300,000
bottles of perfume.
 Fixed
Fixed Costs
Costs

Number of Total Salary Salary per

Bottles for Jane Bottle
Produced Sovissi Produced
50,000 bottles $75,000 $1.500
100,000 75,000 0.750
15,000 75,000 0.500
20,000 75,000 0.375
25,000 75,000 0.300
30,000 75,000 0.250
 Fixed Costs
Total Fixed Cost Graph Unit Fixed Cost Graph
$150,000 $1.50
Total Costs

Cost per Unit

$125,000 $1.25
$100,000 $1.00
$75,000 $.75
$50,000 $.50
$25,000 $.25
0 100 200 300 0 100 200 300
Bottles Produced (000) Units Produced (000)
Number of Total Salary Salary per
Bottles for Jane Bottle
Produced Sovissi Produced
50,000 bottles $75,000 $1.500
100,000 75,000 0.750
15,000 75,000 0.500
20,000 75,000 0.375
25,000 75,000 0.300
30,000 75,000 0.250
 Simpson Inc. manufactures
sails using rented equipment.
The rental charges are
$15,000 per year, plus $1 for
each machine hour used over
10,000 hours.
 Mixed
Mixed Costs
Costs
Mixed
Mixed costs
costs are
are
Total Mixed Cost Graph
sometimes
sometimes called
called
semivariable
semivariable or
or
$45,000
$40,000 semifixed
semifixed costs.
costs.
$35,000
Total Costs

$30,000
$25,000 Mixed
Mixed costs
costs are
are
$20,000 usually
usually separated
separated into
into
$15,000
$10,000
their
their fixed
fixed and
and
$5,000 variable
variable components
components
0 10 20 30 40 for
for management
management
Total Machine Hours (000) analysis.
analysis.
 Mixed
Mixed Costs
Costs
The high-low method is a simple way
to separate mixed costs into their
fixed and variable components.

Low
High
 High-Low Method
Actual costs incurred
ProductionTotal
(Units) Cost
What month has
June 1,000 $45,550
July 1,500 52,000 the highest level
August 2,100 61,500 of activity in
September 1,800 57,500 terms of cost?
October 750 41,250

Highest level of activity ($) minus

lowest level of activity ($)
Variable cost per unit =
Highest level of activity (n) minus
lowest level of activity (n)
 High-Low Method
Actual costs incurred
ProductionTotal
(Units) Cost
What month has
June 1,000 $45,550
July 1,500 52,000 the highest level
August 2,100 61,500 of activity in
September 1,800 57,500 terms of cost?
October 750 41,250

$61,500 minus lowest level of

activity ($)
Variable cost per unit =
Highest level of activity (n) minus
lowest level of activity (n)
 High-Low Method
Actual costs incurred
ProductionTotal
(Units) Cost
For the highest
June 1,000 $45,550
July 1,500 52,000 level of cost,
August 2,100 61,500 what is the level
September 1,800 57,500 of production?
October 750 41,250

$61,500 minus lowest level of

activity ($)
Variable cost per unit =
Highest
2,100level
minusof lowest
activitylevel
(n) minus
of
lowestactivity
level of(n)
activity (n)
 High-Low Method
Actual costs incurred
ProductionTotal
(Units) Cost
What month has
June 1,000 $45,550
July 1,500 52,000 the lowest level of
August 2,100 61,500 activity in terms
September 1,800 57,500 of cost?
October 750 41,250

$61,500 minus lowest level of

$57,500 – $41,250
activity ($)
Variable cost per unit =
2,100 2,100
minus – 750 level of
lowest
activity (n)
 High-Low Method
Actual costs incurred
ProductionTotal
(Units) Cost
June 1,000 $45,550 What is the
July 1,500 52,000 variable cost per
August 2,100 61,500
September 1,800 57,500 unit?
October 750 41,250

$20,250
$57,500 – $41,250
Variable cost per unit = $15
1,350
2,100 – 750
 High-Low Method
Actual costs incurred
ProductionTotal Variable cost per unit = $15
(Units) Cost
June 1,000 $45,550 What is the total
July 1,500 52,000 fixed cost (using the
August 2,100 61,500
September 1,800 57,500 highest level)?
October 750 41,250

Total cost = (Variable cost per unit x Units of production)

+ Fixed cost
$61,500 = ($15 x 2,100) + Fixed cost
$61,500 = ($15 x 2,100) + $30,000
 High-Low Method
Actual costs incurred
ProductionTotal Variable cost per unit = $15
(Units) Cost
June 1,000 $45,550 The fixed cost is
July 1,500 52,000 the same at the
August 2,100 61,500
September 1,800 57,500 lowest level.
October 750 41,250

Total cost = (Variable cost per unit x Units of production)

+ Fixed cost
$41,250 = ($15 x 750) + Fixed cost
$41,250 = ($15 x 750) + $30,000
 Variable Costs Fixed Costs
Total Variable Costs Total Fixed Costs

Total Costs
Total Costs

Total costs increase

Unit costs remain the and decreases with
sameTotal
per Units
unit Produced
regardless activity level.
Review Total Units Produced
of activity.
Total costs increase and Unit
Unitcosts
Fixedremain
Costs the
decreases proportionately
Unit Variable Costs same regardless of
with activity level. activity.
Per Unit Cost

Total Units Produced Per Unit Cost

Total Units Produced

 Contribution Margin Income Statement

Sales (50,000 units) $1,000,000

The
The contribution
contribution
Variable costs 600,000 margin
margin isis
Contribution margin $ 400,000 available
Fixed costs 300,000 available toto cover
cover
Income from operations $ 100,000 the
the fixed
fixed costs
costs
and
and income
income from
from
Contribution operations.
operations.
margin

Income from
FIXED Operations
COSTS
 Contribution Margin Income Statement

Sales (50,000 units) $1,000,000

Variable costs 600,000
Contribution margin $ 400,000
Fixed costs 300,000
Income from operations $ 100,000

Income
Sales = + + from
Variable Fixed
operations
costs costs
Contributio
Sales – =
Variable n
costs margin
 Contribution Margin Ratio

Sales (50,000 units) $1,000,000 100%

Variable costs 600,000 60%
Contribution margin $ 400,000 40%
Fixed costs 300,000 30%
Income from operations $ 100,000 10%

Sales – Variable costs

Contribution margin ratio =
Sales
$1,000,000 – $600,000
Contribution margin ratio =
$1,000,000
Contribution margin ratio = 40%
 Contribution Margin Ratio

Sales (50,000 units) $1,000,000 100% $20

Variable costs 600,000 60% 12
Contribution margin $ 400,000 40% $ 8
Fixed costs 300,000 30%
Income from operations $ 100,000 10%

The
Thecontribution
contributionmargin
margincan
canbe
beexpressed
expressedthree
threeways:
ways:
1.1.Total
Totalcontribution
contributionmargin
margininindollars.
dollars.
2.2.Contribution
Contributionmargin
marginratio
ratio(percentage).
(percentage).
3.3.Unit
Unitcontribution
contributionmargin
margin(dollars
(dollarsper
perunit).
unit).
What
What is
is the
the
break-even
break-even
point?
point?

Revenues = Costs

Break-even
 Calculating
Calculating the
the Break-Even
Break-Even Point
Point

Sales (? units) $ ? $25

Variable costs ? 15
Contribution margin $ 90,000 $10
Fixed costs 90,000
Income from operations $ 0

At
At the
the break-even
break-even point,
point, fixed
fixed
costs
costs and
and the
the contribution
contribution
margin
margin are
are equal.
equal.
 Calculating
Calculating the
the Break-Even
Break-Even Point
Point
In
InUnits
Units

Sales($25
Sales ($25xx?9,000)
units) $ $225,000
? $25
Variablecosts
Variable costs($15
($15xx?9,000)
units) 135,000
? 15
Contributionmargin
Contribution margin $ $90,000
90,000 $10
Fixedcosts
Fixed costs 90,000
90,000
Incomefrom
Income fromoperations
operations $ $ 00

$90,000
Fixed costs
Break-even sales (units) = 9,000 units
$10 margin
Unit contribution

PROOF!
PROOF!
 Calculating
Calculating the
the Break-Even
Break-Even Point
Point
In
InUnits
Units

Sales ($250 x ? units) $ ? $250

Variable costs ($145 x ? units) ? 145
Contribution margin $ ? $105
Fixed costs 840,000
Income from operations $ 0

$840,000
Fixed costs
Break-even sales (units) = 8,000 units
$105 margin
Unit contribution
The unit selling price is $250 and unit variable
cost is $145. Fixed costs are $840,000.
 Calculating
Calculating the
the Break-Even
Break-Even Point
Point
In
InUnits
Units

Sales ($25 x ?Next,

units) assume
Next, assume$ ? $250
$250
variable
Variable costs ($15 x ?costs
variable units)is
costs is ? 145
150
Contribution margin by $5.
increased $ ? $105
$100
Fixed costs
increased by $5. 840,000
Income from operations $ 0

$840,000
Fixed costs
Break-even sales (units) = 8,400 units
$100 margin
Unit contribution
The unit selling price is $250 and unit variable
cost is $145. Fixed costs are $840,000.
 Calculating
Calculating the
the Break-Even
Break-Even Point
Point
In
InUnits
Units

Sales $ ? $50
Variable costs ? 30
Contribution margin $ ? $20
Fixed costs $600,000
Income from operations $ 0

$600,000
Fixed costs
Break-even sales (units) = 30,000 units
$20 margin
Unit contribution
A firm currently sells their product at $50 per
unit and it has a related unit variable cost of
$30. The fixed costs are $600,000.
 Calculating
Calculating the
the Break-Even
Break-Even Point
Point
In
InUnits
Units
Management
Management increases
increases
Salesthe
the selling
selling price
price from$
from ? $60
$50
Variable costs
$50 to $60. ? 30
30
Contribution margin$60.
$50 to $ ? $30
$20
Fixed costs $600,000
Income from operations $ 0

$600,000
Fixed costs
Break-even sales (units) = 20,000 units
$30 margin
Unit contribution
Summary
Summary of
of Effects
Effects of
of Changes
Changes on
on
Break-Even
Break-Even Point
Point
 Target
Target Profit
Profit In
In
Units
Units

Sales (? units) $ ? $75

Variable costs ? 45
Contribution margin $ ? $35
Fixed costs 200,000
Income from operations $ 0

Fixed costs are estimated at $200,000, and the

desired profit is $100,000. The unit selling
price is $75 and the unit variable cost is $45.
The firm wishes to make a $100,000 profit.
 Target
Target Profit
Profit In
In
Units
Units

Target
Target profit
profit isis
Sales (? units) $ ? used
$75 here
used here to
to refer
refer
Variable costs ? 45
to
to “Income
“Income fromfrom
Contribution margin $ ? $35
Fixed costs 200,000 operations.”
operations.”
Income from operations $ 0

Fixed costs ++desired

$200,000 profit
$100,000
Sales (units) = 10,000 units
Unit contribution
$30 margin
 Target
Target Profit
Profit

Sales (10,000 units x $75) $750,000 $75

Variable costs (10,000 x $45) 450,000 45
Contribution margin $300,000 $30
Fixed costs 200,000
Income from operations $100,000

Proof
Proof that
that sales
sales of
of 10,000
10,000 units
units
will
will provide
provide aa profit
profit of
of $100,000.
$100,000.
Graphic Approach to
Cost-Volume-Profit
Analysis
 Cost-Volume-Profit Chart
$500 Total Sales
Sales and Costs ($000)

$450
$400
$350
$300
$250
$200
$150 Variable
$100 60% Costs
$ 50
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (000)

Unit
Unitselling
sellingprice
price $$50
50
Unit
Unitvariable
variablecost
cost 30
30
Unit
Unitcontribution
contributionmargin
margin $$20 20
Total
Totalfixed
fixedcosts
costs $100,000
$100,000
 Cost-Volume-Profit Chart
$500
Sales and Costs ($000)

$450
$400 Contribution
$350 Margin
$300 40%
$250
$200
$150
$100 60%
$ 50
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (000)

Unit
Unitselling
sellingprice
price $$50
50 100%
Unit
Unitvariable
variablecost
cost 30
30 60%
Unit
Unitcontribution
contributionmargin
margin $$20 20 40%
Total
Totalfixed
fixedcosts
costs $100,000
$100,000
 Cost-Volume-Profit Chart
$500 Total
Sales and Costs ($000)

$450 Costs
$400
$350 Fixed Costs
$300
$250
$200
$150
$100
$ 50
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (000)

Unit
Unitselling
sellingprice
price $$50
50 100%
Unit
Unitvariable
variablecost
cost 30
30 60%
Unit
Unitcontribution
contributionmargin
margin $$20 20 40%
Total
Totalfixed
fixedcosts
costs $100,000
$100,000
 Cost-Volume-Profit Chart
$500
Sales and Costs ($000)

$450
$400
$350 Break-Even Point
$300
$250
$200
$150
$100
$ 50
0
1 2 3 4 5 6 7 8 9 10
Units of Sales (000)

Unit
Unitselling
sellingprice
price $$50
50 100%
Unit
Unitvariable
variablecost
cost 30
30 60% $100,000 = 5,000 units
Unit
Unitcontribution
contributionmargin
margin $$20 20 40% $20
Total
Totalfixed
fixedcosts
costs $100,000
$100,000
 Cost-Volume-Profit Chart
$500
Operating Profit Area
Sales and Costs ($000)

$450
$400
$350
$300
$250 Operating Loss Area
$200
$150
$100
$ 50
0
Units of Sales (000)

Unit
Unitselling
sellingprice
price $$50
50 100%
Unit
Unitvariable
variablecost
cost 30
30 60%
Unit
Unitcontribution
contributionmargin
margin $$20 20 40%
Total
Totalfixed
fixedcosts
costs $100,000
$100,000
 $100
$75
Operating Profit

$50
(Loss) $000’s

$25
$ 0
$(25)
$(50) Relevant
Relevant
$(75) range
range isis
$(100)
1 2 3 4 5 6 7 8 10,000
9 10 units
10,000 units
Units of Sales (000’s)

Sales
Sales(10,000
(10,000units
unitsxx$50)
$50) $500,000
$500,000
Variable
Variablecosts
costs(10,000
(10,000units
unitsxx$30)
$30) 300,000
300,000
Contribution
Contributionmargin
margin(10,000
(10,000units
unitsxx$20)
$20) $200,000
$200,000
Fixed
Fixedcosts
costs 100,000
100,000
Operating
Operatingprofit
profit $100,000
$100,000
 $100
$75 Profit Line
Operating Profit

$50 Operating
(Loss) $000’s

$25 profit
$ 0
$(25) Operating Maximum
Maximum
$(50) loss profit
profit within
within
$(75) the
the relevant
relevant
$(100)
1 2 3 4 5 6 7 8 9 10 range.
range.
Units of Sales (000’s)
Maximum
Maximum loss loss
isisequal
Sales
Sales equal to
tothe
(10,000
(10,000 units
unitsxx$50)
the $50) $500,000
$500,000
total
totalfixed
Variablefixed
Variable costs.
costs (10,000
(10,000units
costs.
costs unitsxx$30)
$30) 300,000
300,000
Contribution
Contributionmargin
margin(10,000
(10,000units
unitsxx$20)
$20) $200,000
$200,000
Fixed
Fixedcosts
costs 100,000
100,000
Operating
Operatingprofit
profit $100,000
$100,000
 $100
$75
Operating Profit

$50 Operating
(Loss) $000’s

$25 profit
$ 0
$(25) Operating
$(50) loss Break-Even Point
$(75)
$(100)
1 2 3 4 5 6 7 8 9 10
Units of Sales (000’s)

Sales
Sales(10,000
(10,000units
unitsxx$50)
$50) $500,000
$500,000
Variable
Variablecosts
costs(10,000
(10,000units
unitsxx$30)
$30) 300,000
300,000
Contribution
Contributionmargin
margin(10,000
(10,000units
unitsxx$20)
$20) $200,000
$200,000
Fixed
Fixedcosts
costs 100,000
100,000
Operating
Operatingprofit
profit $100,000
$100,000
 Sales Mix
Considerations
Cascade Company sold 8,000 units of Product A
and 2,000 units of Product B during the past year.
Cascade Company’s fixed costs are $200,000.
Other relevant data are as follows:
Products
A B
Sales $ 90 $140
Variable costs 70 95
Contribution margin $ 20 $ 45
Sales mix 80% 20%
Sales
Sales Mix
Mix Considerations
Considerations
Products
A B
Sales $ 90 $140
Variable costs 70 95
Contribution margin $ 20 $ 45
Sales mix 80% 20%
Product contribution
margin $16 $ 9

$25
Fixed costs, $200,000
Sales
Sales Mix
Mix Considerations
Considerations
Products
Product contribution A B
margin $16 $ 9

$25
Break-even sales units
$200,000
$25

Fixed costs, $200,000

Sales
Sales Mix
Mix Considerations
Considerations
Products
Product contribution A B
margin $16 $ 9

$25
Break-even sales units
$200,000
= 8,000 units
$25

Fixed costs, $200,000

Sales
Sales Mix
Mix Considerations
Considerations
Products
Product contribution A B
margin $16 $ 9

$25
A: 8,000 units x Sales Mix (80%) = 6,400
B: 8,000 units x Sales Mix (20%) = 1,600
 Product A Product B Total
Sales:
6,400 units x $90 $576,000 $576,000
1,600 units x $140 $224,000 224,000
Total sales $576,000 $224,000 $800,000
Variable costs:
6,400 x $70 $448,000 $448,000
1,600 x $95 $152,000 152,000
Total variable costs $448,000 $152,000 $600,000
Contribution margin $128,000 $ 72,000 $200,000

Fixed costs 200,000

Income from operations Break-even point $ 0

PROOF
 Margin
of Safety
 Sales – Sales at break-even point
Margin of Safety =
Sales
$250,000 – $200,000
Margin of Safety =
$250,000
Margin of Safety = 20%

The margin of safety indicates the

possible decrease in sales that may occur
before an operating loss results.
Operating
Operating Leverage
Leverage
 Operating
Operating Leverage
Leverage
Jones Inc. Wilson Inc.
Sales $400,000 $400,000
Variable costs 300,000 300,000
Contribution margin $100,000 $100,000
Fixed costs 80,000 50,000
Income from operations $ 20,000 $ 50,000
Contribution margin ? ?
Both
Bothcompanies
companieshave
havethe
thesame
samecontribution
contributionmargin.
margin.

Contribution margin
Income from operations
 Operating
Operating Leverage
Leverage
Jones Inc. Wilson Inc.
Sales $400,000 $400,000
Variable costs 300,000 300,000
Contribution margin $100,000 $100,000
Fixed costs 80,000 50,000
Income from operations $ 20,000 $ 50,000
Contribution margin 5.0 ?

Contribution
$100,000margin
Jones Inc.: = 5.0
Income $20,000
from operations
 Operating
Operating Leverage
Leverage
Jones Inc. Wilson Inc.
Sales $400,000 $400,000
Variable costs 300,000 300,000
Contribution margin $100,000 $100,000
Fixed costs 80,000 50,000
Income from operations $ 20,000 $ 50,000
Contribution margin 5.0 ?

Contribution
$100,000margin
Jones Inc. = 5.0
Income $20,000
from operations
 Operating
Operating Leverage
Leverage
Jones Inc. Wilson Inc.
Sales $400,000 $400,000
Variable costs 300,000 300,000
Contribution margin $100,000 $100,000
Fixed costs 80,000 50,000
Income from operations $ 20,000 $ 50,000
Contribution margin 5.0 2.0

Capital Labor
intensive? intensive?
Contribution
$100,000margin
Wilson Inc.: = 2.0
Income $50,000
from operations
Assumptions
Assumptions of
of Cost-Volume-Profit
Cost-Volume-Profit Analysis
Analysis
The reliability of cost-volume-profit analysis
depends upon several assumptions.
1. Total sales and total costs can be represented by
straight lines.
2. Within the relevant range of operating activity,
the efficiency of operations does not change.
3. Costs can be accurately divided into fixed and
variable components.
4. The sales mix is constant.
5. There is no change in the inventory quantities
during the period.
Chapter 20

The
The End
End