Variable and Fixed Cost Behavior

A variable cost
changes in direct
proportion to changes
in the cost-driver level.
A fixed cost is
not immediately
affected by changes
in the cost-driver.
Think of variable
costs on a per-unit basis.
The per-unit variable
cost remains unchanged
regardless of changes in
the cost-driver.
Think of fixed costs
on a total-cost basis.
Total fixed costs remain
unchanged regardless of
changes in the cost-driver.
Relevant Range
The relevant range is the limit
of cost-driver activity level within which a
specific relationship between costs
and the cost driver is valid.
Even within the relevant range, a fixed
cost remains fixed only over a given
period of time Usually the budget period.
Fixed Costs and Relevant Range
20 40 60 80 100
$115,000
100,000
60,000
Total Cost-Driver Activity in Thousands
of Cases per Month
T
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M
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F
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C
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Relevant range
$115,000
100,000
60,000
20 40 60 80 100
CVP Scenario
Per Unit Percentage of Sales
Selling price $1.50 100%
Variable cost of each item 1.20 80
Selling price less variable cost $ .30 20%

Monthly fixed expenses:
Rent $3,000
Wages for replenishing and
servicing 13,500
Other fixed expenses 1,500
Total fixed expenses per month $ 18,000

Cost-volume-profit (CVP) analysis is the study of the effects of output
volume on revenue (sales), expenses (costs), and net income (net profit).
Break-Even Point
The break-even point is the level of sales at which
revenue equals expenses and net income is zero.
Sales
- Variable expenses
- Fixed expenses
Zero net income (break-even point)

Contribution Margin Method
$18,000 fixed costs $.30
= 60,000 units (break even)
Contribution margin
Per Unit
Selling price $1.50
Variable costs 1.20
Contribution margin $ .30
Contribution margin ratio
Per Unit %
Selling price 100
Variable costs .80
Contribution margin .20
Contribution Margin Method
$18,000 fixed costs
20% (contribution-margin percentage)
= $90,000 of sales to break even
60,000 units $1.50 = $90,000
in sales to break even
Equation Method
Sales variable expenses fixed expenses = net income
$1.50N $1.20N $18,000 = 0
$.30N = $18,000
N = $18,000 $.30
N = 60,000 Units
Let N = number of units
to be sold to break even.
Equation Method
S .80S $18,000 = 0
.20S = $18,000
S = $18,000 .20
S = $90,000
Let S = sales in dollars
needed to break even.
Shortcut formulas:
Break-even volume in units = fixed expenses
unit contribution margin

Break-even volume in sales = fixed expenses
contribution margin ratio
Cost-Volume-Profit Graph
18,000
30,000
90,000
120,000
138,000
$150,000
0
10 20 30 40 50 60 70 80 90 100
Units (thousands)
D
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a
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s

60,000
Total
Expenses
Sales
Net Income Area
Break-Even Point
60,000 units
or $90,000
Net Loss
Area
A
C
D
B
Fixed Expenses
Variable
Expenses
Net Income
Target Net Profit
Managers use CVP analysis
to determine the total sales,
in units and dollars, needed
To reach a target net profit.
Target sales
variable expenses
fixed expenses
target net income
$1,440 per month
is the minimum
acceptable net income.
Target sales volume in units =
(Fixed expenses + Target net income)
Contribution margin per unit
($18,000 + $1,440) $.30 = 64,800 units
Target Net Profit
Selling price $1.50
Variable costs 1.20
Contribution margin per unit $ .30
Target sales dollars = sales price X sales volume in units
Target sales dollars = $1.50 X 64,800 units = $97,200.
Sales volume in dollars = 18,000 + $1,440 = $97,200
.20
Target Net Profit
Target sales volume in dollars = Fixed expenses + target net income
contribution margin ratio
Contribution margin ratio
Per Unit %
Selling price 100
Variable costs .80
Contribution margin .20
Scenario 1:
Break-even Analysis Simplified
When total revenue is equal to total
cost the process is at the break-even
point.

TC = TR
Break-even Analysis:
Comparing different variables
Company XYZ has to choose
between two machines to purchase.
The selling price is $10 per unit.

Machine A: annual cost of $3000 with
per unit cost (VC) of $5.

Machine B: annual cost of $8000 with
per unit cost (VC) of $2.

Break-even analysis:
Comparative analysis Part 1
Determine break-even point for
Machine A and Machine B.

Where: V = FC
SP - VC
Break-even analysis:
Part 1, Cont.
Machine A:
v = $3,000
$10 - $5
= 600 units
Machine B:
v = $8,000
$10 - $2
= 1000 units
Part 1: Comparison
Compare the two results to
determine minimum quantity sold.

Part 1 shows:
600 units are the minimum.
Demand of 600 you would choose
Machine A.
Part 2: Comparison
Finding point of indifference between
Machine A and Machine B will give
the quantity demand required to
select Machine B over Machine A.

Machine A = Machine B
FC + VC = FC + VC
$3,000 + $5 Q = $8,000 + $2Q
$3Q = $5,000
Q = 1667


Part 2: Comparison
Cont.
Knowing the point of indifference we
will choose:

Machine A when quantity demanded
is between 600 and 1667.

Machine B when quantity demanded
exceeds 1667.
Part 2: Comparison
Graphically displayed
Dolla$
21,000
18,000
15,000
12,000
9,000
6,000
3,000
0
500 1000 1500 2000 2500 3000
Quantity

Machine A
Machine B
Part 2: Comparison
Graphically displayed Cont.
Dolla$
21,000
18,000
15,000
12,000
9,000
6,000
3,000 Point of indifference
0
500 1000 1500 2000 2500 3000
Quantity

Machine A
Machine B
Exercise 1:
Company ABC sell widgets for $30 a
unit.

Their fixed cost is$100,000

Their variable cost is $10 per unit.

What is the break-even point using
the basic algebraic approach?
Exercise 1:
Answer
Revenues Variable cost - Fixed cost = OI

(USP x Q) (UVC x Q) FC = OI
$30Q - $10Q $100,00 = $ 0.00
$20Q = $100,000
Q = 5,000

Exercise 2:
Company DEF has a choice of two
machines to purchase. They both
make the same product which sells
for $10.
Machine A has FC of $5,000 and a per
unit cost of $5.
Machine B has FC of $15,000 and a
per unit cost of $1.

Under what conditions would you
select Machine A?
Exercise 2:
Answer
Step 1: Break-even analysis on both
options.
Machine A:
v = $5,000
$10 - $5
= 1000 units
Machine B:
v = $15,000
$10 - $1
= 1667 units

Exercise 2:
Answer Cont.
Machine A = Machine B
FC + VC = FC + VC
$5,000 + $5 Q = $15,000 + $1Q
$4Q = $10,000
Q = 2500

Machine A should be purchased if
expected demand is between 1000
and 2500 units per year.
Operating Leverage
Operating leverage: a firms ratio of fixed costs to variable costs.
Margin of safety = planned unit sales break-even sales
How far can sales fall below the planned level before losses occur?
Highly leveraged firms have high fixed costs and low variable costs.
A small change in sales volume = a large change in net income.
Low leveraged firms have lower fixed costs and higher variable costs.
Changes in sales volume will have a smaller effect on net income.
Contribution Margin
and Gross Margin

Sales price Cost of goods sold = Gross margin

Sales price - all variable expenses = Contribution margin
Per Unit
Selling price $1.50
Variable costs (acquisition cost) 1.20
Contribution margin and
gross margin are equal $ .30
Contribution Margin and Gross Margin

Contribution Gross
Margin Margin
Per Unit Per Unit
Sales $1.50 $1.50
Acquisition cost of unit sold 1.20 1.20
Variable commission .12
Total variable expense $1.32
Contribution margin .18
Gross margin $.30

Suppose the firm had to pay a commission of $.12 per unit sold.
Sales Mix Analysis
Sales mix is the relative proportions or
combinations of quantities of products
that comprise total sales.
Sales Mix Analysis
Ramos Company Example
Sales in units 300,000 75,000 375,000
Sales @ $8 and $5 $2,400,000 $375,000 $2,775,000
Variable expenses
@ $7 and $3 2,100,000 225,000 2,325,000
Contribution margins
@ $1 and $2 $ 300,000 $150,000 $ 450,000
Fixed expenses 180,000
Net income $ 270,000
Wallets
(W)
Key Cases
(K) Total
Sales Mix Analysis
Break-even point for a constant sales mix
of 4 units of W for every unit of K.
sales variable expenses - fixed expenses = zero net income
[$8(4K) + $5(K)] [$7(4K) + $3(K)] $180,000 = 0
32K + 5K - 28K - 3K - 180,000 = 0
6K = 180,000
K = 30,000
W = 4K = 120,000
Let K = number of units of K to break even, and
4K = number of units of W to break even.
Sales Mix Analysis
If the company sells only key cases:
break-even point = fixed expenses
contribution margin per unit
= $180,000
$2
= 90,000 key cases
If the company sells only wallets:
break-even point = fixed expenses
contribution margin per unit
= $180,000
$1
= 180,000 wallets
Sales Mix Analysis
Suppose total sales
were equal to the
budget of 375,000 units.
However, Ramos sold
only 50,000 key cases
And 325,000 wallets.
What is net income?
Sales Mix Analysis
Ramos Company Example
Sales in units 325,000 50,000 375,000
Sales @ $8 and $5 $2,600,000 $250,000 $2,850,000
Variable expenses
@ $7 and $3 2,275,000 150,000 2,425,000
Contribution margins
@ $1 and $2 $ 325,000 $100,000 $ 425,000
Fixed expenses 180,000
Net income $ 245,000
Wallets
(W)
Key Cases
(K) Total