Chapter 11 Notes

Cost Behavior and Cost-Volume-Profit Analysis
Chapter 11
Cost Behavior
Cost behavior is the manner in which a cost changes as some related activity changes An understanding of cost behavior is necessary to plan and control costs A relevant range is the range over which we are interested in the costs behavior
Cost Behavior
Variable cost
Cost is constant on a per unit basis, but the total cost varies directly with changes in activity
Materials, fuel, etc.
Fixed cost
Cost is constant in total, but varies inversely with changes in activity
Salaries, property taxes, straight-line depreciation, etc.
Cost Behavior
Step cost
Cost which is fixed over small ranges of activity, but varies across wider ranges
Supervision costs, labor costs, etc.
Mixed cost
Cost has both a fixed and a variable component
Utility costs in which you pay a fixed amount to have the service available to you, and a variable charge based on how much you use the utility; rental costs in which you pay a fixed amount per period plus a variable amount based on usage, etc.
Cost Behavior
Mixed costs must be separated into their fixed and variable components in order to predict changes in the cost

High-low method Simple regression Multiple regression
Cost Behavior
High-low method
Compares the points of highest and lowest activities, and their related costs, and calculates the formula for a straight line connecting the two points
Dividing the incremental cost by the incremental units of activity gives the variable cost per unit of activity The variable cost per unit is substituted into the cost formula to determine the fixed cost
Total cost = fixed cost + variable cost per unit * number of units of activity
Cost Behavior
High point $ Low point Difference $ Cost 18,000 12,000 6,000 Units of activity 10,000 6,000 4,000
$6,000 / 4,000 = $1.50 per unit At the low point: $12,000 = Fixed cost + $1.50 per unit * 6,000 units $3,000 = Fixed cost Total cost = $3,000 + $1.50 per unit * number of units
Applications of Cost Behavior Concepts
Contribution margin
Excess of sales over variable costs

Contribution is the incremental amount of each sale that is available to cover fixed costs and provide a profit Knowing the contribution margin allows us to predict changes in net income that will result from a change in sales volume
Sales Variable costs Contribution margin Fixed costs Net income
Total Percentage Per unit* $ 1,000,000 100% $ 1,000 600,000 60% 600 $ 400,000 40% $ 400 300,000 $ 100,000
* - assume 1,000 units are sold
Contribution margin percentage
Proportion of each sales dollar that is available to cover fixed costs and provide a profit
If sales increase by $100,000, profit will increase by $40,000 ($100,000 * 40%)
Contribution margin per unit
Dollar amount that each unit contributes toward covering fixed costs and providing a profit
If 50 more units are sold, profit will increase by $20,000 (50 units * $400)
Breakeven point
Volume of sales needed to earn no profit or no loss Revenues = total costs
Fixed cost + target profit Contribution margin per unit = number of units Fixed cost + target profit Contribution margin percentage = dollars of sales
The breakeven formulas allow us to play what if games
What happens if
Sales price is increased (or decreased)
Variable costs are replaced by fixed costs

Volume increases Additional amounts spent on advertising will increase sales volume Etc.
Margin of safety
The excess of current sales volume over the breakeven point

In units
Current unit sales breakeven unit sales
In percentage
(Current sales breakeven sales) / current sales
The sales figures may be in dollars or units
Operating leverage
Measures the relative mix of fixed and variable costs Contribution margin / operating income Can determine the change in operating income that will result from a change in sales by multiplying the % change in sales by the operating leverage
High operating leverage implies high risk, high reward
Breakeven calculations in a multi-product environment
Assume the mix of products sold remains constant
Determine the contribution margin for a basket of goods (the normal sales mix)
Calculate the breakeven point as the number of baskets needed to break even

Product Laptops Printers Scanners Normal Contribution Total sales mix per unit contribution 6 $ 70 $ 420 2 30 60 1 20 20 $ 500
If fixed costs are $800,000, the breakeven point is $800,000 / 500 = 1,600 "baskets" 9,600 laptops 3,200 printers 1,600 scanners

Chapter 11 Notes

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Cost Behavior and Cost-Volume-Profit Analysis

Materials, fuel, etc.

Cost is constant in total, but varies inversely with changes in activity

Salaries, property taxes, straight-line depreciation, etc.

Supervision costs, labor costs, etc.

Cost has both a fixed and a variable component

High-low method Simple regression Multiple regression

Applications of Cost Behavior Concepts

Excess of sales over variable costs

Applications of Cost Behavior Concepts

Sales Variable costs Contribution margin Fixed costs Net income

* - assume 1,000 units are sold

Applications of Cost Behavior Concepts

Contribution margin percentage

If sales increase by $100,000, profit will increase by $40,000 ($100,000 * 40%)

Contribution margin per unit

Applications of Cost Behavior Concepts

Volume of sales needed to earn no profit or no loss Revenues = total costs

Applications of Cost Behavior Concepts

The breakeven formulas allow us to play what if games

Sales price is increased (or decreased)

Variable costs are replaced by fixed costs

Applications of Cost Behavior Concepts

The excess of current sales volume over the breakeven point

Current unit sales breakeven unit sales

(Current sales breakeven sales) / current sales

The sales figures may be in dollars or units

Applications of Cost Behavior Concepts

High operating leverage implies high risk, high reward

Applications of Cost Behavior Concepts

Breakeven calculations in a multi-product environment

Assume the mix of products sold remains constant

Applications of Cost Behavior Concepts

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