COST-VOLUME-PROFIT

ANALYSIS
Chapter 22

© 2009 The McGraw-Hill Companies, Inc.,

All Rights Reserved
C1
IDENTIFYING COST BEHAVIOR
Cost-volume-profit analysis is used to answer questions
such as:
 What sales volume is needed to earn a target income?
 What is the change in income if selling prices decline
and sales volume increases?
 How much does income increase if we install a new
machine to reduce labor costs?
 What is the income effect if we change the sales mix
of our products or services?

McGraw-Hill/Irwin Slide 2
C1
FIXED COSTS

Monthly Basic Telephone

Bill per Local Call
Telephone Bill
Monthly Basic

Number of Local Calls Number of Local Calls

Total fixed costs Cost per call

remain constant as declines as
activity increases. activity increases.
McGraw-Hill/Irwin Slide 3
C1
VARIABLE COSTS

Cost per Minute

Total Costs

Minutes Talked Minutes Talked

Total variable costs Cost per Minute

increase as is constant as
activity increases. activity increases.

McGraw-Hill/Irwin Slide 4
C1
MIXED COSTS
Mixed costs contain a fixed portion that is incurred even when
facility is unused, and a variable portion that increases with
usage. Utilities typically behave in this manner.
Total Utility Cost

Variable
Cost per KW

Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
McGraw-Hill/Irwin Slide 5
C1 STEP-WISE COSTS
Total cost increases to a
new higher cost for the next
higher range of activity.

Cost
Total cost remains
constant within a
narrow range of
activity. Activity

McGraw-Hill/Irwin Slide 6
C1
CURVILINEAR COSTS

Costs that increase when activity increases,

but in a nonlinear manner.
Total Cost

Activity
McGraw-Hill/Irwin Slide 7
P1
MEASURING COST BEHAVIOR

The objective is to classify all costs as either fixed

or variable. We will look at three methods:
1. Scatter diagrams.
2. The high-low method.
3. Least–squares regression.

A scatter diagram is a plot of cost data points on a

graph. It is almost always helpful to plot cost data to
be able to observe a visual picture of the relationship
between cost and activity.

McGraw-Hill/Irwin Slide 8
P1
SCATTER DIAGRAMS
Draw a line through the plotted data points so that about
equal numbers of points fall above and below the line.

20

* ** *
1,000’s of Dollars

* *
Total Cost in

**
10 * *
Estimated fixed cost = 10,000

0
0 1 2 3 4 5 6
Activity, 1,000’s of Units Produced

McGraw-Hill/Irwin Slide 9
P1
SCATTER DIAGRAMS

Δ in cost
Unit Variable Cost = Slope =
Δ in units

20

* ** * Vertical
1,000’s of Dollars

* *
Total Cost in

distance
** is the
10 * * change
in cost.
Horizontal distance is
the change in activity.
0
0 1 2 3 4 5 6
Activity, 1,000’s of Units Produced

McGraw-Hill/Irwin Slide 10
P1
THE HIGH-LOW METHOD

The following relationships between units

produced and costs are observed:
Units Cost
High activity level 67,500 $ 29,000
Low activity level 17,500 20,500
Change 50,000 $ 8,500

Using these two levels of activity, compute:

 the variable cost per unit.
 the total fixed cost.
McGraw-Hill/Irwin Slide 11
P1
THE HIGH-LOW METHOD

Units Cost
High activity level 67,500 $ 29,000
Low activity level 17,500 20,500
Change 50,000 $ 8,500

 Variable cost per unit = $8,500 ÷ 50,000 = $0.17 per unit

 Fixed cost = Total cost – Total variable cost
Fixed cost = $29,000 – ($.17 per unit × 67,500 units)
Fixed cost = $29,000 – $11,475 = $17,525
 Total cost = Fixed cost + Variable cost
Y = $17,525 + $0.17 × Units
McGraw-Hill/Irwin Slide 12
P1
LEAST-SQUARES REGRESSION

Least-squares regression is usually covered

in advanced cost accounting courses. It is
commonly used with spreadsheet programs
or calculators.

The objective of the cost

analysis remains the
same: determination of
total fixed cost and the
variable unit cost.
McGraw-Hill/Irwin Slide 13
A2
USING BREAK-EVEN ANALYSIS

The break-even point (expressed in

units of product or dollars of sales) is the
unique sales level at which a company
earns neither a profit nor incurs a loss.

McGraw-Hill/Irwin Slide 14
A2
USING BREAK-EVEN ANALYSIS
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

Contribution margin is the amount by which revenue

exceeds the variable costs of producing the revenue.

How much contribution margin must Rydell Company

have to cover its fixed costs (break even)?
Answer: $24,000
McGraw-Hill/Irwin Slide 15
A2
USING BREAK-EVEN ANALYSIS

Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

How many units must Rydell sell to cover its fixed

costs (break even)?
Answer: $24,000 ÷ $30 per unit = 800 units

McGraw-Hill/Irwin Slide 16
P2
COMPUTING BREAK-EVEN POINT

We have just seen one of the basic CVP

relationships – the break-even computation.

Fixed costs
Break-even point in units =
Contribution margin per unit

Unit sales price less unit variable cost

($30 in previous example)

McGraw-Hill/Irwin Slide 17
P2
COMPUTING BREAK-EVEN POINT

The break-even formula may also be

expressed in sales dollars.

Fixed costs
Break-even point in dollars =
Contribution margin ratio

Unit contribution margin

Unit sales price

McGraw-Hill/Irwin Slide 18
P3
PREPARING A CVP CHART

 Plot total fixed costs on the vertical axis.

Costs and Revenue

Total fixed costs

in Dollars

Total costs

 Draw the total cost line with a slope

equal to the unit variable cost.

Volume in Units
McGraw-Hill/Irwin Slide 19
P3
PREPARING A CVP CHART

 Starting at the origen, draw the sales line Sales

revenue
with a slope equal to the unit sales price.
Costs and Revenue

Total fixed costs

in Dollars

Total costs

Break-even
Point

Volume in Units
McGraw-Hill/Irwin Slide 20
C2
MAKING ASSUMPTIONS IN
COST-VOLUME-PROFIT ANALYSIS

 A limited range of activity called the relevant

range, where CVP relationships are linear.
Unit selling price remains constant.
Unit variable costs remain constant.
Total fixed costs remain constant.
 Production = sales (no inventory changes).

McGraw-Hill/Irwin Slide 21
C2
WORKING WITH CHANGES IN ESTIMATES
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

What happens to the breakeven point if management can

increase the sales price to $105, with no changes in fixed or
variable costs?
Fixed costs
Break-even point in units =
Contribution margin per unit
$24,000
Break-even point in units = = 686 units.
$105 – $70
McGraw-Hill/Irwin Slide 22
C3
COMPUTING INCOME
FROM SALES AND COSTS

Income (pretax) = Sales – Variable costs – Fixed costs

Rydell expects to sell 1,500 units at $100 each next month.

Fixed costs are $24,000 per month and the unit variable
cost is $70. What amount of income should Rydell expect?

Income (pretax) = Sales – Variable costs – Fixed costs

= [1,500 units × $100] – [1,500 units × $70] – $24,000
= $21,000

McGraw-Hill/Irwin Slide 23
C3
COMPUTING SALES
FOR A TARGET INCOME

Break-even formulas may be adjusted to show the

sales volume needed to earn any amount of income.

Fixed costs + Target pretax income

Unit sales =
Contribution margin per unit

Fixed costs + Target pretax income

Dollar sales =
Contribution margin ratio

McGraw-Hill/Irwin Slide 24
C3
COMPUTING SALES
FOR A TARGET INCOME

ABC Co. sells product XYZ at $5.00 per unit. If

fixed costs are $200,000 and variable costs
are $3.00 per unit, how many units must be
sold to earn pretax income of $40,000?

Unit contribution = $5.00 - $3.00 = $2.00

a. 100,000 units
Fixed costs + Target pretax income
b. 120,000 units Unit contribution
c. 80,000 units$200,000 + $40,000
= 120,000 units
d. 200,000 units $2.00 per unit

McGraw-Hill/Irwin Slide 25
C3
COMPUTING SALES (DOLLARS) FOR A
TARGET NET INCOME

To convert target net income to before-tax

income, use the following formula:

Target net income

Before-tax income =
1 - tax rate

McGraw-Hill/Irwin Slide 26
C3
COMPUTING SALES (DOLLARS) FOR A
TARGET NET INCOME
Rydell has a monthly target net income of $9,000. The
unit selling price is $100. Monthly fixed costs are
$24,000, the unit variable cost is $70, and the tax rate is
25 percent.

What is Rydell’s target pretax income?

Target net income

Pretax income =
1 - tax rate

$9,000
Pretax income = = $12,000
1 - .25
McGraw-Hill/Irwin Slide 27
C3
COMPUTING SALES (DOLLARS) FOR A
TARGET NET INCOME
Rydell has a monthly targeted after-tax income of $9,000.
The unit selling price is $100. Monthly fixed costs are
$24,000, the unit variable cost is $70, and the tax rate is
25 percent. Let’s compute the sales revenue that Rydell
will need to earn $12,000 of pretax income?

Fixed costs + Target pretax income

Dollar sales =
Contribution margin ratio

$24,000 + $12,000
Dollar sales = = $120,000
30%
McGraw-Hill/Irwin Slide 28
C3
COMPUTING SALES (UNITS) FOR A
TARGET NET INCOME

The formula for computing dollar sales may be

used to compute unit sales by substituting
contribution per unit in the denominator.

Fixed costs + Target pretax income

Unit sales =
Contribution margin per unit

$24,000 + $12,000
Unit sales = = 1,200 units
$30 per unit

McGraw-Hill/Irwin Slide 29
C3
COMPUTING THE MARGIN OF SAFETY
Margin of safety is the amount by which sales can drop
before the company incurs a loss. Margin of safety may
be expressed as a percentage of expected sales.

Margin of safety Expected sales - Break-even sales

=
percentage Expected sales

If Rydell’s sales are $100,000 and break-even sales are

$80,000, what is the margin of safety percentage?

Margin of safety = $100,000 - $80,000 = 20%

percentage $100,000
McGraw-Hill/Irwin Slide 30
C3
USING SENSITIVITY ANALYSIS
Rydell Company is considering buying a new machine
that would increase monthly fixed costs from $24,000 to
$30,000, but decrease unit variable costs from $70 to $60.
The $100 per unit selling price would remain unchanged.
What is the new breakeven point in dollars?

Revised Break-even Revised fixed costs

=
point in dollars Revised contribution margin ratio

Revised Break-even $30,000

= = $75,000
point in dollars 40%

McGraw-Hill/Irwin Slide 31
P4
COMPUTING MULTIPRODUCT
BREAK-EVEN POINT

The CVP formulas may be modified for use when a

company sells more than one product.
 The unit contribution margin is replaced with the
contribution margin for a composite unit.
 A composite unit is composed of specific numbers of
each product in proportion to the product sales mix.
 Sales mix is the ratio of the volumes of the various
products.

McGraw-Hill/Irwin Slide 32
P4
COMPUTING MULTIPRODUCT
BREAK-EVEN POINT

The resulting break-even formula

for composite unit sales is:

Break-even point Fixed costs

= Contribution margin
in composite units
per composite unit

Consider the following example:

Continue

McGraw-Hill/Irwin Slide 33
P4
COMPUTING MULTIPRODUCT
BREAK-EVEN POINT
Hair-Today offers three cuts as shown below. Annual fixed
costs are $192,000. Compute the break-even point in
composite units and in number of units for each haircut at the
given sales mix.

Haircuts
Basic Ultra Budget
Selling Price $ 20.00 $ 32.00 $ 16.00
Variable Cost 13.00 18.00 8.00
Unit Contribution $ 7.00 $ 14.00 $ 8.00
Sales Mix Ratio 4 2 1

A 4:2:1 sales mix means that if there are 500 budget cuts,
then there will be 1,000 ultra cuts, and 2,000 basic cuts.
McGraw-Hill/Irwin Slide 34
P4
COMPUTING MULTIPRODUCT
BREAK-EVEN POINT
Step 1: Compute contribution margin per
composite unit.

Haircuts
Basic Ultra Budget
Selling Price $20.00 $32.00 $16.00
Variable Cost 13.00 18.00 8.00
Unit Contribution $7.00 $14.00 $8.00
Sales Mix Ratio ×4 ×2 ×1
Weighted Contribution $ 28.00 + $ 28.00 + $ 8.00 = $ 64.00

Contribution margin per composite unit

McGraw-Hill/Irwin Slide 35
P4
COMPUTING MULTIPRODUCT
BREAK-EVEN POINT
Step 2: Compute break-even point in
composite units.
Break-even point Fixed costs
= Contribution margin
in composite units
per composite unit

Break-even point $192,000

= $64.00 per
in composite units
composite unit
Break-even point = 3,000 composite units
in composite units

McGraw-Hill/Irwin Slide 36
P4
COMPUTING MULTIPRODUCT
BREAK-EVEN POINT
Step 3: Determine the number of each haircut
that must be sold to break even.

Sales Composite
Product Mix Cuts Haircuts
Basic 4 × 3,000 = 12,000
Ultra 2 × 3,000 = 6,000
Budget 1 × 3,000 = 3,000

McGraw-Hill/Irwin Slide 37
P4
MULTIPRODUCT BREAK-EVEN
INCOME STATEMENT
Step 4: Verify the results.

Haircuts
Basic Ultra Budget Combined
Selling Price $ 20.00 $ 32.00 $ 16.00
Variable Cost 13.00 18.00 8.00
Unit Contribution $ 7.00 $ 14.00 $ 8.00
Sales Volume × 12,000 × 6,000 × 3,000
Total Contribution $ 84,000 $ 84,000 $ 24,000 $ 192,000
Fixed Costs 192,000
Income $ 0

McGraw-Hill/Irwin Slide 38
A3
DEGREE OF OPERATING LEVERAGE

A measure of the extent to which fixed costs are

being used in an organization.

A measure of how a percentage change in

sales will affect profits.

Contribution margin = Degree of operating leverage

Net income

McGraw-Hill/Irwin Slide 39
A3
OPERATING LEVERAGE
Rydell Company
Sales (1,200 units) $120,000
Less: variable expenses 84,000
Contribution margin 36,000
Less: fixed expenses 24,000
Net income $ 12,000

Contribution margin = Degree of operating leverage = $36,000 = 3.0

Net income $12,000

If Rydell increases sales by 10 percent, what will the percentage

increase in income be?

Percent increase in sales 10%

Degree of operating leverage × 3
Percent increase in income 30%
McGraw-Hill/Irwin Slide 40
 END OF CHAPTER 22

McGraw-Hill/Irwin Slide 41