5 Cost-Volume-Profit

Learning Objectives
1 Explain variable, fixed, and mixed costs and the relevant range.

Apply the high-low method to determine the components of

2 mixed costs.

Prepare a CVP income statement to determine contribution

3 margin.

4 Compute the break-even point using three approaches.

Determine the sales required to earn target net income and

5 determine margin of safety.
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LEARNING Explain variable, fixed, and mixed costs and the
OBJECTIVE
1 relevant range.

Cost Behavior Analysis is the study of how specific costs

respond to changes in the level of business activity.
 Some costs change; others remain the same.

 Helps management plan operations and decide between

alternative courses of action.

 Applies to all types of businesses and entities.

 Starting point is measuring key business activities.

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 Cost Behavior Analysis

Cost Behavior Analysis is the study of how specific costs

respond to changes in the level of business activity.
 Activity levels may be expressed in terms of:
► Sales dollars (in a retail company)
► Miles driven (in a trucking company)
► Room occupancy (in a hotel)
► Dance classes taught (by a dance studio)

 Many companies use more than one measurement base.

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 Cost Behavior Analysis

Cost Behavior Analysis is the study of how specific costs

respond to changes in the level of business activity.
 Changes in the level or volume of activity should be
correlated with changes in costs.
 Activity level selected is called activity or volume index.
 Activity index:
► Identifies the activity that causes changes in the behavior
of costs.
► Allows costs to be classified as variable, fixed, or mixed.

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 Variable Costs

 Costs that vary in total directly and proportionately with

changes in the activity level.
► Example: If the activity level increases 10 percent, total
variable costs increase 10 percent.
► Example: If the activity level decreases by 25 percent,
total variable costs decrease by 25 percent.
 Variable costs remain the same per unit at every level of
activity.

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 Variable Costs

Illustration: Damon Company manufactures tablet computers that

contain a $10 camera. The activity index is the number of
tablets produced. As Damon Illustration 5-1

manufactures each tablet, the total cost

of the cameras used increases by $10.
As part (a) of Illustration 5-1 shows,
total cost of the cameras will be $20,000
if Damon produces 2,000 tablets, and
$100,000 when it produces 10,000
tablets. We also can see that a variable
cost remains the same per unit as the
level of activity changes.

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 Variable Costs

Illustration: Damon Company manufactures tablet computers that

contain a $10 camera. The activity index is the number of
tablets produced. As Damon Illustration 5-1
manufactures each tablet, the total cost
of the cameras used increases by $10.
As part (b) of Illustration 5-1 shows, the
unit cost of $10 for the camera is the
same whether Damon produces 2,000 or
10,000 tablets.

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 Variable Costs

Illustration 5-1
Behavior of total and
unit variable costs

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 Fixed Costs

 Costs that remain the same in total regardless of

changes in the activity level within a relevant range.
 Fixed cost per unit cost varies inversely with activity:
As volume increases, unit cost declines, and vice versa
 Examples:
► Property taxes
► Insurance
► Rent
► Depreciation on buildings and equipment

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 Fixed Costs

Illustration: Damon Company leases its productive facilities at a cost

of $10,000 per month. Total fixed costs of the
facilities will remain constant at every Illustration 5-2

level of activity, as part (a) of Illustration

5-2 shows.

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 Fixed Costs

Illustration: Damon Company leases its productive facilities at a cost

of $10,000 per month. Total fixed costs of the
facilities will remain constant at every Illustration 5-2

level of activity. But, on a per unit

basis, the cost of rent will decline as
activity increases, as part (b) of
Illustration 5-2 shows. At 2,000 units, the
unit cost per tablet computer is $5
($10,000 ÷ 2,000). When Damon
produces 10,000 tablets, the unit cost of
the rent is only $1 per tablet ($10,000 ÷
10,000).

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 Fixed Costs

Illustration 5-2
Behavior of total and
unit fixed costs

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 Fixed Costs

Question
Variable costs are costs that:

a. Vary in total directly and proportionately with changes

in the activity level.
b. Remain the same per unit at every activity level.
c. Neither of the above.
d. Both (a) and (b) above.

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 Relevant Range

 Throughout the range of possible levels of activity, a

straight-line relationship usually does not exist for either
variable costs or fixed costs.
 Relationship between variable costs and changes in
activity level is often curvilinear.

 For fixed costs, the

relationship is also nonlinear –
some fixed costs will not change
over the entire range of activities,
while other fixed costs may
change.

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 Relevant Range

Illustration 5-3
Nonlinear behavior of
variable and fixed costs

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 Relevant Range

Range of activity over which a company expects to

operate during a year. Illustration 5-4
Linear behavior within
relevant range

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 Relevant Range

Question
The relevant range is:
a. The range of activity in which variable costs will be
curvilinear.
b. The range of activity in which fixed costs will be
curvilinear.
c. The range over which the company expects to operate
during a year.
d. Usually from zero to 100% of operating capacity.

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 Mixed Costs

 Costs that have both a variable element and a fixed

element.
 Change in total but not proportionately with changes in
activity level.

Illustration 5-5
Behavior of a mixed cost

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 1 Types of Costs

Helena Company, reports the following total costs at two levels

of production.

Classify each cost as variable, fixed, or mixed.

Variable
Fixed
Mixed

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 LEARNING Apply the high-low method to determine the
OBJECTIVE
2 components of mixed costs.

High-Low Method
 High-Low Method uses the total costs incurred at the high
and the low levels of activity to classify mixed costs into
fixed and variable components.
 The difference in costs between the high and low levels
represents variable costs, since only variable-cost element
can change as activity levels change.

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 High-Low Method

STEP 1: Determine variable cost per unit using the following

formula:

Illustration 5-6
Formula for variable cost per
unit using high-low method

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 High-Low Method

Illustration: Metro Transit Company has the

following maintenance costs and mileage data for
Illustration 5-7
its fleet of buses over a 6-month period. Assumed maintenance
costs and mileage data

Change in Costs (63,000 - 30,000) $33,000 $1.10

= cost per
High minus Low (50,000 - 20,000) 30,000
unit

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 High-Low Method

STEP 2: Determine the fixed cost by subtracting

the total variable cost at either the high or the low Illustration 5-8
High-low method
activity level from the total cost at that activity level. computation of
fixed costs

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 High-Low Method

Maintenance costs are therefore $8,000 per month of fixed

costs plus $1.10 per mile of variable costs. This is
represented by the following formula:

Maintenance costs = $8,000 + ($1.10 x Miles driven)

Example: At 45,000 miles, estimated maintenance costs would

be:
Fixed
Variable $ 8,000
($1.10 x 45,000)

49,500
$57,500

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 High-Low Method

Illustration 5-9
Scatter plot for Metro
Transit Company
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 High-Low Method

Question
Mixed costs consist of a:
a. Variable cost element and a fixed cost element.
b. Fixed cost element and a controllable cost element.
c. Relevant cost element and a controllable cost
element.
d. Variable cost element and a relevant cost element.

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 2 High-Low Method

Byrnes Company accumulates the following data concerning a mixed

cost, using units produced as the activity level.

(a) Compute the variable- and fixed-cost elements using the high-low
method.
(b) Estimate the total cost if the company produces 8,000 units.

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 2 High-Low Method

(a) Compute the variable and fixed cost elements using the high-low
method.

Variable cost: ($14,740 - $11,100) / (9,800 - 7,000) = $1.30 per unit

Fixed cost: $14,740 - $12,740 ($1.30 x 9,800 units) = $2,000
or $11,100 - $9,100 ($1.30 x 7,000) = $2,000

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 2 High-Low Method

(b) Estimate the total cost if the company produces 8,000 units.

Total cost (8,000 units): $2,000 + $10,400 ($1.30 x 8,000) = $12,400

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 LEARNING Prepare a CVP income statement to determine
OBJECTIVE
3 contribution margin.

Cost-volume-profit (CVP) analysis is the study of the

effects of changes in costs and volume on a company’s profits.
 Important in profit planning.
 Critical factor in management decisions as
► Setting selling prices,
► Determining product mix, and
► Maximizing use of production facilities.

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 Cost-Volume-Profit Analysis

Basic Components

Illustration 5-10
Components of CVP analysis

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 Basic Components

Assumptions
 Behavior of both costs and revenues is linear throughout
the relevant range of the activity index.
 Costs can be classified accurately as either variable or
fixed.
 Changes in activity are the only factors that affect costs.
 All units produced are sold.
 When more than one type of product is sold, the sales mix
will remain constant.

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 Basic Components

Question
Which of the following is not involved in CVP analysis?
a. Sales mix.
b. Unit selling prices.
c. Fixed costs per unit.
d. Volume or level of activity.

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 Cost-Volume-Profit Analysis

CVP Income Statement

 A statement for internal use.
 Classifies costs and expenses as fixed or variable.
 Reports contribution margin in the body of the
statement.
► Contribution margin – amount of revenue remaining
after deducting variable costs.
 Reports the same net income as a traditional income
statement.

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 CVP Income Statement

Illustration: Vargo Video Company produces a high-definition

digital camcorder. Relevant data for the camcorders sold by
this company in June 2014 are as follows.

Illustration 5-11
Assumed selling and cost data
for Vargo Video

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 CVP Income Statement

Illustration: The CVP income statement for Vargo Video

therefore would be reported as follows.

Illustration 5-12
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 CVP Income Statement

UNIT CONTRIBUTION MARGIN

 Contribution margin is available to cover fixed costs
and to contribute to income.
 Formula for contribution margin per unit and the
computation for Vargo Video are:

Illustration 5-13
Formula for unit contribution margin

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 CVP Income Statement

UNIT CONTRIBUTION MARGIN

Vargo’s CVP income statement assuming a zero net income.

Illustration 5-14
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 CVP Income Statement

UNIT CONTRIBUTION MARGIN

Assume that Vargo sold one more camcorder, for a total of 1,001
camcorders sold.
Illustration 5-15

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 CVP Income Statement

CONTRIBUTION MARGIN RATIO

 Shows the percentage of each sales dollar available to
apply toward fixed costs and profits.
 Formula for contribution margin ratio and the
computation for Vargo Video are:

Illustration 5-17
Formula for contribution
margin ratio

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 CVP Income Statement

CONTRIBUTION MARGIN RATIO

Illustration 5-16
CVP income statement, with
net income and percent of sales
data

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 CVP Income Statement

CONTRIBUTION MARGIN RATIO

Assume Vargo Video’s current sales are $500,000 and it wants to
know the effect of a $100,000 (200-unit) increase in sales.

Illustration 5-18

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 CVP Income Statement

Question
Contribution margin:
a. Is revenue remaining after deducting variable costs.
b. May be expressed as contribution margin per unit.
c. Is selling price less cost of goods sold.
d. Both (a) and (b) above.

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 3 CVP Income Statement

Ampco Industries produces and sells a cell phone-operated

thermostat. Information regarding the costs and sales of
thermostats during September 2017 are provided below.
Unit selling price of thermostat $85
Unit variable costs $32
Total monthly fixed costs $190,000
Units sold 4,000
Prepare a CVP income statement for Ampco Industries for the
month of September. Provide per unit values and total values.

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 3 CVP Income Statement

Prepare a CVP income statement for Ampco Industries for the

month of September. Provide per unit values and total values.

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 LEARNING Compute the break-even point using three
OBJECTIVE
4 approaches.

Break-Even Analysis
 Process of finding the break-even point level of activity at
which total revenues equal total costs (both fixed and
variable).
 Can be computed or derived
► from a mathematical equation,
► by using contribution margin, or
► from a cost-volume profit (CVP) graph.
 Expressed either in sales units or in sales dollars.

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 Mathematical Equation

Break-even occurs where total sales equal variable costs plus

fixed costs; i.e., net income is zero

Computation
of break-
even point in
units.

Illustration 5-20

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 Contribution Margin Technique

 At the break-even point, contribution margin must equal total

fixed costs
(CM = total revenues – variable costs)
 Break-even point can be computed using either contribution
margin per unit or contribution margin ratio.

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 Break-Even Analysis

CONTRIBUTION MARGIN IN UNITS

 When the break-even-point in units is desired,
contribution margin per unit is used in the following
formula which shows the computation for Vargo Video:

Illustration 5-21
Formula for break-even point
in units using unit contribution
margin

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 Break-Even Analysis

CONTRIBUTION MARGIN RATIO

 When the break-even-point in dollars is desired,
contribution margin ratio is used in the following formula
which shows the computation for Vargo Video:

Illustration 5-22
Formula for break-even point
in dollars using contribution
Margin ratio

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 Graphic Presentation

Because this
graph also shows
costs, volume, and
profits, it is
referred to as a
cost-volume-
profit (CVP)
graph.

Illustration 5-23
CVP graph

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 Break-Even Analysis

Question
Gossen Company is planning to sell 200,000 pliers for $4
per unit. The contribution margin ratio is 25%. If Gossen
will break even at this level of sales, what are the fixed
costs?
a. $100,000.
b. $160,000.
c. $200,000.
d. $300,000.

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 4 Break-Even Analysis

Lombardi Company has a unit selling price of $400, variable

costs per unit of $240, and fixed costs of $180,000. Compute
the break-even point in units using (a) a mathematical
equation and (b) contribution margin per unit.
Illustration 5-19

Sales Variable Fixed Net

- - =
Costs Costs Income

$400Q - $240Q - $180,000 = 0

$160Q - $180,000
Q = 1,125 units

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 4 Break-Even Analysis

Lombardi Company has a unit selling price of $400, variable

costs per unit of $240, and fixed costs of $180,000. Compute
the break-even point in units using (a) a mathematical
equation and (b) contribution margin per unit.
Illustration 5-21

Fixed Contribution Break-Even

÷ =
Costs Margin per Unit Point in Units

$180,000 ÷ $160 = 1,125 units

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 LEARNING Determine the sales required to earn target net
OBJECTIVE
5 income and determine margin of safety.

Target Net Income

 Level of sales necessary to achieve a specified income.
 Can be determined from each of the approaches used to
determine break-even sales/units:
► from a mathematical equation,
► by using contribution margin technique, or
► from a cost-volume profit (CVP) graph.
 Expressed either in sales units or in sales dollars.

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 Target Net Income

MATHEMATICAL EQUATION
Formula for required sales to meet target net income.
Illustration 5-24

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 Target Net Income

MATHEMATICAL EQUATION
Using the formula for the break-even point, simply include the
desired net income as a factor.
Illustration 5-25

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 Target Net Income

CONTRIBUTION MARGIN TECHNIQUE

To determine the required sales in units for Vargo Video:

Illustration 5-26
Formula for required sales in
units using unit contribution
margin

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 Target Net Income

CONTRIBUTION MARGIN TECHNIQUE

To determine the required sales in dollars for Vargo Video:

Illustration 5-27
Formula for required sales
in dollars using contribution
margin ratio

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 Target Net Income

GRAPHIC
PRESENTATION
Suppose Vargo Video
sells 1,400 camcorders.
Illustration 5-23 shows
that a vertical line drawn
at 1,400 units intersects
the sales line at $700,000
and the total cost line at
$620,000. The difference
between the two amounts
represents the net income
(profit) of $80,000.

Illustration 5-23

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 Target Net Income

Question
The mathematical equation for computing required sales to
obtain target net income is:
Required sales =
a. Variable costs + Target net income.
b. Variable costs + Fixed costs + Target net income.
c. Fixed costs + Target net income.
d. No correct answer is given.

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 Margin of Safety

 Difference between actual or expected sales and sales

at the break-even point.
 Measures the “cushion” that a particular level of sales
provides.
 May be expressed in dollars or as a ratio.
 Assuming actual/expected sales are $750,000:

Illustration 5-28
Formula for margin of safety
in dollars

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 Margin of Safety Ratio

 Computed by dividing the margin of safety in dollars by

the actual (or expected) sales.
 Assuming actual/expected sales are $750,000:
Illustration 5-29

 The higher the dollars or percentage, the greater the

margin of safety.

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 Margin of Safety

Question
Marshall Company had actual sales of $600,000 when break-
even sales were $420,000. What is the margin of safety ratio?
a. 25%.
b. 30%.
c. 33 1/3%.
d. 45%.

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 5 Break-Even, Margin of Safety, and Target Net
Comprehensive
Income

Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
following:

a) break-even point in dollars using the contribution margin

(CM) ratio;

b) the margin of safety and margin of safety ratio assuming

actual sales are $1,382,400; and

c) the sales dollars required to earn net income of

$410,000.

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 5 Break-Even, Margin of Safety, and Target Net
Comprehensive
Income

Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute
break-even point in dollars using the contribution margin
(CM) ratio.

Contribution margin ratio = [($56 - $42) ÷ $56] = 25%

Break-even sales in dollars = $320,000 ÷ 25% = $1,280,000

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 5 Break-Even, Margin of Safety, and Target Net
Comprehensive
Income

Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
margin of safety and margin of safety ratio assuming
actual sales are $1,382,400.

Margin of safety = $1,382,400 - $1,280,000 = $102,400

Margin of safety ratio = $102,400 ÷ $1,382,400 = 7.4%

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 5 Break-Even, Margin of Safety, and Target Net
Comprehensive
Income

Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
sales dollars required to earn net income of $410,000.

Required sales in dollars =

($320,000 + $410,000) ÷ 25% = $2,920,000

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