Cost Behavior and CostVolume-Profit Analysis

Cost Behavior

Variable 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 Cost
Total Variable Cost Graph
$300,000 $250,000 $200,000 $150,000 $100,000 $50,000

Total Costs

0 10 20 30 Units Produced (in thousands)

Variable Cost
Unit Variable Cost Graph
$20 Cost per Unit $15

$10
$5

10 20 30 Units Produced (000)

Variable Cost
$300,000 $250,000 $200,000 $150,000 $100,000 $50,000 0 10 20 30 Units Produced (000) Number of Units Produced Direct Materials Cost per Unit Total Direct Materials Cost

Total Costs

Cost per Unit

$20 $15 $10 $5 0 10 20 30 Units Produced (000)

5,000 units 10,000 15,000 20,000 25,000 30,000

$10 10 10 10 10 10

$ 50,000 l00,000 150,000 200,000 250,000 300,000

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

La Fleur

Fixed Costs
Number of Bottles Produced 50,000 bottles 100,000 15,000 20,000 25,000 30,000 Total Salary for Jane Sovissi $75,000 75,000 75,000 75,000 75,000 75,000 Salary per Bottle Produced $1.500 0.750 0.500 0.375 0.300 0.250

Fixed Costs
Total Fixed Cost Graph
$150,000 $125,000 $100,000 $75,000 $50,000 $25,000 0 100 200 300 Bottles Produced (000) Number of Bottles Produced Total Salary for Jane Sovissi

Unit Fixed Cost Graph

$1.50 $1.25 $1.00 $.75 $.50 $.25 0 100 200 300 Units Produced (000) Cost per Unit

Total Costs

Salary per Bottle Produced

50,000 bottles 100,000 15,000 20,000 25,000 30,000

$75,000 75,000 75,000 75,000 75,000 75,000

$1.500 0.750 0.500 0.375 0.300 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 Costs
Total Mixed Cost Graph
$45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 0 10 20 30 40 Total Machine Hours (000)

Mixed costs are sometimes called semivariable or semifixed costs. Mixed costs are usually separated into their fixed and variable components for management analysis.

Total Costs

Mixed Costs
The high-low method is a simple way to separate mixed costs into their fixed and variable components.

High-Low Method
Actual costs incurred

ProductionTotal (Units) Cost

June July August September October 1,000 $45,550 1,500 52,000 2,100 61,500 1,800 57,500 750 41,250

What month has the highest level of activity in terms of cost?

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

June July August September October 1,000 $45,550 1,500 52,000 2,100 61,500 1,800 57,500 750 41,250

What month has the highest level of activity in terms of cost?

$61,500 minus lowest level of activity ($) Variable cost per unit = Highest level of activity (n) minus lowest level of activity (n)

High-Low Method
Actual costs incurred

ProductionTotal (Units) Cost

June July August September October 1,000 $45,550 1,500 52,000 2,100 61,500 1,800 57,500 750 41,250

For the highest level of cost, what is the level of production?

$61,500 minus lowest level of activity ($) Variable cost per unit = Highest level of activity (n) minus 2,100 minus lowest level of lowest activity level of (n) activity (n)

High-Low Method
Actual costs incurred

ProductionTotal (Units) Cost

June July August September October 1,000 $45,550 1,500 52,000 2,100 61,500 1,800 57,500 750 41,250

What month has the lowest level of activity in terms of cost?

Variable cost per unit =

$61,500 minus lowest level of $61,500 $41,250 activity ($) 2,100 minus lowest level of 2,100 750 activity (n)

High-Low Method
Actual costs incurred

ProductionTotal (Units) Cost

June July August September October 1,000 $45,550 1,500 52,000 2,100 61,500 1,800 57,500 750 41,250

What is the variable cost per unit?

$20,250 $57,500 $41,250 Variable cost per unit = $15 1,350 2,100 750

High-Low Method
Actual costs incurred

ProductionTotal (Units) Cost

June July August September October 1,000 $45,550 1,500 52,000 2,100 61,500 1,800 57,500 750 41,250

Variable cost per unit = $15

What is the total fixed cost (using the highest level)?

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 (Units) Cost

June July August September October 1,000 $45,550 1,500 52,000 2,100 61,500 1,800 57,500 750 41,250

Variable cost per unit = $15

The fixed cost is the same at the lowest level.

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
Total Variable Costs
Total Costs

Fixed Costs
Total Fixed Costs
Total Costs

Unit costs remain the sameTotal per Units unit Produced regardless Review of activity. Total costs increase and
Per Unit Cost

Total Units Produced Total Units Produced

Per Unit Cost

increases proportionately Unit Variable Costs with activity level.

Unit costs increase and decreases with Total Units level. Produced activity Total remain Unitcosts Fixed Costs the same regardless of activity.

Contribution Margin Income Statement

Sales (50,000 units) Variable costs Contribution margin Fixed costs Income from operations

The contribution margin is available to cover the fixed costs and income from operations. Contribution
$1,000,000 600,000 $ 400,000 300,000 $ 100,000

margin

FIXED COSTS

Income from Operations

Contribution Margin Income Statement

Sales (50,000 units) Variable costs Contribution margin Fixed costs Income from operations $1,000,000 600,000 $ 400,000 300,000 $ 100,000

Sales

Variable costs Variable costs

Fixed + costs

Income from operations

Sales

Contribution margin

Contribution Margin Ratio

Sales (50,000 units) Variable costs Contribution margin Fixed costs Income from operations $1,000,000 600,000 $ 400,000 300,000 $ 100,000

100% 60% 40% 30% 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) Variable costs Contribution margin Fixed costs Income from operations $1,000,000 600,000 $ 400,000 300,000 $ 100,000

100% 60% 40% 30% 10%

$20 12 $ 8

The contribution margin can be expressed three ways: 1. Total contribution margin in dollars. 3. Contribution margin ratio (percentage). 3. Unit contribution margin (dollars per unit).

What is the break-even point?

Revenues

Costs

Break-even

Calculating the Break-Even Point

Sales (? units) Variable costs Contribution margin Fixed costs Income from operations ? ? $ 90,000 90,000 $ 0 $ $25 15 $10

At the break-even point, fixed costs and the contribution margin are equal.

Calculating the Break-Even Point

In Units
Sales ($25 Sales ($25 xx ?9,000) units) $ Variable costs ($15 Variable costs ($15 xx ?9,000) units) Contribution margin Contribution margin $ Fixed costs Fixed costs Income from operations Income from operations $ $225,000 ? 135,000 ? $90,000 90,000 90,000 90,000 $ 00 $25 15 $10

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

PROOF!

Calculating the Break-Even Point

In Units
Sales ($250 x ? units) $ ? Variable costs ($145 x ? units) ? Contribution margin $ ? Fixed costs 840,000 Income from operations $ 0 $250 145 $105

$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 the Break-Even Point

In Units
Sales ($25 x ?Next, units) assume$ ? variable Variable costs ($15 x ?costs units) is ? Contribution margin by $5. $ ? increased Fixed costs 840,000 Income from operations $ 0 $250 145 150 $105 $100

$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 the Break-Even Point

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

$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 the Break-Even Point

In Units

Management increases Salesthe selling price from $ Variable costs $50 to $60.
Contribution margin Fixed costs Income from operations

? ? $ ? $600,000 $ 0

$60 $50 30 $30 $20

$600,000 Fixed costs Break-even sales (units) = 20,000 units $30 margin Unit contribution

Summary of Effects of Changes on Break-Even Point

Target Profit
Sales (? units) Variable costs Contribution margin Fixed costs Income from operations $ ? ? $ ? 200,000 $ 0

In Units

$75 45 $35

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 Profit
Sales (? units) Variable costs Contribution margin Fixed costs Income from operations $ ? ? $ ? 200,000 $ 0

In Units

Target profit is $75 here to refer used 45 to Income from $35 operations.

Fixed costs + target profit $200,000 $100,000 Sales (units) = 10,000 units Unit contribution margin $30

Target Profit
Sales (10,000 units x $75) $750,000 Variable costs (10,000 x $45) 450,000 Contribution margin $300,000 Fixed costs 200,000 Income from operations $100,000 $75 45 $30

Proof that sales of 10,000 units will provide a profit of $100,000.

Graphic Approach to Cost-Volume-Profit Analysis

Cost-Volume-Profit Chart
$500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 0
Sales and Costs ($000)

Total Sales

60%
1 2 3 4 5 6 7 Units of Sales (000) 8 9 10

Variable Costs

Unit selling price $ 50 Unit variable cost 30 Unit contribution margin $ 20 Total fixed costs $100,000

Cost-Volume-Profit Chart
$500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 0
Sales and Costs ($000)

Contribution Margin

40%

60%
1 2 3 4 5 6 7 Units of Sales (000) 8 9 10

Unit selling price $ 50 100% Unit variable cost 30 60% Unit contribution margin $ 20 40% Total fixed costs $100,000

Cost-Volume-Profit Chart
$500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 0
Sales and Costs ($000)

Total Costs Fixed Costs

4 5 6 7 Units of Sales (000)

9 10

Unit selling price $ 50 100% Unit variable cost 30 60% Unit contribution margin $ 20 40% Total fixed costs $100,000

Cost-Volume-Profit Chart
$500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 0
Sales and Costs ($000)

Break-Even Point

4 5 6 7 Units of Sales (000)

9 10

Unit selling price $ 50 100% Unit variable cost 30 60% Unit contribution margin $ 20 40% Total fixed costs $100,000

$100,000 = 5,000 units $20

Cost-Volume-Profit Chart
$500 $450 $400 $350 $300 $250 $200 $150 $100 $ 50 0 Sales and Costs ($000)

Operating Profit Area

Operating Loss Area

Units of Sales (000)

Unit selling price $ 50 100% Unit variable cost 30 60% Unit contribution margin $ 20 40% Total fixed costs $100,000

$100 $75 $50 $25 $ 0 $(25) $(50) $(75) $(100) 1 2 3 4 5 6 7 Units of Sales (000s)

Operating Profit (Loss) $000s

Relevant range is 8 10,000 9 10 units

$500,000 300,000 $200,000 100,000 $100,000

Sales (10,000 units x $50) Variable costs (10,000 units x $30) Contribution margin (10,000 units x $20) Fixed costs Operating profit

$100 $75 $50 $25 $ 0 $(25) Operating loss $(50) $(75) $(100) 1 2 3

Operating Profit (Loss) $000s

Profit Line

Operating profit

Maximum profit within the relevant 10 range.

$500,000 300,000 $200,000 100,000 $100,000

Units of Sales (000s) Maximum loss is equal (10,000 to the total Sales units x $50) fixed costs. Variable costs (10,000 units x $30) Contribution margin (10,000 units x $20) Fixed costs Operating profit

$100 $75 $50 $25 $ 0 $(25) Operating loss $(50) $(75) $(100) 1 2 3

Operating Profit (Loss) $000s

Operating profit
Break-Even Point

9 10

Units of Sales (000s)

Sales (10,000 units x $50) Variable costs (10,000 units x $30) Contribution margin (10,000 units x $20) Fixed costs Operating profit

$500,000 300,000 $200,000 100,000 $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 Companys 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 Mix Considerations

Products A B $ 90 $140 70 95 $ 20 $ 45 80% 20% $16 $ 9 $25 Fixed costs, $200,000

Sales Variable costs Contribution margin Sales mix Product contribution margin

Sales Mix Considerations

Product contribution margin Products A B $16 $ 9 $25
Break-even sales units

$200,000 $25

Fixed costs, $200,000

Sales Mix Considerations

Product contribution margin Products A B $16 $ 9 $25
Break-even sales units

$200,000 $25

= 8,000 units

Fixed costs, $200,000

Sales Mix Considerations

Product contribution margin Products A B $16 $ 9 $25 A: 8,000 units x Sales Mix (80%) = B: 8,000 units x Sales Mix (20%) = 6,400 1,600

Product A Product B Sales: 6,400 units x $90 1,600 units x $140 Total sales Variable costs: 6,400 x $70 1,600 x $95 Total variable costs Contribution margin $576,000 $576,000 $448,000 $448,000 $128,000

Total $576,000 224,000 $800,000 $448,000 152,000 $600,000 $200,000

$224,000 $224,000

$152,000 $152,000 $ 72,000

Fixed costs Income from operations

Break-even point PROOF

200,000 $ 0

Margin of Safety

Margin of Safety = Margin of Safety =

Sales Sales at break-even point Sales $250,000 $200,000 $250,000

Margin of Safety = 20%

The margin of safety indicates the possible decrease in sales that may occur before an operating loss results.

Assumptions of Cost-Volume-Profit 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.