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Cost Classifications for
Predicting Cost Behavior
How a cost will react to
changes in the level of
business activity.
– Total variable costs
change when activity
changes.
– Total fixed costs remain
unchanged when activity
changes.
How a cost will react to
changes in the level of
business activity.
– Total variable costs
change when activity
changes.
– Total fixed costs remain
unchanged when activity
changes.
Total Variable Cost
Your total long distance telephone bill is
based on how many minutes you talk.
Minutes Talked
TotalLongDistance
TelephoneBill
Variable Cost Per Unit
Minutes Talked
PerMinute
TelephoneCharge
The cost per long distance minute talked is
constant. For example, 10 cents per minute.
Total Fixed Cost
Your monthly basic telephone bill probably
does not change when you make more local
calls.
Number of Local Calls
MonthlyBasic
TelephoneBill
Fixed Cost Per Unit
Number of Local Calls
MonthlyBasicTelephone
BillperLocalCall
The average cost per local call decreases as more
local calls are made.
Cost Classifications for
Predicting Cost Behavior
Behavior of Cost (within the relevant range)
Cost In Total Per Unit
Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
The Activity Base
A measure of the
event that causes
the incurrence of a
variable cost – a
cost driver
A measure of the
event that causes
the incurrence of a
variable cost – a
cost driver
Units
produced
Units
produced
Miles
driven
Miles
driven
Labor
hours
Labor
hours
Machine
hours
Machine
hours
Step-Variable Costs
Activity
Cost
Total cost remains
constant within a
narrow range of
activity.
Total cost remains
constant within a
narrow range of
activity.
Step-Variable Costs
Activity
Cost
Total cost increases to a
new higher cost for the
next higher range of
activity.
Total cost increases to a
new higher cost for the
next higher range of
activity.
Relevant
Range
A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.
A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.
Activity
TotalCost
Economist’s
Curvilinear Cost
Function
The Linearity Assumption and
the Relevant Range
Accountant’s Straight-Line
Approximation (constant
unit variable cost)
Exh.
5-4
Cost Behavior
Merchandisers
Cost of Goods Sold
Merchandisers
Cost of Goods Sold
Manufacturers
Direct Material, Direct
Labor, and Variable
Manufacturing Overhead
Manufacturers
Direct Material, Direct
Labor, and Variable
Manufacturing Overhead
Merchandisers and
Manufacturers
Sales commissions and
shipping costs
Merchandisers and
Manufacturers
Sales commissions and
shipping costs
Service Organizations
Supplies and travel
Service Organizations
Supplies and travel
Examples of normally variable costsExamples of normally variable costs
Examples of normally fixed costsExamples of normally fixed costs
Merchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salaries
Depreciation, Advertising
Merchandisers, manufacturers, and
service organizations
Real estate taxes, Insurance, Sales salaries
Depreciation, Advertising
Examples
Advertising and
Research and
Development
Examples
Advertising and
Research and
Development
Examples
Depreciation on
Buildings and
Equipment
Examples
Depreciation on
Buildings and
Equipment
Types of Fixed Costs
Discretionary
May be altered in the
short-term by current
managerial decisions
Discretionary
May be altered in the
short-term by current
managerial decisions
Committed
Long-term, cannot be
reduced in the short
term.
Committed
Long-term, cannot be
reduced in the short
term.
RentCostin
ThousandsofDollars
0 1,000 2,000 3,000
Rented Area (Square Feet)
0
30
60
Fixed Costs and Relevant Range
90
Relevant
Range
Total cost doesn’t
change for a wide
range of activity,
and then jumps to a
new higher cost for
the next higher
range of activity.
Total cost doesn’t
change for a wide
range of activity,
and then jumps to a
new higher cost for
the next higher
range of activity.
Exh.
5-6
Fixed Monthly
Utility Charge
Variable
Cost per KW
Activity (Kilowatt
Hours)
TotalUtilityCost
X
Y
A mixed cost has both fixed and variable
components. Consider the example of utility cost.
A mixed cost has both fixed and variable
components. Consider the example of utility cost.
Mixed Costs
Total mixed cost
Total Per Unit
Sales (500 bikes) 250,000$ 500$
Less: variable expenses 150,000 300
Contribution margin 100,000 200$
Less: fixed expenses 80,000
Net operating income 20,000$
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
The Basics of Cost-Volume-
Profit (CVP) Analysis
Contribution Margin (CM) is the amount remaining
from sales revenue after variable expenses have been
deducted.
Total Per Unit
Sales (500 bikes) 250,000$ 500$
Less: variable expenses 150,000 300
Contribution margin 100,000 200$
Less: fixed expenses 80,000
Net operating income 20,000$
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
The Basics of Cost-Volume-
Profit (CVP) Analysis
CM goes to cover fixed expenses.CM goes to cover fixed expenses.
Total Per Unit
Sales (500 bikes) 250,000$ 500$
Less: variable expenses 150,000 300
Contribution margin 100,000 200$
Less: fixed expenses 80,000
Net operating income 20,000$
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
The Basics of Cost-Volume-
Profit (CVP) Analysis
After covering fixed costs, any remaining CM
contributes to income.
The Contribution Approach
For each additional unit Wind sells, $200
more in contribution margin will help to
cover fixed expenses and profit.
The Contribution Approach
Each month Wind must generate at least
$80,000 in total CM to break even.
The Contribution Approach
If Wind sells 400 units in a month, it will be
operating at the break-even point.
Total Per Unit
Sales (401 bikes) 200,500$ 500$
Less: variable expenses 120,300 300
Contribution margin 80,200 200$
Less: fixed expenses 80,000
Net operating income 200$
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
The Contribution Approach
If Wind sells one more bike (401 bikes), net
operating income will increase by $200.
CVP Relationships in Graphic Form
Viewing CVP relationships in a graph is often helpful.
Consider the following information for Wind Co.:
Income
300 units
Income
400 units
Income
500 units
Sales 150,000$ 200,000$ 250,000$
Less: variable expenses 90,000 120,000 150,000
Contribution margin 60,000$ 80,000$ 100,000$
Less: fixed expenses 80,000 80,000 80,000
Net operating income (20,000)$ -$ 20,000$
-
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
- 100 200 300 400 500 600 700 800
CVP Graph
Fixed expenses
Units
Dollars
Total Expenses
Total Sales
-
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
- 100 200 300 400 500 600 700 800
Units
Dollars
CVP Graph
Break-even point
Profit Area
Loss Area
Contribution Margin Ratio
The contribution margin ratio is:
For Wind Bicycle Co. the ratio is:
$ 80,000
$200,000
= 40%
Total CM
Total sales
CM Ratio =
Contribution Margin Ratio
Or, in terms of units, the contribution margin ratio
is:
For Wind Bicycle Co. the ratio is:
$200
$500
= 40%
Unit CM
Unit selling price
CM Ratio =
Contribution Margin Ratio
At Wind, each $1.00 increase in sales revenue
results in a total contribution margin
increase of 40¢.
If sales increase by $50,000, what will be theIf sales increase by $50,000, what will be the
increase in total contribution margin?increase in total contribution margin?
Contribution Margin Ratio
400 Bikes 500 Bikes
Sales 200,000$ 250,000$
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income -$ 20,000$
A $50,000 increase in sales revenue
Changes in Fixed Costs and Sales
Volume
Wind is currently selling 500 bikes per month. The
company’s sales manager believes that an
increase of $10,000 in the monthly advertising
budget would increase bike sales to 540 units.
Should we authorize the requested increase in the
advertising budget?
Current Sales
(500 bikes)
Projected
Sales (540
bikes)
Sales 250,000$ 270,000$
Less: variable expenses 150,000 162,000
Contribution margin 100,000 108,000
Less: fixed expenses 80,000 90,000
Net operating income 20,000$ 18,000$
Changes in Fixed Costs and Sales
Volume
Sales increased by $20,000, but net
operating income decreased by $2,000..
Sales increased by $20,000, but net
operating income decreased by $2,000..
$80,000 + $10,000 advertising = $90,000$80,000 + $10,000 advertising = $90,000
Changes in Fixed Costs and Sales
Volume
The Shortcut SolutionThe Shortcut Solution
Increase in CM (40 units X $200) 8,000$
Increase in advertising expenses 10,000
Decrease in net operating income (2,000)$
Break-Even Analysis
Break-even analysis can be approached in
three ways:
1. Graphical analysis.
2. Equation method.
3. Contribution margin method.
Equation Method
Profits = Sales – (Variable expenses + Fixed expenses)
Sales = Variable expenses + Fixed expenses + Profits
OR
At the break-even point
profits equal zero.
Break-Even Analysis
Here is the information from Wind Bicycle Co.:
Total Per Unit Percent
Sales (500 bikes) 250,000$ 500$ 100%
Less: variable expenses 150,000 300 60%
Contribution margin 100,000$ 200$ 40%
Less: fixed expenses 80,000
Net operating income 20,000$
Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits
$500Q = $300Q + $80,000 + $0
Where:
Q = Number of bikes sold
$500 = Unit selling price
$300 = Unit variable expense
$80,000 = Total fixed expense
Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits
$500Q = $300Q + $80,000 + $0
$200Q = $80,000
Q = $80,000 ÷ $200 per bike
Q = 400 bikes
Equation Method
We can also use the following equation to compute
the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits
X = 0.60X + $80,000 + $0
Where:
X = Total sales dollars
0.60 = Variable expenses as a % of sales
$80,000 = Total fixed expenses
Equation Method
X = 0.60X + $80,000 + $0
0.40X = $80,000
X = $80,000 ÷ 0.40
X = $200,000
We can also use the following equation to compute
the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits
Contribution Margin Method
The contribution margin method is a variation
of the equation method.
Fixed expenses
Unit contribution margin
=
Break-even point
in units sold
Fixed expenses
CM ratio
=
Break-even point in
total sales dollars
Target Profit Analysis
Suppose Wind Co. wants to know how many
bikes must be sold to earn a profit of
$100,000.
We can use our CVP formula to determine the
sales volume needed to achieve a target net
profit figure.
The CVP Equation
Sales = Variable expenses + Fixed expenses + Profits
$500Q = $300Q + $80,000 + $100,000
$200Q = $180,000
Q = 900 bikes
The CVP Equation
Sales = Variable expenses + Fixed expenses + Profits
$500Q = $300Q + $80,000 + $100,000
$200Q = $180,000
Q = 900 bikes

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  • 1. Cost Classifications for Predicting Cost Behavior How a cost will react to changes in the level of business activity. – Total variable costs change when activity changes. – Total fixed costs remain unchanged when activity changes. How a cost will react to changes in the level of business activity. – Total variable costs change when activity changes. – Total fixed costs remain unchanged when activity changes.
  • 2. Total Variable Cost Your total long distance telephone bill is based on how many minutes you talk. Minutes Talked TotalLongDistance TelephoneBill
  • 3. Variable Cost Per Unit Minutes Talked PerMinute TelephoneCharge The cost per long distance minute talked is constant. For example, 10 cents per minute.
  • 4. Total Fixed Cost Your monthly basic telephone bill probably does not change when you make more local calls. Number of Local Calls MonthlyBasic TelephoneBill
  • 5. Fixed Cost Per Unit Number of Local Calls MonthlyBasicTelephone BillperLocalCall The average cost per local call decreases as more local calls are made.
  • 6. Cost Classifications for Predicting Cost Behavior Behavior of Cost (within the relevant range) Cost In Total Per Unit Variable Total variable cost changes Variable cost per unit remains as activity level changes. the same over wide ranges of activity. Fixed Total fixed cost remains Fixed cost per unit goes the same even when the down as activity level goes up. activity level changes.
  • 7. The Activity Base A measure of the event that causes the incurrence of a variable cost – a cost driver A measure of the event that causes the incurrence of a variable cost – a cost driver Units produced Units produced Miles driven Miles driven Labor hours Labor hours Machine hours Machine hours
  • 8. Step-Variable Costs Activity Cost Total cost remains constant within a narrow range of activity. Total cost remains constant within a narrow range of activity.
  • 9. Step-Variable Costs Activity Cost Total cost increases to a new higher cost for the next higher range of activity. Total cost increases to a new higher cost for the next higher range of activity.
  • 10. Relevant Range A straight line closely approximates a curvilinear variable cost line within the relevant range. A straight line closely approximates a curvilinear variable cost line within the relevant range. Activity TotalCost Economist’s Curvilinear Cost Function The Linearity Assumption and the Relevant Range Accountant’s Straight-Line Approximation (constant unit variable cost) Exh. 5-4
  • 11. Cost Behavior Merchandisers Cost of Goods Sold Merchandisers Cost of Goods Sold Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Manufacturers Direct Material, Direct Labor, and Variable Manufacturing Overhead Merchandisers and Manufacturers Sales commissions and shipping costs Merchandisers and Manufacturers Sales commissions and shipping costs Service Organizations Supplies and travel Service Organizations Supplies and travel Examples of normally variable costsExamples of normally variable costs Examples of normally fixed costsExamples of normally fixed costs Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salaries Depreciation, Advertising Merchandisers, manufacturers, and service organizations Real estate taxes, Insurance, Sales salaries Depreciation, Advertising
  • 12. Examples Advertising and Research and Development Examples Advertising and Research and Development Examples Depreciation on Buildings and Equipment Examples Depreciation on Buildings and Equipment Types of Fixed Costs Discretionary May be altered in the short-term by current managerial decisions Discretionary May be altered in the short-term by current managerial decisions Committed Long-term, cannot be reduced in the short term. Committed Long-term, cannot be reduced in the short term.
  • 13. RentCostin ThousandsofDollars 0 1,000 2,000 3,000 Rented Area (Square Feet) 0 30 60 Fixed Costs and Relevant Range 90 Relevant Range Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Total cost doesn’t change for a wide range of activity, and then jumps to a new higher cost for the next higher range of activity. Exh. 5-6
  • 14. Fixed Monthly Utility Charge Variable Cost per KW Activity (Kilowatt Hours) TotalUtilityCost X Y A mixed cost has both fixed and variable components. Consider the example of utility cost. A mixed cost has both fixed and variable components. Consider the example of utility cost. Mixed Costs Total mixed cost
  • 15. Total Per Unit Sales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$ Less: fixed expenses 80,000 Net operating income 20,000$ WIND BICYCLE CO. Contribution Income Statement For the Month of June The Basics of Cost-Volume- Profit (CVP) Analysis Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted.
  • 16. Total Per Unit Sales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$ Less: fixed expenses 80,000 Net operating income 20,000$ WIND BICYCLE CO. Contribution Income Statement For the Month of June The Basics of Cost-Volume- Profit (CVP) Analysis CM goes to cover fixed expenses.CM goes to cover fixed expenses.
  • 17. Total Per Unit Sales (500 bikes) 250,000$ 500$ Less: variable expenses 150,000 300 Contribution margin 100,000 200$ Less: fixed expenses 80,000 Net operating income 20,000$ WIND BICYCLE CO. Contribution Income Statement For the Month of June The Basics of Cost-Volume- Profit (CVP) Analysis After covering fixed costs, any remaining CM contributes to income.
  • 18. The Contribution Approach For each additional unit Wind sells, $200 more in contribution margin will help to cover fixed expenses and profit.
  • 19. The Contribution Approach Each month Wind must generate at least $80,000 in total CM to break even.
  • 20. The Contribution Approach If Wind sells 400 units in a month, it will be operating at the break-even point.
  • 21. Total Per Unit Sales (401 bikes) 200,500$ 500$ Less: variable expenses 120,300 300 Contribution margin 80,200 200$ Less: fixed expenses 80,000 Net operating income 200$ WIND BICYCLE CO. Contribution Income Statement For the Month of June The Contribution Approach If Wind sells one more bike (401 bikes), net operating income will increase by $200.
  • 22. CVP Relationships in Graphic Form Viewing CVP relationships in a graph is often helpful. Consider the following information for Wind Co.: Income 300 units Income 400 units Income 500 units Sales 150,000$ 200,000$ 250,000$ Less: variable expenses 90,000 120,000 150,000 Contribution margin 60,000$ 80,000$ 100,000$ Less: fixed expenses 80,000 80,000 80,000 Net operating income (20,000)$ -$ 20,000$
  • 23. - 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 - 100 200 300 400 500 600 700 800 CVP Graph Fixed expenses Units Dollars Total Expenses Total Sales
  • 24. - 50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 - 100 200 300 400 500 600 700 800 Units Dollars CVP Graph Break-even point Profit Area Loss Area
  • 25. Contribution Margin Ratio The contribution margin ratio is: For Wind Bicycle Co. the ratio is: $ 80,000 $200,000 = 40% Total CM Total sales CM Ratio =
  • 26. Contribution Margin Ratio Or, in terms of units, the contribution margin ratio is: For Wind Bicycle Co. the ratio is: $200 $500 = 40% Unit CM Unit selling price CM Ratio =
  • 27. Contribution Margin Ratio At Wind, each $1.00 increase in sales revenue results in a total contribution margin increase of 40¢. If sales increase by $50,000, what will be theIf sales increase by $50,000, what will be the increase in total contribution margin?increase in total contribution margin?
  • 28. Contribution Margin Ratio 400 Bikes 500 Bikes Sales 200,000$ 250,000$ Less: variable expenses 120,000 150,000 Contribution margin 80,000 100,000 Less: fixed expenses 80,000 80,000 Net operating income -$ 20,000$ A $50,000 increase in sales revenue
  • 29. Changes in Fixed Costs and Sales Volume Wind is currently selling 500 bikes per month. The company’s sales manager believes that an increase of $10,000 in the monthly advertising budget would increase bike sales to 540 units. Should we authorize the requested increase in the advertising budget?
  • 30. Current Sales (500 bikes) Projected Sales (540 bikes) Sales 250,000$ 270,000$ Less: variable expenses 150,000 162,000 Contribution margin 100,000 108,000 Less: fixed expenses 80,000 90,000 Net operating income 20,000$ 18,000$ Changes in Fixed Costs and Sales Volume Sales increased by $20,000, but net operating income decreased by $2,000.. Sales increased by $20,000, but net operating income decreased by $2,000.. $80,000 + $10,000 advertising = $90,000$80,000 + $10,000 advertising = $90,000
  • 31. Changes in Fixed Costs and Sales Volume The Shortcut SolutionThe Shortcut Solution Increase in CM (40 units X $200) 8,000$ Increase in advertising expenses 10,000 Decrease in net operating income (2,000)$
  • 32. Break-Even Analysis Break-even analysis can be approached in three ways: 1. Graphical analysis. 2. Equation method. 3. Contribution margin method.
  • 33. Equation Method Profits = Sales – (Variable expenses + Fixed expenses) Sales = Variable expenses + Fixed expenses + Profits OR At the break-even point profits equal zero.
  • 34. Break-Even Analysis Here is the information from Wind Bicycle Co.: Total Per Unit Percent Sales (500 bikes) 250,000$ 500$ 100% Less: variable expenses 150,000 300 60% Contribution margin 100,000$ 200$ 40% Less: fixed expenses 80,000 Net operating income 20,000$
  • 35. Equation Method We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 Where: Q = Number of bikes sold $500 = Unit selling price $300 = Unit variable expense $80,000 = Total fixed expense
  • 36. Equation Method We calculate the break-even point as follows: Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $0 $200Q = $80,000 Q = $80,000 ÷ $200 per bike Q = 400 bikes
  • 37. Equation Method We can also use the following equation to compute the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits X = 0.60X + $80,000 + $0 Where: X = Total sales dollars 0.60 = Variable expenses as a % of sales $80,000 = Total fixed expenses
  • 38. Equation Method X = 0.60X + $80,000 + $0 0.40X = $80,000 X = $80,000 ÷ 0.40 X = $200,000 We can also use the following equation to compute the break-even point in sales dollars. Sales = Variable expenses + Fixed expenses + Profits
  • 39. Contribution Margin Method The contribution margin method is a variation of the equation method. Fixed expenses Unit contribution margin = Break-even point in units sold Fixed expenses CM ratio = Break-even point in total sales dollars
  • 40. Target Profit Analysis Suppose Wind Co. wants to know how many bikes must be sold to earn a profit of $100,000. We can use our CVP formula to determine the sales volume needed to achieve a target net profit figure.
  • 41. The CVP Equation Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $100,000 $200Q = $180,000 Q = 900 bikes
  • 42. The CVP Equation Sales = Variable expenses + Fixed expenses + Profits $500Q = $300Q + $80,000 + $100,000 $200Q = $180,000 Q = 900 bikes