CHAPTER ONE

Cost-Volume-Profit Analysis and Cost Estimation

1.1 Introduction
All managers want to know how profits will change as the units sold of a product or service
change. Cost–volume–profit (CVP) analysis examines the behavior of total revenues, total costs
and operating profit as changes occur in the output level, selling price, variable costs or fixed
costs of a product within a short run. A certain company manager Might wonder how many units
of a new product must be sold to break even or make a certain amount of profit and some others
might ask themselves how expanding their business into a particular foreign market would affect
costs, selling price, and profits. Such types of questions can be answered through CVP analysis.
Examining the results of these what-if possibilities and alternatives help managers make better
decisions. Managers must also decide how to price their products and understand the effect of
their pricing decisions on revenues and profits.

In general, Some of the ways cost-volume-profit analysis may be used include: Analyzing the
effects of changes in selling prices on profits; analyzing the effects of changes in costs on profits;
analyzing the effects of changes in volume on profits; Setting selling prices; Selecting the mix of
products to sell and Choosing among marketing strategies. While this chapter deals with the
mechanics and terminology of CVP analysis, you should keep in mind that CVP analysis is an
integral part of financial planning and decision making. Every accountant and manager should be
thoroughly conversant with its concepts, not just the mechanics.

1.2 Assumptions of Cost-Volume-Profit Analysis

Cost-volume-profit analysis (CVP analysis) is a powerful tool for planning and decision making.
Because CVP analysis emphasizes the interrelationships of costs, quantity sold, and price, it
brings together all of the financial information of the firm. CVP analysis can be a valuable tool to
identify the extent and magnitude of the economic trouble a division is facing and to help
pinpoint the necessary solution. Generally, CVP analysis focuses on the factors that affect a
change in the components of profit (such as fixed and variable cost per unit, selling price and
quantity sold).
The profit-volume and cost-volume-profit graphs rely on some important assumptions. Some of
these assumptions are as follows:
1. Changes in the levels of revenues and costs within the relevant range arise only because of
changes in the number of product (or service) units sold. The number of units sold is the only
revenue driver and the only cost driver. Just as a cost driver is any factor that affects costs, a
revenue driver is a variable, such as volume, that causally affects revenues.
2. When it is represented by graph, the behavior of total revenue and total cost is liner. The
analysis assumes a linear revenue function and a linear cost function. In other words,
percentage change in the level of units sold result in the same percentage change in the
revenue and cost level with in the relevant range.

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 When represented graphically, the behaviors of total revenues and total costs are linear
(meaning they can be represented as a straight line) in relation to units sold within a relevant
range (and time period).
Total cost = Total variable cost + Total fixed cost
TC= Variable cost per unit * Quantity of units sold + total fixed cost
TR= selling price per unit * Quantity of units sold
3. Total costs can be separated into two components: a fixed component that does not vary with
units sold and a variable component that changes with respect to units sold. The shorter the
time horizon/relevant range, the higher the percentage of total costs considered fixed.
4. The analysis assumes that selling price, total fixed costs, and unit variable costs can be
accurately identified and remain constant over the relevant range. Within the relevant range
of operating activity, the efficiency of operations does not change.
Fortunately, we do not need to consider all possible ranges of production and sales for a firm.
Remember that CVP analysis is a short-run decision-making tool. (We know that it is short
run in orientation because some costs are fixed.) It is only necessary for us to determine the
current operating range, or relevant range, for which the linear cost and revenue
relationships are valid. The relevant range is the range of volume where total fixed costs
remain constant and the variable cost per unit remains constant. The relevant range is the
range of events (or other activity) where total fixed costs and variable cost per unit stays the
same.
In actuality, firms seldom know prices, variable costs, and fixed costs with certainty. A
change in one variable usually affects the value of others. Often there is a probability
distribution to contend with. Furthermore, there are formal ways of explicitly building
uncertainty into the CVP model.
Note that the cost and revenue relationships are roughly linear in this range, allowing us to
use our linear CVP equations. Of course, if the relevant range changes, different fixed and
variable costs and different prices must be used. Once a relevant range has been identified,
then the cost and price relationships are assumed to be known and constant.
5. The analysis assumes that what is produced is sold. There is no change in inventory over the
period. That inventory has no impact on break-even analysis makes sense. Break-even
analysis is a short-run decision making technique; we are looking to cover all costs of a
particular period of time. Inventory embodies costs of a previous period and is not
considered.
6. For multiple-product analysis, the sales mix is assumed to be known. In single-product
analysis, the sales mix is obviously constant— one product accounts for 100 percent of sales.
Multiple-product break-even analysis requires a constant sales mix. However, it is virtually
impossible to predict with certainty the sales mix. Typically, this constraint is handled in
practice through sensitivity analysis. By using the capabilities of spreadsheet analysis, the
sensitivity of variables to a variety of sales mixes can be readily assessed.
7. We can ignore the time value of money.

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1.3 Break-even point and target operating income/profit
Break-even point (BEP): is that quantity of output sold at which total revenues equal total costs
—that is, the quantity of output sold that results in birr zero of operating income/profit before
income tax. Note that we are using the term operating income to denote income or profit before
income taxes. Operating income includes only revenues and expenses from the firm’s normal
operations. Net income is operating income minus income taxes.

There are three related ways (we will call them methods) to think more deeply about and model
CVP relationships and also break-even:
i. Equation method:
It is also termed as income statement approach.
Revenues - Variable costs - Fixed costs = Operating income
Revenues = Selling price (SP) * Quantity of units sold (Q)
Variable costs = Variable cost per unit (VCU) * Quantity of units sold (Q)
So,
[(Selling price (SP) * quantity of units sold (Q)) – (Variable cost per unit (VCU) * Quantity
of units sold (Q))] – Fixed cost = operating income ---------------- Equation 1
At break-even point the operating revenue is zero, hence,
¿ cost
Break even quantity sold=
selling price – variable cost per unit ( VCU )
ii. Contribution Margin Method
The contribution margin is sales revenue minus variable costs (expenses). It is called the
contribution margin because the excess of sales revenue over variable costs contributes to
covering fixed costs and then to providing operating income.
The only numbers that change from selling different quantities of packages are total revenues
and total variable costs. The difference between total revenues and total variable costs is called
contribution margin. That is,

Contribution margin = Total revenues - Total variable costs

Contribution margin indicates why operating income changes as the number of units sold
changes.
[(Selling price – variable cost per unit )∗(Quantity of units sold)] – ¿ cost =operating income
Contribution margin per unit∗Quantity of units sold – ¿ cost=Operating Income−−−−−−−−Equation 2
¿ cost
Break even number of units=
contribution margin per unit
Breakevenrevenues=Breakevennumber of units∗Selling price
In practice (because they have multiple products), companies usually calculate breakeven point
directly in terms of revenues using contribution margin percentages.
contribution margin per unit
Contribution margin percentage =
selling price

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 ¿ cost
Break even revenue=
contribution margin percentage
While the breakeven point tells managers how much they must sell to avoid a loss, managers are
equally interested in how they will achieve the operating income targets underlying their
strategies and plans.
The target operating income
¿ costs+Target operating income
Quantity of units required ¿ be sold=
contribution margin per unit
iii. Graph Method
In the graph method, we represent total costs and total revenues graphically. Each is shown as a
line on a graph.
The cost-volume-profit chart below is constructed using the following steps:
Step 1: Volume in units of sales is indicated along the horizontal axis. The range of volume
shown is the relevant range in which the company expects to operate. Birr amounts of total sales
and costs are indicated along the vertical axis.
Step 2: A sales line is plotted by beginning at zero on the left corner of the graph. A second
point is determined by multiplying any units of sales on the horizontal axis by the unit sales
price. The sales line is drawn upward to the right from zero through the point found after
multiplying sales price by unit of sale.
Step 3: A cost line is plotted by beginning with total fixed costs, on the vertical axis. A second
point is determined by multiplying any units of sales on the horizontal axis by the unit variable
costs and adding the fixed costs

Step 4: The break-even point is the intersection point of the total sales and total cost lines. A
vertical dotted line drawn downward at the intersection point indicates the units of sales at the
break-even point. A horizontal dotted line drawn to the left at the intersection point indicates the
sales dollars and costs at the break-even point.
TR/TC Total revenue line
Operating income
Operating income area

Total cost line Variable costs

Break-even point
---------------------------------------------------------------------
Operating loss area Fixed costs

0 BEQ Units sold

Slope of the total costs line is the variable cost per unit, whereas, Slope of the total revenues line
is the selling price. The above graph is called a cost-volume-profit (CVP) chart, or a break-
even chart or break-even graph.
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Note: The breakeven point is the quantity of output at which total revenues equal total costs. The
three methods for computing the breakeven point and the quantity of output to achieve target
operating income are the equation method, the contribution margin method, and the graph
method. Each method is merely a restatement of the others. Managers often select the method
they find easiest to use in the specific decision situation.

Illustration: Derba Cement Factory For the coming year, the controller/chief accounting
officer has prepared the following projected income statement:
Sales (2,000 quintals of cement @ birr 160) ------------------------------- birr 320,000
Less: Variable expenses ------------------------------------------------------------120,000
Contribution margin -----------------------------------------------------------birr 200,000
Less: Fixed expenses ------------------------------------------------------------- (120,000)
Operating income --------------------------------------------------------------- birr 80,000
Required: How many quintals of cement Derba should sell in order to break even (BENQ)?
Solution: At the break-even point, the operating-income equation would take the following
form:
Equation method:
0 = (Birr 160/quintal * BENQ – birr 60/quintal * BENQ) – birr 60,000
0 = BENQ (birr 160 - 60) – birr 120,000
Birr 120,000 = birr 100 BENQ
birr 120,000
BENQ= =1,200 quintals of cement
birr 100
Therefore, Derba must sell 1,200 quintals of cement to just cover all fixed and variable expenses.
A good way to check this answer is to formulate an income statement based on 1,200 units sold.
Sales (1,200 units @ birr 160) -------------------------------- birr 192,000
Less: Variable expenses (1,200 units * birr 60) ------------------ 72,000
Contribution margin --------------------------------------------- birr 120,000
Less: Fixed expenses ------------------------------------------------- 120,000
Operating income ----------------------------------------------------- birr 0
Indeed, selling 1,200 quintals of cement does yield a zero profit.
Contribution margin method:
In our Derba example, contribution margin per unit is birr 100 (birr 160- birr 60)
¿ cost
Break even number of Quintals=
con tribution margin per unit
birr 120,000
BENQ=
birr 160−60
BENQ = 1,200
Break even revenue = fixed cost/contribution margin percentage
contribution margin per unit
Contribution margin percentage =
selling price per unit

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 birr 100
¿ =62.5 %
birr 160
120,000
Break even revenue= =birr 192,000
0.625
If Derba sell less than 1,200 quintals of cement, the Factory will incur operating loss because it
cannot cover its fixed costs with its contribution margin.
Note that: at break-even point the total contribution margin is equal to the fixed cost
Birr 60 * 1,200 quintals = birr 120,000 = fixed cost

Target operating income: While the break-even point is useful information, most firms would
like to earn operating income greater than zero. CVP analysis gives us a way to determine how
many units must be sold to earn a particular targeted income. Targeted operating income can be
expressed as a birr amount or as a percentage of sales revenue. Both the operating-income
approach and the contribution margin approach can be easily adjusted to allow for targeted
income.
Illustration: Assume that Derba Cement Factory wants to earn operating income of birr
250,000. How many quintals of cement must be sold to achieve this result? Let’s use the income
statement to find out:
[(Selling price (SP) * quantity of units sold (Q)) – (Variable cost per unit (VCU) * Quantity of
units sold (Q))] – Fixed cost = operating income
Birr 250,000 = [(birr 160 per quintal * number of quintals sold) – (birr 60 per quintal * number
of quintals sold)] – birr 120,000
Birr 250,000 = number of quintals sold (birr 160 - 60) – 120,000
Birr 250,000 + 120,000 = birr 100 * number of quintals sold
Birr 370,000 = birr 100 * number of quintals sold
birr 370,000
Number of quintals ¿ be sold=
birr 100
Number of quintals to be sold = 3,700
Derba must sell 3,700 quintals of cementto earn a before-tax profit of birr 250,000. In general,
assuming that fixed costs remain the same, the impact on a firm’s profits resulting from a change
in the number of units sold can be assessed by multiplying the unit contribution margin by the
change in units sold.

1.4 Target net income and income tax

Net income is operating income plus non-operating revenues (such as interest revenue) minus
non-operating costs (such as interest cost) minus income taxes. For simplicity, throughout this
chapter we assume non-operating revenues and non-operating costs are zero. Thus,
Net income=Operatingincome−Income taxes
Until now, we have ignored the effect of income taxes in our CVP analysis. In many companies,
the income targets for managers in their strategic plans are expressed in terms of net income.
That’s because top management wants subordinate managers to take into account the effects

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their decisions have on operating income after income taxes. Some decisions may not result in
large operating incomes, but they may have favorable tax consequences, making them attractive
on a net income basis—the measure that drives shareholders’ dividends and returns.

When calculating the break-even point, income taxes play no role. This is because the taxes paid
on zero income are zero. However, when the company needs to know how many units to sell to
earn a particular net income, some additional consideration is needed. Recall that net income is
operating income after income taxes and that our targeted income figure was expressed in
before-tax terms. As a result, when the income target is expressed as net income, we must add
back the income taxes to get operating income.

To make net income evaluations, CVP calculations for target income must be stated in terms of
target net income instead of target operating income. In general, income taxes are computed as a
percentage of income. The after-tax profit is computed by subtracting the tax from the operating
income (or before-tax profit).
Target net income=( a target operating income ) – ( a target operating income∗tax rate )
Target net income=( Target operating income )∗( 1−Tax rate )
target net income
Target operating income=
1 – tax rate
Suppose that Derba Cement Factory wants to achieve net income of birr 200,000 and its
corporate income tax rate is 30%. Hence, the before tax target profit for the Factory is:
birr 200,000
Target operating income= =birr 285,714.3
1 – 0.3
In other words, with an income tax rate of 30%, Derba must earn Birr 285,714.3 before income
taxes to have birr 200,000 after income taxes.

1.5 Sensitivity “what if” analysis and margin of safety

Before choosing strategies and plans about how to implement strategies, managers frequently
analyze the sensitivity of their decisions to changes in underlying assumptions of CVP analysis.
Sensitivity analysis is a “what-if” technique that managers use to examine how an outcome will
change if the original predicted data are not achieved or if an underlying assumption changes. In
the context of CVP analysis, sensitivity analysis answers questions such as, “What will operating
income be if the quantity of units sold decreases by 5% from the original prediction?” and “What
will operating income be if variable cost per unit increases by 10%?” Sensitivity analysis
broadens managers’ perspectives to possible outcomes that might occur before costs are
committed.

Note: Because CVP analysis uses estimates, knowing how changes in those estimates impact
break-even is useful. For example, a manager might form three estimates for each of the
components of breakeven: optimistic, most likely, and pessimistic. When selling prices can be
increased without impacting costs, break-even quantity decreases. When competition drives

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selling prices down and the company cannot reduce costs, break-even level quantity increases.
Increases in either variable or fixed costs, if they cannot be passed on to customers via higher
selling prices, will increase break-even quantity. If costs can be reduced and selling prices held
constant, the break-even decreases.

Illustration: Assume that Derba Cement Factory is looking into buying a new machine that
would increase annual fixed costs from birr 120,000 to birr 134,000 but decrease variable costs
from birr 60 per unit to birr 50 per unit. The machine is used to produce output whose selling
price will remain unchanged at birr 160. Hence, what is the revised break even revenue and level
of production and sale?

Revised break−even point ∈birr=revised ¿ cost ¿

revised contribution margin percentage

Revised contribution margin per unit is birr 110 (birr 160 – birr 50)

Revised contribution margin ratio is 68.75% of selling price (birr 110/birr160)

This results in increases in both the unit contribution margin and the contribution margin ratio.

birr 134,000
¿ =birr 194,909
0.6875

Therefore, using CVP analysis, Derba revised break-even point in birr would be birr 194,909.

Revised break even quantity =Revised ¿ cost ¿

revised sel ling price per unit – revised variable cost per unit

birr 134,000
¿ =1,218 quintalsof cement
birr 160 – birr 50

The revised break even revenue and quantity due to the change in the assumption of CVP or
expectation is pessimistic condition. Because of this condition Derba is expected to produce
1,218 quintals of cement (generate birr 194,909) to cover its costs that is above estimated break-
even level of production and sale (i.e. 1,200) by 18.

Another aspect of sensitivity analysis is margin of safety: The margin of safety answers the
“what-if” question: If budgeted revenues are above breakeven and drop, how far can they fall
below budget before the breakeven point is reached? Sales might decrease as a result of a
competitor introducing a better product, or poorly executed marketing programs, and so on.

Margin of safety ∈birr=Budgeted ( ¿ actual ) revenues−Breakevenrevenues

Margin of safety ( ¿ units )=Budgeted ( ¿ actual ) sales quantity −Breakeven quantity

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 margin of safety ∈birr
Margin of safety percentage=
budgeted ( ¿ actual ) revenue
Illustration: Assume that Derba Cement Factory has fixed costs of birr 120,000, a selling price
of birr 160 and variable costs per unit of birr 60. For 2,000 units sold, the budgeted revenues are
birr 320,000 and the budgeted operating profit is birr 80,000. The breakeven point for this set of
assumptions is 1,200 units (birr 120,000 ÷ birr 100). Hence, the margin of safety is birr 128,000
(birr 320,000 – birr 192,000) or 800 units.

Sensitivity analysis is a simple approach to recognizing uncertainty, which is the possibility that
an actual amount will deviate from an expected amount. Sensitivity analysis gives managers a
good feel for the risks involved. As the level of margin of safety rise, the capacity to
accommodate risk will increase.

1.6 CVP analysis with multiple products

Cost-volume-profit analysis is fairly simple in the single-product setting. Most companies sell
more than one product. Selling price and variable costs differ for each product, so each product
makes a different contribution to profits. The same CVP formulas we used earlier apply to a
company with multiple products.

To calculate break even for each product, we must compute the weighted-average contribution
margin of all the company’s products. The sales mix provides the weights that make up total
product sales. The weights equal 100% of total product sales. Sales mix (or product mix) is the
combination of products that make up total sales.

The definition of sales mix

Sales mix: The term sales mix refers to the relative proportions in which a company’s products
are sold. The idea is to achieve the combination, or mix, that will yield the greatest amount of
profits. Most companies have many products, and often these products are not equally profitable.
Hence, profits will depend to some extent on the company’s sales mix. Profits will be greater if
high-margin rather than low-margin items make up a relatively large proportion of total sales.
The sales mix can be measured in units sold or in proportion of revenue.

Sales mix and break even analysis: In contrast to the single-product (or service) situation, the
total number of units that must be sold to break even in a multiproduct company depends on the
sales mix. In preparing a break-even analysis, an assumption must be made concerning the sales
mix. Usually the assumption is that it will not change. However, if the sales mix is expected to
change, then this must be explicitly considered in any CVP computations.
The direct fixed expenses are those fixed costs that can be traced to each product and would be
avoided if the product did not exist. The common fixed expenses are the fixed costs that are not
traceable to the products and would remain even if one of the products was eliminated.

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Illustration 1: Consider ABC PLC, a small company that imports DVDs from abroad. At
present, the company sells two DVDs: the SONY DVD and the SAMSUNG DVD with the sells
mix of 2:8. The company’s forecasted sales, expenses, operating income to sale 20 units of
SONY and 80 units of SAMSUNG for the coming month are shown below:

ABC PLC
Contribution Income Statement
For the Month of September
SONY DVDS UMSUNG DVD Total
Amount Percent Amount Percent Amount Percent
Sales ............................ birr 20,000 100% birr 80,000 100% birr 100,000
100%
Variable expenses ....... 15,000 75% 40,000 50% 55,000 55%
Contribution margin..... . Birr 5,000 25% birr 40,000 50% 45,000 45%
Fixed expenses....................................................................................................................... 27,000
Net operating income ............................................................................................................ birr 18,000

Required:
a) Calculate the break even revenue for the company as a whole and SONY and SAMSUNG
independently for the coming month
b) Determine the break even quantity for the company as a whole and SONY and SAMSUNG
independently for the coming month
Solution:

a) Computation of the break-even revenue:

Break even sales=¿ all ¿ cost ¿
¿ all CM %age

birr 27,000
Break −even sales= =birr 60,000
0.45

Verification of the break-even revenue:

SONY DVD SUMSUNG DVD Total
Current dollar sales ...................... birr 20,000 birr 80,000 birr 100,000
Percentage of total dollar sales ......... 20% 80% 100%
Sales at the break-even point... Birr 12,000 (20% of 60,000) birr 48,000 (80% 0f 60,000) birr 60,000

SONY DVD SUMSUNG DVD Total

Amount Percent Amount Percent Amount Percent
Sales ........................ birr 12,000 100% birr48,000 100% birr 60,000 100%
Variable expenses........... 9,000 75% 24,000 50% 33,000 55%
Contribution margin ... birr 3,000 25% birr 24,000 50% 27,000 45%
Fixed expenses..................................................................................................................... (27,000)
Net operating income ............................................................................................................ birr 0

¿ all Break even quantity=overall ¿ cost ¿

weighted average contribution margin per unit ]

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 birr 27,000
¿ =60 units
birr 450

Break even quantity of SONY = 20% of 60 units = 12 units

Break even quantity of SAMSUNG = 80% of 60 units = 48 units
SONY SAMSUNG Total

Sale price per unit Birr 1000 Birr 1000

Variable cost per unit 750 (15,000/20) 500 (40,000/80)

Contribution margin per unit Birr 250 Birr 500

Sales mix in units 2 8 10

Contribution margin Birr 500 (250 * 2) Birr 4,000 (500 * 8) Birr 4,500

Weighted-average Birr 450

contribution margin per unit
(birr 4,500/10)

Illustration 2
XYZ Furniture sold 6,000 beds and 4,000 office tables during the past year. The sales mix of
6,000 beds and 4,000 tables creates a ratio of 6,000/10,000 or 60% beds and 4,000/10,000 or
40% tables. You could also convert this to the least common ratio, as 6/10 is the same as 3/5
beds and 4/10 is the same as 2/5 tables. So, we say the sales mix or product mix is 3:2, or for
every three beds, XYZ expects to sell two tables. XYZ’s total fixed costs are birr 40,000. The
bed’s unit selling price is birr 44 and variable cost per bed are birr 24. The tables unit selling
price is birr 100 and variable cost per post is birr 30. To compute breakeven sales in units for
both products

XYZ Furniture completes the following two steps.

STEP 1: Calculate the weighted-average contribution margin per unit, as follows:
Calculate the breakeven point for multiple products or services
Beds Tables Total

Sale price per unit Birr 44 Birr 100

Variable cost per unit 24 30
Contribution margin per unit Birr 20 Birr 70
Sales mix in units 3 2 5

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 Contribution margin Birr 60 Birr 140 Birr 200

Weighted-average contribution margin per unit (birr 200/5) Birr 40

STEP 2: Calculate the breakeven point in units for each product. Multiply the“package”
breakeven point in units by each product’s proportion ofthe sales mix.
¿ cost+ operating income
Breakeven sales∈total units=
weighted average contribution margin p er unit
Birr 40,000+birr 0
¿ =1,000items
birr 40
Breakeven sales of beds (1,000 * 3/5)................................ 600 beds
Breakeven sales of tables (1,000 * 2/5).............. 400 tables
Break even revenue = SP/unit of bed * BEQ bed + SP/unit of tables * BEQ table
= birr 44 * 600 + birr 100 * 400
= birr 26,400 + 40,000
= birr 66,400
Break even revenue of bed = 3/5 of birr 66,400 = birr 39,840
Break even revenue of table = 2/5 of birr 66,400 = birr 26,560

1.7 Methods of measuring cost function

Identifying and measuring cost behavior requires careful analysis and judgment. An important
part of this process is to identify costs that can be classified as either fixed or variable, which
often requires analysis of past cost behavior.
Quantitative cost estimation methods
Quantitative analyses of cost relationships are formal methods to fit linear cost functions to past
data observations.

There are six steps in estimating a cost function on the basis of an analysis of current or past cost
relationships. (1) Choose the dependent variable (the variable to be predicted, which is some type
of cost); (2) identify the cost driver(s) (independent variable(s)); (3) collect data on the
dependent variable and the cost driver(s); (4) plot the data; (5) estimate the cost function; and (6)
evaluate the estimated cost function. As we discussed earlier in this chapter, choosing a cost
driver is not always straightforward. Frequently, the cost analyst will cycle through these steps
several times trying alternative economically plausible cost drivers to see which cost driver best
fits the data. Three quantitative methods are commonly used to analyze past costs: scatter
diagrams, high-low method, and least-squares regression.

i. Scatter diagrams display past cost and unit data in graphical form. In preparing a scatter
diagram, units are plotted on the horizontal axis and cost is plotted on the vertical axis.
Each individual point on a scatter diagram reflects the cost and number of units for a
prior period.The estimated line of cost behavior is drawn on a scatter diagram to reflect

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 the relation between cost and unit volume. This line best visually “fits” the points in a
scatter diagram. Fitting this line demands judgment.

.
. .
. . . .
. . . .

change∈cost
Varia blecost per unit =
change∈units
ii. The high-low method is a way to estimate the cost equation by graphically connecting
the two cost amounts at the highest and lowest unit volumes.
Total cost = fixed cost + (variable cost per unit * units)
This cost equation differs slightly from that determined from the scatter diagram method. A
deficiency of the high-low method is that it ignores all cost points except the highest and lowest.
The result is less precise because the high-low method uses the most extreme points rather than
the more usual conditions likely to recur.
iii. Least-squares regression is a statistical method for identifying cost behavior. For our
purposes, we use the cost equation estimated from this method but leave the
computational details for more advanced courses. Such computations for least-squares
regression are readily done using most spreadsheet programs or calculators.

Note that: The three cost estimation methods result in slightly different estimates of fixed and
variable costs. Estimates from the scatter diagram are based on a visual fit of the cost line and are
subject to interpretation. Estimates from the high-low method use only two sets of values
corresponding to the lowest and highest unit volumes. Estimates from least-squares regression
use a statistical technique and all available data points.

We must remember that all three methods use past data. Thus, cost estimates resulting from
these methods are only as good as the data used for estimation. Managers must establish that the
data are reliable in deriving cost estimates for the future.

Qualitative cost estimation methods

iv. Engineering analysis
The industrial engineering method, also called the work-measurement method, estimates
cost functions by analyzing the relationship between inputs and outputs in physical terms. This
method has its roots in studies and techniques developed by Frank and Lillian Gilbreth in the
early twentieth century. Consider, for example, a carpet manufacturer that uses inputs of cotton,
wool, dyes, direct labor, machine time and power. Production output is square meters of carpet.

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Time-and-motion studies analyze the time and materials required to perform the various
operations to produce the carpet. For example, a time-and-motion study may conclude that to
produce 20 square meters of carpet requires 2 kilograms of cotton and 3 liters of dye. Standards
and budgets transform these physical input and output measures into costs. The result is an
estimated cost function relating total manufacturing costs to the cost driver, square meters of
carpet.
The industrial engineering method can be very time-consuming. Some government contracts
mandate its use. Many organizations, however, find it too costly for analyzing their entire cost
structure. More frequently, organizations use this approach for direct-cost categories such as
materials and labor but not for indirect-cost categories such as manufacturing overhead. Physical
relationships between inputs and outputs may be difficult to specify for individual overhead cost
items.
v. Account analysis
The account analysis method estimates cost functions by classifying cost accounts in the ledger
as variable, fixed, or mixed with respect to the identified cost driver. Typically, managers use
qualitative rather than quantitative analysis when making these cost-classification decisions. The
account analysis approach is widely used.

Organizations differ with respect to the care taken in implementing account analysis. In some
organizations, individuals thoroughly knowledgeable about the operations make the cost-
classification decisions. For example, manufacturing personnel may classify costs such as
machine lubricants and materials-handling labor, while marketing personnel may classify costs
such as advertising brochures and sales salaries. In other organizations, only cursory analysis is
conducted, sometimes by individuals with limited knowledge of operations, before cost-
classification decisions are made. Clearly, the former approach would provide more reliable cost
classifications, and hence estimates of the fixed and variable components of the cost, than the
latter. Supplementing the account analysis method by the conference method improves its
credibility.

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