Chapter 3

Cost-Volume-Profit Relationships
 Chapter 3
Cost-Volume-Profit Relationships
After studying this chapter, you should be able to:
1 Distinguish between variable and fixed costs.
2 Explain the meaning and importance of the relevant
range.
3 Explain the concept of mixed costs.
4 State the five components of cost-volume-profit
analysis.
5 Indicate the meaning of contribution margin and the
ways it may be expressed.
 Chapter 3
Cost-Volume-Profit Relationships
After studying this chapter, you should be able to:
6 Identify the three ways that the break-even point may
be determined.
7 Define margin of safety and give the formulas for
computing it.
8 Give the formulas for determining sales required to
earn target net income.
9 Describe the essential features of a cost-volume-profit
income statement.
 Preview of Chapter 3

COST-VOLUME-
Cost Behavior Analysis
PROFIT
• Variable Costs
RELATIONSHIPS
• Fixed Costs
• Relevant Range
• Mixed Costs
• Identifying Variable and Fixed
Costs
 Preview of Chapter 3

Cost-Volume-Profit
COST-VOLUME- Analysis
PROFIT • Basic Components
RELATIONSHIPS • Contribution Margin
• Break-Even Analysis
• Margin of Safety
• Target Net Income
• Changes in Business
Environment
• CVP Income Statement
 Cost Behavior Analysis

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.
 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.

 Cost Behavior Analysis
 Changes in the level or volume of activity
should be correlated with changes in costs .
 The activity level selected is referred to as the
activity or volume index.
 The Activity index is the activity that causes
changes in the behavior of costs.
 The activity index allows costs to be classified
as variable, fixed, or mixed.
 Variable Costs
Variable costs are costs that vary in total directly and
proportionately with changes in the activity level.
Example:
 If the activity level increases by 10%, total variable
costs increase by 10%.
If the activity level decreases by 25%, total variable
costs decrease by 25%.
Variable costs remain the same per unit at every
level of activity.
 Variable Costs
 Damon Company manufactures radios that contain a $10 digital
clock. The activity index is the number of radios produced. As
each radio is manufactured, the total cost of the clocks increases
by $10. (a) (b)
Total Variable Costs Unit Variable Costs
(Digital Clocks) (Digital Clocks)

$100 $25

Cost (per unit)

20
Cost (000)

80
60 15

40 10

20 5

0 0
0 2 4 6 8 10 0 2 4 6 8 10
Radios produced in (000) Radios produced in (000)
 Fixed Costs

 Costs that remain the same in total regardless of changes in

the activity level.
 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
 Fixed Costs
 Damon Company leases all of its productive facilities at
a cost of $10,000 per month. Total fixed costs of the
facilities will remain constant at every level of activity.
(a) (b)
Total Fixed Costs Fixed Costs Per Unit
(Rent Expense) (Rent Expense)

$25 $5

Cost (per unit)

Cost (000)

20 4
15 3
10 2
5 1
0 0
0 2 4 6 8 10 0 2 4 6 8 10
Radios produced in (000) Radios produced in (000)
Illustration 5-2
 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.
Relevant Range
 Relevant Range
Relevant Range – Range of activity over which a
company expects to operate during a year.
 Mixed Costs

 Costs that have both a variable cost element and a fixed cost
element.

 Change in total
but not
proportionately
with changes in
activity level.
 Behavior of a Mixed Cost
The rental of a U-Haul truck is a good example of a mixed cost.

Local rental terms for a

$200
U-Haul truck are $50 per day
plus $.50 per mile. The per e
150 in
diem charge is a fixed cost o st
L
lC
with respect to miles driven, To
t a
Cost 100
while the mileage charge is a Variable Cost Element
variable cost. The graphic
50
presentation of the rental
Fixed Cost Element
cost for a one-day rental is
0
shown on the right. 0 50 100 150 200
Miles
250 300

Illustration 5-5
 Helena Company, reports the following total costs at two levels
of production.

Classify each cost as variable, fixed, or mixed.

Variable
Fixed
Mixed
 Mixed Cost Classification
for CVP Analysis
 In CVP analysis, mixed costs must be classified into
their fixed and variable elements.
 The high-low Method is a mathematical method used
for this purpose.
 The high-low method uses the total costs incurred at
both the high and the low levels of activity to classify
mixed cost.
 The difference in costs between the high and low levels
represents variable costs, since only variable costs
change as activity levels change.
 The High-Low Method
The steps in calculating fixed and variable costs under
this method are as follows:
1 Determine variable cost per unit from the following
formula:

Change in High minus Low Variable Cost

Total Costs  Activity Level = per Unit
 High-Low Method

Illustration: Metro Transit Company has the following maintenance

costs and mileage data for its fleet of buses over a 6-month period.

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

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

STEP 2: Determine the fixed cost by subtracting the total

variable cost at either the high or the low activity level from the
total cost at that level.
 High-Low Method

Maintenance costs are therefore $8,000 per month plus

$1.10 per mile. This is represented by the following formula:

Maintenance costs = Fixed costs + ($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
Cost Behavior Analysis
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 6,000 units.
 (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
 (b) Estimate the total cost if the company produces 6,000 units.

Total cost (6,000 units): $2,000 + $7,800 ($1.30 x 6,000) = $9,800

 Cost-Volume-Profit Analysis

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

changes of 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.

 Cost-Volume Profit
Analysis
 Cost-volume-profit (CVP) analysis is the study of the effects
of changes of costs and volume on a company’s profits.
 CVP analysis involves a consideration of the
interrelationships among the following components:
– Volume or activity level
– Unit selling price
– Variable cost per unit
– Total fixed costs
– Sales mix
 CVP Assumptions
1 The behavior of both costs and revenues is linear
throughout the relevant range of the activity index.
2 All costs can be classified as either variable or fixed
with reasonable accuracy.
3 Changes in activity are the only factors that affect
costs.
4 All units produced are sold.
5 When more than one type of product is sold, the sales
mix will remain constant.
 CVP Analysis
In CVP analysis applications, the term cost includes
manufacturing costs plus selling and administrative expenses.

 We will use Vargo Video Company as an example.

Relevant data for the VCRs made by this company are as
follows:

Unit selling price $500

Unit variable costs $300
Total monthly fixed costs $200,000
 Contribution Margin
Contribution margin is the amount of revenue available to
cover fixed costs and to contribute to income.

 For example, assume that Vargo Video sells 1,000 VCRs in

one month, sales are $500,000 (1,000 x $500) and variable
costs are $300,000 (1,000 x $300). Thus, contribution margin
is $200,000, computed as follows:

Contribution
Sales
- Variable Costs = Margin

$500,000 - $300,000 = $200,000

 Unit Contribution Margin

 At Vargo Video, the contribution margin per unit is $200.

Unit Variable Contribution

Unit Selling Price
- Cost = Margin per Unit

$500 - $300 = $200

 CM per unit indicates that for every VCR sold, Vargo Video will have $200
to cover fixed costs and contribute to income.
 Contribution Margin Ratio
 Shows the percentage of each sales dollar available
to apply toward fixed costs and profits.

Contribution Contribution
Margin per Unit  Unit Selling Price = Margin Ratio

$200  $500 = 40%

 The CM ratio means that 40 cents of each sales dollar ($1 x 40%) is
available to apply to fixed costs and to contribute to income.
 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
 Break-Even Analysis

 Process of finding the break-even level of

activity at which total revenues equal total costs
(both fixed and variable).
 The break-even point can be:
– Computed from a mathematical equation.
– Computed by using contribution margin.
– Derived from a CVP graph.
 Expressed in either sales dollars or sales units.
 Break-Even Analysis:
Mathematical Equation
In its simplest form, the equation for break-
even sales is:

Break-even Sales = Variable Costs + Fixed Costs

 Break-Even Analysis:
Mathematical Equation for Units
The break-even point in units can be computed
directly from the mathematical equation by using
unit selling prices and unit variable costs. Vargo
must sell 1,000 units to break even. The
computation is:
$500X = $300X + $200,000
$200X = $200,000
X = 1,000 units
where:
X = sales volume
$500 = unit selling price
$300 = variable cost per unit
$200,000 = total fixed costs
Illustration 5-16
 Break-Even Analysis:
Mathematical Equation for Dollars

 For Vargo Video, the variable cost percentage is 60%

($300  $500). Sales must be $500,000 for Vargo Video
to break even. The computation to determine sales
dollars at the break-even point is:

X = .60X + $200,000
.40X = $200,000
X = $500,000
where:
X = sales dollars at the break-even point
.60 = variable costs as a percentage of unit selling price
$200,000 = total fixed costs

Illustration 5-15
 Break-Even Analysis:
Mathematical Equation Proof

The accuracy of the previous computations can be

proved as follows:

Sales (1,000 x $500) $500,000

Total costs:
Variable (1,000 x $300) $300,000
Fixed 200,000 500,000
Net Income $ -0-

Illustration 5-16
 Break-Even Analysis:
CM Technique for Units
Because we know that CM equals total revenues less variable costs, it follows that at the break-
even point, contribution margin must equal total fixed costs.
When the CM per unit is used, the formula to compute break-even point in units is shown below:

 Once again, the CM per unit for Vargo Video is $200.

Contribution Break-even Point

Fixed Costs
 Margin per Unit = in Units

$200,000  $200 = 1,000

 Break-Even Analysis:
CM Technique for Dollars
When the CM ratio is used, the formula to compute
break-even point in dollars is shown below:

 Again, the CM ratio for Vargo Video is 40%.

Contribution Break-even Point

Fixed Costs
 Margin Ratio = in Dollars

$200,000  40% = $500,000

 Break-Even Analysis:
Graphic Presentation
The construction of the graph, using the Vargo Video Company data, is as
follows:
1 Plot the total revenue line starting at the zero activity level.
2 Plot the total fixed cost by a horizontal line.
3 Plot the total cost line starting at the fixed cost line at zero activity and
increasing the amount by the variable cost at each level of activity.
4 Determine the break-even point from the intersection of the total cost
line and the total revenue line.
In addition to identifying the break-even point, the CVP graph shows both
the net income and net loss areas. Thus, the amount of income or loss at
each level of sales can be derived from the total sales and total cost lines.
 CVP Graph

Sales Line

$900 a
Are
fit Total Cost
ro
700 P
Line
Break-even Point
600
Dollars (000)

500

400

300

200 Fixed Cost

Loss Area
Line
100

200 400 600 800 1000 1200 1400 1600 1800

Units of Sales
 Review 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.
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.
Variable Fixed Net
Sales - - =
Costs Costs Income

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

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

Fixed Contribution Break-Even

÷ =
Costs Margin per Unit Point in Units

$180,000 ÷ $160 = 1,125 units

 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, or

► from a cost-volume profit (CVP) graph.

 Expressed either in sales units or in sales dollars.
 Target Net Income

Sales necessary to achieve a specified level of income.

Mathematical Equation
Formula for required sales to meet target net income.
 Mathematical Equation

Using the formula for the break-even point, simply include the
desired net income as a factor.
Contribution Margin Technique

To determine the required sales in units for Vargo Video:

 Contribution Margin Technique

To determine the required sales in dollars for Vargo Video:

 Margin of Safety

 Difference between actual or expected sales and sales at the

break-even point.
 Measures the “breathing room” or the “cushion” that
management has if expected sales fail to materialize.
 May be expressed in dollars or as a ratio.
 Assuming actual/expected sales are $750,000:
 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:

 The higher the dollars or percentage, the greater the margin

of safety.
 Review 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%.
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 assuming actual sales are
$1,382,400; and (c) the sales dollars required to earn
net income of $410,000.
Compute: (a) break-even point in dollars using the
contribution margin (CM) ratio.

Unit selling price $56

Unit variable costs - 42
Contribution margin per unit 14
Unit selling price 56
Contribution margin ratio 25%

Fixed costs $320,000

Contribution margin ratio 25%
Break-even sales in dollars $1,280,000
Compute: (b) the margin of safety assuming
actual sales are $1,382,400.

Actual (Expected) sales $ 1,382,400

Break-even sales - 1,280,000
Margin of safety in dollars 102,400
Actual (Expected) sales 1,382,400
Margin of safety ratio 7.4%
Compute: (c) the sales dollars required to
earn net income of $410,000.

Fixed costs $ 320,000

Target net income + 410,000
730,000
Contribution margin ratio 25%
Required sales in dollars $2,920,000
 Comprehensive

Mabo Company makes calculators that sell for $20 each. For the
coming year, management expects fixed costs to total $220,000 and
variable costs to be $9 per unit. Compute:
a) Break-even point in units using the mathematical equation.
b) Break-even point in dollars using the contribution margin (CM)
ratio.

c) Margin of safety percentage assuming actual sales are

$500,000.

d) Sales required in dollars to earn net income of $165,000.

 Comprehensive

Mabo Company makes calculators that sell for $20 each. For
the coming year, management expects fixed costs to total
$220,000 and variable costs to be $9 per unit. Compute
break-even point in units using the mathematical equation.

$20Q = $9Q + $220,000 + $0

$11Q = $220,000

Q = 20,000 units
 Comprehensive

Mabo Company makes calculators that sell for $20 each. For the
coming year, management expects fixed costs to total $220,000 and
variable costs to be $9 per unit. Compute break-even point in
dollars using the contribution margin (CM) ratio.

Contribution margin per unit = $20 - $9 = $11

Contribution margin ratio = $11 / $20 = 55%

Break-even point in dollars = $220,000 / 55%

= $400,000
 Comprehensive

Mabo Company makes calculators that sell for $20 each. For
the coming year, management expects fixed costs to total $220,000
and variable costs to be $9 per unit. Compute the margin of safety
percentage assuming actual sales are $500,000.
$500,000 - $400,000
Margin of safety = = 20%
$500,000
 Comprehensive

Mabo Company makes calculators that sell for $20 each. For the
coming year, management expects fixed costs to total $220,000 and
variable costs to be $9 per unit. Compute the sales required in
dollars to earn net income of $165,000.

$20Q = $9Q + $220,000 + $165,000

$11Q = $385,000

Q = 35,000 units

35,000 units x $20 = $700,000 required sales

 CVP and Changes in the
Business Environment
 Business conditions change rapidly and management
must respond intelligently to these changes.
 CVP analysis can be used in responding to change.
 The original VCR sales and cost data for Vargo
Video Company are shown below.

Unit selling price $ 500

Unit variable cost $ 300
Total fixed costs $ 200,000
Break-even sales $ 500,000 or 1,000 units
Illustration 5-26
 CVP and Changes in the
Business Environment: Case I
 A competitor is offering a 10% discount on the selling price of its
VCRs. Management must decide whether or not to offer a similar
discount.
 Question: What effect will a 10% discount on selling price have on
the break-even point for VCRs?
 Answer: A 10% discount on selling price reduces the selling price
per unit to $450 [$500 – ($500 x 10%)]. Variable cost per unit
remains unchanged at $300. Therefore, the contribution margin per
unit is $150. Assuming no change in fixed costs, break-even sales
are 1,333 units, calculated as follows:

Fixed Costs ÷ Contribution Margin per Unit = Break-even Sales

$ 200,000 ÷ $ 150 = 1,333 units (rounded)

Illustration 5-27
 CVP and Changes in the
Business Environment: Case II
 Management invests in new robotic equipment that will significantly
lower the amount of direct labor required to make the VCRs. It is
estimated that total fixed costs will increase 30% and that variable
cost per unit will decrease 30%.
 Question: What effect will the new equipment have on the sales
volume required to break even?
 Answer: Total fixed costs become $260,000 [$200,000 + ($200,000
x 30%)], and variable cost per unit is now $210 [$300 – ($300 x
30%)]. The new break-even point about 900 units, calculated as
follows:

Fixed Costs ÷ Contribution Margin per Unit = Break-even Sales

$ 260,000 ÷ ($500 - $210) = 900 units (rounded)

 CVP and Changes in the
Business Environment: Case III
 An increase in the price of raw materials will increase the unit variable cost of
VCRs by an estimated $25. Management is striving to hold the line on the
selling price of the VCRs, and plans a cost-cutting program that will save
$17,500 in fixed costs per month. Vargo Video Company is currently realizing
monthly net income of $80,000 on sales of 1,400 VCRs.
 Question: What increase in sales will be needed to to maintain the same level
of net income?
 Answer: The variable cost per unit increases to $325 ($300 + $25), and fixed
costs are reduced to $182,500 ($200,000 – $17,500). Because of the change in
variable cost, the variable cost becomes 65% of sales ($325 ÷ $500). Using the
equation for target net income, required sales are calculated to be $750,000, as
follows:
Required Sales = Variable Costs + Fixed Costs + Target Net Income
X = .65X + $182,500 + $80,000
.35X = $262,500
X = $750,000
 CVP Income Statement
 The CVP income statement classifies costs
and expenses as variable or fixed and
specifically reports contribution margin in the
body of the statement.
 The CVP income statement format is
sometimes called the contribution margin
format.
 This format is for internal management use
only.
 CVP Income Statement
 For purposes of illustrating the CVP income
statement, assume that Vargo Video Company
reaches its target net income of $120,000. From an
analysis of the transactions, the following
information is obtained on the $680,000 of costs
that were incurred in June:
Variable Fixed Total
Cost of goods sold $ 400,000 $ 120,000 $ 520,000
Selling expenses 60,000 40,000 100,000
Administrative expenses 20,000 40,000 60,000
$ 480,000 $ 200,000 $ 680,000
 Traditional versus CVP
Income Statement
 The CVP income statement and the traditional
income statement based on this data are shown side-
by-side on the next slide.
 Note that net income is the same ($120,000) in both
of the statements.
 The major difference is the format for the expenses.
 Also, the traditional statement shows gross profit,
whereas the CVP statement shows contribution
margin.
 Traditional versus CVP
Income Statement

Traditional Format CVP Format

Sales $ 800,000 Sales $ 800,000
Cost of goods sold 520,000 Variable expenses
Gross profit 280,000 Cost of goods sold $ 400,000
Operating expenses Selling expenses 60,000
Selling expenses $ 100,000 Administrative expenses 20,000
Administrative expenses 60,000 Total variable expenses 480,000
Total operating expenses 160,000 Contribution margin 320,000
Net income $ 120,000 Fixed expenses
Cost of goods sold 120,000
Selling expenses 40,000
Administrative expenses 40,000
Total fixed expenses 200,000
Net income $ 120,000