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COST BEHAVIOR

Cost behavior is the general term for describing whether a cost changes when the level of
output changes. Costs can be variable, fixed, or mixed.
Fixed cost is a cost that does not change in total as output changes is a.
Variable cost, increases in total with an increase in output and decreases in total with a
decrease in output.
Cost driver is a causal factor that measures the output of the activity that leads or causes costs
to change. (Fixed and variable costs have meaning only when related to some output measure
which is cost driver.)
Relevant range is the range of output over which the assumed cost relationship is valid for the
normal operations of a firm. It limits the cost relationship to the range of operations that the
firm normally expects to occur.
Fixed costs are costs that in total are constant within the relevant range as the level of output
increases or decreases. Two types of fixed costs are commonly recognized: discretionary fixed
costs and committed fixed costs.
o Discretionary fixed costs are fixed costs that can be changed or avoided relatively easily at
management discretion.
o Committed fixed costs, on the other hand, are fixed costs that cannot be easily changed.
o An example of discretionary fixed cost is advertising, because spending money on it
depends on a management decision. Conversely, lease costs are committed fixed costs
because they locked the company into a long-term contract.
#While the total fixed cost of supervision remains the
same, the unit cost decreases as
more computers are produced.
#The number of computers
processed is called the
output measure, or driver.
Supervision cost is fixed with
respect to the number of computers
produced.

Variable costs are costs that in

total vary in direct proportion to changes in output within the relevant range. Total variable
costs depend on the level of output.
Total variable costs = Variable rate X Amount of output

Mixed costs are costs that have both a fixed and a variable component.

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o For example, overhead for a company may consist of a fixed supervisor salary plus the cost
of supplies that vary with the quantity of output produced. The formula and graph depiction
for a mixed cost is as follows:
Total cost = Total fixed cost + Total variable cost

Methods for Separating Mixed Costs into Fixed and Variable Component
Three methods of separating a mixed cost into its fixed and variable components are
commonly used:
The High-Low Method
The Scattergraph Method
The Method of Least Squares
1. The High-Low Method
The high-low method is method of separating mixed costs into fixed and variable components
by using just the high and low data points (of activity driver).

Step 1: Find the high point and the low point for a given data set.

Step 2: Using the high and low point, calculate the variable rate.

Variable rate = (High point cost - Low point cost) (High point output Low point output)

Step 3: Calculate the fixed cost using the variable rate (from Step 2) and either the
high point or low point.

Fixed cost = Total cost at high point - (Variable rate x Output at high
point)

Step 4: Form the cost formula for materials handling based on the high-low method.
2. Scattergraph Method
The scattergraph method is a way to see the cost relationship by plotting the data points on a
graph.
The first step in applying the scattergraph method is to plot the data points so that the
relationship between materials handling costs and activity output can be seen. Then
inspect the scattergraph to see if it reveals one or more points (outliers) that do not seem
to fit the general pattern of behavior.
Next, question whether the line determined by the high and low points is representative of
the overall relationship. Notice that three points lie above the high-low line, but five
points lie below it. This does not give confidence in the high-low results for fixed and
variable costs.
Finally, use the scattergraph to visually fit a line to the data points on the graph. Of
course, the manager or cost analyst will choose the line that appears to fit the points
the best, and perhaps that choice will take into account past experience with the
behavior of the cost item.

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3.
3.
3.
3.
3.
3.
3. The Method of Least Squares
The method of least squares (regression) is a statistical way to find the best-fitting line
through a set of data points. One advantage of the method of least squares is that for a given
set of data, it will always produce the same cost formula. Basically, the best-fitting line is the
one in which the data points are closer to the line than to any other line.
o Line Deviations
The regression line better describes the pattern of
the data than other possible lines, because the
squared deviations between the regression line and
each data point are, in total, smaller than the sum of
the squared deviations of the data points and any
other line.
The least squares statistical formulas can find the
one line with the smallest sum of squared
deviations or the line which minimizes the cost
prediction errors or differences between predicted
costs and actual costs.
Comparison of Methods for Separating Fixed Costs into Fixed and Variable Components

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Accounting English Class

COST VOLUME PROFIT ANALYSIS: A MANAGERIAL PLANNING TOOL

Break-Even Point in Units and Sales Dollars

Cost-volume-profit (CVP) analysis estimates how changes in the following three factors
affect a companys profit.
o
Costs (both variable and fixed)
o
Sales volume
o
Price

Companies use CVP analysis to help them reach important benchmarks, like breakeven
point.

The break-even point is the point where total revenue equals total cost (i.e., the point of zero
profit). The break-even point is the level of sales at which contribution margin just covers
fixed costs and consequently net income is equal to zero. Since new companies typically
experience losses (negative operating income) initially, they view their first break-even period
as a significant milestone.

Besides breakeven point, CVP analysis can address many other issues as well, including:
o
the number of units that must be sold to break even
o
the impact of a given reduction in fixed costs on the break-even point
o
the impact of an increase in price on profit

In CVP analysis, the terms cost and expense are often used interchangeably. This is
because the conceptual foundation of CVP analysis is the economics of breakeven analysis in
the short run. For this, it is assumed that all units produced are sold. Therefore, all product and
period costs do end up as expenses on the income statement. For the income statement,
expenses are classified according to function; that is, the manufacturing (or service provision)
function, the selling function, and the administrative function. For CVP analysis, however, it
is much more useful to organize costs into fixed and variable components. The focus is on the
firm as a whole. Therefore, the costs refer to all costs of the companyproduction, selling,
and administration. So variable costs are all costs that increase as more units are sold,
including:
o Direct materials
o Direct labor
o Variable overhead
o Variable selling and administrative costs
Similarly, fixed costs include:
o Fixed overhead
o Fixed selling and administrative expenses

The income statement format given below is based on the separation of costs into fixed and
variable components and is called the contribution margin income statement.

Contribution margin is the difference between sales and variable expense. It is the amount of
sales revenue left over after all the variable expenses are covered that can be used to
contribute to fixed expense and operating income.

If the contribution margin income statement is recast as an equation, it becomes more useful
for solving CVP problems. The operating income equation is:

We can further expand the operating income equation by expressing sales revenues and
variable expenses in terms of unit dollar amounts and the number of units sold. More

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specifically, sales revenue equals the unit selling price times the number of units sold, and
total variable costs equal the unit variable cost times the number of units sold.

Break-Even Point in Units

The break-even units are equal to the fixed cost divided by the contribution margin per unit.
So, if a company sells enough units for the contribution margin to just cover fixed costs, it
will earn zero operating income: it will break even. It is quicker to solve break-even problems
using this break-even version of the operating income equation than it is using the original
operating income equation.

Break-Even Point in Sales Dollars

Sometimes, managers using CVP analysis may prefer to use sales revenue as the measure of
sales activity instead of units sold. A unit sold measure can be converted to a sales revenue
measure by multiplying the unit selling price by the units sold:

Variable Cost Ratio and Contribution Margin Ratio

Any answer expressed in units sold can be easily converted to one expressed in sales
revenues, but the answer can be computed more directly by developing a separate formula for
the sales revenue case. Here, the important variable is sales dollars, so both the revenue and
the variable costs must be expressed in dollars instead of units
Variable Cost Ratio
Contribution Margin Ratio

Alternatively:

The variable cost ratio is the proportion of each sales

dollar that must be used to cover variable costs. The variable cost ratio can be computed using
either total data or unit data. The contribution margin ratio is the proportion of each sales
dollar available to cover fixed costs and provide for profit.
Fixed Costs Relationship with the Variable Cost Ratio and the Contribution Margin Ratio

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Since the total contribution margin is the revenue remaining after total variable costs are
covered, it must be the revenue available to cover fixed costs and contribute to profit. How
does the relationship of fixed cost to contribution margin affect operating income?
There are three possibilities:
o
Fixed cost equals contribution margin; operating income is zero; the company
breaks even.
o
Fixed cost is less than contribution margin; operating income is greater than zero; the
company makes a profit.
o
Fixed cost is greater than contribution margin; operating income is less than zero; the
company makes a loss.
Calculating Break-Even in Sales Dollars

Units to Be Sold to Achieve a Target Income

While the break-even point is useful information and an important benchmark for relatively
young companies, most companies would like to earn operating income greater than $0. CVP
allows us to do this by adding the target income amount to the fixed cost. First, lets look in
terms of the units that must be sold to earn a desired income.

Impact of Change in Revenue on Change in Profit

Assuming that fixed costs remain unchanged, the contribution margin ratio can be used to find
the profit impact of a change in sales revenue. To obtain the total change in profits from a
change in revenues, multiply the contribution margin ratio times the change in sales.
Change in Profits = Contribution Margin Ratio x Change in Sales
Graphs of Cost-Volume-Profit Relationships: The Profit-Volume Graph
A profit-volume graph visually portrays the relationship between profits (operating income) and
units sold. The profit-volume graph is the graph of the operating
income equation.
Operating income = (Price x Units) - (Unit variable cost x Units) Total fixed cost
In this graph, operating income is the dependent variable, and unit is
the independent variable.

Graphs of Cost-Volume-Profit Relationships: The Cost-VolumeProfit Graph

Graphically, the break-even point can be found by comparing a
companys total
revenue with its total costs (both fixed and variable). The cost-volume-profit graph depicts the
relationships among cost, volume, and profits (operating income) by plotting the total revenue

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line and the total cost line on a graph. As

shown, the break-even point is the volume
total revenue is equal to total cost.

at which

CVP Analysis Assumptions

The profit-volume and cost-volume-profit
graphs rely
on important assumptions. Some of these
assumptions are as
follows:
o There are identifiable linear
revenue and linear cost functions
that
remain constant over the relevant
range.
o Selling prices and costs are known with
certainty.
o Units produced are soldthere are no finished goods inventories.
o Sales mix is known with certainty for multiple-product break-even settings.
Multiple-Product Analysis
Cost-volume-profit analysis is fairly simple in the single-product setting.
How do we adapt the formulas used in a single-product setting to a multiple-product setting?
One important distinction is to separate direct fixed expenses from common fixed expenses.
Direct fixed expenses are those fixed costs that can be traced to each segment and
would be avoided if the segment did not exist.
Common fixed expenses are the fixed costs that are not traceable to the segments and
would remain even if one of the segments was eliminated.
Break-Even Calculations for Multiple Products
When more than one product is produced and sold, managers must estimate the sales mix
and calculate a package contribution margin. Sales mix is the relative combination of
products being sold by a firm.
Total

Break Even Packages= Cost

Package Contribution Margin
Cost-Volume-Profit Analysis and Risk and Uncertainty
Because firms operate in a dynamic world, they must be aware of changes in prices, variable
costs, and fixed costs. They must also account for the effect of risk and uncertainty. The
break-even point can be affected by changes in price, unit contribution margin, and fixed cost.
Managers can use CVP analysis to handle risk and uncertainty.
Risk and Uncertainty
An important assumption of CVP analysis is that prices and costs are known with certainty.
However, risk and uncertainty are a part of business decision making and must be dealt with
somehow.
Methods to Deal with Uncertainty and Risk
Management must realize the uncertain nature of future prices, costs, and quantities.
Managers move from consideration of a break-even point to what might be called a breakeven band.
Managers may engage in sensitivity or what-if analysis.
Margin of Safety

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The margin of safety is the units sold or the revenue earned above the break-even volume. It
can be calculated in units, in terms of sales revenue and as a percentage of total sales dollars.
Operating Leverage
Operating leverage is the use of fixed costs to extract higher percentage changes in profits as
sales activity changes. It is the measure of the proportion of fixed costs in a companys cost
structure. It is used as an indicator of how sensitive profit is to changes in sales volume.
The degree of operating leverage (DOL) can be measured for a given level of sales by
taking the ratio of contribution margin to operating income or:
Contribution margin Operating income
When fixed costs are used to lower variable costs such that contribution margin increases and
operating income decreases, then the degree of operating leverage increases and this signals
an increase in risk.
Summary of Operating Leverage
Operating
Leverage
HIGH

LOW

% profit increase with sales

increase

Large

Small

% loss increase with sales decrease

Large

Small

To summarize, when operating leverage is high, a change in sales results in large changes in
profit. On the other hand, when operating leverage is low, a change in sales results in small
changes in profits. Put another way, the greater the degree of operating leverage, the more that
changes in sales will affect operating income.