COST BEHAVIOR AND COST VOLUME PROFIT ANALYSIS

Types of Cost Behavior Patterns

Cost behavior is the manner in which a cost changes as a related activity
changes. Thebehavior of costs is useful to managers for a variety of reasons.
For example, knowinghow costs behave allows managers to predict profits as
sales and production volumeschange. Knowing how costs behave is also useful
for estimating costs, which affects avariety of decisions such as whether to
replace a machine.

Understanding the behavior of a cost depends on:

1. Identifying the activities that cause the cost to change. These activities are
called activitybases (or activity drivers).

2. Specifying the range of activity over which the changes in the cost are of
interest.This range of activity is called the relevant range.

There are three main types of costs according to their behavior:

Fixed Costs

Fixed costs are those which do not change with the level of activity within the
relevant range. These costs will incur even if no units are produced. For
example rent expense, straight-line depreciation expense, etc.
Fixed cost per unit decreases with increase in production. Following example
explains this fact:
Total Fixed Cost $30,000 $30,000 $30,000

÷ Units Produced 5,000 10,000 15,000

Fixed Cost per Unit $6.00 $3.00 $2.00

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Types of Fixed Costs

Fixed costs are sometimes referred to as capacity costs because they result
from outlays made for buildings, equipment, skilled professional employees,
and other items needed to provide the basic capacity for sustained operations.
For planning purposes, fixed costs can be viewed as either committed or
discretionary.

Committed Fixed Costs Investments in facilities, equipment, and the basic

organizationoften can’t be significantly reduced even for short periods of time
without makingfundamental changes. Such costs are referred to as committed
fixed costs . Examplesinclude depreciation of buildings and equipment, real
estate taxes, insurance expenses,and salaries of top management and
operating personnel. Even if operations are interruptedor cut back, committed
fixed costs remain largely unchanged in the short term.

During a recession, for example, a company won’t usually eliminate key

executive positionsor sell off key facilities—the basic organizational structure
and facilities ordinarilyare kept intact. The costs of restoring them later are
likely to be far greater than anyshort-run savings that might be realized.

Once a decision is made to acquire committed fixed resources, the company

may belocked into that decision for many years to come. Consequently, such
commitments should be made only after careful analysis of the available
alternatives.

Discretionary Fixed Costs Discretionary fixed costs (often referred to as

managedfixed costs ) usually arise from annual decisions by management to
spend on certain fixedcost items. Examples of discretionary fixed costs include
advertising, research, publicrelations, management development programs,
and internships for students.

Two key differences exist between discretionary fixed costs and committed
fixedcosts. First, the planning horizon for a discretionary fixed cost is short

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term—usually asingle year. By contrast, committed fixed costs have a planning
horizon that encompassesmany years. Second, discretionary fixed costs can be
cut for short periods of time withminimal damage to the long-run goals of the
organization. For example, spending onmanagement development programs
can be reduced because of poor economic conditions.

Although some unfavorable consequences may result from the cutback, it is

doubtful thatthese consequences would be as great as those that would result
if the company decidedto economize by laying off key personnel.

Whether a particular cost is regarded as committed or discretionary may

depend onmanagement’s strategy. For example, during recessions when the
level of home buildingis down, many construction companies lay off most of
their workers and virtually disbandoperations. Other construction companies
retain large numbers of employees on the payroll,even though the workers have
little or no work to do. While these latter companiesmay be faced with short-
term cash flow problems, it will be easier for them to respondquickly when
economic conditions improve. And the higher morale and loyalty of
theiremployees may give these companies a significant competitive advantage.

The most important characteristic of discretionary fixed costs is that

management isnot locked into its decisions regarding such costs. Discretionary
costs can be adjustedfrom year to year or even perhaps during the course of a
year if necessary.

Variable Costs

Variable costs change in direct proportion to the level of production. This

means that total variable cost increase when more units are produced and
decreases when less units are produced. Although variable in total, these costs
are constant per unit.

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For example

Total Variable Cost $10,000 $20,000 $30,000

÷ Units Produced 5,000 10,000 15,000

Variable Cost per Unit $2.00 $2.00 $2.00

Types of Variable Costs

Not all variable costs have exactly the same behavior pattern. Some variable
costs behavein a true variable or proportionately variable pattern. Other variable
costs behave in astep-variable pattern.

True Variable Costs.Direct material is a true or proportionately variable

costbecause the amount used during a period will vary in direct proportion to
the level ofproduction activity. Moreover, any amounts purchased but not used
can be stored andcarried forward to the next period as inventory.

Step-Variable Costs.The cost of a resource that is obtained in large chunks

and thatincreases or decreases only in response to fairly wide changes in
activity is known as astep-variable cost. For example, the wages of skilled
repair technicians are often consideredto be a step-variable cost. Such a
technician’s time can only be obtained in largechunks—it is difficult to hire a
skilled technician on anything other than a full-time basis.

Moreover, any technician’s time not currently used cannot be stored as

inventory andcarried forward to the next period. If the time is not used
effectively, it is gone forever.Furthermore, a repair technician can work at a
leisurely pace if pressures are light butintensify his or her efforts if pressures
build up. For this reason, small changes in the levelof production may have no
effect on the number of technicians employed by thecompany.

Notice that the cost of repair technicians changes only with fairlywide changes
in volume and that additional technicians come in large, indivisiblechunks.
Great care must be taken in working with these kinds of costs to prevent

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“fat”from building up in an organization. There may be a tendency to employ
additionalhelp more quickly than needed, and there is a natural reluctance to
lay people off whenvolume declines.

Mixed Costs

Mixed costs or semi-variable costs have properties of both fixed and variable
costs due to presence of both variable and fixed components in them. An
example of mixed cost is telephone expense because it usually consists of a
fixed component such as line rent and fixed subscription charges as well as
variable cost charged per minute cost. Another example of mixed cost is
delivery cost which has a fixed component of depreciation cost of trucks and a
variable component of fuel expense.

Since mixed cost figures are not useful in their raw form, therefore they are
split into their fixed and variable components by using cost behavior analysis
techniques such as High-Low Method, Scatter Diagram Method and Regression
Analysis.

Analysis of Mixed Costs

High Low Method

High-Low method is one of the several techniques used to split a mixed cost
into its fixed and variable components. Although easy to understand, high
low method is relatively unreliable. This is because it only takes two extreme
activity levels (i.e. labor hours, machine hours, etc.) from a set of actual data of
various activity levels and their corresponding total cost figures. These figures
are then used to calculate the approximate variable cost per unit (b) and total
fixed cost (a) to obtain a cost volume formula:

y = a + bx

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 High-Low Method Formulas

Variable Cost per Unit

Variable cost per unit (b) is calculated using the following formula:
Variable Cost per Unit y2 − y1
= x2 − x1
Where,
y2 is the total cost at highest level of activity;
y1 is the total cost at lowest level of activity;
x2 are the number of units/labor hours etc. at highest level of activity; and
x1 are the number of units/labor hours etc. at lowest level of activity
The variable cost per unit is equal to the slope of the cost volume line (i.e.
change in total cost ÷ change in number of units produced).

Total Fixed Cost

Total fixed cost (a) is calculated by subtracting total variable cost from total
cost, thus:
Total Fixed Cost = y2 − bx2 = y1 − bx1

Example

Company A wants to determine the cost-volume relation between its factory

overhead cost and number of units produced. Use the high-low method to split
its factory overhead (FOH) costs into fixed and variable components and create
a cost volume formula. The volume and the corresponding total cost
information of the factory for past eight months are given below:
Month Units FOH
1 1,520 $36,375
2 1,250 38,000
3 1,750 41,750
4 1,600 42,360
5 2,350 55,080
6 2,100 48,100
7 3,000 59,000
8 2,750 56,800

Solution:

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We have,
at highest activity: x2 = 3,000; y2 = $59,000
at lowest activity: x1 = 1,250; y1 = $38,000
Variable Cost per Unit = ($59,000 − $38,000) ÷ (3,000 − 1,250) = $12 per unit
Total Fixed Cost = $59,000 − ($12 × 3,000) = $38,000 − ($12 × 1,250)
= $23,000
Cost Volume Formula: y = $23,000 + 12x
Due to its unreliability, high low method is rarely used.

Scatter Graph Method

Scatter graph method is a graphical technique of separating fixed and variable

components of mixed cost by plotting activity level along x-axis and
corresponding total cost (mixed cost) along y-axis. A regression line is then
drawn on the graph by visual inspection. The line thus drawn is used to
estimate the total fixed cost and variable cost per unit. The point where the line
intercepts y-axis is the estimated fixed cost and the slope of the line is the
average variable cost per unit. Since the visual inspection does not involve any
mathematical testing therefore this method should be applied with great care.

Procedure

Step 1: Draw scatter graph

Plot the data on scatter graph. Plot activity level (i.e. number of units, labor
hours etc.) along x-axis and total mixed cost along y-axis.

Step 2: Draw regression line

Draw a regression line over the scatter graph by visual inspection and try to
minimize the total vertical distance between the line and all the points. Extend
the line towards y-axis.

Step 3: Find total fixed cost

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Total fixed is given by the y-intercept of the line. Y-intercept is the point at
which the line cuts y-axis.

Step 4: Find variable cost per unit

Variable cost per unit is equal to the slope of the line. Take two points (x 1,y1)
and (x2,y2) on the line and calculate variable cost using the following formula:

y2 − y1
Variable Cost per Unit = Slope of Regression Line = 
x2 − x1

Example

Company A decides to use scatter graph method to split its factory overhead
(FOH) into variable and fixed components. Following is the data which is
provided for the analysis.
Month Units FOH
1 1,520 $36,375
2 1,250 38,000
3 1,750 41,750
4 1,600 42,360
5 2,350 55,080
6 2,100 48,100
7 3,000 59,000
8 2,750 56,800

Solution:

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Fixed Cost = y-intercept = $18,000
Variable Cost per Unit = Slope of Regression Line
To calculate slop we will take two points on line: (0,18000) and (3500,68000)
Variable Cost per Unit = (68000 − 18000) ÷ (3500 − 0) = $14.286

Least-Squares Regression Method

Least-squares linear regression is a statistical technique that may be used to

estimate the total cost at the given level of activity (units, labor/machine hours
etc.) based on past cost data. It mathematically fits a straight cost line over a
scatter-chart of a number of activity and total-cost pairs in such a way that the
sum of squares of the vertical distances between the scattered points and the
cost line is minimized. The term least-squares regression implies that the ideal
fitting of the regression line is achieved by minimizing the sum of squares of
the distances between the straight line and all the points on the graph.

Assuming that the cost varies along y-axis and activity levels along x-axis, the
required cost line may be represented in the form of following equation:

y = a + bx

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 In the above equation, a is the y-intercept of the line and it equals the
approximate fixed cost at any level of activity. Whereas b is the slope of the line
and it equals the average variable cost per unit of activity.
By using mathematical techniques beyond the scope of this article, the
following formulas to calculate a and b may be derived:
Unit Variable Cost = b = nΣxy – Σx.Σy

nΣx2 - (Σx)2

Total Fixed Cost = a = Σy – bΣx

Where,
n is number of pairs of units—total-cost used in the calculation;
Σy is the sum of total costs of all data pairs;
Σx is the sum of units of all data pairs;
Σxy is the sum of the products of cost and units of all data pairs; and
Σx2 is the sum of squares of units of all data pairs.
The following example based on the same data as in high-low method tries to
illustrate the usage of least squares linear regression method to split a mixed
cost into its fixed and variable components:

Example

Based on the following data of number of units produced and the

corresponding total cost, estimate the total cost of producing 4,000 units. Use
the least-squares linear regression method.
Month Units Cost
1 1,520 $36,375
2 1,250 38,000
3 1,750 41,750
4 1,600 42,360
5 2,350 55,080
6 2,100 48,100
7 3,000 59,000
8 2,750 56,800

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 Solution:
x y x2 xy
1,520 $36,375 2,310,400 55,290,000
1,250 38,000 1,562,500 47,500,000
1,750 41,750 3,062,500 73,062,500
1,600 42,360 2,560,000 67,776,000
2,350 55,080 5,522,500 129,438,000
2,100 48,100 4,410,000 101,010,000
3,000 59,000 9,000,000 177,000,000
2,750 56,800 7,562,500 156,200,000
16,32 377,465 35,990,400 807,276,500
0

We have,
n = 8;
Σx = 16,320;
Σy = 377,465;
Σx2 = 35,990,400; and 
Σxy = 807,276,500

Calculating the average variable cost per unit:

B = 8 X 807,276,500 - 16,320 X 377,465 = 13.8

8 X 35,990,400 – (16,320)2

Calculating the approximate total fixed cost:

A = 377,465 - 13.8078 X 16,320 = 19,015

The cost-volume formula now becomes:

y = 19,015 + 13.8x
At 4,000 activity level, the estimated total cost is $74,215 [= 19,015 + 13.8 ×
4,000].

Coefficient of Determination

R2 is a statistic that will give some information about the goodness of fit of a
model. In regression, the R2 coefficient of determination is a statistical
measure of how well the regression line approximates the real data points.
An R2 of 1 indicates that the regression line perfectly fits the data.

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The coefficient of determination (denoted by R2) is a key output
of regression analysis. It is interpreted as the proportion of the variance in the
dependent variable that is predictable from the independent variable.

 The coefficient of determination is the square of the correlation (r)

between predicted y scores and actual y scores; thus, it ranges from 0 to
1.

 With linear regression, the coefficient of determination is also equal to

the square of the correlation between x and y scores.

 An R2 of 0 means that the dependent variable cannot be predicted from

the independent variable.

 An R2 of 1 means the dependent variable can be predicted without error

from the independent variable.

 An R2 between 0 and 1 indicates the extent to which the dependent

variable is predictable. An R2 of 0.10 means that 10 percent of the
variance in Y is predictable from X; an R2 of 0.20 means that 20 percent
is predictable; and so on.

The formula for computing the coefficient of determination for a linear

regression model with one independent variable is given below.

R2 = { ( 1 / N ) * Σ [ (xi - x) * (yi - y) ] / (σx * σy ) }2

where N is the number of observations used to fit the model, Σ is the

summation symbol, xi is the x value for observation i, x is the mean x value,
yi is the y value for observation i, y is the mean y value, σx is the standard
deviation of x, and σy is the standard deviation of y.

CVP analysis with multiple products

Cost-volume-profit (CVP) analysis is a helpful tool regardless of the number of
products a company sells. CVP analysis is more complex with multiple

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products. Two complications are encountered when multiple products are sold
by companies. First, companies rarely sell exactly the same number of units of
each product. Second, most products differ in their selling price and variable
cost per unit. As a consequence, in order to determine sales levels at breakeven
or target profit levels, these two issues must be addressed.

Sales Mix Break-even Point Calculation

Sales mix is the proportion in which two or more products are sold. For the
calculation of break-even point for sales mix, following assumptions are made
in addition to those already made for CVP analysis:

1. The proportion of sales mix must be predetermined.

2. The sales mix must not change within the relevant time period.

The calculation method for the break-even point of sales mix is based on the
contribution approach method. Since we have multiple products in sales mix
therefore it is most likely that we will be dealing with products with different
contribution margin per unit and contribution margin ratios. This problem is
overcome by calculating weighted average contribution margin per unit and
contribution margin ratio. These are then used to calculate the break-even
point for sales mix.

The calculation procedure and the formulas are discussed via following
example:

Example: Formulas and Calculation Procedure

Following information is related to sales mix of product A, B and C.

Product A B C
Sales Price per Unit $15 $21 $36
Variable Cost per $9 $14 $19
Unit
Sales Mix Percentage 20 20% 60%
%
Total Fixed Cost $40,000

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Calculate the break-even point in units and in dollars.

Calculation

Step 1: Calculate the contribution margin per unit for each product:
Product A B C
Sales Price per Unit $1 $21 $36
5
− Variable Cost per Unit $9 $14 $19
Contribution Margin per $6 $7 $17
Unit
Step 2: Calculate the weighted-average contribution margin per unit for the
sales mix using the following formula:

Product A CM per Unit × Product A Sales Mix Percentage

+ Product B CM per Unit × Product B Sales Mix Percentage
+ Product C CM per Unit × Product C Sales Mix Percentage
= Weighted Average Unit Contribution Margin

Product A B C
Sales Price per Unit $15 $21 $36
− Variable Cost per Unit $9 $14 $19
Contribution Margin per Unit $6 $7 $17
× Sales Mix Percentage 20% 20% 60%
  $1.2 $1. $10.2
4
Sum: Weighted Average CM per $12.80
Unit

Step 3: Calculate total units of sales mix required to break-even using the
formula:
Break-even Point in Units of Sales Mix = Total Fixed Cost ÷ Weighted Average
CM per Unit
Total Fixed Cost $40,000
÷ Weighted Average CM per Unit $12.80
Break-even Point in Units of Sales 3,125
Mix

Step 4: Calculate number units of product A, B and C at break-even point:

Product A B C
Sales Mix Ratio 20% 20% 60%

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× Total Break-even Units 3,125 3,12 3,125
5
Product Units at Break-even 625 625 1,875
Point

Step 5: Calculate Break-even Point in dollars as follows:

Product A B C
Product Units at Break-even 625 625 1,875
Point
× Price per Unit $15 $21 $36
Product Sales in Dollars $9,37 $13,125 $67,500
5
Sum: Break-even Point in Dollars $90,000

Assumptions Underlying CVP Analysis

For any cost-volume-profit analysis to be valid, the following important

assumptions must be reasonably satisfied within the relevant range.

1. The behavior of total revenue is linear (straight-line). This implies that

the price of the product or service will not change as sales volume varies
within the relevant range.
2. The behavior of total expenses is linear (straight- line) over the relevant
range. This implies the following more specific assumptions.
a) Expenses can be categorized as fixed, variable, or semi variable.
Total fixed expenses remain constant as activity changes, and the
unit variable expense remains unchanged as activity varies.
b) The efficiency and productivity of the production process and
workers remain constant.
3. In multiproduct organizations, the sales mix remains constant over the
relevant range.

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 4. In manufacturing firms, the inventory levels at the beginning and end of
the period are the same. This implies that the number of units produced
during the period equals the number of units sold.

CVP Relationships and the Income statement

The management functions of planning, control, and decision making all are
facilitated by an understanding of cost-volume-profit relationships. These
relationships are important enough to operating managers that some
businesses prepare income statements in a way that highlights CVP issues.

Traditional and contribution margin income statements provide a detailed

picture of a company's finances for a given period of time. While both serve the
purpose of showing whether a company has a net profit or loss, they differ in
the way they arrive at that figure.

Traditional income statement

Also known as a profit and loss statement, a traditional income statement

shows the extent to which a company is profitable or not during a given
accounting period. It provides a summary of how the company generates
revenues and incurs expenses through both operating and non-operating
activities. This income statement is prepared in the traditional manner. Cost of
goods sold includes both variable and fixed manufacturing costs, as measured
by the firm’s product costing system. The gross margin is computed by
subtracting cost of goods sold from sales. Selling and administrative expense
are then subtracted; each expense includes both variable and fixed costs. The
traditional income statement does not disclose the breakdown of each expense
into its variable and fixed components.

Contribution margin income statement

In a contribution margin income statement, a company's variable expenses are

deducted from sales to arrive at a contribution margin. A contribution margin

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is essentially a company's revenues minus its variable expenses, and it shows
how much of a company's revenues are contributing to its fixed costs and net
income. Once a contribution margin is determined, a company can subtract all
applicable fixed costs to arrive at a net profit or loss for the accounting period
in question.

Differences
While a traditional income statement works by separating product costs (those
incurred in the process of manufacturing a product) from period costs (those
incurred in the process of selling products, as opposed to making them), the
contribution margin income statement separates variable costs from fixed
costs. In a contribution margin income statement, variable selling and
administrative periods costs are grouped with variable product costs to arrive
at the contribution margin.

A traditional income statement uses absorption or full costing, where both

variable and fixed manufacturing costs are included when calculating the cost
of goods sold. The contribution margin income statement, by contrast, uses
variable costing, which means fixed manufacturing costs are assigned to
overhead costs and therefore not included in product costs.

Companies are generally required to present traditional income statements for

external reporting purposes. Contribution margin income statements, by
contrast, are often presented to managers and stakeholders to analyze the
performance of individual products or product categories. Companies can
benefit from contribution margin income statements because they can provide
more detail as to the costs and resources needed to produce a given product or
unit of a product. While both income statements ultimately serve the purpose
of showing whether a company is profitable or not over a certain period of time,
the contribution margin income statement can offer additional insight as how
to that net profit or loss came to be.

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Cost structure and Operating Leverage
The cost structure of an organization is the relative proportion of its fixed and
variable costs. Cost structures differ widely among industries and among firms
within an industry. A company using a computer-integrated manufacturing
system has a large investment in plant and equipment, which results in a cost
structure dominated by fixed costs. In contrast, a public accounting firm’s cost
structure has a much higher proportion of variable costs. The highly
automated manufacturing firm is capital intensive, whereas the accounting
firm is labor-intensive.

An organization’s cost structure has a significant effect on the sensitivity of its

profit to changes in volume. To summarize, the greater the proportion of fixed
costs in a firm’s cost structure, the greater the impact on profit will be from a
given percentage change in sales revenue.

Operating Leverage
Operating leverage measures a company’s fixed costs as a percentage of its
total costs. It is used to evaluate the breakeven point of a business, as well as
the likely profit levels on individual sales. The following two scenarios describe
an organization having high operating leverage and low operating leverage.

1. High operating leverage. A large proportion of the company’s costs are

fixed costs. In this case, the firm earns a large profit on each incremental
sale, but must attain sufficient sales volume to cover its substantial fixed
costs. If it can do so, then the entity will earn a major profit on all sales
after it has paid for its fixed costs.
2. Low operating leverage. A large proportion of the company’s sales are
variable costs, so it only incurs these costs if there is a sale. In this case,
the firm earns a smaller profit on each incremental sale, but does not
have to generate much sales volume in order to cover its lower fixed
costs. It is easier for this type of company to earn a profit at low sales

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 levels, but it does not earn outsized profits if it can generate additional
sales.

For example, a software company has substantial fixed costs in the form of
developer salaries, but has almost no variable costs associated with each
incremental software sale; this firm has high operating leverage. Conversely, a
consulting firm bills its clients by the hour, and incurs variable costs in the
form of consultant wages. This firm has low operating leverage.

To a physical scientist, leverage refers to the ability of a small force to move a

heavy weight. To the managerial accountant, operating leverage refers to the
ability of the firm to generate an increase in net income when sales revenue
increases.

The managerial accountant can measure a firm’s operating leverage, at a

particular sales volume, using the operating leverage factor:

Operating leverage factor = Contribution margin

Net income
For example, the Alaskan Barrel Company (ABC) has the following financial
results:

Revenues $100,000
Variable expenses     30,000

Fixed expenses     60,000

Net operating income   $10,000

 
ABC has a contribution margin of 70% and net operating income of $10,000,
which gives it a degree of operating leverage of 7. ABC’s sales then increase by
20%, resulting in the following financial results:

Revenues $120,000

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Variable expenses     36,000

Fixed expenses     60,000

Net operating income   $24,000

 
The contribution margin of 70% has stayed the same, and fixed costs have not
changed. Because of ABC’s high degree of operating leverage, the 20% increase
in sales translates into a greater than doubling of its net operating income.

When using the operating leverage measurement, constant monitoring of

operating leverage is more important for a firm having high operating leverage,
since a small percentage change in sales can result in a dramatic increase (or
decrease) in profits. A firm must be especially careful to forecast its revenues
carefully in such situations, since a small forecasting error translates into
much larger errors in both net income and cash flows. On the other hand, a
firm with high operating leverage has a relatively high break-even point.

Knowledge of the level of operating leverage can have a profound impact on

pricing policy, since a company with a large amount of operating leverage must
be careful not to set its prices so low that it can never generate enough
contribution margin to fully offset its fixed costs.

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