CHAPTER I

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.
The behavior of costs is useful to managers for a variety of reasons. For example,
knowing how costs behave allows managers to predict profits as sales and
production volumes change. Knowing how costs behave is also useful for estimating
costs, which affects a variety 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
activity bases (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

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
organization often can’t be significantly reduced even for short periods of time
without making fundamental changes. Such costs are referred to as committed
fixed costs. Examples include depreciation of buildings and equipment, real estate

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taxes, insurance expenses, and salaries of top management and operating
personnel. Even if operations are interrupted or 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
positions or sell off key facilities—the basic organizational structure and facilities
ordinarily are kept intact. The costs of restoring them later are likely to be far
greater than any short-run savings that might be realized.
Once a decision is made to acquire committed fixed resources, the company may be
locked 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 managed fixed costs) usually arise
from annual decisions by management to spend on certain fixed cost items.
Examples of discretionary fixed costs include advertising, research, public relations,
management development programs, and internships for students.
Two key differences exist between discretionary fixed costs and committed fixed
costs. First, the planning horizon for a discretionary fixed cost is short term usually
a single year. By contrast, committed fixed costs have a planning horizon that
encompasses many years. Second, discretionary fixed costs can be cut for short
periods of time with minimal damage to the long-run goals of the organization. For
example, spending on management development programs can be reduced because
of poor economic conditions.
Although some unfavorable consequences may result from the cutback, it is
doubtful that these consequences would be as great as those that would result if
the company decided to economize by laying off key personnel.
Whether a particular cost is regarded as committed or discretionary may depend on
management’s strategy. For example, during recessions when the level of home
building is down, many construction companies lay off most of their workers and
virtually disband operations. Other construction companies retain large numbers of
employees on the payroll, even though the workers have little or no work to do.

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While these latter companies may be faced with short-term cash flow problems, it
will be easier for them to respond quickly when economic conditions improve. And
the higher morale and loyalty of their employees may give these companies a
significant competitive advantage.
The most important characteristic of discretionary fixed costs is that management
is not locked into its decisions regarding such costs. Discretionary costs can be
adjusted from 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.
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
behave in a true variable or proportionately variable pattern. Other variable costs
behave in a step-variable pattern.
True Variable Costs; Direct material is a true or proportionately variable cost
because the amount used during a period will vary in direct proportion to the level
of production activity. Moreover, any amounts purchased but not used can be
stored and carried forward to the next period as inventory.
Step-Variable Costs; The cost of a resource that is obtained in large chunks
/amounts/and that increases or decreases only in response to fairly wide changes
in activity is known as a step-variable cost. For example, the wages of skilled
repair technicians are often considered to be a step-variable cost. Such a
technician’s time can only be obtained in large chunks—it is difficult to hire a
skilled technician on anything other than a full-time basis.

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Moreover, any technician’s time not currently used cannot be stored as inventory
and carried 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 but intensify his or her efforts if pressures build up. For this reason, small
changes in the level of production may have no effect on the number of technicians
employed by the company.
Notice that the cost of repair technicians changes only with fairly wide changes in
volume and that additional technicians come in large, indivisible chunks. Great
care must be taken in working with these kinds of costs to prevent “fat” from
building up in an organization. There may be a tendency to employ additional help
more quickly than needed, and there is a natural reluctance to lay people off when
volume 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:

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 y = a + bx
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:
We have,
at highest activity: x2 = 3,000; y2 = $59,000
at lowest activity: x1 = 1,250; y1 = $38,000

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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
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:
Variable Cost per Unit = Slope of Regression Line = y2 − y1
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.

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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:

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

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 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
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 – bΣxn
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.

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.

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  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, y i is the y value
for observation i, y is the mean y value, σ x 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 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:
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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
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

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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%
× 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.

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 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.
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.

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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 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.
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

14
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 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

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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
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.

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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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