Copyright © 2014 Pearson Education 2-1

Ch 2 – Horngren et al 2014

Tutorial Chapter 12

Introduction to Cost Behavior

and Cost-Volume-Profit
Relationships
Presented by

Dr Noor Ajian Mohd Lair

Senior Lecturer
Mechaincal Engineering Program
Faculty of Engineering
Universiti Malaysia Sabah

Office No 43, 2nd floor

Ext: 3422 2-2
Copyright © 2014 Pearson Education
email: [email protected]
 Fixed Costs and Relevant Range
Example 1

Suppose that total monthly fixed costs are $100,000

for a General Electric lightbulb plant as long as
production is between 40,000 and 85,000 cases of
lightbulbs per month. However, if production falls
below 40,000 cases, changes in production
processes will slash fixed costs to $60,000 per
month. On the other hand, if operations rise above
85,000 cases, rentals of additional facilities will
boost fixed costs to $115,000 per month. Exhibit
2-6 graphs
these assumptions about cost behavior. The top
figure shows a refined analysis that reflects all the
complexities described previously.
Copyright © 2014 Pearson Education 2-3
Fixed Costs and Relevant Range

Copyright © 2014 Pearson Education 2-4

 Fixed Costs and Relevant Range
Example 1

The bottom figure shows a simplified analysis that

focuses only on the cost in the relevant range,
ignoring the issue of cost behavior outside the
relevant range. Within the relevant range
highlighted in yellow, the refined and simplified
analyses coincide. However, the refined
description at the top of Exhibit 2-6 explicitly
shows the rental costs at the levels of activity
outside the relevant range. The simplified
description at the bottom of the exhibit shows only
the rental costs for the relevant range, and uses a
dashed line outside the relevant range to remind
the user that the graphed cost is outside the limits
of Copyright
the relevant range.
© 2014 Pearson Education 2-5
 Example 2: Cost-Volume-Profit
(CVP) (or Break even analysis)

Amy Winston, the manager of food services for

one of Boeing’s plants, is trying to decide
whether to rent a line of snack vending
machines. Although individual snack items
have various acquisition costs and selling
prices, Winston has decided that an average
selling price of $1.50 per unit and an average
acquisition cost of $1.20 per unit will suffice
for purposes of this analysis. She predicts the
revenue and expense relationships.

Copyright © 2014 Pearson Education 2-6

 Example 2: CVP

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

effects of output volume on revenue (sales), expenses
(costs), and net income (net profit).

Per Unit Percentage of

Sales
Selling price $1.50 100%
Variable cost of each item 1.20 80
Selling price less variable cost $ .30 20%

Monthly fixed expenses:

Rent $3,000
Wages for replenishing and
servicing 13,500
Other fixed expenses 1,500
Total fixed expenses per month $18,000

Copyright © 2014 Pearson Education 2-7

 Cost-Volume-Profit Graph
$150,000 A
Net Income
138,000 Sales C
120,000 Net Income Area
Dollars

D
90,000 Variable
Total Break-Even Point Expenses
60,000 Expenses 60,000 units
Net Loss
30,000 or $90,000
Area
18,000 B
Fixed Expenses
0 10 20 30 40 50 60 70 80 90 100

Units (thousands)

Break even where: total expenses = total sales (revenue)

Therefore, no loss and net income is zero
Copyright © 2014 Pearson Education 2-8
 Example
Break-Even Point: Contribution
Margin Method

Contribution margin Contribution margin ratio

Per Unit Per Unit %
Selling price $1.50 Selling price 100
Variable costs 1.20 Variable costs 80
Contribution margin$ .30 Contribution margin 20

$18,000 fixed costs ÷ $.30 =

60,000 units (break even)
Copyright © 2014 Pearson Education 2-9
 Break-Even Point: Contribution
Margin Method

60,000 units × $1.50 (Sales Price) = $90,000

in sales to break even

$18,000 fixed costs

÷ 20% (contribution-margin percentage)
= $90,000 of sales to break even

Copyright © 2014 Pearson Education 2 - 10

 Example
Break-Even Point:
Equation Method

Let N = number of units

to be sold to break even.

Variable Fixed
Sales – Expenses – Expenses = net income
$1.50N – $1.20N – $18,000 = 0
$.30N = $18,000
N = $18,000 ÷ $.30
N = 60,000 Units
Copyright © 2014 Pearson Education 2 - 11
 Break-Even Point: Equation
Method
Let S = sales in dollars
needed to break even.

S – .80S – $18,000 = 0
.20S = $18,000
S = $18,000 ÷ .20
S = $90,000

Shortcut formulas:
Break-even = fixed expenses = $18,000 = 60,000
volume in units unit contribution margin .30

Break-even = fixed expenses = $18,000 = $90,000

volume in sales contribution margin ratio .2

Copyright © 2014 Pearson Education 2 - 12

 Learning
Objective 6 Example
Target Net Profit
Managers use CVP analysis
to determine the total sales,
in units and dollars, needed
to reach a target net profit.

Target sales
– variable expenses
– fixed expenses
target net income
Copyright © 2014 Pearson Education 2 - 13
 Example
Target Net Profit

Winston considers $1,440 per month the

minimum acceptable net income. How many
units will she have to sell to justify the
adoption of the vending machine plan? How
does the number of units “translate” into
dollar sales?

Copyright © 2014 Pearson Education 2 - 14

 Target Net Profit

Target sales volume in units =

(Fixed expenses + Target net income)
÷ Contribution margin per unit

Selling price $1.50

Variable costs 1.20
Contribution margin per unit $ .30

($18,000 + $1,440) ÷ $.30 = 64,800 units

Target sales dollars = sales price X sales volume in units

Target sales dollars = $1.50 X 64,800 units = $97,200.

Copyright © 2014 Pearson Education 2 - 15

 Target Net Profit

Contribution margin ratio

Per Unit %
Selling price 100
Variable costs 80
Contribution margin 20

Target sales volume in dollars =

Fixed expenses + target net income
contribution margin ratio
Sales volume in dollars =
18,000 + $1,440 = $97,200
.20
Copyright © 2014 Pearson Education 2 - 16
 Example
Nonprofit Application
Suppose a city has a $100,000
lump-sum budget appropriation
to conduct a counseling program.

Variable costs per prescription

are $400 per patient per day.

Fixed costs are $60,000 in the

relevant range of 50 to 150 patients.

If the city spends the entire budget appropriation,

how many patients can it serve in a year?. 2 - 17
Copyright © 2014 Pearson Education
 Nonprofit Application

If the city spends the entire budget

appropriation, how many patients
can it serve in a year?

Variable + Fixed
Sales = expenses + expenses
$100,000 = $400N + $60,000
$400N = $100,000 – $60,000
N = $40,000 ÷ $400
N = 100 patients

Copyright © 2014 Pearson Education 2 - 18

 Nonprofit Application

If the city cuts the total budget appropriation by

10%, how many patients can it serve in a year?

Budget after 10% Cut

$100,000 X (1 - .1) = $90,000

Variable + Fixed
Sales = expenses + expenses
$90,000 = $400N + $60,000
$400N = $90,000 – $60,000
N = $30,000 ÷ $400
N = 75 patients
Copyright © 2014 Pearson Education 2 - 19
 Example
Contribution Margin and Gross Margin

(Revisit) Amy Winston, the manager of food

services for one of Boeing’s plants, is trying to
decide whether to rent a line of snack vending
machines. Although individual snack items
have various acquisition costs and selling
prices, Winston has decided that an average
selling price of $1.50 per unit and an average
acquisition cost of $1.20 per unit will suffice
for purposes of this analysis. She predicts the
revenue and expense relationships.

Copyright © 2014 Pearson Education 2 - 20

 Example
Contribution Margin and Gross Margin

Sales price – Cost of goods sold = Gross margin

Sales price - all variable expenses =

Contribution margin

Per Unit
Selling price $1.50
Variable costs (acquisition cost) 1.20
Contribution margin and
gross margin are equal $ .30

The contribution margin and the gross margin are identical

because the cost of goods sold is the only variable cost
Copyright © 2014 Pearson Education 2 - 21
 Contribution Margin and Gross Margin

However, Suppose the firm paid a commission

of $.12 per unit sold.

Contribution Gross
Margin Margin
Per Unit Per Unit
Sales $1.50 $1.50
Acquisition cost of unit sold 1.20 1.20
Variable commission .12
Total variable expense $1.32
Contribution margin .18
Gross margin $.30

In this case the contribution and gross margin are not identical.
Copyright © 2014 Pearson Education 2 - 22
 Ch 3 – Horngren et al 2014

Tutorial: Chapter 12 (Cont)

Copyright © 2014 Pearson Education 2 - 23

 Examples of Committed
and Discretionary Fixed Costs
Marietta Corporation is experiencing financial difficulties. Sales
for its major products are down, and Marietta’s management is
considering cutting back on costs temporarily. Marietta’s
management must determine which of the above fixed costs it can
reduce or eliminate and how much money each would save.
Fixed Costs Planned
Amounts
Advertising and promotion $ 50,000
Depreciation 400,000
Employee training 100,000
Management salaries 800,000
Mortgage payment 250,000
Property taxes 600,000
Research and development 1,500,000
Total Copyright © 2014 Pearson Education$3,700,000 2 - 24
 Examples of Committed
and Discretionary Fixed Costs
Fixed Costs Planned Amounts
Committed
Depreciation $ 400,000
Mortgage payment 250,000
Property taxes 600,000
Total committed $1,250,000

Discretionary (potential savings)

Advertising and promotion $ 50,000
Employee training 100,000
Management salaries 800,000
Research and development 1,500,000
Total discretionary $2,450,000
Total committed and discretionary $3,700,000
Copyright © 2014 Pearson Education 2 - 25
Can Marietta reduce or eliminate any of the fixed costs?
The answer depends on Marietta’s long-run outlook.
Marietta could reduce costs but also greatly reduce
its ability to compete in the future if it cuts fixed
costs carelessly. Suppose rearranging these costs by
categories of committed and discretionary costs
yields the above analysis.
Eliminating all discretionary fixed costs would save
Marietta $2,450,000 per year. However, Marietta
might be unwise to cut all discretionary costs
completely. This could severely impair the company’s
long-run prospects and its future competitive
position. Distinguishing committed and discretionary
fixed costs would be the company’s first step in
identifying where costs could be reduced.
Copyright © 2014 Pearson Education 2 - 26
Example: Choice of Cost Drivers:
Activity Analysis

Northwestern Computers makes two

products: Mozart-Plus and Powerdrive

In the past, most of the support costs

were twice as much as labor costs.

Northwest has upgraded the production

function, which has increased support
costs and reduced labor cost.

Copyright © 2014 Pearson Education 2 - 27

 Northwestern has just finished upgrading the
production process. Now the company uses
computer-controlled assembly equipment, which has
increased the costs of support activities, such as
engineering and maintenance, and has reduced labor
cost. Its cost function has now changed; specifically,
labor cost is now only 5% of the total costs at
Northwestern. An activity analysis has shown that
the number of components added to products (a
measure of product complexity), not labor cost, is
the primary cost driver for support costs.

Copyright © 2014 Pearson Education 2 - 28

Choice of Cost Drivers: Activity
Analysis

Using the old cost driver, labor cost, the

prediction of support costs would be:

Mozart-Plus Powerdrive
Labor cost $ 8.50 $130.00
Support cost:
2 × Direct labor
cost $17.00 $260.00

Copyright © 2014 Pearson Education 2 - 29

 Choice of Cost Drivers: Activity
Analysis
Using the more appropriate cost driver,
the number of components added to products,
companies can predict support costs more accurately.

Mozart-Plus Powerdrive
Support cost at $20
per component
$20 × 5 components $100.00
$20 × 9 components $180.00
Difference in predicted
support cost $ 83.00 $ 80.00
higher lower

Managers will make better decisions with this more

accurate information.

Copyright © 2014 Pearson Education 2 - 30

 Learning
Objective 4 Methods of Measuring Cost Functions

Examples covers as followed:

Account analysis
High-low analysis
Least-squares regression analysis

Copyright © 2014 Pearson Education 2 - 31

 Example: Parkview Medical Center

The facilities maintenance department at the

Parkview Medical Center analyzes cost for a
recent month. The following table shows
costs recorded in a month with 3,700 patient-
days:

Monthly cost Amount

Supervisor’s salary and benefits $ 3,800
Hourly workers’ wages and benefits 14,674
Equipment depreciation and rentals 5,873
Equipment repairs 5,604
Cleaning supplies 7,472
Total maintenance costs $37,423

Copyright © 2014 Pearson Education 2 - 32

 Example:
Account Analysis
The simplest method of account analysis selects a plausible
cost driver and classifies each account as a variable or fixed cost.
For this case, the most plausible and reliable cost driver is
the number of patient-day serviced per month.

Parkview Medical Center

Monthly cost Amount Fixed Variable

Supervisor’s salary and benefits $ 3,800 $3,800

Hourly workers’ wages and benefits 14,674 $14,674
Equipment depreciation and rentals 5,873 5,873
Equipment repairs 5,604 5,604
Cleaning supplies 7,472 7,472
Total maintenance costs $37,423 $9,673 $27,750

Copyright © 2014 Pearson Education 2 - 33

 Account Analysis Example

3,700 patient-days

Fixed cost per month = $9,673

Variable cost per patient-day

= $27,750 ÷ 3,700
= $7.50 per patient-day

Y = $9,673 + ($7.50 × patient-days)

Copyright © 2014 Pearson Education 2 - 34

 Example:High-Low Method
The following table shows the monthly data collected
for the Parkview Medical Center on facitlities
maintenance department costs and the number of
patient-days serviced over the past year.

Month FMD Cost(Y) Num of Patient-Days (X)

January $37,000 3,700
February 23,000 1,600
March 37,000 4,100
April 47,000 4,900
May 33,000 3,300
June 39,000 4,400
July 32,000 3,500
August 33,000 4,000
Sept 17,000 1,200
October 18,000 1,300
Novermber 22,000 1,800
December 20,000 1,600

Copyright © 2014 Pearson Education 2 - 35

 Example:
High-Low Method
Plot historical data points on a graph.

Focus on the highest- and lowest-activity points.

High month: April

Maintenance cost: $47,000
Number of patient-days: 4,900

Low month: September

Maintenance cost: $17,000
Number of patient-days: 1,200

Copyright © 2014 Pearson Education 2 - 36

 High-Low Method Example

The point at which the line intersects the Y axis is

the intercept, F, or estimate of Fixed Costs, and the
slope of the line measures the variable cost.
Copyright © 2014 Pearson Education 2 - 37
 High-Low Method Example

What is the variable cost (V)?

Using algebra to solve for variable and fixed costs.

Variable costs = Change in costs

change in activity

V = ($47,000 – $17,000) ÷ (4,900 – 1,200)

= $30,000 ÷ 3,700 = $8.1081

Copyright © 2014 Pearson Education 2 - 38

 High-Low Method Example

What is the fixed cost (F)?

F = Total mixed cost – total variable cost

At X (high): F = $47,000 - ($8.1081× 4,900 patient-days)
= $47,000 – $39,730
= $7,270 a month

At X (low): F = $17,000 = ($8.1081× 1,200 patient-days)

= $17,000 – $9,730
= $7,270 a month

Cost function measured by high-low method:

Y = $7,270 per month + ($8.1081 × patient-days)

Copyright © 2014 Pearson Education 2 - 39

 Example:
Least-Squares Regression Method

Y = $9,329 + ($6.951 × patient-days)

Copyright © 2014 Pearson Education 2 - 40
Coefficient of Determination

One measure of reliability,

or goodness of fit, is the
coefficient of determination,
R² (or R-squared).

The coefficient of determination

measures how much of the
fluctuation of a cost is explained
by changes in the cost driver.

Copyright © 2014 Pearson Education 2 - 41

 The End

Copyright © 2014 Pearson Education 2 - 42

All rights reserved. No part of this publication may
be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording,
or otherwise, without the prior written permission
of the publisher. Printed in the United States of
America.

Copyright © 2014 Pearson Education 2 - 43

 Example
Sales Mix Analysis
Ramos Company Example
Wallets Key Cases
(W) (K) Total

Sales in units 300,000 75,000 375,000

Sales @ $8 and $5 $2,400,000 $375,000 $2,775,000
Variable expenses
@ $7 and $3 2,100,000 225,000 2,325,000
Contribution margins
@ $1 and $2 $ 300,000 $150,000 $ 450,000
Fixed expenses 180,000
Net income $ 270,000

Copyright © 2014 Pearson Education 2 - 44

 Example: CVP – Port William Gift
Shop
The budgeted income statement of Port William Gift Shop
follows:
Net revenue $800,000
Less Expenses, including $400,000 of fixed expense 880,000
Net Loss $(80,000)

The manager believes that an additional outlay of

$200,000 for advertising will increase sales but is
wondering how much sales will have to increase in order
to achieve 1) breakeven or 2) a $40,000 profit.
1. At what sales volume in dollar will the shop break even
after spending $200,000 on advertiting?
2. What sales volume in dollars will result in a net profit of
$40,000 after spending the $200,000 on advertising? 2 - 45
Copyright © 2014 Pearson Education
 Example: CVP – Port William Gift
Shop
Solution:
1. Note that all data are in dollars. The variable
costs are $880,000-$400,000 and the variable-
cost ratio is $480,000/800,000 = 0.60.
Therefore, the contribution-margin ratio is 0.40.
Let S = break even sales in dollars. Then
Sales – variable cost – fixed cost = net profit
S - 0.60S – ($400,000 + 200,000) = 0
S = $1,500,000
2. Required sales = (fixed costs + target net
profit)/(Contribution-margin ratio)
Required sales = (600,000+40,000)/0.40
= $1,600,000
Copyright © 2014 Pearson Education 2 - 46
 Example: Sales Mix Analysis
Let K = number of units of K to break even, and
4K = number of units of W to break even.

Break-even point for a constant sales mix of 4 units of W

for every unit of K.
sales – variable – fixed = zero net income
expense expenses

[$8(4K) + $5(K)] – [$7(4K) + $3(K)] – $180,000 = 0

32K + 5K - 28K - 3K - 180,000 = 0

6K = 180,000
K = 30,000
W = 4K = 120,000

30,000K + 120,000W = 150,000 total units (K + W).

Copyright © 2014 Pearson Education 2 - 47
Example: Sales Mix Analysis

If the company sells only key cases:

break-even point = fixed expenses
contribution margin per unit
= $180,000
$2
= 90,000 key cases

If the company sells only wallets:

break-even point = fixed expenses
contribution margin per unit
= $180,000
$1
= 180,000 wallets

Copyright © 2014 Pearson Education 2 - 48

Example: Sales Mix Analysis

Suppose total sales

were equal to the
budget of 375,000 units.

However, Ramos sold

only 50,000 key cases
And 325,000 wallets.
What is net income?

Copyright © 2014 Pearson Education 2 - 49

 Example: Sales Mix Analysis

Ramos Company Example

Wallets Key Cases
(W) (K) Total

Sales in units 325,000 50,000 375,000

Sales @ $8 and $5 $ 2,600,000 $250,000 $2,850,000
Variable expenses
@ $7 and $3 2,275,000 150,000 2,425,000
Contribution margins
@ $1 and $2 $ 325,000 $100,000 $ 425,000
Fixed expenses 180,000
Net income $ 245,000

Copyright © 2014 Pearson Education 2 - 50

 Learning
Objective 9 Example
Impact of Income Taxes

Income taxes do not affect the break-even point.

There is no income tax at a level of zero income.

Income taxes affect the calculation of the volume

required to achieve a specified after-tax target
profit.

Suppose that a company earns $1,440 before

Taxes and pays income tax at a rate of 40%.

Copyright © 2014 Pearson Education 2 - 51

 Impact of Income Taxes

Suppose the target net income after taxes was $864

Target income before taxes = Target after-tax net income

1 – tax rate

Target income before taxes = $ 864 = $1,440

1 – 0.40

Copyright © 2014 Pearson Education 2 - 52

 Impact of Income Taxes

Target sales - Variable expenses - Fixed expenses

= Target after-tax net income ÷ (1 – tax rate)

$1.50N - $1.20N - $18,000 = $864 ÷ (1 – 0.40)

$.30N = $18,000 + ($864/.6)
$.18N = $10,800 + $864 = $11,664
N = $11,664/$.18
N = 64,800 units

Copyright © 2014 Pearson Education 2 - 53

 Impact of Income Taxes

Suppose target net income after taxes was $1,440

$1.50N - $1.20N - $18,000 = $1,440 ÷ (1 – 0.40)

$.30N = $18,000 + ($1,440/.6)
$.18N = $10,800 + $1,440 = $12,240
N = $12,240/$.18
N = 68,000 units

Copyright © 2014 Pearson Education 2 - 54