Chapter 2

Introduction to Cost Behavior

And Cost-volume Relationship

1
 Objective 1
Explain how cost drivers affect
cost behavior

2
 Cost Drivers

are factors or activities that have a

direct cause-effect relationship to a cost, For

example, production volume has a direct
effect on the total cost of raw material used
and can be said to "drive" that cost, In
addition, volume could be used as a valid
"driver" of raw material cost,
3
 In most situations, the cause-effect
relationship is less clear, since costs are
commonly caused by multiple factors, For
example, quality control costs are affected
by a variety of factors, such as production
volume, quality of material used, skill level
of workers, and level of automation, Any of
these factors could be chosen as a cost
driver if a reasonable amount of confidence
exists as to the factor's ability to correlate
with cost changes,
A major task in specifying cost behavior
is to identify the cost drivers-that is to
determine the activities that cause costs to
be incurred,
4
This chapter focuses on volume-
related cost drivers, Volume-related
cost drivers include:
➢ The number of orders processed,
➢ Production volume in a production
department,
➢ The hours of labor worked in an assembly
department,
➢ Sales in a retail business,
Of course, when only one product is
being produced the units of production is
the most obvious volume related cost driver
for production-related costs,
5
 Objective 2
Show how changes in cost- driver
activity levels affect variable and
fixed costs

6
 Comparison of variable and fixed costs
Costs are classified as variable or fixed depending
on how much they change as the level of a particular
cost driver changes,
A variable cost is a cost that changes in direct
proportion to changes in the cost driver,
A fixed cost is not immediately affected by changes
in the cost driver,
Variable costs vary in direct proportion to the
volume of activity, that is doubling the level of activity
will double the total variable costs, Consequently, per
unit variable cost is constant, Figure 2.1 illustrates a
variable cost where the variable cost per unit of
activity is LE. 10 7
 Figure 2-1 variable costs
A : Total Variable Cost B : Unit variable cost
Total
Unit
Variable
Variable
Cost
Cost

5000 ------------------------------
4000
3000 ------------------- L,E
2000 10
1000 --------
100 200 300 400 500 100 200 300 400 500

Activity level Activity level

(Units of output) (Units of output)

8
 Examples of variable manufacturing
costs include direct labor, direct material and
power,
These costs are assumed to fluctuate directly
in proportion to operating activity within a
certain range of activity,
Examples of non-manufacturing
variable costs include sales commissions,
which fluctuate with sales value,
Suppose for example, a firm pays its sales
persons a sales commission, As sales value
increases, the commission paid will increase
proportionally, If a firm pays a commission of
10 % of sales value, The total commission paid
will be as follows:
9
 Month Sales value Commission paid
(L E) (L E)
1 100000 10000
2 120000 12000
3 150000 15000
Note that variable cost (commission
paid) varies proportionally with the level of
activity (as expressed in sales value) where as
the unit variable cost remains unchanged at
10 p, per LE. 1 of sales.
Fixed costs remain constant over wide
ranges of activity for a specified time period,
Examples of fixed costs include supervisors
salaries, straight-line depreciation, and
insurance, Figure 2-2 illustrates fixed cost . 10
 You will see that the total fixed costs
are constant for all levels of activity (within
relevant range), whereas unit fixed costs
decrease proportionally with the level of
activity, for example, if the total of the fixed
costs LE. 5000 for a month , the fixed costs
per unit will be as follows:

Units produced Fixed cost per unit (L,E)

1 5000
10 500
100 50
1000 5
11
 Figure 2-2 Fixed costs

A : Total Fixed Costs B : Unit Fixed Costs

Unit
Total
Fixed
Fixed
Cost
Cost
(L,E)
(L,E)

100 200 300 400 500 100 200 300 400 500

Activity level Activity level

12
 Note carefully from these examples
that the “variable” or “fixed” characteristic
of a cost relates to its total amount and not
to its per unit amount, The following table
summarizes these relationships,

If cost – driver Activity Level Increases (or Decreases)

Type of cost Total cost cost per unit

Fixed costs No change decrease
(or increase)
Variable costs Increases No change
(or decrease)

13
 When predicting costs, two rules of
thumb are useful :
1. Think of fixed costs as a total, Total fixed
costs remain unchanged regardless of
changes in cost-driver activity,

2. Think of variable costs on a per-unit basis,

The per-unit variable cost remains
unchanged regardless of changes in cost-
driver activity,

14
Relevant Range

is a range of activity over which a

variable cost per unit remains constant or a fixed
cost remains fixed in total,

In other words, a relevant range is a range

of activity in which costs behave in accordance
with the way they have been defined,

The relevant range is generally the normal

operating range for a company, In addition
remember that even within the relevant range a
fixed cost remains fixed only over a given period
of time-usually the budget period, 15
 In addition to theses pure versions of cost
two additional types of costs combine
characteristics of both fixed and variable cost
behavior. These are step costs and mixed
costs.
Step costs (semi-
fixed) : are fixed for a given
level of activity but they eventually increase by
a constant amount at some critical points. We
can distinguish fixed costs from semi-fixed
costs by the range between the activity levels
before the steps in total fixed costs occur. If
the ranges between the steps are relatively
wide and apply to a specific,
16 broad range of
 An example of a semi-fixed cost is the
salaries of supervisors; assume that the
supervisory staff can supervise direct labor up
to 500 hours of activity per week, For each
increase in 500 hours of activity per week the
supervision cost of an additional supervisor,

17
 Mixed costs
Mixed costs contain elements of both
fixed and variable-cost behavior, Like step
costs, the fixed element is determined by the
planned range of activity level Un like step
costs, however, usually in a mixed cost there
is only one relevant range of activity and one
level of fixed costs, The variable-cost
element of the mixed cost is a purely
variable cost that varies proportionately with
activity within the single relevant range, In a
mixed cost the variable cost is incurred in
addition to the fixed cost : the total mixed
cost is the sum of the fixed cost plus the
variable cost. 18
 Mixed cost is a purely variable cost that
varies proportionately with activity within the
single relevant range. In a mixed cost the variable
cost is incurred in addition to the fixed cost : The
total mixed cost is the sum of the fixed cost plus
the variables cost.

Note: A mixed cost does not fluctuate in

direct proportion with activity, nor does it
remain constant with changes in activity.

19
,, Note: A mixed cost does not fluctuate in
direct proportion with activity, nor does it
remain constant with changes in activity,

20
 An example of a mixed cost is rent that is computed
as a flat charge (the fixed component) plus a stated
percentage of sales pounds (the variable component),
Fig, 3.4 shows a graph of a rent charge the store pays
rent to the owners of the shopping center at a flat rate of
LE. 1000 per month plus 10% of sales, If the shop has
sales of LE. 300,000 in a month, its total rent is LE.
4,000, If sales are LE. 600,000, the rent is LE. 7,000.

21
 Another example of a mixed cost is maintenance, The
XYZ company maintenance cost has a monthly fixed
component of LE. 4800 for maintenance worker salaries, In
addition, maintenance charges for items such as lubricants and
replacement parts average LE. 1.2 for every unit produced,
Total monthly maintenance cost can be predicted by
multiplying the LE. 1,200 per-unit variable cost times the
number of units produced and adding the LE. 4800 fixed cost
as follows:
Expected production 2,000 units 3,000 units
Variable cost (units × LE. 1.2 ) LE. 2,400 LE. 3,600
Fixed cost 4,800 4,800
Total predicted maintenance cost L E 7,200 8,400

22
 Cost accountants often separate mixed costs into
their variable and fixed components so that changes
in these costs are more readily apparent, This
separation allows managers to focus on two basic
types of costs: Variable and fixed,

An administrator at XYZ company could

use knowledge of the maintenance
department cost behavior to :

1)Plan costs: Suppose the company expected to

produce 4,000 units next month, The month’s
predicated maintenance costs are LE. 4,800
fixed plus the variable cost of LE. 4,800 ( 4,000
units times LE. 1.2 ) , for a total of LE. 9,600
23
2) Provide feedback to managers: suppose
actual maintenance costs were LE. 11,000 in a
month when production were 4,000 units as
planned, Managers would want to know why
the maintenance department overspent by LE.
1,400 ( LE. 11,000 less the planned LE. 9,600 )
so that they could take corrective action,

3) Make decisions: for example, manager could

evaluate an alternative to acquire a new highly,
Automated equipment against doing
maintenance work manually,

24
 Cost – volume-profit Analysis
➢ Cost-volume-profit (CVP) analysis means
the study of the effects of output volume
on revenue (sales), expenses (costs), and
net income (net profit)
➢ The study of cost-volume-profit
relationship is often called break-even
analysis, This term is misleading, because
finding the break-even point is often just
the first step in a planning decision.
➢ To apply CVP analysis, the major
simplification-in this chapter- is to classify
costs as either variable or fixed with
respect to a single measure of the volume
of output activity. 25
 Objective 3
Calculate break-even sales
volume in total pounds and total
units

26
Break-Even Point – Contribution Margin
and Equation Techniques,

Break-even point is the level of sales at

which revenue equal expenses and net
income is zero,

Contribution-Margin Technique
Contribution margin or marginal income is the
sales price minus the variable production,
selling and administrative costs per unit,
27
 Fixed costs
Break-even point (units) =
Unit contributi on margin

Break-even point (L E) =
Break-even point (units) X sales price

Note:

Contribution margin per unit is constant

because revenue and variable cost have been
defined as remaining constant per unit,

28
 Contribution-margin percentage (or ratio) =
Contribution margin per unit
Sales price per unit

Variable-cost percentage (or ratio) =

Variable cost per unit
Sales price per unit
Note:

Contribution-margin percentage + variable-

cost percentage = 100 %
29
 Break-even point (L,E) =

Fixed costs
Contributi on margin percentage (or ratio)
Using the contribution-margin
percentage, you can compute the break-even
volume in pounds (LE.) without determining
the break-even point in units.
Example:
Data needed to compute break- even point
and perform CVP analysis are given in the
income statement in Exhibit 2-3 for XYZ
company. 30
 Exhibit 2-3
XYZ Company
Income statement
For the Year Ended Dec,31,2020
Total Per Unit Percent
LE LE
Sales (12000 units) 1,200,000 100 100 %

Variable costs:
Production 360,000 30 30%
Selling 120,000 10 10%
Total variable cost 480,000 40 40%
Contribution margin 720,000 60 60%
Fixed costs:
Production 250,000
Selling administrative 50,000
Total fixed costs 300,000
Net income 420,000
31
Break-even point & contribution margin technique
Contribution margin per unit = LE.100 – L,E 40
= LE. 60
Contribution margin percentage = 60%
Break-even point (units) = L E 300000
L E 60
= 5000 units
Break-even point (pounds) =
5000(units) X L E 100 (selling price)
= LE. 500,000
Or
= LE. 300000 Fixed costs / 60% Contribution margin
percent = LE. 500,000
32
The income statement at the break-even point is
Total Per Unit Percent
LE LE
Sales (5000 units) 500,000 100 100 %

Variable costs:
Production 150,000 30 30%
Selling 50,000 10 10%
Total variable cost 200,000 40 40%
Contribution margin 300,000 60 60%
Fixed costs:
Production 250,000
Selling administrative 50,000
Total fixed costs 300,000
Net income 0

33
 Equation Technique
Any income statement can be expressed in
equation form, as follows :
Sales – Variable expenses – Fixed expenses
= net income
That is,
(Unit sales Price X number of units)
– (Unit Variable Cost X number of units )
– Fixed costs
= net income
34
 At the break-even point net income is zero :
Sales – Variable expenses – Fixed expense = 0
Let X = number of unit to be sold to break-
even, Then for XYZ company example,

LE. 100 X - L,E 40 X - L,E 300,000 = 0

LE. 60 X = LE. 300,000
X = LE. 300,000  LE. 6
X = 5000 units

Break-even point in pounds (L,E)

= 5000 units X unit sales price
= 5000 X LE. 100
= 500,000 35
 You can also solve the equation for sales
pounds without computing the unit break-even
point by using the relationship of variable costs
and profits as a percentage of sales :
Variable-cost percentage = Variable cost per unit
(or ratio ) Sales price per unit
= LE. 40
LE. 100
= 40% or .40
Let S = Sales in pounds (LE.) needed to break-
even , Then
S - , 40 S - LE. 300,000 = 0
, 60 S = LE.300,000
S = LE. 300,000  ,60
= LE. 500,000 36
General shortcut break-even formulas:

Break-even volume= Fixed expenses

In units Contribution margin per unit

Break-even volume = Fixed expenses

In pounds (LE.) Contribution margin ratio

37
 Objective 4
Construct a cost - volume- profit
graph

38
Break–even chart-Graphical techniques
A break- even chart

is a graph that depicts the relationship

among revenues, variable costs, fixed costs
and profits (or losses0, the break-even point is
located at the point where the total cost and
total revenue lines cross,
There are two approaches to prepare
break- even charts :

The traditional approach the contemporary

approach

The third graphical presentation, the profit-volume

graph, is closely related to the break- even chart 39
 Traditional Approach
The traditional approach focuses on the
relationships among revenues, costs, and profits
(Losses), This approach does not show contribution
margin, A traditional break – even Chart for XYZ
company is prepared in the following manner:
1) Draw the axes, The horizontal axis is the sales
volume, and the vertical axis is pounds of cost and
revenue,

2) Plot sales volume, select a convenient sales volume

(within the relevant range), say, 15,000 units, and
plot point A for total sales at that volume : 15,000
X L,E 100 = LE.1,500,000, Draw the revenue( i,e,
sales) Line from point A to the origin, point 0
40
3) Plot fixed expenses, Draw a horizontal Line
intersecting the vertical axis at L,E 300,000, point B
4) Plot variable expenses, Determine the variable
portion of expenses at a convenient level of activity
: 15,000 X LE. 40 = L,E 600,000 , Add this to the
fixed expenses : L,E 600,000 + L,E 300,000 = LE.
900,000, Plot point C for 15,000 units and LE.
900,000, Then draw a line between point C and
point B, This is the total expenses line,
5) Locate the Break- even point is where the total
expenses line crosses the sales line, 5000 units or
LE. 500,000, namely where total sales revenues
exactly equal total costs, point D,
Exhibit 2-4 is a graph of the cost – volume- profit
relationship in our XYZ company example,

41
Exhibit 2-4
Cost – volume-profit Graph

Volume in thousands of 42
Contemporary Approach – contribution Graph

The contribution margin provided by

each level of sales volume is not apparent on
the preceding traditional break-even chart,
Since contribution margin is so important in
CVP analysis, another graphic approach can be
used, The contemporary graphic approach
specifically presents CM in the break – even
chart,

The preparation of this chart is detailed in

the following steps:
43
Step (1) plot the variable cost firstly:
The revenue line is plotted next, and the
contribution margin area is indicated,

Volume in thousands of 44
Step (2) Total cost is graphed by adding a line
parallel to the total variable cost Line,
The distance between the total cost line
and the variable cost line is the amount of
fixed cost, The break-even point is located
where the revenue and total cost lines
intersect,

45
The contemporary graphic approach allows the
following important observations to be made:

➢ Contribution margin is created by the

excess of revenues over variable costs,

➢ Total contribution margin is always equal

to total fixed cost plus profit or minus loss,

➢ Before profits can be generated,

contribution margin must exceed fixed
costs,
46
 Profit-Volume (PV) Graph

The profit-volume graph reflects the

amount of profit or loss associated
with each level of sales, The horizontal
axis on the PV graph represents sales
volume, The vertical axis represents
profits and losses, Amounts above the
horizontal axis are positive and
represent profits; amounts below the
horizontal axis are negative and
represent losses,
47
Two points are located on the graph:
If sales are zero, the loss will be the
amount of the fixed costs, To plot the other
point, select any other level of sales
volume; say 15,000 units ( in our XYZ
example), Determine profit (or loss) for
this level, (15,000 units X LE. 60 (CM) =
LE.900,000- LE. 300,000 (Fixed costs) =
LE.600,000 So, the two points are
Sales Volume Profit (or loss)
0 LE. 300,000 (loss)
15,000 LE. 600,000 (profit)
48
 The last step in preparing the PV graph
is to draw a profit line that passes between
and extends through the two located points,
Using this Line, the amount of profit or loss
for any sales volume can be read from the
vertical axis,

The profit Line is really a contribution

margin Line, and the slope of the line is
determined by the unit contribution margin,
The Line shows that no profit is earned until
the contribution margin covers the fixed
costs,

49
The PV graph for XYZ Company is shown below:

50
 With each unit sold, a contribution of
L,E 60 is obtained toward the fixed costs,
and the break-even point is at 5,000 units
when the total contribution (5000 units X
LE.60 = LE 300,000) exactly equal the total
of the fixed costs, With each additional unit
sold beyond 5000 units a surplus of LE.60
per unit is obtained, If 12,000 units are sold,
the profit will be LE. 420,000(7000 units at
LE.60 contribution).

51
 Changes in fixed costs
Changes in fixed costs causes changes
in the break-even point, For example, if
fixed costs increase from 300,000 to
360,000 (in our example), what would be
the break-even point in units and in
pounds?
Break-even point = Fixed expenses
(in units) Contribution margin per unit
= LE. 360,000
LE 60
= 6000 units 52
Break-even point = Fixed expenses
(in pounds) Contribution margin ratio

= LE.360,000
.60

= LE. 600,000
Note that a one-fifth increase in fixed
expenses altered the break-even point by one-
fifth: from 5,000 units to 6,000 units, and from
L,E 500,000 to L,E 600,000, This type of
relationship always exists if every thing else
remains constant, The P/V graph is shown
below:
53
54
 Changes in Contribution margin per Unit
Changes in variable costs also cause the
break – even point to shift, Companies can
reduce their break-even points by increasing
their contribution margins per unit of product
through either increases in sales prices or
decreases in unit variable costs, or both.
For example, assume that
(1) the variable expenses increase from LE.
40 per unit to LE. 50.
(2) the selling price falls from LE.100 to L,E ,
80 per unit, and the original variable
costs per unit are unchanged, find the
break-even point in units and pounds. 55
 1. Unit contribution margin = L,E 100 – LE. 50
= LE.50
Contribution margin ratio = LE. 50
LE.100
= .50
The original fixed expenses of LE. 300,000
would be unaffected, but the denominators
would change from those previously used, Thus
Break-even point = LE. 300,000
(in units) LE.50
= 6000 units

Break-even point = LE. 300,000

( in pounds) .50
= LE. 600,000 56
2. Unit contribution margin = LE. 80 – LE. 40
= LE. 40
Contribution margin ratio = LE.40
LE.80
= ,50
Break-even point = LE.300,000 = 7500
(in units) LE. 40 Units

Break-even point = LE.300,000 =

.50
(in pounds) LE.600,000

57
The P/V graphs for the above two cases
compared with the original case of XYZ
company is shown below :
Case 1

58
 Objective 5
Calculate sales volume in total units
and total pounds to reach a target
(a planned) profit,

59
Using Cost – Volume-profit Analysis

Managers can also use CUP analysis to

determine the total sales ,in units and
pounds, needed to reach a target profit,

Profit may be stated as either a fixed or a

variable amount,

60
1, Fixed amount of profit,

The method for computing the target or

desired sales volume in units and pounds
is the same as was used in break-even
computation,

Target sales volume in units =

Fixed expenses + target net in come
Contribution margin per unit

Target sales volume in pounds =

Fixed expenses + target net in come
Contribution margin ratio
61
For example, in our XYZ company, suppose
that the target net in come is LE. 120,000
find the target sales volume in units and
pounds :
Target sales volume in units =
LE. 300,000 + LE. 120,000
LE. 60
= units 7,000
Target sales volume in pounds =
LE. 300,000 + LE. 120,000
.60
= LE. 700,000 62
 Another way of getting the same answer is to
adopt an incremental approach, The term
incremental refers to to the change in total results
(such as revenues, expenses, or income) under a
new condition in comparison with some given or
known condition,
In this instance the known condition is
assumed to be the 5,000- unit break-even point, All
expenses would be recovered at that volume, There
fore the change or increment in net income for
every unit beyond 5000 would be equal to the
contribution margin of LE. 60, After the break-even
point is reached, each pound of contribution margin
is a pound of profit, If LE. 120,000 were the target
net profit, the target sales volume must exceed the
break-even volume by LE. 120,000 ÷ LE .60 = 2000
units; it would be there fore 5,000 + 2,000 = 7,000
units. 63
 To find the answer in terms of pounds with the
incremental approach, every sales pound after the
break-even point of LE. 500,000 contributes LE. ,60
to net profit, Sales in pounds must exceed the break-
even volume by LE. 120,000 ÷ ,60 = LE.200,000 to
produce a net profit of LE. 120,000; Thus the sales in
pounds would be LE. 500,000 + LE. 200,000 = LE.
700,000,
The following table summarizes these computations:
Break-even Increment New
Point condition
Volume in units 5,000 2,000 7,000
Sales 500,000 200,000 700,000
Variable expenses 200,000 80,000 280,000
Contribution margin 300,000 120,000 420,000
Fixed expenses 300,000 - 300,000
Net income 0 120,000 LE.120,000
64
2. Variable amount of profit
Managers may wish to state profits as a
variable amount so that as units sold or
sales in pounds increase, profit will increase
at a constant rate, Profit on a variable basis
can be stated either as a percent of revenues
or as a per-unit profit, The CVP formula must
be adjusted to recognize that profit (p) is
related to volume of activity.

The adjusted CVP formula for computing

the necessary unit volume of sales to earn a
specified variable amount of profit per unit
is as follows:
65
 R (x) – Vc (x) – Fc = Ppu (x)

Where:
R = selling price per unit
x = number of units
R(x) = total revenue
VC = Variable cost per unit
VC(x) = total Variable cost
Fc = total fixed cost
Ppu = Profit per unit
66
 Rearranging the above formula gives the
following:
R(x) – Vc(x) – Ppu (x) = Fc
X (R – Vc- Ppu ) = Fc
X (Cm – Ppu ) = Fc

Where Cm = contribution margin per unit

Solving for x (volume ) gives the following:

X= Fc
( R – VC – Ppu )
67
 The variable profit is treated in the CVP
formula as if it were an additional variable cost
to be covered, This treatment adjusts the
original contribution margin and contribution
margin ratio, When setting the desired profit
as a percentage of selling price (or sales
revenue), that percentage cannot exceed the
contribution margin ratio, If it does, an
infeasible problem is created, since the
variable cost percentage plus the desired profit
percentage would exceed 100 percent of
selling price such a condition cannot occur,

68
 Assume that the president of XYZ company
wants to know what level of sales (in units and
pounds ) would be required to earn a 30%
profit on sales, The following calculations
provide answers to this questions:
In Units
Profit desired = 30 % of sales revenues

Profit per unit (Ppu) = ,30 x LE. 100 = 30

Target sales volume in units (x) = FC

(R – VC – Ppu)
= L,E 300,000
( LE. 100 – LE.40 – LE.30)
= 10,000 Units 69
In Sales Pounds
The following relationships exist
Per unit Percent
Selling price LE. 100 100 %
Variable cost LE. 40 (40%)
Variable profit LE. 30 (30%)
"Adjusted" Contribution Margin LE. 30 30 %
Target sales volume (in pounds)
= FC
contribution Margin ratio – profit desired ratio

= FC
"Adjusted" CM ratio
= L,E 300,000
.30
= L,E , 1,000,000 70
The income statement for this volume of activity
is shown below :
Total Per Percent
LE Unit
LE
Sales (10,000Units) 1,000,000 100 100 %

Variable costs:
Production 300,000 30 30%
Selling 100,000 10 10%
Total variable cost 400,000 40 40%
Contribution margin 600,000 60 60%
Fixed costs
Production 250,000
Selling administrative 50,000
Total fixed costs 300,000
Net in come 300,000 30%
71
Margin of Safety
The margin of safety is defined as the excess of
the budgeted or actual sales of a company over the
company's break-even point, The margin of safety can
be expressed as units, pounds, or a percentage, The
following formulas are applicable
Margin of safety in units =
Planned ( or actual ) units – Break-even units
Margin of safety in pounds =
Planned (or actual) sales LE – Break- even sales LE
Margin of safety % =
Margin of safety in units or LE
Planned (or actual ) sales in units or LE.
72
 Margin of safety is one direct uses of CVP analysis,
It shows how far sales can fall below the planned (or
actual ) Level before losses occur,
The break-even point for XYZ company is 5,000
units or LE. 500,000 of sales, The income statement
for the company in Exhibit 2-3 showed actual sales for
the year ended December,31,97, of 12,000units,or LE.
1,200,000, The margin of safety for XYZ is computed
as shown below:
In units = 12,000 (actual ) – 5000 BEP = 7,000 units
In sales LE. = LE. 1,200,000(actual) – LE. 500,000
(BEP)
= LE. 700,000
Percentage = 7,000 ÷ 12,000
or LE. 700,000 ÷ LE. 1,200,000 = 58%
The margin of safety for XYZ is quite high, since it is
operating far a above its break-even point. 73
 The margin of safety calculation
allows management to assess possible
risks; by determining how close to a
danger level the company is operating,

The lower the margin of safety,

the more carefully management must
watch sales figures and control costs
so as not to generate a net loss,

74
 Objective 6
Distinguish between contribution
margin and gross margin

75
 Contribution margin & Gross margin
Gross margin

(Gross profit) is the excess of sales

over the cost of goods sold (that is, the cost
of the merchandise that is acquired or
manufactured and then sold )

Contribution margin

is sales less all variable costs, The

variable costs will include part of the cost of
goods sold and also part of the other
operating expenses 76
 Example: Problem 2- 42 P,71
General Mills produces and sells food products
and backing products, A condensed 2020 in come
statement follows ( in millions):

Sales LE 8,517

Cost of goods sold 4,458

Gross margin 4,059

Other operating 3,306

expenses
Operating income 753
77
 Assume that LE.960 million of the cost of
goods sold is a fixed cost representing
depreciation and other producing costs that
does not change with the volume Of
production, In addition LE 2,120 million of
the other operating expenses is fixed

Compute the total contribution margin

for 2020 and the contribution margin
percentage.

78
 Solution
Variable costs =
Cost of goods sold LE 4,458
- Fixed production costs 960
3,498
+Variable other operating Expenses 1,186
(L,E 3,306_ L,E 2,2120 )
4,684

Fixed costs =
Production costs LE 960
+ Other operating expenses 2,2120
3080
79
Condensed Income Statement
For 1994
Sales LE 8,517

Variable costs 4,684

Contribution margin 3,833

Fixed costs 3,080

Operating income 753

Contribution margin percentage

= LE. 3,833 ÷ LE. 8,517 = 45%
80
 Objective 7
Identify the limiting assumptions
that underlie cost- volume-profit
analysis

81
Underlying Assumptions of CVP Analysis

The cost – volume-profit analysis is a

useful planning tool that can provide
information on the impact on profits when
changes are made in costs or in sales levels,
Several important assumptions are made in
CVP analysis, They are necessary, but they
limit the accuracy of the results, Some of
these assumptions follow:
1) Expenses may be classified into variable
and fixed categories, Total variable
expenses vary directly with activity level,
(With in the relevant range)
82
 2) Selling prices do not change with
production and sales over the relevant range
( a constant selling price per unit )
3)Efficiency and productivity will be
unchanged (Labor productivity, production
technology and market conditions will not
change),
4) Sales mix will be constant, The sales mix is
the relative proportions or combinations of
quantities of products that constitute total
sales,
5) The difference in inventory level at the
beginning and at the end of a period is
insignificant (sales = production ) 83
 Solution strategies
Most CUP problems are solvable by using a
numerator, denominator approach, All numerators and
denominators and the type of problem each relates to
are listed below :
Problem situation Numerator denominator
BEP in units FC CM
BEP in pounds FC CM%
Target sales with Lump-sum FC+P CM
profit in units
Target sales with Lump-sum FC+P CM%
profit in pounds
Target sales with Variable FC CM- Ppu
Profit in units
Target sales with Variable FC CM% - Ppu%
Profit in pounds 84
Where:
FC = Fixed cost,
CM = Contribution margin per unit,
CM% = Contribution margin percentage,
P = Total planned profit,
PPU = Profit per unit,
PPU% = Profit per unit percentage
( profit desired ratio ),

85
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