19

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Chapter
Cost-Volume-Profit
Analysis

Managerial
Accounting
14e

Warren
Reeve
Duchac

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Cost Behavior

• Cost behavior is the manner in which a cost

changes as a related activity changes.
• Understanding the behavior of a cost depends
on the following:
• Identifying the activities that cause the cost to change.
• These activities are called activity bases (or activity drivers).
• Specifying the range of activity over which the
changes in the cost are of interest.
• This range of activity is called the relevant range.

• Costs are normally classified as variable costs,

fixed costs, or mixed costs.
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Variable Costs

• Variable costs are costs that vary in proportion to

changes in the activity base.
• When the activity base is units produced, direct materials
and direct labor costs are normally classified as variable
costs.
• Variable costs have the following characteristics:
• Cost per unit remains the same regardless of changes in the
activity base.
• Total cost changes in proportion to changes in the activity base.

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Variable Costs and Their Activity Bases

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Fixed Costs

• Fixed costs are costs that remain the same in

total dollar amount as the activity base changes.
• When the activity base is units produced, many
factory overhead costs such as straight-line
depreciation are classified as fixed costs.
• Fixed costs have the following characteristics:
• Cost per unit decreases as the activity level increases
and increases as the activity level decreases.
• Total cost remains the same regardless of changes in
the activity base.

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Fixed Costs and Their Activity Bases

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Mixed Costs

• Mixed costs are costs that have characteristics

of both a variable and a fixed cost. Mixed costs
are sometimes called semivariable or semifixed
costs.
• The high-low method is a cost estimation
method that may be used to separate mixed
costs into their fixed and variable components.
• The fixed cost is estimated by subtracting the
total variable costs from the total costs for the
units produced, as follows:

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Summary of Cost Behavior Concepts

• One method of reporting variable and fixed costs

is called variable costing or direct costing.
• Under variable costing, only the variable
manufacturing costs (direct materials, direct labor,
and variable factory overhead) are included in the
product cost.
• The fixed factory overhead is treated as an expense
of the period in which it is incurred.

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Variable and Fixed Cost Behavior

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Variable, Fixed, and Mixed Cost

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Cost-Volume-Profit Relationships

• Cost-volume-profit analysis is the examination of the

relationships among selling prices, sales and production
volume, costs, expenses, and profits.
• Some of the ways cost-volume-profit analysis may be
used include the following:
• Analyzing the effects of changes in selling prices on
profits
• Analyzing the effects of changes in costs on profits
• Analyzing the effects of changes in volume on profits
• Setting selling prices
• Selecting the mix of products to sell
• Choosing among marketing strategies
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Contribution Margin

• Contribution margin is the excess of sales over

variable costs, computed as follows:

Contribution Margin = Sales − Variable Costs

• Contribution margin covers fixed costs. Once the

fixed costs are covered, any additional
contribution margin increases income from
operations.

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Contribution Margin Ratio

(slide 1 of 2)

• The contribution margin ratio, sometimes called

the profit-volume ratio, indicates the percentage of
each sales dollar available to cover fixed costs
and to provide income from operations.
• The contribution margin ratio is computed as
follows:
Contribution Margin
Contribution Margin Ratio =
Sales

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Contribution Margin Ratio

(slide 2 of 2)

• The contribution margin ratio is most useful

when the increase or decrease in sales volume
is measured in sales dollars. In this case, the
change in sales dollars multiplied by the
contribution margin ratio equals the change in
income from operations, computed as follows:

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Unit Contribution Margin

(slide 1 of 2)

• The unit contribution margin is useful for

analyzing the profit potential of proposed
decisions.
• The unit contribution margin is computed as:
Unit Contribution Margin = Sales Price per Unit − Variable Cost per Unit

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Unit Contribution Margin

(slide 2 of 2)

• The unit contribution margin is most useful when

the increase or decrease in sales volume is
measured in sales units (quantities). In this case,
the change in sales volume (units) multiplied by
the unit contribution margin equals the change in
income from operations, computed as follows:

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Break-Even Point
(slide 1 of 2)

• The break-even point is the level of operations

at which a company’s revenues and expenses
are equal.
• At break-even, a company reports neither
income nor a loss from operations.
• The break-even point in sales units is computed
as follows:

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Break-even point

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Break-Even Point
(slide 2 of 2)

• The break-even point in sales dollars can be

determined directly as follows:

• The contribution margin ratio can be computed using

the unit contribution margin and unit selling price as
follows:

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Effect of Changes in Fixed Costs

• Fixed costs do not change in total with changes

in the level of activity. However, fixed costs may
change because of other factors such as
advertising campaigns, changes in property tax
rates, or changes in factory supervisors’ salaries.
• Changes in fixed costs affect the break-even point as
follows:
• Increases in fixed costs increase the break-even
point.
• Decreases in fixed costs decrease the break-even
point.
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Effect of Change in Fixed

Costs on Break-Even Point

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Effect of Changes in Unit Variable Costs

• Unit variable costs do not change with changes in the

level of activity. However, unit variable costs may be
affected by other factors such as changes in the cost per
unit of direct materials, changes in the wage rate for
direct labor, or changes in the sales commission paid to
salespeople.
• Changes in unit variable costs affect the break-even
point as follows:
• Increases in unit variable costs increase the break-even point.
• Decreases in unit variable costs decrease the break-even point.

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Effect of Change in Unit Variable Cost on

Break-Even Point

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Effect of Changes in Unit Selling Price

• Changes in the unit selling price affect the

break-even point as follows:
• Increases in the unit selling price decrease the break-
even point.
• Decreases in the unit selling price increase the break-
even point.

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Effect of Change in Unit Selling

Price on Break-Even Point

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Effects of Changes in Selling Price

and Costs on Break-Even Point

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Target Profit

• The sales required to earn a target or desired

amount of profit is determined by modifying the
break-even equation as follows:

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Cost-Volume-Profit (Break-Even) Chart

(slide 1 of 2)

• A cost-volume-profit chart, sometimes called a

break-even chart, graphically shows sales,
costs, and the related profit or loss for various
levels of units sold.

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Cost-Volume-Profit (Break-Even) Chart

(slide 2 of 2)

• The cost-volume-profit chart is constructed using the following steps:

• Step 1: Volume in units of sales is indicated along the horizontal axis. The range
of volume shown is the relevant range in which the company expects to operate.
Dollar amounts of total sales and total costs are indicated along the vertical axis.
• Step 2: A total sales line is plotted by connecting the point at zero on the left
corner of the graph to a second point on the chart. The second point is
determined by multiplying the maximum number of units in the relevant range,
which is found on the far right of the horizontal axis, by the unit sales price. A line
is then drawn through both of these points. This is the total sales line.
• Step 3: A total cost line is plotted by beginning with total fixed costs on the vertical
axis. A second point is determined by multiplying the maximum number of units in
the relevant range, which is found on the far right of the horizontal axis by the unit
variable costs and adding the total fixed costs. A line is then drawn through both
of these points. This is the total cost line.
• Step 4: The break-even point is the intersection point of the total sales and total
cost lines. A vertical dotted line drawn downward at the intersection point
indicates the units of sales at the break-even point. A horizontal dotted line drawn
to the left at the intersection point indicates the sales dollars and costs at the
break-even point.

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Profit-Volume Chart
(slide 1 of 2)

• Another graphic approach to cost-volume-profit

analysis is the profit-volume chart, which plots
only the difference between total sales and total
costs (or profits).
• In this way, the profit-volume chart allows managers
to determine the operating profit (or loss) for various
levels of units sold.

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Profit-Volume Chart
(slide 2 of 2)

• The profit-volume chart is constructed using the following steps:

• Step 1: Volume in units of sales is indicated along the horizontal axis.
The range of volume shown is the relevant range in which the company
expects to operate. Dollar amounts indicating operating profits and
losses are shown along the vertical axis.
• Step 2: A point representing the maximum operating loss is plotted on
the vertical axis at the left. This loss is equal to the total fixed costs at
the zero level of sales.
• Step 3: A point representing the maximum operating profit within the
relevant range is plotted on the right.
• Step 4: A diagonal profit line is drawn connecting the maximum
operating loss point with the maximum operating profit point.
• Step 5: The profit line intersects the horizontal zero operating profit line
at the break-even point in units of sales. The area indicating an
operating profit is identified to the right of the intersection, and the area
indicating an operating loss is identified to the left of the intersection.

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Assumptions of Cost-Volume-Profit Analysis

• Cost-volume-profit analysis depends on several

assumptions. The primary assumptions are as
follows:
• Total sales and total costs can be represented by
straight lines.
• Within the relevant range of operating activity, the
efficiency of operations does not change.
• Costs can be divided into fixed and variable
components.
• The sales mix is constant.
• There is no change in the inventory quantities during
the period.
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Sales Mix Considerations

(slide 1 of 2)

• Many companies sell more than one product at

different selling prices. In addition, the products
normally have different unit variable costs and,
thus, different unit contribution margins.
• In such cases, break-even analysis can still be
performed by considering the sales mix.
• The sales mix is the relative distribution of sales
among the products sold by a company.

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Sales Mix Considerations

(slide 2 of 2)

• For break-even analysis, it is useful to think of the

individual products as components of one overall
enterprise product.
• The unit selling price of the overall enterprise
product equals the sum of the unit selling prices of
each product multiplied by its sales mix percentage.
• Likewise, the unit variable cost and unit contribution
margin of the overall enterprise product equal the
sum of the unit variable costs and unit contribution
margins of each product multiplied by its sales mix
percentage.

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Operating Leverage
(slide 1 of 2)

• The relationship between a company’s

contribution margin and income from operations
is measured by operating leverage.
• A company’s operating leverage is computed as
follows:

• The difference between contribution margin and

income from operations is fixed costs.
• Thus, companies with high fixed costs will normally have high
operating leverage.
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Operating Leverage
(slide 2 of 2)

• Operating leverage can be used to measure the impact

of changes in sales on income from operations.
• Using operating leverage, the effect of changes in sales
on income from operations follows:

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Effect of Operating Leverage

on Income from Operations

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Margin of Safety
(slide 1 of 2)

• The margin of safety indicates the possible

decrease in sales that may occur before an
operating loss results.
• Thus, if the margin of safety is low, even a small decline
in sales revenue may result in an operating loss.

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Margin of Safety
(slide 2 of 2)

• The margin of safety may be expressed in the following ways:

• Dollars of sales
• The margin of safety expressed in dollars of sales is computed as
follows:

• Units of sales
▪ The margin of safety expressed in units of sales is computed as
follows:

• Percent of current sales

▪ The margin of safety expressed as a percent of current sales is
computed as follows:

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