 A company’s break-even point (BEP) is that level of activity, in units or dollars, at which total

revenue equal total cost. Th us, at BEP, the company generates neither a profi t nor a loss on
operating activities. Companies, however, do not wish merely to “break even” on operations. The BEP
is calculated to establish a point of reference.

 Relevant range - determine revenue and cost information used in each assumptions

 Revenue: Revenue per unit is assumed to remain constant; fluctuations in per-unit revenue for factors
such as quantity discounts are ignored. Thus, total revenue fl uctuates in direct proportion to level of
activity or volume.

 Variable cost: On a per-unit basis, variable costs are assumed to remain constant. Therefore, total
variable cost fluctuates in direct proportion to level of activity or volume. Variable production costs
include direct material, direct labour, and variable overhead; variable selling costs include charges
for items such as commissions and shipping. Variable administrative costs can exist in areas such as
purchasing; however, in the illustrations that follow, administrative costs are assumed to be fixed.

 Fixed cost: Total fixed costs are assumed to remain constant, and, as such, per-unit fixed cost
decreases as volume increases. (Per-unit fixed cost increases as volume decreases.) Fixed costs include
both fixed manufacturing overhead and fixed selling and administrative expenses.

 Mixed cost: Mixed costs are separated into their variable and fixed elements before they are used in
BEP or CVP analysis. Any method (such as regression analysis or the high– low method) that validly
separates these costs in relation to one or more predictors can be used.

An important measure in break-even analysis is contribution margin (CM), which can be defined on
either a per-unit or a total basis. CM per unit equals selling price per unit minus total variable cost per
unit, which includes production, selling, and administrative cost. Unit contribution margin is constant
because revenue and variable cost have been defined as being constant per unit. Total CM is the difference
between total revenue and total variable cost for all units sold. This amount fluctuates in direct proportion
to sales volume. On either a per-unit or a total basis, CM indicates the amount of revenue remaining after
all variable costs have been covered. This amount contributes to the coverage of fixed cost and the
generation of profit.

 Fixed cost line is drawn parallel to the x-axis (volume)

 Variable cost line begins where the fixed cost line intersects the y-axis

 Slope of variable cost line is per-unit variable cost ($29)

 The resulting line represents total cost. The distance between the fixed cost and the total cost
lines represents total variable cost at each activity level.

 Chart the revenue line, beginning at $0

  BEP is located at the intersection of the revenue line and the total cost line.

 vertical distance to the right of the BEP and between the revenue and total cost lines represents
profit

 Distance between the revenue and total cost lines to the left of the BEP represents loss

 Profit-volume (PV) graph provides a depiction of the amount of profit or loss associated with
each sales level

 Horizontal, or x, axis on the PV graph represents sales volume

 Vertical, or y, axis represents dollars of profit or loss.

 Amounts shown above the x-axis are positive and represent profits; amounts shown below the x-
axis are negative and represent losses.

 Two points can be located on the graph: total fixed cost and break-even point. Total fixed cost is
shown on the y-axis below the sales volume line as a negative amount. If no products were sold,
the fixed cost would still be incurred and a loss of that amount would result.

 Location of the BEP in units may be determined algebraically and is shown at the point where the
profit line intersects the x-axis; at that point, there is no profit or loss.

 Amount of profit or loss for any sales volume can be read from the y-axis.

 Slope of the profit (diagonal) line is determined by the unit contribution margin ($11), and the
points on the line represent the contribution margin earned at each volume level. The line shows
that no profit is earned until total contribution margin covers total fixed cost

 Bcoz profit can’t be achieved until BEP is reached, starting point of CVP analysis is BEP point.
Examining shifts in cost and volume and resulting effects on profits is called (CVP) analysis -used
to calculate sales volume necessary to achieve a target profit, stated as either a fixed or variable
amount on a before- or after-tax basis

Analysis (CVP)

 one of most hallowed, and yet one of the simplest, analytical tools in management accounting

 allows managers to examine the possible impacts of a wide range of strategic decisions [in] such
crucial areas as pricing policies, product mixes, market expansions or contractions, outsourcing
contracts, idle plant usage, discretionary expense planning, and a variety of other important
considerations in the planning process
  armed with just three inputs of data—sales price, variable cost per unit, and fixed cost

 Important application of CVP analysis allows managers to set a desired target profit and focus on
relationships between it and other known income statement amounts to find an unknown

 One common unknown in such applications is sales volume needed to generate a profit

 Because selling price and volume are often directly related and because certain costs are considered
fixed, managers can use CVP to determine how high variable cost can be while allowing the company
to produce a desired amount of profit.

 To perform CVP analysis in a multiproduct company, one must assume either that

 the product sales mix stays constant as total sales volume changes

 the average contribution margin ratio stays constant as total sales volume changes

 Any shift in the product sales mix will change the weighted average CM% and BEP

 if sales mix shifts toward a product with a lower dollar contribution margin, the BEP will
increase and profits will decrease unless there is a corresponding increase in total revenues

 A shift toward higher dollar contribution margin products without a corresponding decrease in
revenues will cause a lower BEP and increase profits.

 MS calculations allow management to determine how close to a “danger level” the company is
operating and, as such, provide an indication of risk.

 lower MS, more carefully management must watch revenue and control cost to avoid operating
losses

 At low margins of safety, managers are less likely to take advantage of opportunities that, if
incorrectly analysed or forecasted, could send the company into a loss position.

Operating Leverage - another measure that is closely related to the MS and provides useful
management information, relationship between a company’s variable and fixed costs is reflected

highly labor-intensive organizations have high variable cost and low fixed cost; these
organizations have low operating leverage

 (DOL) measures how a percentage change in sales from the current level will affect company profits,
 indicates how sensitive the company’s profit is to sales volume increases and decreases

 DOL decreases as sales move upward from the BEP

 when the margin of safety is low, the degree of operating leverage is high

 at the BEP, the DOL is infinite because any increase from zero is an infinite percentage change

 If a company is operating close to BEP, each percentage increase in sales can make a dramatic impact on net
income

 As sales increase from the break-even point, margin of safety increases but DOL declines

CVP analysis is a short-run model that focuses on relationships among selling price, variable cost, fixed cost,
volume, and profit. This model is a useful planning tool that can provide information about the impact on
profit when changes are made in the cost structure or in the sales level. Although limiting the accuracy of the
results, several important but necessary assumptions are made in the CVP model. These assumptions follow:

1. All revenue and variable cost behaviour patterns are constant per unit and linear within the relevant range.

2. Total contribution margin (total revenue total variable cost) is linear within the relevant range and increases
proportionally with output. This assumption follows directly from assumption 1.

3. Total fixed cost is constant within the relevant range. This assumption, in part, indicates that no capacity
additions will be made during the period under consideration.

4. Mixed costs can be accurately separated into fixed and variable elements. Although accuracy of separation
can be questioned, reliable estimates can be developed from the use of regression analysis or the high–low
method (as discussed in Chapter 3).

5. Sales and production are equal; thus, there is no material fluctuation in inventory levels. This assumption is
necessary because fixed cost can be allocated to inventory at a different rate each year. Thus, variable costing
information must be available. Because CVP and variable costing both focus on cost behaviour, they are
distinctly compatible with one another.

6. In a multiproduct firm, the sales mix remains constant. This assumption is necessary so that a weighted
average contribution margin and CM% can be computed

7. Labour productivity, production technology, and market conditions will not change. If any of these changes
were to occur, cost would change correspondingly, and selling prices might change. Such changes would
invalidate assumptions 1 through 3.

These assumptions limit the activity volume for which the calculations can be made as well as the time frame
for the usefulness of the calculations. If changes occur in selling price or cost, new computations must be
made for break-even and CVP analyses.
 Absorption costing treats the costs of all manufacturing components (direct material, direct labor,
variable overhead, and fixed overhead) as inventoriable, or product, costs in accordance with GAAP.

 known as full costing, and this method fits the product cost definition given in Chapter 2

 Under absorption costing, costs incurred in the nonmanufacturing areas of the organization are
considered period costs and are expensed in a manner that properly matches them with revenues.

 Absorption costing presents expenses on an income statement according to their functional

classifications. A functional classification is a group of costs that were all incurred for the same
principal purpose. Functional classifications generally include cost of goods sold, selling expense, and
administrative expense.

 In contrast, variable costing is a cost accumulation method that includes only direct material, direct
labor, and variable overhead as product costs. This method treats fixed manufacturing overhead (FOH)
as a period cost.

 Like absorption costing, variable costing treats costs incurred in the organization’s selling and
administrative areas as period costs. Variable costing income statements typically present expenses
according to cost behavior (variable and fixed), although expenses can also be presented by functional
classifications within the behavioral categories.
 Variable costing is also known as direct costing

 Two differences exist between absorption and variable costing: one relates to cost accumulation and the
other relates to cost presentation.

 Cost accumulation difference is that absorption costing treats FOH as a product cost; variable costing
treats it as a period cost.

 Absorption costing advocates contend that products cannot be made without the production capacity
provided by fixed manufacturing overhead costs, and, therefore, these costs “belong” to the product.

 Variable costing advocates contend that FOH costs would be incurred whether any products are
manufactured; thus, such costs are not caused by production and cannot be product costs.

 The cost presentation difference is that absorption costing classifies expenses by function on both the
income statement and management reports, whereas variable costing categorizes expenses first by
behavior and then, possibly, by function.

 Under variable costing cost of goods sold is more appropriately called variable cost of goods sold
because it is composed only of variable production costs.

Sales minus variable cost of goods sold is called product contribution margin; it indicates how much
revenue is available to cover all period expenses and to provide net income.

Variable nonmanufacturing period expenses, such as sales commissions set at 10 percent of product
selling price, are deducted from product contribution margin to determine the amount of total
contribution margin.

Total contribution margin is the difference between total revenues and total variable expenses. This
amount indicates the dollars available to “contribute” to cover all fixed expenses, both

manufacturing and nonmanufacturing, and to provide net income A variable costing income statement is
also referred to as a contribution income statement.

Major authoritative bodies of the accounting profession, such as the Financial Accounting Standards
Board (FASB) and the Securities and Exchange Commission (SEC), require the use of absorption
costing to prepare external financial statements. Absorption costing is also required for fi ling tax
returns with the Internal Revenue Service. The accounting profession has, in effect, disallowed the
use of variable costing as a generally accepted inventory method for external reporting purposes.
Because absorption costing classifies expenses by functional category, cost behavior (relative to
changes in activity) cannot be observed from an absorption costing income statement or management
report. Understanding cost behavior is extremely important for many managerial activities including
budgeting, cost-volume-profit analysis, and relevant costing.9 Th us, internal fi nancial reports
distinguishing costs by behavior are often prepared for use in management decision making and
analysis. Th e next section provides a detailed illustration using both absorption and variable costing.