Chapter 22

COST-VOLUME-PROFIT
ANALYSIS

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 22 - 2

IDENTIFYING COST BEHAVIOR

Cost-volume-profit analysis is used to answer questions
such as:
 What sales volume is needed to earn a target income?
 What is the change in income if selling prices decline
and sales volume increases?
 How much does income increase if we install a new
machine to reduce labor costs?
 What is the income effect if we change the sales mix
of our products or services?
 22 - 3

C1
FIXED COSTS

Monthly Basic Telephone

Bill per Local Call
Telephone Bill
Monthly Basic

Number of Local Calls Number of Local Calls

Total fixed costs Cost per call

remain constant as declines as
activity increases. activity increases.
 22 - 4

C1
VARIABLE COSTS

Cost per Minute

Total Costs

Minutes Talked Minutes Talked

Total variable costs Cost per Minute

increase as is constant as
activity increases. activity increases.
 22 - 5

C1
MIXED COSTS
Mixed costs contain a fixed portion that is incurred even when
the facility is unused, and a variable portion that increases with
usage. Utilities typically behave in this manner.
Total Utility Cost

ost
d c
i xe
l m
ta
To Variable
Cost per KW

Fixed Monthly
Activity (Kilowatt Hours)
Utility Charge
 22 - 6

C1
STEP-WISE COSTS

Total cost increases to a new higher cost for the next

higher range of activity, but remains constant within a
range of activity.
 22 - 7

C1
CURVILINEAR COSTS

Costs that increase when activity

increases, but in a nonlinear
manner.
 22 - 8

P1
MEASURING COST BEHAVIOR

The objective is to classify all costs as either fixed

or variable. We will look at three methods:
1.Scatter diagrams.
2.The high-low method.
3. Least–squares regression.

A scatter diagram is a plot of cost data points on a

graph. It is almost always helpful to plot cost data to
be able to observe a visual picture of the relationship
between cost and activity.
 22 - 9

P1
SCATTER DIAGRAMS
Draw a line through the plotted data points so that about
equal numbers of points fall above and below the line.

20

* ** *
1,000’s of Dollars

* *
Total Cost in

**
10 * *
Estimated fixed cost = 10,000

0
0 1 2 3 4 5 6
Activity, 1,000’s of Units Produced
 22 - 10

P1
SCATTER DIAGRAMS

Δ in cost
Unit Variable Cost = Slope =
Δ in units

20

* ** * Vertical
1,000’s of Dollars

* * distance
Total Cost in

** is the
10 * * change
in cost.
Horizontal distance is
the change in activity.
0
0 1 2 3 4 5 6
Activity, 1,000’s of Units Produced
 22 - 11

P1 THE HIGH-LOW METHOD

The following relationships between units
produced and total cost are observed:

Using these two levels of activity, compute:

 the variable cost per unit.
 the total fixed cost.
 22 - 12

P1
THE HIGH-LOW METHOD
Units Cost
High activity level - December 67,500 $ 29,000
Low activity level - January 17,500 20,500
Change in activity 50,000 $ 8,500

 Variable cost per unit is determined as follows:

 Fixed costs are determined as follows:

Total cost = $17,525 + $0.17 per unit produced

 22 - 13

P1
LEAST-SQUARES REGRESSION
Least-squares regression is usually covered
in advanced cost accounting courses. It is
commonly used with spreadsheet programs
or calculators.

The objective of the cost

analysis remains the
same: determination of
total fixed cost and the
variable unit cost.
 22 - 14

A1
USING BREAK-EVEN ANALYSIS
The break-even point (expressed in
units of product or dollars of sales) is
the unique sales level at which a
company earns neither a profit nor
incurs a loss.
 22 - 15

A1 CONTRIBUTION MARGIN AND ITS

MEASURES
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

Contribution margin is the amount by which revenue

exceeds the variable costs of producing the revenue.

Total contribution margin is $60,000 and the

contribution margin per unit sold is $30.
 22 - 16

A1 CONTRIBUTION MARGIN AND ITS

MEASURES
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

Contribution Contribution margin per unit

margin ratio =
Sales price per unit

Contribution $30 per unit

= = 30%
margin ratio $100 per unit
 22 - 17

P2
COMPUTING THE BREAK-EVEN
POINT
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

How much contribution margin must Rydell Company

have to cover its fixed costs (break-even)?
Answer: $24,000

How many units must Rydell sell to cover its fixed

costs (break-even)?
Answer: $24,000 ÷ $30 per unit = 800 units
 22 - 18

P2 COMPUTING THE BREAK-EVEN

POINT
We have just seen one of the basic CVP
relationships – the break-even computation.

Fixed costs
Break-even point in units =
Contribution margin per unit

Unit sales price less unit variable cost

($30 in previous example)
 22 - 19

P2 COMPUTING THE BREAK-EVEN

POINT
The break-even formula may also be
expressed in sales dollars.

Fixed costs
Break-even point in dollars =
Contribution margin ratio

Unit contribution margin

Unit sales price
 22 - 20

P3
PREPARING A CVP CHART
 22 - 21

P3 MAKING ASSUMPTIONS IN
COST-VOLUME-PROFIT ANALYSIS
 A limited range of activity called the relevant
range, where CVP relationships are linear.
 Unit selling price remains constant.
 Unit variable costs remain constant.
 Total fixed costs remain constant.
 Production = sales (no inventory changes).
 22 - 22

P3 WORKING WITH CHANGES

IN ESTIMATES
Total Unit
Sales Revenue (2,000 units) $ 200,000 $ 100
Less: Variable costs 140,000 70
Contribution margin $ 60,000 $ 30
Less: Fixed costs 24,000
Net income $ 36,000

What happens to the break-even point if management can

increase the sales price to $105, with no changes in fixed or
variable costs?
Fixed costs
Break-even point in units =
Contribution margin per unit
$24,000
Break-even point in units = = 686 units
$105 – $70
 22 - 23

C2 COMPUTING INCOME
FROM SALES AND COSTS
Income (pretax) = Sales – Variable costs – Fixed costs

Rydell expects to sell 1,500 units at $100 each next month.

Fixed costs are $24,000 per month and the unit variable
cost is $70. What amount of income should Rydell expect?

Income (pretax) = Sales – Variable costs – Fixed costs

= [1,500 units × $100] – [1,500 units × $70] – $24,000
= $21,000
 22 - 24

C2 COMPUTING SALES
FOR A TARGET INCOME

Break-even formulas may be adjusted to show the

sales volume needed to earn any amount of income.

Fixed costs + Target pretax income

Unit sales =
Contribution margin per unit

Fixed costs + Target pretax income

Dollar sales =
Contribution margin ratio
 22 - 25

C2 COMPUTING SALES (DOLLARS)

FOR A
TARGET NET INCOME
To convert target net income to before-tax
income, use the following formula:

Target net income

Before-tax income =
1 - tax rate
 COMPUTING SALES (DOLLARS)
22 - 26

C2
FOR A
TARGET NET INCOME
Rydell has a monthly target net income of $9,000. The
unit selling price is $100. Monthly fixed costs are
$24,000, the unit variable cost is $70, and the tax rate is
25 percent.

What is Rydell’s target pretax income?

Target net income

Pretax income =
1 - tax rate

$9,000
Pretax income = = $12,000
1 - .25
 COMPUTING SALES (DOLLARS)
22 - 27

C2
FOR A
TARGET NET INCOME
Rydell has a monthly target after-tax income of $9,000.
The unit selling price is $100. Monthly fixed costs are
$24,000, the unit variable cost is $70, and the tax rate is
25 percent. Let’s compute the sales revenue that Rydell
will need to earn $12,000 of pretax income?

Fixed costs + Target pretax income

Dollar sales =
Contribution margin ratio

$24,000 + $12,000
Dollar sales = = $120,000
30%
 22 - 28

C2 COMPUTING SALES (UNITS)

FOR A TARGET NET INCOME

The formula for computing dollar sales may be

used to compute unit sales by substituting
contribution per unit in the denominator.

Fixed costs + Target pretax income

Unit sales =
Contribution margin per unit

$24,000 + $12,000
Unit sales = = 1,200
units $30 per unit
 22 - 29

C2
COMPUTING THE MARGIN OF
SAFETY
Margin of safety is the amount by which sales can drop
before the company incurs a loss. Margin of safety may
be expressed as a percentage of expected sales.

Margin of safety Expected sales - Break-even sales

=
percentage Expected sales

If Rydell’s sales are $100,000 and break-even sales are

$80,000, what is the margin of safety percentage?

Margin of safety $100,000 - $80,000

= = 20%
percentage $100,000
 22 - 30

C2
USING SENSITIVITY ANALYSIS
Rydell Company is considering buying a new machine
that would increase monthly fixed costs from $24,000 to
$30,000, but decrease unit variable costs from $70 to $60.
The $100 per unit selling price would remain unchanged.
What is the new break-even point in dollars?

Revised Break-even Revised fixed costs

=
point in dollars Revised contribution margin ratio

Revised Break-even $30,000

= = $75,000
point in dollars 40%
 22 - 31

P4 COMPUTING A MULTIPRODUCT
BREAK-EVEN POINT
The CVP formulas can be modified for use when a
company sells more than one product.
 The unit contribution margin is replaced with the
contribution margin for a composite unit.
 A composite unit is composed of specific numbers of
each product in proportion to the product sales mix.
 Sales mix is the ratio of the volumes of the various
products.
 22 - 32

P4 COMPUTING A MULTIPRODUCT
BREAK-EVEN POINT

The resulting break-even formula

for composite unit sales is:

Break-even point Fixed costs

= Contribution margin
in composite units
per composite unit

Consider the following example:

Continue
 22 - 33

P4 COMPUTING A MULTIPRODUCT
BREAK-EVEN POINT
Hair-Today offers three cuts as shown below. Annual fixed
costs are $192,000. Compute the break-even point in
composite units and in number of units for each haircut at the
given sales mix.

Haircuts
Basic Ultra Budget
Selling Price $ 20.00 $ 32.00 $ 16.00
Variable Cost 13.00 18.00 8.00
Unit Contribution $ 7.00 $ 14.00 $ 8.00
Sales Mix Ratio 4 2 1

A 4:2:1 sales mix means that if there are 500 budget cuts,
then there will be 1,000 ultra cuts, and 2,000 basic cuts.
 22 - 34

P4 COMPUTING A MULTIPRODUCT
BREAK-EVEN POINT
Step 1: Compute contribution margin per
composite unit.

Haircuts
Basic Ultra Budget
Selling Price $20.00 $32.00 $16.00
Variable Cost 13.00 18.00 8.00
Unit Contribution $7.00 $14.00 $8.00
Sales Mix Ratio ×4 ×2 ×1
Weighted Contribution $ 28.00 + $ 28.00 + $ 8.00 = $ 64.00

Contribution margin per composite unit

 22 - 35

P4 COMPUTING A MULTIPRODUCT
BREAK-EVEN POINT
Step 2: Compute break-even point in
composite units.
Break-even point Fixed costs
= Contribution margin
in composite units
per composite unit

Break-even point $192,000

= $64.00 per
in composite units
composite unit
Break-even point
= 3,000 composite units
in composite units
 22 - 36

P4 COMPUTING A MULTIPRODUCT
BREAK-EVEN POINT
Step 3: Determine the number of each haircut
that must be sold to break-even.

Sales Composite
Product Mix Cuts Haircuts
Basic 4 × 3,000 = 12,000
Ultra 2 × 3,000 = 6,000
Budget 1 × 3,000 = 3,000
Total 21,000
 22 - 37

P4 MULTIPRODUCT BREAK-EVEN
INCOME STATEMENT

Step 4: Verify the results.

Haircuts
Basic Ultra Budget Combined
Selling Price $ 20.00 $ 32.00 $ 16.00
Variable Cost 13.00 18.00 8.00
Unit Contribution $ 7.00 $ 14.00 $ 8.00
Sales Volume × 12,000 × 6,000 × 3,000
Total Contribution $ 84,000 $ 84,000 $ 24,000 $192,000
Fixed Costs 192,000
Income $ 0
 22 - 38

GLOBAL VIEW

Over 90 percent of German companies

surveyed report their cost accounting systems
focus on contribution margin. This focus helps
German companies like Volkswagen control
costs and plan their production levels.
 22 - 39

A2
DEGREE OF OPERATING LEVERAGE

A measure of the extent to which fixed costs are

being used in an organization.

A measure of how a percentage change in

sales will affect profits.

Contribution margin = Degree of operating leverage

Pretax income
 22 - 40

A2
OPERATING LEVERAGE
Rydell Company
Sales (1,200 units) $120,000
Less: variable expenses 84,000
Contribution margin 36,000
Less: fixed expenses 24,000
Pretax income $ 12,000

Contribution margin = Degree of operating leverage = $36,000 = 3.0

Net income $12,000

If Rydell increases sales by 10 percent, what will the

percentage increase in income be?

Percent increase in sales 10%

Degree of operating leverage × 3
Percent increase in pretax income 30%
APPENDIX 22A: USING EXCEL TO
22 - 41

ESTIMATE LEAST-SQUARES
REGRESSION
 22 - 42

END OF CHAPTER 22