Cost Behavior:

Analysis and Use

CHAPTER#5
• Three cost behavior patterns—variable, fixed,
and mixed—are found in most organizations.
• The relative proportion of each type of cost in
an organization is known as its cost structure.
Variable Costs
A variable cost is a cost whose total dollar amount varies
in direct proportion to changes in the activity level.
• A variable cost remains constant if expressed on a per
unit basis.
The Activity Base
An activity base is a measure of whatever causes the
incurrence of variable cost. An activity base is
sometimes referred to as a cost driver.
• Some of the most common activity bases are direct
labor-hours, machine-hours, units produced, and
units sold.
 True Variable versus Step-Variable Costs
• True Variable Costs Direct materials is a true or
proportionately variable cost because the amount used
during a period will vary in direct proportion to the
level of production activity. Moreover, any amounts
purchased but not used can be stored and carried
forward to the next period as inventory.

• Step-Variable Costs The cost of a resource that is

obtainable only in large chunks and that increases or
decreases only in response to fairly wide changes in
activity is known as a step-variable cost. For example,
the wages of skilled repair technicians are often
considered to be a step-variable cost.
 The Linearity Assumption and the Relevant Range
• Economists correctly point out that many costs
that the accountant classifies as variable actually
behave in a curvilinear fashion; that is, the
relation between cost and activity is a curve.
• Although many costs are not strictly linear, a
curvilinear cost can be satisfactorily
approximated with a straight line within a
narrow band of activity known as the relevant
range.
• The relevant range is that range of activity
within which the assumptions made about cost
behavior are reasonably valid.
 Fixed Costs Behavior
• The total fixed costs remain constant within
the relevant range of activity.
 Types of Fixed Costs
• Fixed costs are sometimes referred to as
capacity costs, since they result from outlays
made for buildings, equipment, skilled
professional employees, and other items
needed to provide the basic capacity for
sustained operations. For planning purposes,
fixed costs can be viewed as either committed
or discretionary.
Committed Fixed Costs
Investments in facilities, equipment, and the
basic organization that can’t be significantly
reduced even for short periods of time without
making fundamental changes are referred to as
committed fixed costs.
Examples of such costs-
depreciation of buildings and equipment, real
estate taxes, insurance expenses, and salaries
of top management and operating personnel.
• Discretionary Fixed Costs
Discretionary fixed costs (often referred to as
managed fixed costs ) usually arise from annual
decisions by management to spend on certain fixed
cost items.

• Examples of discretionary fixed costs include

advertising, research, public relations, management
development programs, and internships for
students.
 Two Difference-
• First, the planning horizon for a discretionary
fixed cost is short term—usually a single year.
By contrast, committed fixed costs have a
planning horizon that encompasses many years.
• Second, discretionary fixed costs can be cut
for short periods of time with minimal damage
to the long-run goals of the organization.
Is Labor a Variable or a Fixed Cost?
• The behavior of wage and salary costs will differ
from one country to another, depending on
labor regulations, labor contracts, and custom.
• In some countries, such as France, Germany,
and Japan, management has little flexibility in
adjusting the labor force to changes in business
activity. In countries such as the United States
and the United Kingdom, management typically
has much greater latitude.
Fixed Costs and the Relevant Range
• The concept of the relevant range, which was
introduced in the discussion of variable costs,
is also important in understanding fixed costs
—particularly discretionary fixed costs.
• The levels of discretionary fixed costs are
typically decided at the beginning of the year
and depend on the needs of planned
programs such as advertising and training.
 Mixed Costs
A mixed cost contains both variable and fixed cost
elements. Mixed costs are also known as semi variable
costs.
The Nooksack Expeditions example, the company must pay
• a license fee of $25,000 per year plus $3 per rafting
party to the state’s Department of Natural Resources.
• If the company runs 1,000 rafting parties this year, then
the total fees paid to the state would be $28,000, made
up of $25,000 in fixed cost plus $3,000 in variable cost.
 The Analysis of Mixed Costs
• Diagnosing Cost Behavior with a Scattergraph Plot
Two things should be noted about this scattergraph:
1. The total maintenance cost, Y, is plotted on the vertical
axis. Cost is known as the dependent variable, since the
amount of cost incurred during a period depends on the
level of activity for the period. (That is, as the level of
activity increases, total cost will also ordinarily increase.)
2. The activity, X (patient-days in this case), is plotted on
the horizontal axis. Activity is known as the independent
variable, since it causes variations in the cost.
Scatter Graph
Method of Cost
Analysis
More than One Relevant
Range
A Diagnostic Scattergraph
Plot
 The High-Low Method
• Assuming that the scatter graph plot indicates a linear
relation between cost and activity, the fixed and variable
cost elements of a mixed cost can be estimated using
the high-low method or the least-squares regression
method.
• If the relation between cost and activity can be
represented by a straight line, then the slope of the
straight line is equal to the variable cost per unit of
activity.
 The Least-Squares Regression Method
• The least-squares regression method, unlike
the high-low method, uses all of the data to
separate a mixed cost into its fixed and
variable components.
• A regression line of the form Y= a+bX is fitted
to the data, where a represents the total fixed
cost and b represents the variable cost per
unit of activity.
The Concept of Least-Squares Regression
Review Problem 1: Cost Behavior
Review Problem 2: High-Low Method
Cost-Volume-Profit
Relationships
CHAPTER#6
 Cost-volume-profit (CVP) analysis
Cost-volume-profit (CVP) analysis is a powerful tool that
helps managers understand the relationships among
cost, volume, and profit.
 CVP analysis focuses on how profits are affected by the
following five factors:
1. Selling prices.
2. Sales volume.
3. Unit variable costs.
4. Total fixed costs.
5. Mix of products sold.
CVP analysis helps managers understand-
how profits are affected by these key factors
what products and services to offer
what prices to charge
what marketing strategy to use
what cost structure to implement
 The Basics of Cost-Volume-Profit (CVP) Analysis
• The contribution income statement
emphasizes the behavior of costs and
therefore is extremely helpful to managers in
judging the impact on profits of changes in
selling price, cost, or volume.
 Contribution Margin
• Contribution margin is the amount remaining
from sales revenue after variable expenses
have been deducted. Thus, it is the amount
available to cover fixed expenses and then to
provide profits for the period.
• break-even point is the level of sales at which
profit is zero.
• Once the break-even point has been reached,
net operating income will increase by the
amount of the unit contribution margin for
each additional unit sold.
CVP Relationships in Graphic Form
The relationships among revenue, cost, profit,
and volume are illustrated on a cost-volume
profit (CVP) graph. A CVP graph highlights CVP
relationships over wide ranges of activity.
• Preparing the CVP Graph
In a CVP graph (sometimes called a break-even
chart), unit volume is represented on the
horizontal (X) axis and dollars on the vertical (Y)
axis.
 Preparing a CVP graph involves three steps
Draw a line parallel to the volume axis to
represent total fixed expense. For Acoustic
Concepts, total fixed expenses are $35,000.
Choose some volume of unit sales and plot
the point representing total expense (fixed
and variable) at the activity level you have
selected.
Again choose some volume of unit sales and
plot the point representing total sales dollars
at the activity level you have selected.
Preparing the CVP Graph
The Completed CVP Graph
 Contribution Margin Ratio (CM Ratio)

• the contribution margin ratio can be used in

cost-volume-profit calculations.
 CM ratio of 40% means that for each dollar increase in sales,
total contribution margin will increase by 40 cents ($1 sales
CM ratio of 40%).
 Net operating income will also increase by 40 cents, assuming
that fixed costs are not affected by the increase in sales.
Some Applications of CVP Concepts
• the impact on net operating income of any
given dollar change in total sales can be
computed by simply applying the CM ratio to
the dollar change.
• Change in Fixed Cost and Sales Volume
Acoustic Concepts is currently selling 400
speakers per month at $250 per speaker for
total monthly sales of $100,000. The sales
manager feels that a $10,000 increase in the
monthly advertising budget would increase
monthly sales by $30,000 to a total of 520
units. Should the advertising budget be
increased?
Alternative Solutions
 Change in Variable Costs and Sales Volume
Refer to the original data. Recall that Acoustic
Concepts is currently selling 400 speakers per
month. Prem is considering the use of higher-
quality components, which would increase
variable costs (and thereby reduce the
contribution margin) by $10 per speaker.
However, the sales manager predicts that using
higher-quality components would increase sales
to 480 speakers per month. Should the higher-
quality components be used?
 Change in Fixed Cost, Sales Price, and Sales Volume
• Refer to the original data and recall again that
Acoustic Concepts is currently selling 400 speakers
per month. To increase sales, the sales manager
would like to cut the selling price by $20 per speaker
and increase the advertising budget by $15,000 per
month. The sales manager believes that if these two
steps are taken, unit sales will increase by 50% to 600
speakers per month. Should the changes be made?
• A decrease in the selling price of $20 per speaker
would decrease the unit contribution margin by $20
down to $80.
Solution
Change in Variable Cost, Fixed Cost, and Sales Volume
• Refer to Acoustic Concepts’ original data. As
before, the company is currently selling 400
speakers per month. The sales manager would
like to pay salespersons a sales commission of
$15 per speaker sold, rather than the flat
salaries that now total $6,000 per month. The
sales manager is confident that the change
would increase monthly sales by 15% to 460
speakers per month. Should the change be
made?
 Change in Selling Price
• Refer to the original data where Acoustic Concepts
is currently selling 400 speakers per month. The
company has an opportunity to make a bulk sale of
150 speakers to a wholesaler if an acceptable price
can be negotiated. This sale would not disturb the
company’s regular sales and would not affect the
company’s total fixed expenses. What price per
speaker should be quoted to the wholesaler if
Acoustic Concepts wants to increase its total
monthly profits by $3,000?
Solution
 Break-Even Analysis
• Break-even analysis is an aspect of CVP analysis
that is designed to answer questions such as how
far could sales drop before the company begins to
lose money?
• Break-Even Computations
• The break-even point as the level of sales at which
the company’s profit is zero. The break-even point
can be computed using either the equation method
or the contribution margin method —the two
methods are equivalent.
The Equation Method
 The Contribution Margin Method
• The contribution margin method is a shortcut
version of the equation method already
described. The approach centers on the idea
discussed earlier that each unit sold provides a
certain amount of contribution margin that
goes toward covering fixed costs.
 Target Profit Analysis
• CVP formulas can be used to determine the
sales volume needed to achieve a target
profit. Suppose that Prem Narayan of Acoustic
Concepts wishes to earn a target profit of
$40,000 per month. How many speakers
would have to be sold?
• The CVP Equation: One approach is to use the
equation method. Instead of solving for the
unit sales where profits are zero, solve for the
unit sales where profits are $40,000.
Where
 The Margin of Safety
• The margin of safety is the excess of budgeted (or actual)
sales dollars over the break-even volume of sales dollars. It
is the amount by which sales can drop before losses are
incurred. The higher the margin of safety, the lower the risk
of not breaking even and incurring a loss.
 CVP Considerations in Choosing a
Cost Structure

• Cost structure refers to the relative proportion

of fixed and variable costs in an organization.
Managers often have some latitude in trading
off between these two types of costs. For
example, fixed investments in automated
equipment can reduce variable labor costs.
Cost Structure and Profit Stability
• What if sales drop below $100,000? What are
the farms’ break-even points? What are their
margins of safety? The computations needed
to answer these questions are shown below
using the contribution margin method:
 Operating Leverage
• A lever is a tool for multiplying force. Using a lever,
a massive object can be moved with only a modest
amount of force. In business, operating leverage
serves a similar purpose.
• Operating leverage is a measure of how sensitive
net operating income is to a given percentage
change in dollar sales. Operating leverage acts as a
multiplier. If operating leverage is high, a small
percentage increase in sales can produce a much
larger percentage increase in net operating income.
 The Definition of Sales Mix
• The term sales mix refers to the relative
proportions in which a company’s products
are sold.
• The idea is to achieve the combination, or mix,
that will yield the greatest amount of profits.
Sales Mix and Break-Even Analysis
 Assumptions of CVP Analysis
A number of assumptions commonly underlie CVP
analysis:
1. Selling price is constant. The price of a product or
service will not change as volume changes.
2. Costs are linear and can be accurately divided into
variable and fixed elements. The variable element is
constant per unit, and the fixed element is constant in
total over the entire relevant range.
3. In multiproduct companies, the sales mix is constant.
4. In manufacturing companies, inventories do not
change. The number of units produced equals the
number of units sold.
Review Problem
Solution to Review Problem