Chapter 2

Introduction to Cost Behavior

and Cost-Volume-Profit
Relationships

1
 Chapter 2 Learning Objectives

When you have finished studying this chapter, you

should be able to:

1. Explain how cost drivers affect cost behavior.

2. Show how changes in cost-driver levels affect

variable and fixed costs.

3. Explain step- and mixed-cost behavior.

4. Create a cost-volume-profit (CVP) graph and

understand the assumptions behind it.

5. Calculate break-even sales volume in total dollars

and total units.

When you have finished studying this chapter, you should be able to:

1. Explain how cost drivers affect cost behavior.

2. Show how changes in cost-driver levels affect variable and fixed costs.

3. Explain step- and mixed-cost behavior.

4. Create a cost-volume-profit (CVP) graph and understand the assumptions

behind it.

5. Calculate break-even sales volume in total dollars and total units.

6. Calculate sales volume in total dollars and total units to reach a target profit.

7. Differentiate between contribution margin and gross margin.

8. Explain the effects of sales mix on profits (Appendix 2A).

Copyright 2003 Prentice Hall Publishing 2

9. Compute cost-volume-profit (CVP) relationships on an after-tax basis (Appendix
2B).

2
 Chapter 2 Learning Objectives

6. Calculate sales volume in total dollars and total

units to reach a target profit.

7. Differentiate between contribution margin and

gross margin.

8. Explain the effects of sales mix on profits

(Appendix 2A).

9. Compute cost-volume-profit (CVP) relationships on

an after-tax basis (Appendix 2B).

When you have finished studying this chapter, you should be able to:

1. Explain how cost drivers affect cost behavior.

2. Show how changes in cost-driver levels affect variable and fixed costs.

3. Explain step- and mixed-cost behavior.

4. Create a cost-volume-profit (CVP) graph and understand the assumptions

behind it.

5. Calculate break-even sales volume in total dollars and total units.

6. Calculate sales volume in total dollars and total units to reach a target profit.

7. Differentiate between contribution margin and gross margin.

8. Explain the effects of sales mix on profits (Appendix 2A).

Copyright 2003 Prentice Hall Publishing 3

9. Compute cost-volume-profit (CVP) relationships on an after-tax basis (Appendix
2B).

3
 Cost Drivers and Cost Behavior

Cost drivers are measures

of activities that require
the use of resources
and thereby cause costs.

Cost behavior is how the

activities of an
organization affect its costs.

Cost drivers are measures of activities that require the use of resources and
thereby cause costs.
Cost behavior is how the activities of an organization affect its costs.
An organization has many cost drivers across the various activities of its value
chain.

4
 Learning
Objective 1
Cost Drivers and Cost Behavior

Exhibit 2-1 shows how activities link resources and their costs with the output
of products or services. For example, an activity that requires resources and
therefore causes costs for Boeing is installing seats. This activity uses many
resources, but let’s consider just two: 1) the seats themselves, which Boeing
purchases from a subcontractor, and 2) labor for installing the seats. One
measure of activity, number of seats installed, is an appropriate cost driver for
the cost of the seats. A different measure of activity, labor hours used in
installing the seats, is a cost driver for the cost of labor resources.

5
 Value Chain Functions, Costs, and Cost Drivers

Value Chain Function Example Cost Drivers

And Resource Costs
Research and development
•Salaries of sales personnel Number of new product proposals
costs of market surveys
•Salaries of product and process Complexity of proposed products
engineers

Design of products, services, and

processes
•Salaries of product and process Number of engineering hours
engineers
•Cost of computer-aided design Number of distinct parts per
equipment used to develop product
prototype of product for testing

An organization has many cost drivers across the various activities of its value
chain.
The exhibit lists examples of resource costs and potential cost drivers for
activities in each of the value-chain functions. How well we identify the most
appropriate cost drivers determines how well managers understand cost
behavior and how well managers can control costs.
Value-Chain and Example Costs
Research and development
• Salaries of sales personnel, costs of market surveys
• Salaries of product and process engineers
Design of products, services, and processes
• Salaries of product and process engineers
• Cost of computer-aided design equipment used to develop prototype of
product for testing
Production
• Labor wages
• Supervisory salaries
• Maintenance wages

6
• Depreciation of plant and machinery, supplies
• Energy cost
Marketing
• Cost of advertisements
• Salaries of marketing personnel, travel costs, entertainment costs
Distribution
• Wages of shipping personnel
• Transportation costs including depreciation of vehicles and fuel
Customer service
• Salaries of service personnel
• Costs of supplies, travel
Example of Cost Drivers:
Number of new product proposals
Complexity of proposed products
Number of engineering hours
Number of distinct parts per product
Labor hours
Number of people supervised
Number of mechanic hours
Number of machine hours
Kilowatt hours
Number of advertisements
Sales dollars
Labor hours
Weight of items delivered
Hours spent servicing products
Number of service calls

6
 Value Chain Functions, Costs, and Cost Drivers

Value Chain Function Example Cost Drivers

and Resource Costs

Production
•Labor wages Labor hours
•Supervisory salaries Number of people supervised
•Maintenance wages Number of mechanic hours
•Depreciation of plant and machinery, Number of machine hours
supplies
• Energy cost Kilowatt hours

Marketing
•Cost of advertisements Number of advertisements
•Salaries of marketing personnel, Sales dollars
travel costs, entertainment costs

The exhibit lists examples of resource costs and potential cost drivers for
activities in each of the value-chain functions. How well we identify the most
appropriate cost drivers determines how well managers understand cost
behavior and how well managers can control costs.
Value-Chain and Example Costs
Research and development
• Salaries of sales personnel, costs of market surveys
• Salaries of product and process engineers
Design of products, services, and processes
• Salaries of product and process engineers
• Cost of computer-aided design equipment used to develop prototype of
product for testing
Production
• Labor wages
• Supervisory salaries
• Maintenance wages
• Depreciation of plant and machinery, supplies
• Energy cost

7
Marketing
• Cost of advertisements
• Salaries of marketing personnel, travel costs, entertainment costs
Distribution
• Wages of shipping personnel
• Transportation costs including depreciation of vehicles and fuel
Customer service
• Salaries of service personnel
• Costs of supplies, travel
Example of Cost Drivers:
Number of new product proposals
Complexity of proposed products
Number of engineering hours
Number of distinct parts per product
Labor hours
Number of people supervised
Number of mechanic hours
Number of machine hours
Kilowatt hours
Number of advertisements
Sales dollars
Labor hours
Weight of items delivered
Hours spent servicing products
Number of service calls

7
 Value Chain Functions, Costs, and Cost Drivers

Value Chain Function Example Cost Drivers

And Resource Costs

Distribution
•Wages of shipping personnel Labor hours
•Transportation costs including Weight of items delivered
depreciation of vehicles and fuel

Customer service
•Salaries of service personnel Hours spent servicing products
•Costs of supplies, travel Number of service calls

The exhibit lists examples of resource costs and potential cost drivers for
activities in each of the value-chain functions. How well we identify the most
appropriate cost drivers determines how well managers understand cost
behavior and how well managers can control costs.
Value-Chain and Example Costs
Research and development
• Salaries of sales personnel, costs of market surveys
• Salaries of product and process engineers
Design of products, services, and processes
• Salaries of product and process engineers
• Cost of computer-aided design equipment used to develop prototype of
product for testing
Production
• Labor wages
• Supervisory salaries
• Maintenance wages
• Depreciation of plant and machinery, supplies
• Energy cost

8
Marketing
• Cost of advertisements
• Salaries of marketing personnel, travel costs, entertainment costs
Distribution
• Wages of shipping personnel
• Transportation costs including depreciation of vehicles and fuel
Customer service
• Salaries of service personnel
• Costs of supplies, travel
Example of Cost Drivers:
Number of new product proposals
Complexity of proposed products
Number of engineering hours
Number of distinct parts per product
Labor hours
Number of people supervised
Number of mechanic hours
Number of machine hours
Kilowatt hours
Number of advertisements
Sales dollars
Labor hours
Weight of items delivered
Hours spent servicing products
Number of service calls

8
 Learning
Objective 2 Variable and Fixed Cost Behavior

A variable cost A fixed cost is

changes in direct not immediately
proportion to changes affected by changes
in the cost-driver level. in the cost-driver level.

Think of variable Think of fixed costs

costs on a per-unit basis. on a total-cost basis.

The per-unit variable

Total fixed costs remain
cost remains unchanged
unchanged regardless of
regardless of changes in
changes in the cost-driver.
the cost-driver.

To understand cost behavior, it is important to distinguish variable costs from

fixed costs. Accountants classify costs as variable or fixed depending on how
much they change as the level of a particular cost driver changes. A variable
cost changes in direct proportion to changes in the cost driver. In contrast,
changes in the cost driver do not immediately affect a fixed cost.
The term “fixed cost” describes the behavior of cost with respect to the cost
driver, but a fixed cost can change due to factors other than changes in the cost
driver. For example, heating costs are commonly fixed and do not change with
respect to the production volume cost driver. Nonetheless, heating costs
change with respect to factors not related to the cost driver, such as changes in
the price of oil or electricity, or unusually warm or unusually cold weather.
Pay special attention to the fact that the terms “variable” or “fixed” describe
the behavior of the total dollar cost, not the per-unit cost, which has the
opposite behavior.

9
 Cost Behavior of Variable and Fixed

Total variable costs increase as the cost driver increases but variable costs per
unit remain constant. Total fixed costs remain constant as cost driver activity
increases but fixed costs per unit decrease.

10
 Cost Behavior: Further Considerations

Cost behavior depends on the decision

context, the circumstances surrounding
the decision for which the cost will be
used.

Cost behavior also depends on

management decisions—management
choices determine cost behavior.

Cost behavior cannot always be accurately described as simply variable or

fixed. Cost behavior depends on the decision context, the circumstances
surrounding the decision for which the cost will be used, as illustrated by
examples in the discussion that follows. Further, cost behavior also depends on
management decisions—management choices determine cost behavior.

11
 Relevant Range

The relevant range is the limit

of cost-driver activity level within which a
specific relationship between costs
and the cost driver is valid.

Even within the relevant range, a fixed

cost remains fixed only over a given
period of time—usually the budget period.

Although we described fixed costs as unchanging regardless of changes in the

cost driver, this description holds true only within limits. For example, rent
costs for a production building are generally fixed within a limited range of
activity but may rise if activity increases enough to require additional rental
space or may decline if activity decreases so much that it allows the company
to rent less space. The relevant range is the limit of cost-driver level within
which a specific relationship between costs and the cost driver is valid.

12
 Fixed Costs and Relevant Range

Suppose that total monthly fixed costs are $100,000 for a General Electric
lightbulb plant as long as production is between 40,000 and 85,000 cases of
lightbulbs per month. However, if production falls below 40,000 cases,
changes in production processes will slash fixed costs to $60,000 per month.
On the other hand, if operations rise above 85,000 cases, rentals of additional
facilities will boost fixed costs to $115,000 per month. Exhibit 2-6 graphs
these assumptions about cost behavior. The top figure shows a refined analysis
that reflects all the complexities described previously. The bottom figure
shows a simplified analysis that focuses only on the cost in the relevant range,
ignoring the issue of cost behavior outside the relevant range. Within the
relevant range highlighted in yellow, the refined and simplified analyses
coincide. However, the refined description at the top of Exhibit 2-6 explicitly
shows the rental costs at the levels of activity outside the relevant range. The
simplified description at the bottom of the exhibit shows only the rental costs
for the relevant range, and uses a dashed line outside the relevant range to
remind the user that the graphed cost is outside the limits of the relevant range.

13
 Learning Step- and Mixed-Cost
Objective 3
Behavior Patterns

Step cost:
Mixed Cost:
A cost that changes
abruptly at different A cost that contains
intervals of activity elements of both
because the resources fixed- and variable-
and their costs come cost behavior
in indivisible chunks.

STEP COSTS: Costs that change abruptly at different levels of activity

because the resources are available only in indivisible chunks are step costs.
For decisions where the range of activity is limited to a single step of the cost
function, we consider the cost a fixed cost. For decisions where the range of
activity encompasses many steps, the cost behaves more like a variable cost.
MIXED COSTS: Many costs are mixed costs, which contain elements of both
fixed- and variable-cost behavior. The fixed-cost element is unchanged over
the relevant range of activity levels while the variable-cost element of the
mixed cost varies proportionately with cost-driver activity. You might think of
the fixed cost element as the cost of creating the capacity to operate, and the
variable cost element as the additional cost of actually using that capacity.

14
 Step-Cost Behavior

Step cost treated as a fixed cost Step cost treated as a variable cost

Panel A of Exhibit 2-7 illustrates a decision where a step cost could be treated
as a fixed cost. In this example, when oil and gas exploration activity reaches a
certain level, the company must lease an additional rig. Each additional rig
leased defines a new step in the cost function, which supports a new, higher
volume of exploration activity. This step cost behaves as a fixed cost as long as
all the decision alternatives remain within the relevant range of a single step,
such as within the highlighted relevant range of the second step in the cost
function shown in Panel A of Exhibit 2-7.
Panel B of Exhibit 2-7 illustrates a decision where a step cost could be treated
as a variable cost. The cost function shows the wage cost of cashiers at a
supermarket where the individual cost steps are uniform. Each cashier can
serve an average of 20 shoppers per hour. In a decision about staffing, where
the number of shoppers is expected to range from 40 per hour to 440 per hour,
the required number of cashiers to match the number of shoppers would range
between 2 and 22. Because the range of the number of shoppers in this
decision spans a large number of equal-sized steps, this step cost behaves
much like a variable cost, and for this decision we can assume the step cost is
variable with little loss of accuracy.
Many costs cannot accurately be described as simply fixed or variable. Several
factors make the behavior of these costs more complex. First, cost behavior
sometimes differs across different ranges of activity, and it is important to

15
always consider whether the assumptions about cost behavior apply in the relevant
range for your decision.

15
 Learning Cost-volume-profit (CVP)
Objective 4
analysis

Managers trying to evaluate the effects of

changes in volume of goods or services produced
might be interested in upward changes such as
increased sales expected from increases in
promotion or advertising.
AND
Managers might be interested in downward
changes such as decreased sales expected due to
a new competitor entering the market or due to
a decline in economic conditions.

Consider situations where managers are trying to evaluate the effects of

changes in the volume of goods or services produced. For example, managers
might be interested in upward changes such as increased sales expected from
increases in promotion or advertising. On the other hand, managers might be
interested in downward changes such as decreased sales expected due to a new
competitor entering the market or due to a decline in economic conditions.
While such changes in volume have many effects, managers are always
interested in the relationship between volume and revenue (sales), expenses
(costs), and net income (net profit). We call this cost-volume-profit (CVP)
analysis.

16
 CVP Scenario
Cost-volume-profit (CVP) analysis is the study of the
effects of output volume on revenue (sales), expenses
(costs), and net income (net profit).

Per Unit Percentage of

Sales
Selling price $1.50 100%
Variable cost of each item 1.20 80
Selling price less variable cost $ .30 20%

Monthly fixed expenses:

Rent $3,000
Wages for replenishing and
servicing 13,500
Other fixed expenses 1,500
Total fixed expenses per month $18,000

Amy Winston, the manager of food services for one of Boeing’s plants, is
trying to decide whether to rent a line of snack vending machines. Although
individual snack items have various acquisition costs and selling prices,
Winston has decided that an average selling price of $1.50 per unit and an
average acquisition cost of $1.20 per unit will suffice for purposes of this
analysis. She predicts the revenue and expense relationships.

The managers of profit-seeking organizations usually study the effects of

output volume on revenue (sales), expenses (costs), and net income (net
profit). We call this study cost-volume-profit (CVP) analysis. The managers of
nonprofit organizations also benefit from the study of CVP relationships.

17
 Cost-Volume-Profit Graph

$150,000 A
Net Income
138,000 Sales C
120,000 Net Income Area
Dollars

D
90,000 Variable
Total Break-Even Point Expenses
60,000 Expenses 60,000 units
Net Loss
30,000 or $90,000
Area
18,000 B
Fixed Expenses
0 10 20 30 40 50 60 70 80 90 100

Units (thousands)

Managers often use break-even graphs because these graphs show potential
profits over a wide range of volume more easily than numerical exhibits.
Whether you use graphs or other presentations depends largely on your
preferences. However, if you need to explain a CVP model to an audience, a
graphical approach can be most helpful.
Note that the concept of relevant range applies to the break-even graph.
Almost all breakeven graphs show revenue and cost lines extending back to
the vertical axis as shown in Exhibit 2-7. This approach is misleading because
the relationships depicted in such graphs are valid only within a particular
relevant range of volume. Nevertheless, for presentation purposes, most
managers extend revenue and cost lines beyond the relevant range.

18
 Learning
Objective 5 Break-Even Point

The break-even point is the level of sales at which

revenue equals expenses and net income is zero.

Sales
- Variable expenses
- Fixed expenses
Zero net income (break-even point)

The most basic CVP analysis computes the monthly break-even point in
number of units and in dollar sales. The break-even point is the level of sales
at which revenue equals expenses and net income is zero.

19
 Contribution Margin Method

Contribution margin Contribution margin ratio

Per Unit Per Unit %
Selling price $1.50 Selling price 100
Variable costs 1.20 Variable costs 80
Contribution margin$ .30 Contribution margin 20

$18,000 fixed costs ÷ $.30 =

60,000 units (break even)

Every unit sold generates a unit contribution margin or marginal income,

which is the unit sales price minus the variable cost per unit. The number of
units that we must sell to break even is 60,000 =($18,000 ÷ $.30).

20
 Contribution Margin Method

60,000 units × $1.50 (Sales Price) = $90,000

in sales to break even

$18,000 fixed costs

÷ 20% (contribution-margin percentage)
= $90,000 of sales to break even

When we sell enough units to generate a total contribution margin (total

number of units sold X unit contribution margin) equal to the total fixed costs
of $18,000.

21
 Equation Method

Let N = number of units

to be sold to break even.

Variable Fixed
Sales – Expenses – Expenses = net income
$1.50N – $1.20N – $18,000 = 0
$.30N = $18,000
N = $18,000 ÷ $.30
N = 60,000 Units

The equation method is the most general form of analysis, one you can adapt
to any conceivable cost-volume-profit situation. You are familiar with a typical
income statement. We can express any income statement in equation form, or
as a mathematical model.

22
 Equation Method

Let S = sales in dollars

needed to break even.

S – .80S – $18,000 = 0
.20S = $18,000
S = $18,000 ÷ .20
S = $90,000

Shortcut formulas:
Break-even = fixed expenses = $18,000 = 60,000
volume in units unit contribution margin .30

Break-even = fixed expenses = $18,000 = $90,000

volume in sales contribution margin ratio .2

Total sales in the equation is a price-times-quantity relationship, which we

expressed in our example as $1.50N. To find the dollar sales, multiply 60,000
units by $1.50, which yields the break-even dollar sales of $90,000.

You can also solve the equation for break-even sales dollars without
computing the unit break-even point by using the relationship of variable costs
and profits as a percentage of sales.

23
 Learning
Objective 6 Target Net Profit

Managers use CVP analysis

to determine the total sales,
in units and dollars, needed
to reach a target net profit.

Target sales $1,440 per month

– variable expenses is the minimum
– fixed expenses acceptable
target net income net income.

To compute the target sales volume in units needed to meet the desired or
target net income, we adapt the basic break-even formula. The only real
difference from the normal break-even analysis is that here we use a positive
target net income instead of a break-even net income of $0.

24
 Target Net Profit

Target sales volume in units =

(Fixed expenses + Target net income)
÷ Contribution margin per unit

Selling price $1.50

Variable costs 1.20
Contribution margin per unit $ .30

($18,000 + $1,440) ÷ $.30 = 64,800 units

Target sales dollars = sales price X sales volume in units

Target sales dollars = $1.50 X 64,800 units = $97,200.

In this case, the given condition is the 60,000-unit break-even point. We would
recover all expenses at that volume. Therefore, the change or increment in net
income for every unit of sales beyond 60,000 would be equal to the unit
contribution margin of $1.50 – $1.20 = $.30. If $1,440 were the target net
profit, $1,440 ÷ $.30 would show that the target volume must exceed the
break-even volume by 4,800 units; it would therefore be 60,000 + 4,800 =
64,800 units. Target sales volume in dollars is $97,200.

25
 Target Net Profit

Contribution margin ratio

Per Unit %
Selling price 100
Variable costs 80
Contribution margin 20

Target sales volume in dollars =

Fixed expenses + target net income
contribution margin ratio
Sales volume in dollars =
18,000 + $1,440 = $97,200
.20

In this case, the given condition is the 60,000-unit break-even point. We would
recover all expenses at that volume. Therefore, the change or increment in net
income for every unit of sales beyond 60,000 would be equal to the unit
contribution margin of $1.50 – $1.20 = $.30. If $1,440 were the target net
profit, $1,440 ÷ $.30 would show that the target volume must exceed the
break-even volume by 4,800 units; it would therefore be 60,000 + 4,800 =
64,800 units. Target sales volume in dollars is $97,200.

26
 Nonprofit Application

Suppose a city has a $100,000

lump-sum budget appropriation
to conduct a counseling program.

Variable costs per prescription

are $400 per patient per day.

Fixed costs are $60,000 in the

relevant range of 50 to 150 patients.

Consider how cost-volume-profit relationships apply to nonprofit

organizations. Suppose a city has a $100,000 lump-sum budget appropriation
to conduct a counseling program for drug addicts. The variable costs for
counseling are $400 per patient per year. Fixed costs are $60,000 in the
relevant range of 50 to 150 patients.

27
 Nonprofit Application

If the city spends the entire budget

appropriation, how many patients
can it serve in a year?

Variable + Fixed
Sales = expenses + expenses
$100,000 = $400N + $60,000
$400N = $100,000 – $60,000
N = $40,000 ÷ $400
N = 100 patients

We can use the break-even equation to solve the problem. Let N be the number
of patients, substitute the $100,000 lump-sum budget for sales, and note that
sales equals variable expenses plus fixed expenses if the city completely
spends its budget. The city can serve 100 patients.

28
 Nonprofit Application

If the city cuts the total budget appropriation by

10%, how many patients can it serve in a year?

Budget after 10% Cut

$100,000 X (1 - .1) = $90,000

Variable + Fixed
Sales = expenses + expenses
$90,000 = $400N + $60,000
$400N = $90,000 – $60,000
N = $30,000 ÷ $400
N = 75 patients

Now, suppose the city cuts the total budget appropriation for the following
year by 10%. Fixed costs will be unaffected, but service will decline. The
percentage reduction in service is (100 – 75) ÷ 100 = 25%, which is more than
the 10% reduction in the budget. Unless the city restructures its operations, the
service volume must fall by 25% to stay within budget.

29
 Operating Leverage

Low leveraged firms have lower fixed costs

and higher variable costs.
Changes in sales volume will have a
smaller effect on net income.

Margin of safety = planned unit sales –

break-even sales. How far can sales fall
below the planned level before losses occur?

In addition to weighing the varied effects of changes in fixed and variable

costs, managers need to consider their firm’s ratio of fixed to variable costs,
called operating leverage. In highly leveraged companies—those with high
fixed costs and low variable costs—small changes in sales volume result in
large changes in net income. Changes in sales volume have a smaller effect on
companies with less leverage (that is, lower fixed costs and higher variable
costs).

30
 Operating Leverage

Operating leverage:
a firm’s ratio of fixed costs to variable costs.

Highly leveraged firms have high fixed costs

and low variable costs. A small change in sales
volume = a large change in net income.

In addition to weighing the varied effects of changes in fixed and variable

costs, managers need to consider their firm’s ratio of fixed to variable costs,
called operating leverage. In highly leveraged companies—those with high
fixed costs and low variable costs—small changes in sales volume result in
large changes in net income. Changes in sales volume have a smaller effect on
companies with less leverage (that is, lower fixed costs and higher variable
costs).

31
 Learning Contribution Margin
Objective 7 and Gross Margin

The exhibit shows costs divided on two different dimensions. As shown at the
bottom of the exhibit, the gross margin uses the division on the production or
acquisition cost versus selling and administrative cost dimension, and the
contribution margin uses the division based on the variable-cost versus fixed-
cost dimension.

32
 Contribution Margin
and Gross Margin

Sales price – Cost of goods sold = Gross margin

Sales price - all variable expenses =

Contribution margin

Per Unit
Selling price $1.50
Variable costs (acquisition cost) 1.20
Contribution margin and
gross margin are equal $ .30

Too often people confuse the terms contribution margin and gross margin.
Gross margin, also called gross profit, is the excess of sales over the cost of
goods sold. Cost of goods sold is the cost of the merchandise that a company
acquires or produces and then sells.

33
 Contribution Margin and Gross Margin

Suppose the firm paid a commission of $.12 per unit sold.

Contribution Gross
Margin Margin
Per Unit Per Unit
Sales $1.50 $1.50
Acquisition cost of unit sold 1.20 1.20
Variable commission .12
Total variable expense $1.32
Contribution margin .18
Gross margin $.30

In our illustration, the contribution margin and the gross margin are identical
because the cost of goods sold is the only variable cost.

34
 Learning Appendix 2A
Objective 8
Sales Mix Analysis

Sales mix is the relative proportions or

combinations of quantities of products
that comprise total sales.

If the proportions of the mix change,

the cost-volume-profit relationships
also change.

Volume is determined not just by total sales but also by sales mix. Sales mix is
the relative proportions or combinations of quantities of products that comprise
total sales. If the proportions of the mix change, the cost-volume-profit
relationships also change.

35
 Sales Mix Analysis

Ramos Company Example

Wallets Key Cases
(W) (K) Total

Sales in units 300,000 75,000 375,000

Sales @ $8 and $5 $2,400,000 $375,000 $2,775,000
Variable expenses
@ $7 and $3 2,100,000 225,000 2,325,000
Contribution margins
@ $1 and $2 $ 300,000 $150,000 $ 450,000
Fixed expenses 180,000
Net income $ 270,000

Suppose Ramos Company has two products, wallets (W) and key cases (K).
What is the break-even point for each product?

36
 Sales Mix Analysis
Let K = number of units of K to break even, and
4K = number of units of W to break even.

Break-even point for a constant sales mix of 4 units of W

for every unit of K.
sales – variable – fixed = zero net income
expense expenses

[$8(4K) + $5(K)] – [$7(4K) + $3(K)] – $180,000 = 0

32K + 5K - 28K - 3K - 180,000 = 0

6K = 180,000
K = 30,000
W = 4K = 120,000

30,000K + 120,000W = 150,000 total units (K + W).

The typical answer assumes a constant mix of four units of W for every unit of
K. Therefore, let K = number of units of product K to break even, and 4K =
number of units of product W to break even. The break-even point is 30,000K
+ 120,000W = 150,000 units.

37
 Sales Mix Analysis

If the company sells only key cases:

break-even point = fixed expenses
contribution margin per unit
= $180,000
$2
= 90,000 key cases

If the company sells only wallets:

break-even point = fixed expenses
contribution margin per unit
= $180,000
$1
= 180,000 wallets

Suppose Ramos Company sells only key cases, and fixed expenses stay at
$180,000, break-even point = 90,000. If Ramos sells only wallets, and fixed
expenses stay at $180,000, break-even point = 180,000 wallets.

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 Sales Mix Analysis

Suppose total sales

were equal to the
budget of 375,000 units.

However, Ramos sold

only 50,000 key cases
And 325,000 wallets.
What is net income?

When the sales mix changes, the break-even point and the expected net
income at various sales levels change also. For example, suppose overall
actual total sales were equal to the budget of 375,000 units. However, Ramos
sold only 50,000 key cases.

39
 Sales Mix Analysis

Ramos Company Example

Wallets Key Cases
(W) (K) Total

Sales in units 325,000 50,000 375,000

Sales @ $8 and $5 $ 2,600,000 $250,000 $2,850,000
Variable expenses
@ $7 and $3 2,275,000 150,000 2,425,000
Contribution margins
@ $1 and $2 $ 325,000 $100,000 $ 425,000
Fixed expenses 180,000
Net income $ 245,000

The change in sales mix has resulted in a $245,000 actual net income rather
than the $270,000 budgeted net income, an unfavorable difference of $25,000.
The budgeted and actual sales in number of units were identical, but the
proportion of sales of the product bearing the higher unit contribution margin
declined.

40
 Learning
Objective 9 Impact of Income Taxes

Income taxes do not affect the break-even point.

There is no income tax at a level of zero income.

Income taxes affect the calculation of the volume

required to achieve a specified after-tax target
profit.

Suppose that a company earns $1,440 before

Taxes and pays income tax at a rate of 40%.

As part of our CVP analysis, we discussed the sales necessary to achieve a

target income before income taxes of $1,440. If Boeing pays income tax at a
rate of 40%, what would the new result be?

41
 Impact of Income Taxes

Suppose the target net income after taxes was $864

Target income before taxes = Target after-tax net income

1 – tax rate

Target income before taxes = $ 864 = $1,440

1 – 0.40

Suppose the target net income after taxes was $864. The only change required
to introduce taxes into the general equation illustrated in the chapter for
calculation of volume required to achieve a given target income is to substitute
[target after-tax net income/(1 - tax rate)] on the right-hand side of the
equation: target sales - variable expenses - fixed expenses = [target after-tax
net income/(1 - tax rate)

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 Impact of Income Taxes

Target sales - Variable expenses - Fixed expenses

= Target after-tax net income ÷ (1 – tax rate)

$1.50N - $1.20N - $18,000 = $864 ÷ (1 – 0.40)

$.30N = $18,000 + ($864/.6)
$.18N = $10,800 + $864 = $11,664
N = $11,664/$.18
N = 64,800 units

Thus, letting N be the number of units to be sold at $1.50 each with a variable
cost of $1.20 each and total fixed costs of $18,000, sales will be 64,800 units
produce an after-tax profit of $864 as shown here and a before-tax profit of
$1,440.

43
 Impact of Income Taxes

Suppose target net income after taxes was $1,440

$1.50N - $1.20N - $18,000 = $1,440 ÷ (1 – 0.40)

$.30N = $18,000 + ($1,440/.6)
$.18N = $10,800 + $1,440 = $12,240
N = $12,240/$.18
N = 68,000 units

Suppose the target net income after taxes was $1,440. The volume needed
would rise to 68,000 units.

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