3 Cost Behaviour and CVP

SMU Classification: Restricted
ACCT 102:
Management Accounting
Cost Behaviour
and
Cost-Volume-Profit Analysis
(CVP)
2021-2022 S1 Cost Behaviour and CVP 1

Learning Objectives
1. Use various methods to analyze cost behaviour
2. Use cost-volume-profit (CVP) relations and it’s various approaches to
compute break-even points
2.1 Equation
2.2 Contribution Margin
2.3 Break-Even Percentage
2.4 Graph
3. Understand the meaning of, and be able to deal with:
3.1 Target Profit
3.2 Sensitivity Analysis
3.3 Margin of Safety
3.4 Operating Leverage
3.5 Multiple Products
Learning Objective 1
Criteria for Classifying Variable & Fixed Components of a Cost
1. Choice of Cost Object – different objects may result in different

classification of the same cost
2. Time Horizon – the longer the period, the more likely the cost will be
variable
3. Relevant Range – behaviour is predictable only within this band of
activity

The Linear Cost Function: Mixed Costs
Y
+ bX
Total Utility Cost
= a
t Y
cos
ed
a l mi x
To t
X
Activity (e.g. Machine Hours)

Cost Estimation Methods
Quantitative Analysis Methods

1. Regression Analysis
2. Account Analysis Method
3. High-Low Method

Least-Squares Regression Method
A method used to analyze mixed costs if a scatter graph

plot reveals an approximately linear relationship between
the X and Y variables.
This method uses all of the

data points to estimate
the fixed and variable
cost components of a
mixed cost.
The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.

Least-Squares Regression Method

• Excel can be used to fit a regression line through the
data points.
• The cost analysis objective is the same:
Y = a + bX
Least-squares regression also provides a statistic, called the

R2, that is a measure of the goodness
of fit of the regression line to the data points.

Simple Regression Analysis – An Example
Using
Using the
the same
same data
data of
of maintenance
maintenance work,
work, let’s
let’s see
see how
how
to
to do
do aa regression
regression using
using Microsoft
Microsoft Excel.
Excel.
Hours of Maintenance Total Maintenance Cost
January 625 $7,950
February 450 $7,400
March 700 $8,275
April 550 $7,625
May 775 $9,100
June 850 $9,800
You will need three pieces of information from your regression analysis:
1. Estimated Variable Cost Per Unit, excel formula “slope (…..)”
2. Estimated Fixed Costs, excel formula “intercept (…..)”
3. Goodness of fit, or R2, excel formula “RSQ(…..)”
Alternatively, “Data Analysis” function in excel can be used.

Account Analysis Method: An example
An airline’s financial data:

$ million Cost Behavior Assumptions
Staff costs (667) 20% variable, 80% fixed
Depreciation of property, plant and equipment (719) 100% fixed
Aircraft fuel expenses (2,254) 100% variable
Maintenance and overhaul (149) 40% variable, 60% fixed
User charges and other related expenses (545) 100% variable
Aircraft operating lease expenses (198) 100% fixed

The High-Low Method – An Example

Assume the following hours of maintenance work and the total
maintenance costs for six months.

The variable cost per

hour of maintenance
is equal to the change
in cost divided by the
change in hours.
$2,400
= $6.00/hour
400

Total Fixed Cost = Total Cost – Total Variable Cost

Total Fixed Cost = $9,800 – ($6/hour × 850 hours)
Total Fixed Cost = $9,800 – $5,100
Total Fixed Cost = $4,700

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
The High-Low Method
Is High Low Method useful at all?

Cost Behaviour
Why do we need to know the difference

between variable costs and fixed costs?

The Trend Toward Fixed Costs
The trend in many industries is toward greater fixed

costs relative to variable costs.
As machines take over Knowledge workers

many mundane tasks tend to be salaried,
previously performed highly-trained and
by humans, difficult to replace. The
“knowledge workers” cost of compensating
are demanded for these valued employees
their minds rather is relatively fixed
than their muscles. rather than variable.

Discretionary versus Committed Fixed Cost
A discretionary fixed cost A committed fixed cost has a

arises from short term long future planning horizon, e.g.
decisions of management to a company’s investment in
spend in specific fixed cost facilities and equipment. Once
areas, such as advertising, such costs have been incurred,
research and development. the company is required to make
A discretionary fixed cost is future payments. A committed
associated with activities fixed cost cannot be eliminated
that are not legally without incurring legal or other
mandated. consequences.

The Contribution Format
Used primarily for Used primarily by

external reporting. management.
Uses of the Contribution Format
• The contribution income statement format is used as an internal

planning and decision-making tool. This approach is used throughout
many Management Accounting Topics. For example:
• Cost-volume-profit analysis
• Absorption Costing and Variable Costing
• Budgeting
• Flexible Budget and Variance Analysis
• Differential Costing

Cost-Volume-Profit (CVP) Analysis
Break-even point
Revenue = Expenses (i.e. net income=0)
Sales $250,000
Less: variable expenses $150,000
Contribution margin $100,000
Less: fixed expenses $100,000
Net income $0

Equation Approach
Sales revenue – Variable expenses – Fixed expenses = Profit
($500 × X) – ($300 × X) – $80,000 = $0

($200X) – $80,000 = $0
X = 400 units (break even units)
Selling price is $500 per unit

400 units * $500 = $200,000 (break even sales $)

Contribution-Margin Approach
Consider the following information developed by the

accountant at Adam Ltd:

The contribution margin method has

two key equations:
Break-even point Fixed expenses

=
in units sold CM per unit
Break-even point in Fixed expenses

total sales dollars =
CM ratio

Break-even Units
$80,000
= 400 printers
$200

Contribution-Margin Ratio
Break-even Sales Dollars
_$80,000_ $200,000 sales

=
40%
The Contribution Approach

If the company sells one more bike (401 units), net
operating income will increase by $200.

The Contribution Approach
We do not need to prepare an income statement to

estimate profits at a particular sales volume. Simply
multiply the number of units sold above break-even by the
contribution margin per unit.

Break-Even Ratio Approach

If we can compute the break-even ratio, we can use the
ratio to compute break-even dollars or units.
Fixed expenses
Break-even Ratio =
Contribution margin

Graphing CVP Relationships
Viewing CVP relationships in a graph gives

managers a perspective that can be obtained in no
other way.

CVP Graph
Break-even point
(400 units or $200,000 in sales)
Total
rea
Sales
ofi tA
Pr
Dollars
Total Expenses
Fixed Expenses
Area
s
Los
Units
CVP Applications
• CVP has many applications, for example, setting prices, finding sales
volume required for a target profit and answering a variety of “what-if”
scenarios. “What” happens to profit “if”:
• Selling price changes
• Volume changes
• Cost structure changes
• Variable cost per unit changes
• Fixed cost changes

Target Net Profit
We can determine the number of printers that Adam Ltd must sell to earn
a profit of $100,000 using the contribution margin approach and the
equation approach.
Recall Adam Ltd’s financial information as follows:
Selling Price per unit = $500
Variable Expense per unit = $300
Total Fixed Cost = $80,000

Changes in Fixed Costs

• Adam Ltd is currently selling 500 printers per month. The owner believes
that an increase of $10,000 in the monthly advertising budget, would
increase sales to 540 units.
• Based on the financial information as below, should we authorize the
requested increase in the advertising budget?
Information to use:
Selling Price per unit = $500
Variable Expense per unit = $300
Total Fixed Cost without the additional $10,000 advertising cost = $80,000

Changes in Fixed Costs
Sales will increase by $20,000, but net income

will decrease by $2,000.
Margin of Safety
• The margin of safety is the excess of budgeted (or

actual) sales over the break-even volume of sales.
• The amount by which sales can drop before losses
begin to be incurred.
Margin of safety = Total sales - Break-even sales

Margin of Safety
Adam Ltd has a break-even (BE) point of $200,000. If

actual sales are $250,000, the safety margin is $50,000 or
100 printers.

Margin of Safety Ratio

1. Can we compute the margin of safety ratio for Adam Ltd?
2. Can we link the margin of safety ratio to break-even ratio?

Cost Structure and Operating Leverage
• The cost structure of an organization is the relative proportion of its

fixed and variable costs. Managers often have some latitude in
determining their organization’s cost structure.
• Operating leverage is
• the extent to which an organization uses fixed costs in its cost structure.
• a firm with proportionally high fixed costs has relatively high operating
leverage.

Operating Leverage
Operating leverage is a measure of how sensitive net operating income

is to percentage changes in sales. It is a measure, at any given level of
sales, of how a percentage change in sales volume will affect profits.
Degree of Contribution margin

operating leverage
= Net operating income

Measuring Operating Leverage
Operating leverage Contribution margin

=
factor Net income
$100,000
= 5
$20,000
Measuring Operating Leverage
A measure of how a percentage change in sales will affect

profits. If the company increases its sales by 1%, what will be
the percentage increase in net income?
Percent increase in sales 1%

Operating leverage factor X5
Percent increase in profits = 5%

Comparison of Cost Structures

Lo-Lev Company Hi-Lev Company
Units 500,000 500,000
Sales $1,000,000 $1,000,000
Variable Costs $750,000 $200,000
Contribution Margin $250,000 $800,000
Fixed Costs $50,000 $600,000
Operating Profit $200,000 $200,000
If Sales are increased by 1%, what are the effects to the Operating Profits?
Lo-Lev Company Hi-Lev Company
DOL 1.25 4
DOL * 1% 1.25% 4%
New Operating Profit $200,000 * 1.0125 $200,000 * 1.04 =
=$202,500 $208,000
What does higher value of DOL mean?
• High Operating Leverage ratio

• signals the existence of high fixed costs.
• increases risk of making loss in adverse market conditions.
• increases opportunity to make profit when higher demand exists.
• has lower margin of safety ratio (MoS ratio)

Usefulness of Operating Leverage
• Help determine how sensitive profits are to

changes to sales.
• Affect manager’s decision regarding risk
management.

Cost Structure and Profit Stability – High and Low Fixed Cost Structures
There are advantages and disadvantages to high fixed cost (or low variable
cost) and low fixed cost (or high variable cost) structures.
An advantage of a high fixed cost

structure is that income will be higher Companies with
in good years compared to companies low fixed cost
with lower proportion of fixed costs. structures enjoy
greater stability
A disadvantage of a high fixed cost
in income across
structure is that income will be
lower in bad years compared to good and bad
companies with lower proportion of years.
fixed costs.
Multi-Product Break-Even Analysis
 The formulae presented up to this point have assumed a single product is

produced and sold. A more realistic scenario involves multiple products
sold, in different volumes, with different costs.
 With multi-products, the same breakeven formulae are used:
 Breakeven units
 Breakeven sales $


Sales mix information
 Sales mix is the relative combination in which a company’s products are sold, sales
mix can be in terms of the
1. relative number of units
2. relative total sales $
 What are the differences between the two sale mixes?
 We must determine whether the sales mix given to us is in units or in sales dollars
and use the information correctly:
Sales mix To compute
In units Weighted average unit contribution margin and breakeven units
In dollars Weighted contribution margin ratio and breakeven $


Assume the company plans to sell printers and cameras with budgeted data:
Compute the sale mix in
1. Units
2. Dollars

Say if we are only given the following information, we need to first

compute the Weighted Unit CM.


With ratios in units: use weighted average unit CM
Break-even point
Break-even FE
=
point Unit CM
Break-even $4,500
=
point $60
Break-even
= 75 combined unit sales
point Using the same
ratio in units
4:6 to split the total
Printers 30 Cameras 45
Say if we are only given the following information,

we need to first compute the Weighted CM ratio.


With ratios in sales $: use weighted average
Dollar sales to Fixed expenses

=
break even CM ratio **
**=Company overall CM ratio Company’s

i.e. weighted average CM ratio CM Ratio=
$6,000
$16,000
Dollar sales to $4,500
=
break even 37.5%
= $12,000
Using the same
ratio in sales $
Printers Cameras 1:3 to split the total
$3,000 $9,000
2021-2022 S1 Cost Behaviour and CVP 52 52

Using break-even ratio method
FE
BE Ratio =
CM
$4,500 = 0.75
BE Ratio =
$6,000

Planned profit
To find BE, we can use the BE ratio


Using BE Ratio method
• This method is very useful to find the break-even points of various

products for companies producing and selling many different
products.
• Provided the product mix is stable and the overall contribution
margin and total fixed expense are available, we can use the BE
Ratio method to very easily and quickly compute the various
break-even points of different products.

Key Assumptions of CVP Analysis
• Selling price is constant.

• Costs are linear.
• In multiproduct companies, the sales mix is constant.
• In manufacturing companies, inventories do not change (units
produced = units sold).
End of Topic
Appendix 1: Derivation of breakeven formulae

Let Contribution Margin Approach: BE units & BE $
Q = units sold Both are derived from the Equation Approach
SP*Q – Unit VC*Q – FC = 0
SP = unit selling price
Q*(SP – Unit VC) = FC
VC = variable cost
Q=
FC = total fixed cost
Since
CM = contribution margin
BE units =
BE = break-even

Equation Approach Q*(SP – Unit VC) = FC
For BE: *Q*(SP – Unit VC) = FC
SP*Q*() = FC
Since
BE $ =

Appendix 2: Derivation of breakeven formulae

Let BE Ratio Approach
Q = units sold BE Ratio =
SP = unit selling price As per the contribution margin
VC = variable cost approach,
TFC = total fixed cost BE$ =
CM = contribution margin Substituting this to the first formula
BE = break-even above, we have
BE Ratio =
BE Ratio

Appendix 3: Proof

MoS Ratio =
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 $ − 𝐵𝐸$
MoS Ratio = 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 $
𝐵𝐸$
= 1−
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 $ 𝐶𝑀
𝐷𝑂𝐿=
𝐹𝐶 𝑃𝑟𝑜𝑓𝑖𝑡
𝐶𝑀 𝑅𝑎𝑡𝑖𝑜
= 1 − 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 $
𝐹𝐶
=1− 1 𝑃𝑟𝑜𝑓𝑖𝑡
𝐶𝑀
=
𝐶𝑀−𝐹𝐶 𝑃𝑟𝑜𝑓𝑖𝑡 𝐷𝑂𝐿 𝐶𝑀
= 𝐶𝑀 = 𝐶𝑀

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SMU Classification: Restricted

2021-2022 S1 Cost Behaviour and CVP 1

1. Choice of Cost Object – different objects may result in different

2021-2022 S1 Cost Behaviour and CVP 3

The Linear Cost Function: Mixed Costs

2021-2022 S1 Cost Behaviour and CVP 4

Cost Estimation Methods

Quantitative Analysis Methods

2021-2022 S1 Cost Behaviour and CVP 5

Least-Squares Regression Method

A method used to analyze mixed costs if a scatter graph

This method uses all of the

2021-2022 S1 Cost Behaviour and CVP 6

Least-Squares Regression Method

Least-squares regression also provides a statistic, called the

2021-2022 S1 Cost Behaviour and CVP 7

Simple Regression Analysis – An Example

2021-2022 S1 Cost Behaviour and CVP 8

Account Analysis Method: An example

An airline’s financial data:

2021-2022 S1 Cost Behaviour and CVP 9

The High-Low Method – An Example

2021-2022 S1 Cost Behaviour and CVP 10

The High-Low Method – An Example

The variable cost per

2021-2022 S1 Cost Behaviour and CVP 11

The High-Low Method – An Example

Total Fixed Cost = Total Cost – Total Variable Cost

2021-2022 S1 Cost Behaviour and CVP 12

The High-Low Method – An Example

The Cost Equation for Maintenance

The High-Low Method

Is High Low Method useful at all?

2021-2022 S1 Cost Behaviour and CVP 14

Why do we need to know the difference

2021-2022 S1 Cost Behaviour and CVP 15

The Trend Toward Fixed Costs

The trend in many industries is toward greater fixed

As machines take over Knowledge workers

2021-2022 S1 Cost Behaviour and CVP 16

Discretionary versus Committed Fixed Cost

A discretionary fixed cost A committed fixed cost has a

2021-2022 S1 Cost Behaviour and CVP 17

The Contribution Format

Used primarily for Used primarily by

Uses of the Contribution Format

• The contribution income statement format is used as an internal

2021-2022 S1 Cost Behaviour and CVP 19

2021-2022 S1 Cost Behaviour and CVP 20

Sales revenue – Variable expenses – Fixed expenses = Profit

($500 × X) – ($300 × X) – $80,000 = $0

Selling price is $500 per unit

2021-2022 S1 Cost Behaviour and CVP 21

Consider the following information developed by the

2021-2022 S1 Cost Behaviour and CVP 22

The contribution margin method has

Break-even point Fixed expenses

Break-even point in Fixed expenses

2021-2022 S1 Cost Behaviour and CVP 23