CHAPTER 2

Analyzing Cost-Volume-
Profit Relationships
 Learning Objective 1

Understand the key factors

involved in cost-volume-
profit (C-V-P) analysis and
why it is such an important
tool in management
decision making.
CVP - What Questions Does It Answer?
What happens to
What happens to
profits if we change our
profits if we change
selling price?
the number of units
 How many sold?
units do we  How much sales
need to sell to revenue do we need
break even? to meet our pretax
profit goal?
What happens
to profits if we What happens to
change our profits if we
advertising discontinue
expenses? certain products?
 CVP Key Variables

 Revenues – Price x Quantity

 Fixed costs – Independent of
volume
 Variable costs – Dependent upon
volume
 Volume – Level of activity
 Product mix – Different products
 Efficiency & quality of production
 Combinations of above
 Learning Objective 2

Explain and analyze the basic cost

behavior patterns—variable, fixed,
mixed, and stepped.
 What are Variable Costs?
Costs that change in Unit Cost: Constant
total in direct proportion
to changes in activity Total Cost: Varies
level.
Total Cost
30

25

20

15

10

0
0 1 2 3 4 5
Units Produced
 Define Relevant Range and Curvilinear
Costs
Relevant range:
The range of operating level, or volume of activity,
over which the relationship between total costs
(variable + fixed) and activity level is approximately
linear.
Curvilinear costs:
Variable costs that do not vary in direct proportion
to changes in activity level but vary at decreasing or
increasing rates due to economies of scale,
productivity changes, and so on.
 Define Fixed Costs

Costs that remain constant

in total, regardless of
activity level, at least over a Unit Cost: Varies
certain range of activity. Total Cost: Constant
Total $600
Cost $500

$400

$300

$200

$100

$0
0 1 2 3 4 5
Units Produced
 Fixed Costs are Used to Calculate
Break-Even
 What does break-even mean?
 Break-even is the point where revenues equal
all costs, neither profit nor loss is incurred.
 What is the formula for break-even?

Total fixed costs

(Sales price per unit - Variable cost per unit)
 Define Stepped Costs
Stepped costs change in total in a stair-
step fashion (in large amounts) with
changes in volume of activity.
Relevant Range
Cost
Over the relevant
range, stepped
costs may
appear to be
fixed.
Production Volume
 Define Mixed Costs
Mixed costs contain both variable and fixed cost
components.

For Example: A leased machine might

cost $1,000 per month (fixed) plus $20
per hour of usage (variable).

Variable
Cost

Fixed
Production Volume
 Learning Objective 3

Analyze mixed costs

using the scattergraph
and high-low methods.
What is the Scattergraph (Visual-Fit)
Method?
A method of segregating the fixed and variable
components of a mixed cost by plotting on a graph
total costs at several activity levels and drawing a
regression line through the points.

Cost Regression Line

Volume of Activity
 Scattergraph (Visual-Fit)
Variable costs per unit
are equal to the slope
of the regression line. Fixed costs are
represented by
the intersection
of the regression
Cost
line and the Costs
Variable
vertical axis.

Fixed Costs

Volume of Activity
 Define the High-Low Method

A method of segregating
the fixed and variable
components of a mixed
cost by analyzing the costs
at the highest and lowest
activity levels within a
relevant range.
 High-Low Method

Cost

Step 1: Identify the highest

and lowest activity levels.

Volume of Activity
 High-Low Method

Cost Step 2: Determine the

differences between the high
and low points.

Volume of Activity
 High-Low Method
Step 3: Calculate the variable cost per unit
by finding the slope of the regression line
between the two points (which reflect total
mixed costs).

Cost

Rise Variable
Run
= Cost
per Unit

Volume of Activity
 Learning Objective 4

Perform C-V-P analyses, and

describe the effects potential
changes in C-V-P variables
have on company profitability.
 Contribution Margin Approach
Contribution margin is the portion of sales
revenue available to cover fixed costs and
provide a profit.

Sales revenue
– Variable costs
= Contribution margin
– Fixed costs
= Profit
 Contribution Margin Approach
If a computer sells for $2,000 with variable costs
of $800 per computer and fixed costs of
$350,000 per year:
 What is the total contribution margin on 500

computers?
Total
Sales revenue $1,000,000
Less variable costs 400,000
Contribution margin $ 600,000
 Contribution Margin Approach
If a computer sells for $2,000 with variable costs
of $800 per computer and fixed costs of
$350,000 per year:
 What is the total contribution margin on 500

 What is the contribution margin per unit?

computers?
Total Per Unit
Sales revenue $1,000,000 $2,000
Less variable costs 400,000 800
Contribution margin $ 600,000 $1,200
 Contribution Margin Approach
If a computer sells for $2,000 with variable costs of $800 per
computer and fixed costs of $350,000 per year:
 What is the total contribution margin on 500 computers?
 What is the contribution margin per unit?
 What is the contribution margin ratio?

Total Per Unit Ratio

Sales revenue $1,000,000 $2,000 100%
Less variable costs 400,000 800 40%
Contribution margin $ 600,000 $1,200 60%
 Contribution Margin Approach
If a computer sells for $2,000 with $800 variable costs
per computer and $350,000 fixed costs per year:
 What is the total contribution margin on 500
computers?
 What is the contribution margin per unit?
 What is the contribution margin ratio?
 What is the total dollar profit after one year?

Total Per Unit Ratio

Sales revenue $1,000,000 $2,000 100%
Less variable costs 400,000 800 40%
Contribution margin $ 600,000 $1,200 60%
Less fixed costs 350,000
Profit $ 250,000
 The Break-Even Point

Sales price Variable cost Independent Target

x units x units of units Income
Example: How many computers will the store have
to sell in order to break even if one computer sells
for $2,000, costs $800 to make (variable cost), and
fixed costs are $350,000?

$2,000(x) - $800(x) - $350,000 = 0

1,200(x) - $350,000 = 0
1,200(x) = 350,000
x = 292 computers
 Multiple Variable Changes

Sales price Variable cost Costs Zero for

independent
x units x units of units break-even
OR

OR

etc.
 Multiple Variable Changes
Assume prior year profits of $250,000 for The Store.

What if this year the price of our $2,000 computers is

reduced by 15 percent due to a decrease in variable
costs from $800 to $700 per computer and a decrease in
fixed costs from $350,000 to $325,000? What would be
the effect on target income (or profit) assuming the
production of 500 computers?

Target Income = Revenue - variable - fixed

X = $1,700(500) - $700(500) - $325,000
X = $850,000 - $350,000 - $325,000
X = $175,000 or a 30% decrease in profit
 Learning Objective 5

Visualize C-V-P
relationships using
graphs.
 The Graphic Approach
Identify the Break-Even Point, Revenue
Line, Total Cost Line, and Fixed Costs

Break-Even Point Revenue Line

Revenue
& Cost

$584,000 Total Cost Line

Fixed Costs
($350,000)
292
Number of Computers Sold
 Learning Objective 6

Identify the limiting

assumptions of C-V-P
analysis, and explain
the issues of quality and
time relative to C-V-P
analysis decisions.
 What are the Limiting Assumptions
of C-V-P Analysis?

1. The behavior of revenues and

costs is linear throughout the
relevant range.
2. All costs can be categorized
as either fixed or variable.
3. Sales mix does not change.
 How Do Quality & Time Affect C-V-P
Decisions?
Change in Quality:
- Will it increase cost?
- Will it decrease production speed?
Change in Production Time:
- Will it increase cost?
- Will it decrease production speed?

If a change in quality or production time either

increases cost or decreases production speed,
careful consideration should be given to the
change.
 Expanded Material
Learning Objective 7

Analyze mixed costs using

the least squares method.
Identify the Parts of the Least Squares
Method Equation
Total Fixed Costs
 Another method (besides
Mixed (Y-intercept)
visual-fit and high-low)
Costs
for separating total mixed
costs into variable and
fixed portions.
 More precise than visual-
fit or high-low methods.
 Regression calculations
Variable Cost Rate are generally done on a
(Slope) calculator or computer.
Activity Level
 Least Squares Method
For Example:

Month Computers Produced Total Cost

Jan. 500 $ 750,000
Feb. 800 900,000
Mar. 650 600,000
April 1,000 1,100,000
May 450 420,000

Using least squares regression output:

a = Y-intercept = total fixed costs = $49,211.82

b = slope = variable cost rate = $ 1,036.45
 Expanded Material
Learning Objective 8

Explain the effects of sales

mix on profitability.
 Sales Mix

Can Openers Microwaves Total

Amount % Amount % Amount %

Sales revenue $5,000 100% $25,000 100% $30,000 100%

Less variable costs 3,000 60% 20,000 80% 23,000 77%
Contribution margin $2,000 40% $ 5,000 20% $ 7,000 23%

Sales mix 17% 83% 100%

Product Revenue = 5,000 = 17%

Total Revenue 30,000
 Sales Mix
To maximize profit in a company with multiple
products, management should emphasize products
with the highest contribution margin ratio. Which
product should they choose?
Can Openers Microwaves Total
Amount % Amount % Amount %

Sales revenue $5,000 100% $25,000 100% $30,000 100%

Less variable costs 3,000 60% 20,000 80% 23,000 77%
Contribution margin $2,000 40% $ 5,000 20% $ 7,000 23%

Sales mix 17% 83% 100%

 Expanded Material
Learning Objective 9
Describe how fixed and
variable costs differ in
manufacturing, service,
merchandising, and e-
commerce organizations,
and illustrate these
differences with the
operating leverage
concept.
 Define Operating Leverage
 The extent to which fixed costs are part of a
company’s cost structure.

 The higher the proportion of fixed costs to

variable costs, the faster income increases
or decreases with sales volume.
Contribution
Margin

Operating Net
Leverage Income
 Operating Leverage
For example: Assume the following data.
Total Per Unit Ratio
Sales revenue $1,000,000 $2,000 100%
Less variable costs 400,000 800 40%
Contribution margin $ 600,000 $1,200 60%
Less fixed costs 450,000
Net income $ 150,000
What is the operating leverage?
Operating leverage = 2.4
 What happens to net income if
sales are increased by 20 percent? Net income increases 48%
 Increase fixed costs to $450,000.
What is the operating leverage (no Operating leverage = 4
sales increase)?
 Now what happens to net income if
sales are increased by 20 percent? Net income increases 80%