CHAPTER 4

Cost estimation, Cost behaviour

and Cost-Volume-Profit (CVP)
Analysis
 COST ESTIMATION
General principles

 A regression equation (or cost function) measures past relationships

between a dependent variable (total cost)and potential independent
variables (i.e.cost drivers/activity measures).

 Simple regression y = a + bx
Where y = Total cost
a = Total fixed cost for the period
b = Average unit variable cost
x = Volume of activity or cost driver for the period

 Multiple regression y = a + b1 x1 + b2 x2

 Resulting cost functions must make sense and be economically plausible.

Cost estimation methods:

1. Engineering methods

2. Inspection of accounts method

3. Graphical or scattergraph method

4. High-low method

5. Least squares method.

ENGINEERING METHODS
 Analysis based on direct observations of physical quantities required for
an activity and then converted into cost estimates.

 Useful for estimating the costs of repetitive processes where input-output

relationships are clearly defined.

 Appropriate for estimating the costs associated with direct labour,

materials and machine time.

 Inspection of accounts

 Departmental manager and accountant inspect each item of expenditure

within the accounts for a particular period and classify each item as fixed,
variable or semi-variable.
GRAPHICAL OR SCATTER GRAPH
METHOD

 Past observations are plotted on a graph and a line of

best fit is drawn.
HIGH – LOW METHOD

 Involves selecting the periods of highest and lowest

activity levels and comparing changes in costs that
result from the two levels.

 Example
Lowest activity 5,000 units RM 22,000
Highest activity 10,000units RM 32,000

Cost per unit = £10,000/5,000 units = RM 2 per unit

Fixed costs = RM 22,000 – (5,000 × RM 2) = RM 12,000
COST BEHAVIOUR
 Cost behavior is an indicator of how a cost will change
in total when there is a change in some activity. In cost
accounting and managerial accounting, three types of
cost behavior are usually discussed:

 3 types of cost:
 Fixed Cost
 Variable Cost
 Semi-fixed and variable cost
 Variable costs. The total amount of a variable cost
increases in proportion to the increase in an activity. The
total amount of a variable cost will also decrease in
proportion to the decrease in an activity.

 Fixed costs. The total amount of a fixed cost will not

change when an activity increases or decreases.

 Mixed or semivariable costs. These costs are partially

fixed and partially variable.
 Understanding how costs behave is important for
management's planning and controlling of its
organization's costs, and for cost-volume-profit analyses
(including the calculation of a company's 
break-even point).
 COST VOLUME PROFITS ANALYSIS (CVP
ANALYSIS)
 CVP Analysis is a systematic method to examining the
relationship between changes in activity (output) and
changes in total sales revenue, expenses and net profit.

 The objectives of CVP Analysis is to establish what will

happen to the financial results if specified level of
activity or volume fluctuates.
 CVP Analysis is based on the relationship between
volume and sales revenue, cost and profit in the short run
(period less than 1 year), where the number of output is
based on upon the current operating capacity and
resources.

 In short-run, some inputs can be increased, additional

supplies of materials and unskilled labor may be obtained,
but not other attributes such as to expand the capacity of
plant and machinery (which requires time) and reduction
of company capacity.
 Short-run profitability is most sensitive to sales volume
as most of the costs and prices of company’s products
have already been determined.
 Decision makers often like to combine information about
flexible and capacity-related costs with revenue information
to project profits for different levels of volume

 Conventional cost-volume-profit (CVP) analysis rests on the

following assumptions:
 All organization costs are either purely variable or fixed
 Units made equal units sold
 Revenue per unit does not change as volume changes
 Cost-volume-profit (CVP) model summarizes the
effects of volume changes on a firm’s costs,
revenues, and profit

Analysis can be extended to determine the impact

on profit of changes in selling prices, service fees,
costs, income tax rates, and the mix of products
and services

 Break-even point is the volume of activity that

produces equal revenues and costs for the firm
No profit or loss at this point
THE CVP PROFIT EQUATION
Profit:
= Revenue - Flexible costs - Capacity-related
costs
= (Units sold x Revenue per unit) - (Units sold
x flexible cost per unit) - Capacity-related
costs
= [Units sold x (Revenue per unit-Flexible cost
per unit)] - Capacity-related costs
= (Units sold x Contribution margin per unit)
- Capacity-related costs
BREAK-EVEN VOLUME
 Using the CVP profit equation, break-even volume
is determined by calculating the volume where profit
=0

0 = (Units sold x Contribution margin per unit) -

Fixed costs

 Units
sold to break even = Fixed costs
÷ Contribution margin per unit
TARGET PROFIT

 CVP analysis can be used to determine the sales volume

required to achieve a specified target profit

 Note that the previous break-even analysis was used to

determine the unit sales required to achieve a target
profit of $0
MARGIN OF SAFETY
 Margin of safety - excess of projected sales units over
break-even sales level, calculated as follows:
Sales Units - Break-Even Sales Units = Margin of Safety
 Provides an estimate of the amount that sales can drop
before the firm incurs a loss
GRAPHICAL
APPROACH
 1) CURVILINEAR CVP
RELATIONSHIPS

Curvilinear CVP relationships

1. Curvilinear graph results in two break-even points.
2. Note the shape of the total cost function:
• initial steep rise, levels off, followed by a further steep rise.
3. The total revenue line initially rises steeply, then levels off and declines
Curvilinear variable cost function
1. Output levels between 0 and Q1 = Increasing returns to
scale
2. Output levels between Q1 and Q2 = Constant returns to
scale
3. Output levels beyond Q2 = Decreasing returns to scale
 2) LINEAR CVP RELATIONSHIPS

1. Constant variable cost and selling price is assumed.

2. Only one break-even point, and profit increases as

volume increases.

3. The diagram is not intended to provide an accurate

representation for all levels of output. The objective is
to provide an accurate representation of cost and
revenue behaviour only within the relevant range of
output.
Linear cost–volume–profit model

1. Constant variable cost and selling price is assumed.

2. Only one break-even point and profit increases as volume
increases.
3. The diagram is not intended to provide an accurate
representation for all levels of output. The objective is to
provide an accurate representation of cost and revenue
behaviour only within the relevant range.
Fixed cost function
1. Within the short term the firm anticipates that it will operate
between output levels Q2 and Q3 and commits itself to fixed
costs of 0A.
2. Costs are fixed in the short term, but can be changed in the
longer term.
NUMERICAL
APPROACH
 3) A NUMERICAL APPROACH TO
CVP ANALYSIS
Formula:
Contribution per unit = SP per
a) Contribution margin approach:
unit – VC per unit

1. Break-even point (unit)/ BEP (units)

Fixed costs
Contribution per unit

2. Break-even point (RM)/ BEP (RM)

Fixed costs X Selling Price per unit
Contribution per unit

3. Break-even point (RM)/ BEP (RM)

Fixed costs X 1
c/s ratio C/S Ratio = Contribution per unit X 100
Sales per unit
4. Break-even point (RM)/ BEP (RM)
Break-even point in unit X Selling price per unit
5. Units to be sold to obtain a targeted profit
Fixed costs + Targeted profit
Contribution per unit

6. Profit volume ratio

Contribution x 100
Sales revenue

7. Margin of Safety (Mos) in units MoS indicates

Expected sales (unit) – BEP (units) by how much sales
decreased before a
company will
8. Margin of Safety (MoS) in RM suffer a loss.

Expected sales (RM) – BEP (RM)

9. Margin of Safety (%)

Expected sales – BEP sales x 100
Expected sales
10. Targeted sales in units
Fixed costs + Targeted profit
Contribution per unit

11. Targeted sales in RM

Targeted sales in unit X Selling price per unit

12. Profit (RM)

(Targeted sales in unit X Contribution per unit) – Fixed Cost

b) Equation approach:
NP = SPx – (a+bx)

Where:
NP = Net profit, x = Units sold, SP = Selling price, a = total fixed cost,
b = variable cost per unit
4) BEP CHART
 5) CVP ANALYSIS ASSUMPTION
1. All other variables remain constant
• e.g. sales mix, production efficiency, price levels, production methods.

2. Total costs and total revenues are linear functions of output.

3. Profits are calculated on a variable costing basis.

4. Single product or constant sales mix.

5. The analysis applies over the relevant range only.

6. Costs can be accurately divided into their fixed and variable elements.

7. The analysis applies only to a short-time time horizon.

DISCUSSIONS QUEST
IONS
THANK YOU…