LECTURE 3

Cost Behavior, Variable Costing

and CVP Analysis
Learning Objectives
1. Explain the meaning of cost behavior, and define and
describe fixed and variable costs
2. Define and describe mixed and step costs
3. Separate mixed costs into their fixed and variable
components using the high-low method, the scattergraph
method, and the method of least squares
4. Explain the difference between absorption and variable
costing
5. Use a personal computer spreadsheet program to perform
the method of least squares
Basics of Cost Behavior

• Cost behavior is the foundation upon which

managerial accounting is built
• Describes whether a cost changes when the level of
output changes
• Costs can be variable, fixed, or mixed
• A cost that does not change in total as output
changes is a fixed cost
 Basics of Cost Behavior

• A variable cost, on the other hand, increases in total

with an increase in output and decreases in total
with a decrease in output
• Knowing how costs change as output changes is
essential to planning, controlling, and decision
making
 Measures of Output and the Relevant Range
• Fixed and variable costs only have meaning when related
to some output measure
• A cost driver is a causal factor that measures the output of
the activity that leads (or causes) costs to change
• Identifying and managing drivers helps managers better
predict and control costs
• For example: weather is a significant driver in the airline
industry
Relevant Range and Cost Relationships

• Relevant range is the range of output over

which the assumed cost relationship is valid for
the normal operations of a firm
• Limits the cost relationship to the range of
operations that the firm normally expects to
occur
Fixed Costs
• Fixed costs are costs that in total are constant within the
relevant range as the level of output increases or decreases
• Fixed costs are extremely important to understand because
they usually are relatively large in amount
• Effective business decisions involving financial estimations
often include fixed costs
• In this example of Colley Computers, notice that while the
total fixed cost of supervision remains the same, the unit
cost decreases as more computers are produced
Fixed Costs

• The number of computers processed is called

the output measure, or driver
• Even though fixed costs may change, this does
not make them variable
• They are fixed at a new higher (or lower) rate
Fixed Costs
• A graph of Colley’s fixed supervision costs is shown below:
Discretionary Fixed Costs Versus Committed Fixed Costs

• Two types of fixed costs: discretionary fixed

costs and committed fixed costs
• Discretionary fixed costs are fixed costs that
can be changed or avoided relatively easily in
the short run at management discretion
• Committed fixed costs, on the other hand,
are fixed costs that cannot be easily changed
Discretionary Fixed Costs Versus Committed Fixed Costs

• Advertising is a discretionary fixed cost,

because it depends on a management
decision
• Lease cost is a committed fixed cost
because it involves a long-term contract
Variable Costs
• Variable costs are costs that vary in direct proportion to
changes in output within the relevant range
• Variable costs are part of several critically important
performance measures used throughout managerial
accounting, including contribution margin, segment
margin, and variable costing
• Variable costs can also be represented by a linear
equation
• Total variable costs depend on the level of output
Variable Costs
• This relationship can be described by the following equation
or graphs:
Total Variable Costs = Variable rate x Number of output
The Reasonableness of Straight-Line Cost Relationships

• Caution when applying cost behavior

assumptions to output levels that fall
outside of the company’s relevant range of
operations
• Straight-line cost relationships that are
assumed within the relevant range may
actually be semi-variable costs
The Reasonableness of Straight-Line Cost Relationships

• Example: At extremely low levels of output,

workers often use more materials per unit or
require more time per unit than they do at
higher levels of output
• As the level of output increases, workers learn
how to use materials and time more efficiently
so that the variable cost per unit decreases as
more and more output is produced
The Reasonableness of Straight-Line Cost Relationships

Semi-Variable Cost: Decreasing Rate

The Reasonableness of Straight-Line Cost Relationships

Semi-Variable Cost: Increasing Rate

Mixed Costs

• Mixed costs are costs that have both a fixed

and a variable component
• Example: Overhead for a company may
consist of a fixed supervisor salary plus the
cost of supplies that vary with the quantity
of output produced
Mixed Cost Behavior
• The formula for a mixed cost is as follows:
Total Cost = Total Fixed Cost + Total Variable Cost
Step Costs: Narrow Steps

• Some cost functions may be discontinuous

• Known as step costs (or semi-fixed)
• Displays a constant level of total cost for a
range of output and then jumps to a higher
level (or step) of total cost at some point,
where they remain for a similar range of
output
Step Costs: Wide Steps
• Step cost with wide steps are more characteristic of
fixed costs
• Example: A company may have to lease production
machinery
• If the machine can only produce 1,000 units and the
company grows, they will have to lease additional
machines for each 1,000 units of production needed
• Resulting in the wide steps shown in the following graph
Accounting Records and Need for Cost Separation

• Only through a formal effort to separate costs

can all costs be classified into the appropriate
cost behavior categories
• If mixed costs are a very small percentage of
total costs, formal cost separation may be more
trouble than it’s worth
Accounting Records and Need for Cost Separation
• Mixed costs could be assigned to either the fixed or
variable cost category without much concern for the
classification error or its effect on decision making
• Alternatively, the total mixed cost could be arbitrarily
divided between the two cost categories. (This is
rarely done and not a good option)
• Typically, mixed costs for many firms are large enough
to call for separation
Methods for Separating Mixed Costs into Fixed and
Variable Components
• The purpose of creating a cost formula is to
provide a quantitative estimate of both total
fixed costs and the variable cost per unit of the
cost driver(s)
• Cost formula components are determined,
managers can predict total costs at various
levels of output
Methods for Separating Mixed Costs into Fixed and
Variable Components
• Three commonly used methods of separating a
mixed cost into its fixed and variable
components are:
1. the high-low method
2. the scattergraph method
3. the method of least squares
• Each method requires the simplifying
assumption of a linear cost relationship
Methods for Separating Mixed Costs into Fixed and
Variable Components
• Expression of cost as an equation for a straight line is:
Total Cost = Total Fixed Cost + (Variable Rate x Units of Output)
• The dependent variable is a variable whose value depends
on the value of another variable
• In the previous equation, total cost is the dependent
variable; it is the cost we are trying to predict
Methods for Separating Mixed Costs into Fixed and
Variable Components
• The independent variable explains changes in the
dependent variable
• A good independent variable is one that causes or is
closely associated with the dependent variable
• Many managers refer to an independent variable as a
cost driver
• The intercept corresponds to fixed cost
• The slope of the cost line corresponds to the variable
rate
How to Create and Use a Cost Formula
How to Create and Use a Cost Formula
The High-Low Method
• Given two points, the slope and the intercept
can be determined
• The high-low method is method of separating
mixed costs into fixed and variable components
by using just the high and low data points
• The high-low method provides managers with a
quick way to estimate cost behavior
The High-Low Method
• To demonstrate, we will use data from the next slide
• Four steps must be taken in the high-low method:
• Step 1: Find the high point and the low point for a given data
set
• Step 2: Using the high and low points, calculate the variable
rate

(High Point Cost - Low Point Cost)

Variable Rate =
(High Point Output - Low Point Output)
Methods for Separating Mixed Costs into Fixed and
Variable Components
The High-Low Method
• Step 3: Calculate the fixed cost using the variable rate (from
Step 2) and either the high point or low point
Fixed cost = Total Cost at High Point − (Variable Rate x Output at High Point)
• Step 4: Form the cost formula for materials handling based
on the high-low method
How to Use the High- Low Method to Calculate Fixed Cost and the
Variable Rate and to Construct a Cost Formula
How to Use the High- Low Method to Calculate Fixed Cost and the
Variable Rate and to Construct a Cost Formula
How to Use the High- Low Method to Calculate Fixed Cost and the
Variable Rate and to Construct a Cost Formula
How to Use the High-Low Method to Calculate Predicted Total
Variable Cost and Total Cost for Budgeted Output
How to Use the High-Low Method to Calculate Predicted Total Variable Cost and
Total Cost for a Time Period That Differs from the Data Period
How to Use the High-Low Method to Calculate Predicted Total Variable Cost and
Total Cost for a Time Period That Differs from the Data Period
Scattergraph Method
• The scattergraph method is a
way to see the cost relationship
by plotting the data points on a
graph
• The first step in applying the
scattergraph method is to plot
the data points so that the
relationship between materials
handling costs and activity
output can be seen
Scattergraph Method
• Inspect the scattergraph to see if
it reveals one or more points
(outliers) that do not seem to fit
the pattern of behavior
• This might justify their
elimination and perhaps lead to
a better estimate of the
underlying cost function
Scattergraph Method
• If the line determined by the
high and low points is
representative of the overall
relationship
• Notice that three points lie
above the high-low line and five
lie below it
Scattergraph Method
• This does not give us confidence
in the high-low results for fixed
and variable costs
• We might wonder if the variable
cost (slope) is somewhat higher
than it should be and the fixed
cost is somewhat lower than it
should be
Scattergraph Method
• Finally, we can use the
scattergraph to visually fit a line
to the data points on the graph
• The manager or cost analyst will
choose the line that appears to
fit the points the best
Scattergraph Method
• An infinite number of lines might
go through the data, but this one
goes through the point for
January (100, P2,000) and
intersects the y-axis at P800
Scattergraph Method
• Our two points are (100, P2,000) and (0, P800). Next, use
these two points to compute the variable rate (the slope):
(High Point Cost − Low Point Cost)
Variable Rate =
(High Point Number of Moves − Low Point Number of Moves)

Variable rate = (P2,000 - P800)

P100 - 0
= P1,200
100
= P12
Scattergraph Method
• The variable rate is P12 per material move
• The fixed cost and variable rate for materials handling cost
have now been identified
• The cost formula for the materials handling activity can be
expressed as:
Total Cost = P800 + (P12 x Number of Moves)
Using the Formula from the Scattergraph Method
• Using this formula, the total cost of materials handling for
between 100 and 500 moves can be predicted and then
broken down into fixed and variable components
• For example, assume that 350 moves are planned for
November
Using the Formula from the Scattergraph Method
• Using the cost formula, the predicted cost is:
P5,000 = P800 + (P12 x 350)
• Of this total cost, P800 is fixed, and P4,200 is variable
• Unfortunately, the scattergraph method suffers from the
lack of any objective criterion for choosing the best-fitting
line
• The quality of the cost formula depends on the quality of
the subjective judgment of the analyst
The Method of Least Squares
• The method of least squares (regression) is a statistical way
to find the best-fitting line through a set of data points
• One advantage is that for a given set of data, it will always
produce the same cost formula
• The best-fitting line is the one in which the data points are
closer to the line than to any other line
 The Method of Least Squares
• The high-low method can yield sufficiently accurate cost estimates
when neither the high nor low point is an outlier
• When the need for accuracy is high, the regression method has
considerable appeal, because it uses all of the given data points,
thereby producing the best estimates possible of the intercept and
slope
• The value of such potential greater accuracy must be weighed
against the cost of greater complexity to perform the cost analysis
and to explain it to other managers as compared to less
sophisticated methods such as the high-low method
 Line Deviations
• The regression line better describes the pattern of the data than
other possible lines
• Results because the squared deviations between the regression
line and each data point are, in total, smaller than the sum of the
squared deviations of the data points and any other line
• The least squares statistical formulas can find the one line with
the smallest sum of squared deviations or the line which
minimizes the cost prediction errors or differences between
predicted costs (i.e., on the regression line) and actual costs (i.e.,
the actual data points)
How to Use the Regression Method to Calculate Fixed Cost and the Variable Rate
and to Construct a Cost Formula and to Determine Budgeted Cost
How to Use the Regression Method to Calculate Fixed Cost and the Variable Rate
and to Construct a Cost Formula and to Determine Budgeted Cost
Using the Regression Programs
• Computing the regression formula manually is tedious, even
with only a few data points
• As the number of data points increases, manual
computation becomes impractical
• Fortunately, software packages such as Excel XLstat®,
Minitab®, JMP®, and Citrix® have regression routines that
will perform the computations
Using the Regression Programs
• All you need to do is input the data and the spreadsheet
regression program supplies more than the estimates of the
coefficients
• It also provides information that can be used to see how
reliable the cost equation is—a feature that is not available
for the scattergraph and high-low methods
Spreadsheet Data
• The first step in using the computer to calculate regression
coefficients is to enter the data. The exhibit here shows the
computer screen that you would see if you entered the data
on material moves into a spreadsheet
Spreadsheet Data
It is a good idea to label your variables as in the example below
Regression Output
• Once we run the regression, we find the fixed cost is P789
and the variable rate is 12.38 (rounded)
• Using this information, the cost formula for materials
handling cost is:
Materials Handling Cost = P789 + (P12.38 × Number of Moves)

• For 350 moves, the total materials handling cost predicted

by the least squares line is:
P5,122 = P789 + (P12.38 × 350)
Regression Output
 Goodness of Fit
• Regression routines provide information on goodness of fit
• Goodness of fit tells us how well the independent
variable(s) predict(s) the dependent variable
• The percentage of variability in the dependent variable
explained by an independent variable (in this case, a
measure of activity output) is called the coefficient of
determination (R2)
 Goodness of Fit
• The higher the percentage of cost variability
explained, the better job the independent variable
does of explaining the dependent variable
• Since R2 is the percentage of variability explained, it
always has a value between 0 and 1.00
 Regression Output
• Note that the summary output shows that the coefficient of
determination, labeled as R Squared (R2) is 0.85
• In other words, material moves explain about 85% of the
variability in the materials handling cost
• This is not bad
• However, something else explains the remaining 15%. The
company’s controller may want to keep this in mind when using
the regression results
 Comparison of Methods
• Knowing how costs change in relation to changes in output is
essential to planning, controlling, and decision making
• Each of the methods for separating mixed costs into fixed and
variable components helps managers understand cost behavior
and consequently make good business decisions
Comparison of Methods for Separating Mixed Costs into
Fixed and Variable Components
 Managerial Judgment
• Managerial judgment is critically important in determining cost
behavior and is by far the most widely used method in practice
• Many managers simply use their experience and past observation
of cost relationships to determine fixed and variable costs
• This method may take a number of forms
• Some managers simply assign some costs to the fixed category
and others to the variable category and ignore the possibility of
mixed costs
• Other managers may identify mixed costs and divide these into
fixed and variable components
 Managerial Judgment
• The use of quantitative analysis—whether relatively simple
techniques such as the high-low method or relatively complex
techniques such as the regression method can add helpful insights
into variable and fixed costs beyond what judgment along might
provide
• Effective managers often estimate the costs associated with
important decisions by using a combination of judgment and some
form of quantitative analysis
 Managerial Judgment
• Management may use experience and judgment to refine statistical
estimation results
• The experienced manager might “eyeball” the data and throw out
several points as being highly unusual or revise the results of estimation
to account for projected changes in cost structure or technology
• The advantage of using managerial judgment to separate fixed and
variable costs is its simplicity
• In situations in which the manager has a deep understanding of the firm
and its cost patterns, this method can give good results
• However, if the manager does not have good judgment, errors will
occur
Ethical Decisions
• There are ethical implications to the use of managerial judgment
• Managers use their knowledge of fixed and variable costs to make
important decisions, such as whether to switch suppliers, expand
or contract production, or lay off workers
• These decisions affect the lives of workers, suppliers, and
customers
• Ethical managers will make sure that they have the best
information possible when making these decisions
VARIABLE COSTING
Two Ways of Measuring Income

• Two methods of computing

income have been developed:
1. one based on variable costing
2. the other based on full or
absorption costing
Absorption Costing
• Absorption Costing assigns ALL manufacturing costs to the
product
• Direct materials, direct labor, variable overhead, and fixed
overhead define the cost of a product
• Under absorption costing, fixed overhead is viewed as a product
cost, not a period cost
• Under this method, fixed overhead is assigned to the product
through the use of a predetermined fixed overhead rate and is
not expensed until the product is sold
• Fixed overhead is an inventoriable cost
Variable Costing
• Variable costing stresses the difference between fixed and variable
manufacturing costs
• Variable costing assigns ONLY variable manufacturing costs to the
product; these costs include direct materials, direct labor, and
variable overhead
• The rationale for excluding fixed overhead from period costs when
preparing variable-costing income statements is that fixed
overhead is a cost of capacity—or staying in business—such as the
lease cost on a manufacturing plant
Variable Costing
• Understanding variable-costing income statements is important
because they can provide useful insights into various capacity
cost management decisions
• Fixed overhead is treated as a period expense and is excluded
from the product cost
• Under variable costing, fixed overhead of a period is seen as
expiring that period and is charged in total against the revenues
of the period
Comparison of Variable and Absorption Costing Methods
 Comparison of Variable and Absorption Costing Methods

• PFRS require absorption costing for external reporting.

• Yet variable costing can supply vital cost information for decision
making and control, information not supplied by absorption
costing
• For internal application, variable costing is an important
managerial tool
Inventory Valuation
• Inventory is valued at product or manufacturing cost
• Under absorption costing, product cost includes direct materials,
direct labor, variable overhead, and fixed overhead
• Under variable costing, the product cost includes only direct
materials, direct labor, and variable overhead
How to Compute Inventory Cost under Absorption Costing
How to Compute Inventory Cost under Absorption Costing
How to Compute Inventory Cost under Variable Costing
How to Compute Inventory Cost under Variable Costing
Comparison of Variable and Absorption Costing Methods

The only difference between the two approaches is the

treatment of fixed factory overhead. As a result, the unit
product cost under absorption costing is always greater
than the unit product cost under variable costing
Income Statements Using Variable and Absorption Costing

• Because unit product costs are the basis for cost of goods
sold, the variable and absorption-costing methods can lead
to different operating income figures
• The difference arises because of the amount of fixed
overhead recognized as an expense under the two methods
How to Prepare an Absorption-Costing Income Statement
How to Prepare an Absorption-Costing Income Statement
How to Prepare a Variable-Costing Income Statement
How to Prepare a Variable-Costing Income Statement
Production, Sales, and Income Relationships
• The relationship between variable-costing income and
absorption-costing income changes as the relationship
between production and sales changes
• If more units are sold than were produced, variable-costing
income is greater than absorption-costing income
COST-VOLUME-PROFIT ANALYSIS
Learning Objectives
1. Determine the break-even point in number of units and in
total sales peso
2. Determine the number of units that must be sold, and the
amount of revenue required, to earn a targeted profit
3. Prepare a cost-volume-profit graph, and explain its meaning
4. Apply cost-volume-profit analysis in a multiple-product
setting
5. Explain the impact of risk, uncertainty, and changing
variables on cost-volume-profit analysis
 Break-Even Point in Units and in Sales peso
• Cost-volume-profit (CVP) analysis estimates how
changes in the following three factors affect a company’s
profit
• Costs (both variable and fixed)
• Sales volume
• Price
• Companies use CVP analysis to help them reach
important benchmarks, such as breakeven point
Break-Even Point in Units and in Sales peso
• The break-even point is the point where total revenue
equals total cost (i.e., the point of zero profit)
• The level of sales at which contribution margin just
covers fixed costs and consequently, net income is equal
to zero
• Since new companies experience losses (negative
operating income) initially, they view their first break-
even period as a significant milestone
Break-Even Point in Units and in Sales peso

CVP analysis can address many other

issues:

1 The number of units that must be

sold to break even

2 The impact of a given reduction in

fixed costs on the break-even point

3 The impact of an increase in price

on profit
Break-Even Point in Units and in Sales peso

The basics of CVP analysis:

1 The contribution margin income

statement
2 Calculating the break-even point in
units
3 Calculating the contribution margin
ratio and the variable cost ratio
4 Calculating the break-even point in
sales peso
Using Operating Income in Cost-Volume-Profit Analysis

• In CVP analysis, the terms “cost” and “expense” are

often used interchangeably. This is because the
conceptual foundation of CVP analysis is the
economics of break-even analysis in the short run
• It is assumed that all units produced are sold.
Therefore, all product and period costs do end up as
expenses on the income statement
Operating Income = Total Revenue – Total Expense
Using Operating Income in Cost-Volume-Profit Analysis

• For the income statement, expenses are

classified according to function; that is, the
manufacturing (or service provision) function,
the selling function, and the administrative
function
• For CVP analysis, however, it is much more
useful to organize costs into fixed and variable
components
Using Operating Income in Cost-Volume-Profit Analysis

• Variable costs are all costs that increase as more units are
sold, including:
• direct materials
• direct labor
• variable overhead
• variable selling expenses
• Fixed costs include:
• fixed overhead
• fixed selling and administrative expenses
Using Operating Income in Cost-Volume-Profit Analysis

• The income statement format that is based on the

separation of costs into fixed and variable components is
called the contribution margin income statement
Using Operating Income in Cost-Volume-Profit Analysis

Direct
Variable selling and
materials
administrative costs
Direct labor

Variable
overhead

Fixed selling and

Fixed administrative costs
overhead
Using Operating Income in Cost-Volume-Profit Analysis

Contribution margin is the difference between sales and

variable expense. It is the amount of sales revenue left over
after all the variable expenses are covered that can be used
to contribute to fixed expense and operating income
How to Prepare a Contribution Margin Income Statement
How to Prepare a Contribution Margin Income Statement
How to Prepare a Contribution Margin Income Statement
Break-Even Point in Units
• If the contribution margin income statement is recast as an
equation, it becomes more useful for solving CVP problems
• Basic CVP Equations:
Operating Income = Sales – Total Variable Expenses – Total Fixed Expenses

Operating Income = (Price × Number of Units Sold) – (Variable Cost per Unit
hgk
× Number of Units Sold) – Total Fixed Cost

• The break-even point tells managers how many units must

be sold to cover all costs. Once more than the break-even
units are sold, the company begins to earn a profit
How to Calculate the Break-Even Point in Units
How to Calculate the Break-Even Point in Units
Break-Even Point in Units
• Break-even units are equal to the fixed cost divided by the
contribution margin per unit

Total Fixed Cost

Break-Even Units =
Unit Contribution Margin
Break-Even Point in Peso Sales
• Managers using CVP analysis may use sales revenue as the
measure of sales activity instead of units sold. A units sold
measure can be converted to a sales revenue measure by
multiplying the unit selling price by the units sold:
Sales Revenue = Price × Units Sold

For example, the break-even point for Whittier is 600 mulching

mowers; the selling cost is P400 per mower.
Breakeven in Sales P’s = 600 x P400 = P240,000
Variable Cost Ratio and Contribution Margin Ratio

Any answer expressed in units sold can be easily

converted to one expressed in sales revenues

Variable Cost Ratio Contribution Margin Ratio

Price – Variable cost per unit = P10 - P6 = P4 Total Contribution Margin P40
= = 40%
Variable Cost × Units Sold = P6 × 10 units = P60 Total Sales P100
Alternatively:
Variable Cost per Unit P6
= = 60% Contribution Margin per Unit P4
Price P10 = = 40%
Price P10
How to Calculate the Variable Cost Ratio and the
Contribution Margin Ratio
How to Calculate the Variable Cost Ratio and the
Contribution Margin Ratio
Fixed Cost’s Relationship, Variable Cost Ratio, Contribution
Margin Ratio
• How do fixed costs relate to the variable cost ratio and
contribution margin ratio?
• Since the total contribution margin is the revenue remaining
after total variable costs are covered, it must be the revenue
available to cover fixed costs and contribute to profit
• How does the relationship of fixed cost to contribution
margin affect operating income?
Fixed Cost’s Relationship, Variable Cost Ratio, Contribution
Margin Ratio
• There are three possibilities:
• Fixed cost equals contribution margin; operating income is
zero; the company breaks even
• Fixed cost is less than contribution margin; operating income
is greater than zero; the company makes a profit
• Fixed cost is greater than contribution margin; operating
income is less than zero; the company makes a loss
Calculating Break-Even Point in Peso Sales
• The break-even point in sales peso makes it easy for
managers to see instantly how close they are to breaking
even using only sales revenue data
• Since sales are typically recorded immediately, the manager
does not have to wait to have an income statement
prepared in order to see how close the company is to
breaking even
• The equation to figure the break-even sales peso is:
Total Fixed Expenses
Break-Even Sales =
Contribution Margin Ratio
How to Calculate the Break-Even Point in Peso Sales
How to Calculate the Break-Even Point in Peso Sales
How to Calculate the Break-Even Point in Peso Sales
Units And Peso Sales Needed to Achieve a Target Income

• By looking at the number of units or sales peso needed to

earn a target operating income, managers turn their focus
away from a point of zero profit and can aim toward making
a particular positive profit
• Managers can easily compare, at any point in time, the
actual sales revenue made with the sales revenue needed to
earn a particular profit objective
Units to Be Sold to Achieve a Target Income
• The break-even point is useful information and an
important benchmark for relatively young companies, most
companies would like to earn operating income greater than
P0
• CVP allows us to do this by adding the target income
amount to the fixed cost
• First, let’s look in terms of units that must be sold
Total Fixed Cost + Target Income
Number of Units to Earn Target Income =
Contribution Margin per Unit
How to Calculate the Number of Units to Be Sold to Earn a
Target Operating Income
How to Calculate the Number of Units to Be Sold to Earn a
Target Operating Income
Units to Be Sold to Achieve a Target Income
• How much sales revenue must Whittier generate to earn an
operating income of P37,500?
• This question is similar to the one we asked earlier in terms
of units but phrases the question directly in terms of sales
revenue
Units to Be Sold to Achieve a Target Income
• To answer the question, add the targeted operating income
of P37,500 to the P45,000 of fixed cost and divide by the
contribution margin ratio. This equation is:
Total Fixed Cost + Target Income
Sales peso to Earn Target Income =
Contribution Margin Ratio
How to Calculate Sales Needed to Earn a Target Operating
Income
How to Calculate Sales Needed to Earn a Target Operating
Income
Impact of Change in Revenue on Change in Profit
• Assuming that fixed costs remain unchanged, the
contribution margin ratio can be used to find the profit
impact of a change in sales revenue
• To obtain the total change in profits from a change in
revenues, multiply the contribution margin ratio times the
change in sales:

Change in Profits = Contribution Margin Ratio × Change in Sales

Graphs of cost-Volume-Profit Relationships
• Graphing sales revenue and total costs against units sold
helps managers clearly see the difference between variable
cost and revenue
• It may also help them understand quickly what impact an
increase or decrease in sales will have on the break-even
point
The Cost-Volume-Profit Graph
• The cost-volume-profit graph depicts the relationships
among cost, volume, and profits (operating income) by
plotting the total revenue line and the total cost line on a
graph
• To obtain the more detailed relationships, it is necessary to
graph two separate lines—the total revenue line and the
total cost line
The Cost-Volume-Profit Graph
• These two lines are represented by the following two
equations:
Revenue = Price × Units

Total Cost = (Unit Variable Cost × Units) + Fixed Cost

The Cost-Volume-Profit Graph
CVP Analysis Assumptions
Major assumptions of CVP analysis include:
1 2
Linear revenue and cost
Selling prices and costs
functions remain constant
are known with certainty
over the relevant range

3 4
Sales mix is known with
All units produced are
certainty for multiple-
sold; there are no finished
product break-even
goods inventories
settings
Multiple-Product Analysis
• Cost-volume-profit analysis is simple in a single-product
setting. However, most firms produce and sell a number of
products or services
• When managers calculate the break-even point for
individual products, they can see the contribution each
makes to profit and can tell at any point in time how close a
product is to breaking even
• How do we adapt the formulas used in a single-product
setting to a multiple-product setting?
Multiple-Product Analysis
• One important distinction is to separate direct fixed
expenses from common fixed expenses
• Direct fixed expenses are those fixed costs that can be traced
to each segment and would be avoided if the segment did
not exist
• Common fixed expenses are the fixed costs that are not
traceable to the segments and would remain even if one of
the segments was eliminated
Break-Even Calculations for Multiple Products
• When more than one product is produced and sold,
managers must estimate the sales mix and calculate a
package contribution margin
• Sales mix is the relative combination of products being sold
by a firm
Total Fixed Costs
Break-Even Packages =
Package Contribution Margin
How to Calculate the Break-Even Units for a Multiple-
Product Firm
How to Calculate the Break-Even Units for a Multiple-
Product Firm
How to Calculate the Break-Even Units for a Multiple-
Product Firm
How to Calculate the Break-Even Peso Sales for a Multiple-
Product Firm
How to Calculate the Break-Even Peso Sales for a Multiple-
Product Firm
How to Calculate the Break-Even Peso Sales for a Multiple-
Product Firm
Cost-Volume-Profit Analysis and Risk and Uncertainty
• Managers must be aware of many factors in our dynamic
world. CVP analysis is a tool that managers use to handle
risk and uncertainty

Variable costs?
Introducing Risk and Uncertainty
• An important assumption of CVP analysis is that prices and
costs are known with certainty
• However, risk and uncertainty are a part of business
decision making and must be dealt with
Methods to Deal with Uncertainty and Risk

1. Management must realize the

uncertain nature of future prices,
costs, and quantities
2. Management must assume a
“break-even band” rather than a
breakeven point
3. Managers should use sensitivity or
“what-if” analysis
Margin of Safety
• The margin of safety is the units sold or the revenue earned
above the break-even volume
• For example, if the break-even volume for a company is 200
units and the company is currently selling 500 units, the
margin of safety in units is:

Margin of Safety= Sales – Break-Even Units

= 500 – 200 = 300
Margin of Safety
• If the break-even volume for a company is P200,000 and the
current revenues are P500,000, the margin of safety in sales
revenue is:
Revenues – Margin of Safety = P500,000 – P200,000 = P300,000

• In addition, the margin of safety can be expressed as a

percentage of total sales peso 60%:
Margin of Safety P300,000
=
Revenues P500,000
Margin of Safety
• Two concepts useful to management are margin of safety
and operating leverage
• Both of these concepts may be considered measures of risk
• Each requires knowledge of fixed and variable costs
How to Calculate the Margin of Safety
Operating Leverage
• Operating leverage is the use of fixed costs to extract higher
percentage changes in profits as sales activity changes
• It is the measure of the proportion of fixed costs in a
company’s cost structure
• It is used as an indicator of how sensitive profit changes in
sales volume
Margin of Safety
• The degree of operating leverage (DOL) can be measured
for a given level of sales by taking the ratio of contribution
margin to operating income, as follows:
Total Contribution Margin
Degree of Operating Leverage =
Operating Income
How to Calculate the Degree of Operating Leverage
Summary of Operating Leverage

Operating Leverage
HIGH LOW
% profit increase with sales increase Large Small
% loss increase with sales decrease Large Small
How to Calculate the Impact of Increased Sales on Operating
Income Using the Degree of Operating Leverage
Differences between a Manual and an Automated System
Sensitivity Analysis and Cost-Volume-Profit

• As the text presented, the widespread use of personal

computers and spreadsheets has placed sensitivity analysis
within reach of most managers
• Sensitivity analysis is a “what-if” technique that examines
the impact of changes in underlying assumptions on an
answer
• It is relatively simple to input data on prices, variable costs,
fixed costs, and sales mix and to set up formulas to calculate
break-even points and expected profits
Sensitivity Analysis and Cost-Volume-Profit

• The data can be varied as desired to see how changes

impact the expected profit
• This comparison will allow the manager to make informed
decisions about whether to migrate operations from a
manual system to a more automated one