Hope Enterprise University College

Department of Accounting & Finance

Cost & Management Accounting II

Chapter Two: Cost Behavior and Cost Volume Relationship

Every organization needs to calculate future revenues in order to help the managers
carry out their operations effectively. Cost volume is the approach used for this purpose.
Cost Volume Profit analysis or CVP analysis helps in identifying the operating activity
levels with a purpose to avoid any kind of losses and achieve profits. Moreover, it also
helps the companies to plan their future operations and see whether their
organizational performance is going on the right track or not. While conducting a
business, the companies also have to face various risks and in order to counter those
risks, CVP analysis is an effective tool.
Cost volume profit analysis can also help the organizations in calculating the breakeven
point which is the point at which the profits become equal to zero. This can be done by
finding the breakeven volume and then using it to make graphical representations. The
breakeven volume can either be expressed in dollars or in units depending upon the
nature and type of the organization. For instance: if the organization makes a large
amounts of products, then the company must prefer to calculate the breakeven volume
in the form of sales dollars while in case of one product company, the unit method
might be a more effective calculation of sales volume. The calculation method and the
graphical representation in both cases:
1. Break even volume in unit method = Fixed costs/Unit contribution margin
2. Break even volume in sales dollar method = Fixed costs/Contribution margin
ratio

Cost behavior- is the general term for describing whether a cost changes when the level
of output changes. For example: producing one additional product in manufacturing
company increase material, labor and other necessary costs to manufacture. But the
cost of the plant and salaries of key managers stays the same regardless of the number
of units produced.
Fixed costs: are costs that in total are constant within the relevant range as the level of
the activity deriver varies. A cost that does not change as activities output changes is
fixed cost.
A variable cost: on the other hand, increases in total with an increase in activity output
and decreases in total with a decrease in activity output. Variable costs are defined as
costs that in total vary in direct proportion to changes in an activity driver.
Mixed costs: are costs that have both fixed and variable component.

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 Total Variable Cost
Cost
Slop (Variable Cost per unit)

Volume
Relevant range is the range of activity within which assumption about variable and fixed
costs are valid. The total fixed cost change only if the relevant range changes. When the
total fixed cost is depicted on a graph, the slop is zero.

Total Fixed Cost

Cost

Volume
The total fixed cost graph starts from a positive figure on the cost line (y-axis). This
shows that there is a cost incurred whether there is volume of activity or not.
Total Cost
Total cost is simply the sum of total variable cost and total fixed costs. The total cost can
be expressed in an equation form as follows:
If the total cost is portrayed on a graph, “B” is the slop of the line and “FC” is the Y-
intercept.

Cost TC= VC + FC

Volume (N)

Cost volume profit (CVP) Analysis

With increased competition, in any organization profits can be improved more by
controlling (reducing) costs than by increasing prices to customers. The main question at
this time will be, what will happen to financial results (profit or cost), if a specified level
of activity or volume changes. Although, financial results are based on revenue and
costs.
CVP analysis is the study of the effects of output volume on sales (revenue), costs and
net income (Net profit). It shows the net effect of costs, prices and volume has on
profits. The concept of CVP is relevant to all decision-making areas. The managers use
this technique extensively to determine break-even point, margin of safety, profit or loss
at various level of output. It is an important tool for short-term planning and forecasting

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business activities. It helps to answer questions of interest to management decision
making areas such as:

 What should be the volume of sales to achieve a desired profit?

 What changes in price affect profit position?
 How variation of cost affects profit? E.t.c…
 Break-even point analysis
Breakeven point is the level of sales at which total revenue equals total cost and net
income (Net Profit) will become zero.
The breakeven point can be computed in three different ways (a) equation method, (b)
Contribution margin method and (c) graphical method. Each method is discussed by
using the following example.
Example 1:
Assume that WAW Company manufactures and sells a single product. The following
summarized data is collected from its accounting records.
Fixed costs (total) ------------------------------------- Br. 200,000
Selling price per unit --------------------------------- 60
Variable cost per unit -------------------------------- 40
A) The equation method
The first method for computing a breakeven point is an equation method. The equation
method is derived from the relationship that exists among income statement items:
revenues, costs, and net income. The equation approach provides the most general
approach to cost – volume – profit analysis and is easy to remember. The operating
income is determined by deducting total costs from revenue as stated below:
The break – even point is the point where total costs equal the total revenue. Which
means the operating income is zero.
B) The Contribution Margin method
Contribution margin (CM) is the difference between total revenue and total variable
costs. The CMPU is selling price per unit minus variable cost per unit. The formula to
determine the CM is derived from the formula to determine the operating income.
C) The graphical method
The relationship among revenue, cost, profit and volume can be expressed graphically
by preparing a cost- volume profit (CVP) graph. A CVP graph highlights CVP relationships
over a wide range of activity and can give managers a perspective that can be obtained
in no other way. Of course the third method to compute the break-even point in units
and birr of sales using graphical method. In graphical method, we plot the total cost line
and total revenue line to get the point of intersection, which is the break-even point.
Assuming the linear relationship between costs and revenues, we need only two lines to
depict costs and revenues on X-Y graph.
The total cost line shows the sum of variable costs and fixed costs and the total revenue
line shows the revenue that could be generated at different volume of sales in units. The
cost line starts at a point on the vertical axis which shows the total fixed cost and
extends upward to the right at a slop which equals the variable cost per unit. The

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 revenue line starts form the origin and extends upward to the right at a slop which
equals the unit selling price.
 Breakeven point
The breakeven point is determined by the intersection of the total revenue line and
total cost line. The result agrees with the conclusions that are reached at by the
equation and contribution margin methods.
 Profit and loss areas
The CVP graph discloses more information than the breakeven calculation. From the
graph, a manager can observe the effect on profit of changes in volume. The vertical
distance between the total revenue and total cost lines on the graph represents the
profit or loss at a particular sales volume.
To summarize, information may be presented to management in a more visual format
such as graphs. A chart called CVP graph or break even chart can be prepared to depict
the relationship among cost, volume and profit.
The breakeven point in a break even chart is located at the point where the total
revenue and total cost lines cross or intersect.

1,000,000

900,000 Profit Area

800,000
Total Cost
700,000

600,000
Total
500,000 Variable
Breakeven point Cost
10,000 units or Br 6000,000
400,000 Sales

300,000 Total
Revenue

200,000

Loss Total
Area fixed
Cost

0
5000 10,000 15,000 20,000
Volume in units
Cost Volume Profit Graph

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 The margin of safety (MOS)
The margin of safety is the access of actual (budget) sales volume over the break-even
sales volume. Margin of safety show the amount by which sales can drop before losses
begin to be incurred.
The margin of safety gives the management to feel for how close projected or actual
operations are to the organizations break-even point.
If the budgeted or actual sales are significantly above the break-even sales, there is high
margin of safety and profitability can be expected even if the budgeted (Actual) sales
fall. The larger the margin of safety, safer the firm will be. A high margin of safety is
particularly significant in time of depression when the demand of the firm’s product is
falling. A low margin of safety result for a firm which has a low contribution margin
ratio.
When both the margin of safety and the contribution margin ratio are low, management
should think of the possibilities of increasing the selling price, provided it does not
adversely affect the sales volume or reducing variable costs by bringing improvements in
the manufacturing process.
Example 2: Assume that WAW Company is currently selling 12,000 units of a product.
Required: compute a) Margin of safety in Units and Birr of sales
b) Margin of safety percentage
3.3 Target Profit
Cost-volume- profit analysis can be used by management to plan in advance. A number
of questions are answered through cost- volume-profit analysis. For example, questions
like what is the minimum level of output required for covering costs? What is the
change in costs if the level of output is changed? What is the required sales volume to
earn a particular profit amount? With the existing cost and output data, what should be
the selling price per unit to achieve a targeted profit? And other questions are answered
by the cost-volume-profit analysis.

Target profit analysis

The breakeven point provides strategy point of planning operations. Manger wants to
earn operating profit rather than simply cover costs. Consequently, CVP analysis can be
used to answer the following questions.
How much sales volume in units and in birr should a company generate if a fixed
amount of profit before or after tax is desired?
Managers use CVP analysis to determine sales volume needed to achieve a desired
profit called target or planned profit. In making target profit analysis, you are required
to find a contribution margin figure that is sufficient to cover fixed costs and to provide
the desired profit.
The problem of computing volume of sales required to earn a particular amount of
target profit is very similar to the problem of finding the breakeven point.

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Example 3: Assume that the management of WAW Company above has planned that
the company’s operation should produce a yearly profit before tax of Br 90,000.
a) Determine the number of units the company should produce and sale to produce a
yearly profit of Br 90,000.
b) Determine the sales volume in birr to attain its target profit of Br 90,000.
Answer the above requirements using:
a) Equation method b) The contribution margin method

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