Introduction to Cost Behavior

and Cost-Volume Relationships

Chapter 2
 Cost Behavior and Cost
Drivers
Cost behavior is how the activities of
an organization affect its costs

Cost drivers are Any output measure

that cause the use of costly resources
 Examples of Value Chain Functions,
Costs, and Cost Drivers
Value Chain Function
and Example Costs Example Cost Drivers
Research and development
· Salaries of marketing research Number of new product proposals
personnel, costs of
of market surveys
Production
· Labor wages Labor hours
Marketing
· Cost of advertisements Number of advertisements
Distribution
· Wages of shipping personnel Labor hours
Customer service
· Salaries of service personnel Hours spent servicing products
Impact of changes of cost driver
level on variable and fixed Costs
 AA variable
variable cost
cost changes
changes in in direct
direct proportion
proportion
to
to changes
changes in
in the
the cost-driver
cost-driver level.
level.

• Per unit
$
V
• Total
$

V
 AA fixed
fixed cost
cost is
is not
not immediately
immediately affected
affected
by
by changes
changes in in the
the cost-driver
cost-driver level.
level.

• Per Unit
$
V
• Total
$

V
 Rules of Thumb
Per-unit variable cost remains unchanged
regardless of changes in cost-driver activity;
however, the total cost changes directly
with changes in the cost-driver

Total fixed costs remain unchanged

regardless of changes in cost-driver
activity; however, per unit costs change
inversely with changes in the activity-
driver.
 Relevant Range

The
The relevant
relevant range
range specifies
specifies the
the limits
limits
of
of cost-driver
cost-driver activity
activity within
within which
which aa
specific
specific relationship
relationship between
between aa cost
cost
and
and its
its cost
cost driver
driver will
will be
be valid.
valid.

Relevant Range
 Relevant Range
$115,000 Normal activity
Less than
100,000 normal Above
production level normal
pro-
Costs
Fixed

Relevant duction
60,000 level
range

0 20 40 60 80 100
Volume in Thousands of Units
 Let’s put our
knowledge of cost
behavior to work by
preparing a
contribution format
income statement.
The Contribution Margin
Statement
 The Contribution Format
Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000

The
The contribution
contribution margin
margin format
format emphasizes
emphasizes
cost
cost behavior.
behavior. Contribution
Contribution margin
margin covers
covers fixed
fixed
costs
costs and
and provides
provides for
for income.
income.
 The Contribution Format

Used primarily for Used primarily by

external reporting. management.
 Uses of the Contribution Format
The
The contribution
contribution income
income statement
statement format
format is
is used
used
as
as an
an internal
internal planning
planning and
and decision
decision making
making tool.
tool.
We
We will
will use
use this
this approach
approach for:
for:
1.
1. Cost-volume-profit
Cost-volume-profit analysis
analysis
2.
2. Budgeting
Budgeting
3.
3. Segmented
Segmented reporting
reporting of
of profit
profit data
data
4.
4. Special
Special decisions
decisions such
such as
as pricing
pricing and
and make-or-
make-or-
buy
buy analysis
analysis
 CVP Equation--

Sales - Variable costs - FC = Profit

[Sales Volume (SV) – [Sales Volume (SV) - FC = P

X Sales Price (SP)] X Variable Cost (VC)]

• Reduced:
[(SP – VC) x SV] - FC = P

Contribution margin
 Cost-Volume-Profit
Analysis (CVP)
What
What is
is cost-volume-profit
cost-volume-profit analysis?
analysis?

ItIt is
is the
the study
study of
of the
the effects
effects of
of output
output
volume
volume on on revenue
revenue (sales),
(sales), expenses
expenses
(costs),
(costs), andand net
net income
income (net
(net profit).
profit).
 Scenario

Total Unit
Sales Revenue $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Net operating income $ 10,000
 As a CVP analysis
Sales - Variable Costs - Fixed Cost =
Profit

100,000 - 60,000 - 30,000 = 10,000

 Break-Even Point –
Contribution-Margin and
Equation Methods
The
The break-even
break-even point
point is
is the
the level
level
of
of sales
sales at
at which
which revenue
revenue equals
equals
expenses
expenses and and net
net income
income is is zero.
zero.
 Break-Even Point –
Contribution-Margin and
Equation Methods

Contribution
Contribution margin
margin

Equation
Equation
 Contribution Margin
Method
Per
Per Unit
Unit %
%
Selling
Selling price
price $100
$100 100
100
Variable
Variable costs
costs 60
60 60
60
Contribution
Contribution margin
margin $$ 40
40 40
40

$30,000
$30,000 fixed
fixed costs
costs ÷÷ $40
$40
== 750
750 units
units (break
(break even)
even)
 Contribution Margin
Method

$30,000
$30,000 fixed
fixed costs
costs
÷÷ 40%
40% (contribution-margin
(contribution-margin percentage)
percentage)
== $75,000
$75,000 ofof sales
sales to
to break
break even
even
 Equation Method
Net
Net income
income equals
equals zero
zero at
at the
the break-even
break-even point.
point.

Sales
Sales

– Variable
Variable expenses
expenses

– Fixed
Fixed expenses
expenses

= Zero
Zero net
net income
income (break-even
(break-even point)
point)
Sales - Variable Costs - Fixed Cost = Profit
[Sales Volume (SV) – [Sales Volume (SV) FC = P
X Sales Price (SP)] X Variable Cost (VC)]
• Reduced:
[(SP – VC) x SV] - FC = P
__________________________________________________________________________________

(100 –60) SV - 30,000 = 0

40SV = 30,000
SV = 750 Units
 Equation Method

Let
Let N
N == number
number of of units
units
to
to be
be sold
sold to
to break
break even.
even.

$.50N
$.50N –– $.40N
$.40N –– $6,000
$6,000 == 00
$.10N
$.10N == $6,000
$6,000
NN == $6,000
$6,000 ÷÷ $.10
$.10
N
N == 60,000
60,000 Units
Units
Equation Method

Let
Let SS == sales
sales in
in dollars
dollars
needed
needed to to break
break even.
even.

SS –– .80S
.80S –– $6,000
$6,000 == 00
.20S
.20S == $6,000
$6,000
SS == $6,000
$6,000 ÷÷ .20
.20
SS == $30,000
$30,000
 Assumptions
Expenses
Expenses can
can bebe classified
classified into
into
variable
variable and
and fixed
fixed categories.
categories.

The
The behavior
behavior of of revenues
revenues and
and expenses
expenses
is
is linear
linear over
over the
the relevant
relevant range.
range.

Expect
Expect no
no changes
changes inin efficiency
efficiency
and
and productivity.
productivity.
 Assumptions

Sales
Sales mix
mix remains
remains constant.
constant.

The
The difference
difference inin inventory
inventory level
level
at
at the
the beginning
beginning andand at
at the
the
end
end of
of aa period
period is
is insignificant.
insignificant.
Multiple Changes in Key Factors

Construct
Construct and
and solve
solve equations
equations

Incremental
Incremental approach
approach
Additional Uses of Cost-Volume
Analysis
Best
Best cost
cost structure
structure

Operating
Operating leverage
leverage

Margin
Margin of
of safety
safety