Cost Behaviour
Topic 3A
2012 McGrawHill Education (Asia)
Preview of This Weeks Class
Classify costs by behaviour and use it to answer the
following questions:
How will my profits change if I change my selling price,
volume, or costs?
Breakeven and target profit analysis (this week)
How can the income statement be presented for better
control purposes?
Variable costing vs. absorption costing (next week)
McGrawHill Education (Asia)
Slide 2
Topic 3A Learning Objectives
1.
Understand various types of cost behaviour
2.
Variable
Fixed
Mixed
Use various methods to analyze cost behaviour
Scattergraph Method
Highlow Method
Least Squares Regression Method
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Slide 3
Learning Objective 1
Understand Various Types
of Cost Behaviour:
Variable, Fixed and Mixed.
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Slide 4
Cost Classifications for Predicting Cost
Behavior (Recap)
Behavior of Cost (within the relevant range)
Cost
In Total
Per Unit
Variable
Total variable cost changes
as activity level changes.
Variable cost per unit remains
the same over wide ranges
of activity.
Fixed
Total fixed cost remains
the same even when the
activity level changes.
Average fixed cost per unit goes
down as activity level goes up.
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Slide 5
The Activity Base (also called a cost driver)
Activity Base:
A measure of what causes the incurrence of a variable
cost
Variable costs
Activity base (cost driver)
Direct materials
Number of units produced
Equipment maintenance cost
Number of machine hours
Direct labor cost/Employee fringe
benefits
Number of labor hours
Delivery/Shipping cost
Number of miles driven
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Slide 6
The Linearity Assumption and the Relevant Range
A relevant range is the range of activity within which the assumptions
made about cost behaviors are reasonably valid
Total Cost
Economists
Curvilinear Cost
Function
Relevant
Range
A straight line
closely
approximates a
curvilinear
variable cost
line within the
relevant range.
Accountants StraightLine
Approximation (constant unit
variable cost)
Activity
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Slide 7
1a. True Variable Costs
Cost
The amount of a true variable cost used during the
period varies in direct proportion to the activity level.
The apps download charge on a cell phone bill was
one example of a true variable cost.
Volume
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Direct material is
another example
of a cost that
behaves in a true
variable pattern.
Slide 8
1b. StepVariable Costs
Cost
A stepvariable cost is a resource that is obtainable only
in large chunks (such as maintenance workers) and
whose costs change only in response to fairly wide
changes in activity.
E.g., A maintenance worker is
required for every 1,000 units
of production
Volume
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Slide 9
1b. StepVariable Costs
Cost
Small changes in the level of production are not
likely to have any effect on the number of
maintenance workers employed.
Volume
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Slide 10
1b. StepVariable Costs
Cost
Only fairly wide changes
in the activity level will
cause a change in the
number of maintenance
workers employed.
Volume
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Slide 11
2. Types of Fixed Costs
Committed
Discretionary
Longterm, cannot be
significantly reduced in
the short term.
May be altered in the
shortterm by current
managerial decisions
Examples
Examples
Depreciation on Buildings
and Equipment and Real
Estate Taxes
Advertising and
Research and
Development
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Slide 12
2. Fixed Costs and the Relevant Range
For example, assume office space is available at
a rental rate of $30,000 per year in increments of
1,000 square feet.
Fixed costs would increase
in a step fashion at a rate of
$30,000 for each additional
1,000 square feet.
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Slide 13
Rent Cost in Thousands
of Dollars
2. Fixed Costs and the Relevant Range
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90
Relevant
60
Range
30
0
The relevant range
of activity for a fixed
cost is the range of
activity over which
the graph of the
cost is flat.
1,000
2,000
3,000
Rented Area (Square Feet)
Slide 14
2. Fixed Costs and the Relevant Range
How does this
stepfunction
pattern differ from a
stepvariable cost?
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Stepvariable costs
can be adjusted more
quickly as conditions
change and . . .
The width of the activity
steps is much wider for
the fixed cost.
Slide 15
Is Labor a Variable or a Fixed Cost?
The behavior of wage and salary costs can differ
across countries, depending on labor regulations,
labor contracts, and custom.
In France, Germany, China, and Japan, management has
little flexibility in adjusting the size of the labor force.
Labor costs are more fixed in nature.
In the United States and the United Kingdom, management
has greater latitude. Labor costs are more variable in nature.
Within countries managers can view labor costs differently
depending upon their strategy. Most companies in the
United States continue to view direct labor as a variable cost.
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Slide 16
Quick Check
Which of the following statements about
cost behavior are true?
a. Fixed costs per unit vary with the level of
activity.
b. Variable costs per unit are constant within the
relevant range.
c. Total fixed costs are constant within the
relevant range.
d. Total variable costs are constant within the
relevant range.
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Slide 17
3.Mixed Costs
A mixed cost (also called semivariable cost)
contains both variable and fixed elements.
Consider the example of utility cost.
Total Utility Cost
Variable
Cost per KW
X
Activity (Kilowatt Hours)
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Fixed Monthly
Utility Charge
Slide 18
3.Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where:
Y
a
Total Utility Cost
b
X
= The total mixed cost.
= The total fixed cost (the
vertical intercept of the line).
= The variable cost per unit of
activity (the slope of the line).
= The level of activity.
Variable
Cost per KW
X
Activity (Kilowatt Hours)
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Fixed Monthly
Utility Charge
Slide 19
3.Mixed Costs An Example
If your fixed monthly utility charge is $40, your
variable cost is $0.03 per kilowatt hour, and your
monthly activity level is 2,000 kilowatt hours, what is
the amount of your utility bill?
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Slide 20
Analysis of Mixed Costs
Account Analysis and the Engineering Approach
In account analysis, each account is
classified as either variable or fixed based
on the analysts knowledge of how
the account behaves.
The engineering approach classifies
costs based upon an industrial
engineers evaluation of production
methods, and material, labor and
overhead requirements.
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Slide 21
Learning Objective 2
Use Various Methods to Analyze Cost
Behavior.
1. Scattergraph Method
2. HighLow Method
3. LeastSquares Regression
Method
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Slide 22
1. The Scattergraph Method
Plot the data points on a graph
(Total Cost Y vs. Activity X).
Maintenance Cost
1,000s of Dollars
Y
20
* *
* *
10
* ** *
**
Patientdays in 1,000s
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Slide 23
1. The Scattergraph Method
Draw a line through the data points with about an
equal numbers of points above and below the line.
Maintenance Cost
1,000s of Dollars
Y
20
* *
* *
10
* ** *
**
Patientdays in 1,000s
McGrawHill Education (Asia)
Slide 24
1. The Scattergraph Method
Maintenance Cost
1,000s of Dollars
Use one data point to estimate the total level of activity
and the total cost.
Y Total maintenance cost = $11,000
20
* *
* *
10
* ** *
**
Intercept = Fixed cost: $10,000
Patient days = 800
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Patientdays in 1,000s
Slide 25
1. The Scattergraph Method
Make a quick estimate of variable cost per unit and
determine the cost equation.
Total maintenance at 800 patients
Less: Fixed cost
Estimated total variable cost for 800 patients
Variable cost per unit = $1,000
800
$ 11,000
10,000
$ 1,000
= $1.25/patientday
Y = $10,000 + $1.25X
Total maintenance cost
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Number of patient days
Slide 26
2. The HighLow Method An Example
Assume the following hours of maintenance work
and the total maintenance costs for six months.
7,350
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Slide 27
2. The HighLow Method An Example
7,350
The variable cost
per hour of
maintenance is
equal to the change
in cost divided by
the change in hours.
$2,400
= $6.00/hour
400
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Slide 28
2. The HighLow Method An Example
Total Fixed Cost = Total Cost Total Variable Cost
Total Fixed Cost = $9,800 ($6/hour 850 hours)
Total Fixed Cost = $9,800 $5,100
Total Fixed Cost = $4,700
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Slide 29
2. The HighLow Method An Example
The Cost Equation for Maintenance
Y = $4,700 + $6.00X
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Slide 30
Quick Check 1
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the highlow method, what is the
variable portion of sales salaries and commission?
a. $0.08 per unit
b. $0.10 per unit
c. $0.12 per unit
d. $0.125 per unit
McGrawHill Education (Asia)
Slide 31
Quick Check 2
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000
units are sold. Using the highlow method, what is
the fixed portion of sales salaries and commissions?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
McGrawHill Education (Asia)
Slide 32
3. LeastSquares Regression Method
A method used to analyze mixed costs if a
scattergraph plot reveals an approximately linear
relationship between the X and Y variables.
This method uses all of the
data points to estimate
the fixed and variable
cost components of a
mixed cost.
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The goal of this method is
to fit a straight line to the
data that minimizes the
sum of the squared errors.
Slide 33
3. LeastSquares Regression Method
Software can be used to fit a
regression line through the data
points.
The cost analysis objective is
the same: Y = a + bX
=1[( )( )
2
=1( )
; =
Leastsquares regression also provides a statistic, called
the R2, which is a measure of the goodness
of fit of the regression line to the data points.
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Slide 34
3. LeastSquares Regression Method
Total Cost
R2 is the percentage of the variation in the dependent
variable (total cost) that is explained by variation in the
independent variable (activity).
Y
20
* *
* *2
10
* ** *
**
R varies from 0% to 100%, and
the higher the percentage the better.
0
0
McGrawHill Education (Asia)
2
3
Activity
Slide 35
Comparing Results From the Three Methods
The three methods just discussed provide
slightly different estimates of the fixed and
variable cost components of the mixed cost.
This is to be expected because each method
uses differing amounts of the data points to
provide estimates.
Leastsquares regression provides the most
accurate estimate because it uses all the data
points.
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Slide 36
End of Topic 3A
McGrawHill Education (Asia)
Slide 37
CostVolumeProfit Analysis
Topic 3B
2012 McGrawHill Education (Asia)
Topic 3B Learning Objectives
1.
2.
Prepare an income statement using the contribution
format
Understand costvolumeprofit (CVP) relations using
four approaches:
3.
Equation Method
Formula Method
BE Percentage Method
Graphical Method
Understand the meaning of, and be able to deal with:
Sensitivity Analysis
Margin of Safety
Operating Leverage
Multiple Products CVP
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Slide 39
Learning Objective 1
Prepare an income
statement using the
contribution format.
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Slide 40
The Contribution Format
Sales Revenue
Less: Variable costs
Contribution margin
Total
$ 100,000
60,000
$ 40,000
Less: Fixed costs
Net operating income
30,000
$ 10,000
Unit
$ 50
30
$ 20
The contribution margin format emphasizes cost
behavior. Contribution margin covers fixed costs
and provides for income.
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Slide 41
The Contribution Format
Used primarily for
external reporting.
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Used primarily by
management.
Slide 42
Learning Objective 2
Understand costvolumeprofit (CVP)
relations using four approaches:
1) Equation Method
2) Formula Method
3) BE Percentage Method
4) Graphical Method
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Slide 43
Basics of CostVolumeProfit Analysis
The contribution income statement is helpful to managers in judging the impact
on profits of changes in selling price, cost, or volume. The emphasis is on cost
behavior.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Sales (500 bicycles)
$
250,000
Less: Variable expenses
150,000
Contribution margin
100,000
Less: Fixed expenses
80,000
Net operating income
$
20,000
Contribution Margin (CM) is the amount remaining from sales revenue after
variable expenses have been deducted.
CM is used first to cover fixed expenses. Any remaining CM contributes to
net operating income.
McGrawHill Education (Asia)
Slide 44
Basics of CostVolumeProfit Analysis
Sales, variable expenses, and contribution margin can
also be expressed on a per unit basis. If Racing sells an
additional bicycle, $200 additional CM will be generated
to cover fixed expenses and profit.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
$
250,000
$
500
Less: Variable expenses
150,000
300
Contribution margin
100,000
$
200
Less: Fixed expenses
80,000
Net operating income
$
20,000
McGrawHill Education (Asia)
Slide 45
Basics of CostVolumeProfit Analysis
Each month, RBC must generate at least
$80,000 in total contribution margin to breakeven
(which is the level of sales at which profit is zero).
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
$
250,000
$
500
Less: Variable expenses
150,000
300
Contribution margin
100,000
$
200
Less: Fixed expenses
80,000
Net operating income
$
20,000
McGrawHill Education (Asia)
Slide 46
Basics of CostVolumeProfit Analysis
If RBC sells 400 units in a month, it will be
operating at the breakeven point.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (400 bicycles)
$
200,000
$
500
Less: Variable expenses
120,000
300
Contribution margin
80,000
$
200
Less: Fixed expenses
80,000
Net operating income
$

McGrawHill Education (Asia)
Slide 47
Basics of CostVolumeProfit Analysis
If RBC sells one more bike (401 bikes), net
operating income will increase by $200.
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (401 bicycles)
$
200,500
$
500
Less: Variable expenses
120,300
300
Contribution margin
80,200
$
200
Less: Fixed expenses
80,000
Net operating income
$
200
McGrawHill Education (Asia)
Slide 48
Basics of CostVolumeProfit Analysis
We do not need to prepare an income statement to
estimate profits at a particular sales volume. Simply
multiply the number of units sold above breakeven
by the contribution margin per unit.
If Racing sells
430 bikes, its net
operating income
will be $6,000.
McGrawHill Education (Asia)
Slide 49
CVP Relationships in Equation Form
The contribution format income statement can be
expressed in the following equation:
Profit = (Sales Variable expenses) Fixed expenses
= (SP x Q VC x Q) Fixed expenses
= (SP VC) x Q Fixed expenses
= Unit CM x Q Fixed expenses
where:
Unit CM = Selling price per unit Variable expenses per unit
= SP  VC
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Slide 50
CVP Relationships in Equation Form
To compute RBCs profit where 401 bikes are sold
using the equation method:
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Slide 51
Breakeven Analysis
Assume the following information for Racing Bicycle
Company (RBC). Determine the breakeven point in:
1) unit sales; 2) dollar sales
Racing Bicycle Company
Contribution Income Statement
For the Month of June
Total
Per Unit
Sales (500 bicycles)
$ 250,000
$ 500
Less: Variable expenses
150,000
300
Contribution margin
100,000
$ 200
Less: Fixed expenses
80,000
Net operating income
$ 20,000
McGrawHill Education (Asia)
Percent
100%
60%
40%
VC Ratio
CM Ratio
Slide 52
Contribution Margin Ratio (CM Ratio)
The contribution margin ratio at Racing Bicycle is:
CM per unit
=
CM Ratio =
SP per unit
$200
$500
= 40%
OR
$100,000
Total CM
= 40%
=
CM Ratio =
$250,000
Total Sales
The relationship between profit and the CM ratio can be
expressed using the following equation:
Profit = CM ratio Sales Fixed expenses
The CM ratio indicates the change in contribution margin
for every dollar change in sales. For e.g. if sales increase
by $50,000, total contribution margin will increase by
$20,000 (40% x $50,000)
McGrawHill Education (Asia)
Slide 53
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139
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Slide 54
Breakeven in Unit Sales:
1. Equation Method
Profits = Unit CM Q Fixed expenses
Profits are zero at the breakeven point, hence
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Slide 55
Breakeven in Unit Sales:
2. Formula Method
Lets apply the formula method to solve for
the breakeven point.
Unit sales to
=
break even
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Fixed expenses
CM per unit
Slide 56
Breakeven in Dollar Sales:
1. Equation Method
Profit = CM ratio Sales Fixed expenses
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Slide 57
Breakeven in Dollar Sales:
2. Formula Method
Now, lets use the formula method to calculate the
dollar sales at the breakeven point.
Dollar sales to
Fixed expenses
=
break even
CM ratio
McGrawHill Education (Asia)
Slide 58
Breakeven:
3. The BE Percentage Method
Now, lets use the 3rd method: the breakeven percentage
(BE%) method to calculate the breakeven point in units as
well as in sales $. This method also efficiently calculates
breakeven for multiple products.
BE% =
Since BE Sales $ =
BE% =
BE Sales $
Total Sales $
x 100%
FE
CM%
FE
CM%
Total Sales $
x 100% =
FE
CM%
1
Total Sales $
x 100%
Since CM% x Total Sales $ = CM
% =
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%
Slide 59
Breakeven in Unit and Dollar Sales:
3. The BE Percentage Method
Applying the BE% formula to the same company RBC
% =
% =
$,
$,
% = %
This means that the company requires 80% of its current
sales in order to breakeven.
Currently, the companys sales are $250,000 or 500 units.
A BE% of 80% means if the company sales are $200,000
($250,000 x 80%) or 400 units (500 units x 80%), the
company is breakeven.
These figures are consistent with both the equation and
the formula methods.
McGrawHill Education (Asia)
Slide 60
Quick Check 1
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the breakeven sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129
McGrawHill Education (Asia)
Slide 61
Quick Check 2
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the breakeven sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
McGrawHill Education (Asia)
Slide 62
Target Profit Analysis in Unit Sales
1. Equation Method
Suppose Racing Bicycle management wants to
know how many bikes must be sold to earn a
target profit of $100,000.
Profit = Unit CM Q Fixed expenses
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Slide 63
Target Profit Analysis in Unit Sales
2. Formula Method
Suppose Racing Bicycle management wants to
know how many bikes must be sold to earn a
target profit of $100,000.
Unit sales to attain
Target profit + Fixed expenses
=
the target profit
CM per unit
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Slide 64
Target Profit Analysis in Dollar Sales
1. Equation Method
Profit = CM ratio Sales Fixed expenses
Our goal is to solve for the unknown Sales
which represents the dollar amount of sales
that must be sold to attain the target profit.
Suppose RBC management wants to know the
sales volume that must be generated to earn a
target profit of $100,000.
McGrawHill Education (Asia)
Slide 65
Target Profit Analysis in Dollar Sales
2.Formula Method
We can calculate the dollar sales needed to
attain a target profit (net operating profit) of
$100,000 at Racing Bicycle.
Dollar sales to attain
Target profit + Fixed expenses
=
the target profit
CM ratio
McGrawHill Education (Asia)
Slide 66
Target Profit Analysis:
3. The BE Percentage Method
Modifying the BE% formula to add target profit to FE
+
Target Profit% =
%
$,+$,
Target Profit% =
x % =
$,
This means that the company requires 180% of its current
sales in order to obtain the target profit.
Currently, the companys sales are $250,000 or 500 units.
A Target Profit % of 180% means if the company sales
are $450,000 ($250,000 x 180%) or 900 units (500 units x
180%), the company has a target profit of $100,000.
These figures are consistent with both the equation and
the formula methods.
McGrawHill Education (Asia)
Slide 67
Quick Check 1
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense per month is $1,300.
Use the formula method to determine how many cups of
coffee would have to be sold to attain target profits of
$2,500 per month.
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
McGrawHill Education (Asia)
Slide 68
Quick Check 2
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
$0.36. The average fixed expense per month is $1,300.
Use the formula method to determine the sales dollars
that must be generated to attain target profits of $2,500
per month.
a. $2,550
b. $5,011
c. $8,458
d. $10,555
McGrawHill Education (Asia)
Slide 69
CVP Relationships in Graphic Form
The relationships among revenue, cost, profit and volume
can be expressed graphically by preparing a CVP graph.
Racing Bicycle developed contribution margin income
statements at 0, 200, 400, and 600 units sold. We will
use this information to prepare the CVP graph.
Units Sold
200
0
Sales
100,000
400
200,000
600
$
300,000
Total variable expenses
60,000
120,000
180,000
Contribution margin
40,000
80,000
120,000
80,000
80,000
80,000
80,000
Fixed expenses
Net operating income (loss)
McGrawHill Education (Asia)
(80,000)
(40,000)
40,000
Slide 70
Preparing the CVP Graph
$350,000
$300,000
$250,000
$200,000
$150,000
In a CVP graph, unit volume is usually
represented on the horizontal (X) axis
and dollars on the vertical (Y) axis.
$100,000
$50,000
$0
100
200
300
400
500
600
Units
McGrawHill Education (Asia)
Slide 71
Preparing the CVP Graph
Draw a line parallel to the volume axis
to represent total fixed expenses.
$350,000
$300,000
$250,000
$200,000
Fixed expenses
$150,000
$100,000
$50,000
$0
100
200
300
400
500
600
Units
McGrawHill Education (Asia)
Slide 72
Preparing the CVP Graph
Choose some sales volume, say 400 units, and plot the point representing
$300,000
total expenses
(fixed and variable). Draw a line through the data point
back to where the fixed expenses line intersects the dollar axis.
$350,000
$250,000
$200,000
Total expenses
Fixed expenses
$150,000
$100,000
$50,000
$0
100
200
300
400
500
600
Units
McGrawHill Education (Asia)
Slide 73
Preparing the CVP Graph
Choose some sales volume, say 400 units, and plot the point representing
$300,000
total sales.
Draw a line through the data point back to the point of origin.
$350,000
$250,000
$200,000
Sales
Total expenses
Fixed expenses
$150,000
$100,000
$50,000
$0
100
200
300
400
500
600
Units
McGrawHill Education (Asia)
Slide 74
Preparing the CVP Graph
Breakeven point
(400 units or $200,000 in sales)
$350,000
Profit Area
$300,000
$250,000
$200,000
Sales
Total expenses
Fixed expenses
$150,000
$100,000
$50,000
$0
Loss Area
McGrawHill Education (Asia)
100
200
300
400
500
600
Units
Slide 75
Preparing the CVP Graph
Profit = Unit CM Q Fixed Costs
$ 60,000
$ 40,000
Profit
$ 20,000
$0
$20,000
An even simpler form of
the CVP graph is called
the profit graph.
$40,000
$60,000
0
McGrawHill Education (Asia)
100
200
300
400
Number of bicycles sold
500
600
Slide 76
Preparing the CVP Graph
$ 60,000
Breakeven point, where
profit is zero , is 400
units sold.
$ 40,000
Profit
$ 20,000
$0
$20,000
$40,000
$60,000
0
McGrawHill Education (Asia)
100
200
300
400
Number of bicycles sold
500
600
Slide 77
Learning Objective 3
Understand the meaning of, and be
able to deal with:
1) Sensitivity Analysis
2) Margin of Safety
3) Operating Leverage
4) Multiple Products CVP
McGrawHill Education (Asia)
Slide 78
1. Sensitivity Analysis: Example 1
Changes in Fixed Costs and Sales Volume
What is the profit impact if Racing
Bicycle can increase unit sales from
500 to 540 by increasing the monthly
advertising budget by $10,000?
McGrawHill Education (Asia)
Slide 79
1. Sensitivity Analysis: Example 1
Changes in Fixed Costs and Sales Volume
$80,000 + $10,000 advertising = $90,000
Sales
Less: Variable expenses
Contribution margin
Less: Fixed expenses
Net operating income
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
540 units
$ 270,000
162,000
108,000
90,000
$
18,000
Sales increased by $20,000, but net operating
income decreased by $2,000.
McGrawHill Education (Asia)
Slide 80
1. Sensitivity Analysis: Example 1
Changes in Fixed Costs and Sales Volume
A shortcut solution using incremental
analysis
Increase in CM (40 units X $200)
Increase in advertising expenses
Decrease in net operating income
McGrawHill Education (Asia)
$ 8,000
10,000
$ (2,000)
Slide 81
1. Sensitivity Analysis: Example 2
Change in Variable Costs and Sales Volume
What is the profit impact if Racing
Bicycle can use higher quality raw
materials, thus increasing variable costs
per unit by $10, to generate an increase
in unit sales from 500 to 580?
McGrawHill Education (Asia)
Slide 82
1. Sensitivity Analysis:
Change in Variable Costs and Sales Volume
580 units $310 variable cost/unit = $179,800
Sales
Less: Variable expenses
Contribution margin
Less: Fixed expenses
Net operating income
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
580 units
$ 290,000
179,800
110,200
80,000
$
30,200
Sales increase by $40,000, and net operating income
increases by $10,200.
McGrawHill Education (Asia)
Slide 83
2. The Margin of Safety in Dollars
The margin of safety in dollars is the
excess of budgeted (or actual) sales over
the breakeven volume of sales.
Margin of safety in dollars = Total sales  Breakeven sales
Lets look at Racing Bicycle Company and
determine the margin of safety.
McGrawHill Education (Asia)
Slide 84
2. The Margin of Safety in Units
The margin of safety can be expressed in terms of
the number of units sold. The margin of safety at
RBC is $50,000, and each bike sells for $500;
hence, RBCs margin of safety is 100 bikes.
Margin of
=
Safety in units
$50,000
= 100 bikes
$500
OR
Margin of
=
Safety in units
McGrawHill Education (Asia)
500 400 = 100 bikes
Slide 85
2. The Margin of Safety in Percentage
If we assume that RBC has actual sales of $250,000, given that
we have already determined the breakeven sales to be
$200,000, the margin of safety is $50,000 as shown.
Breakeven
sales
400 units
Sales
$ 200,000
Less: variable expenses
120,000
Contribution margin
80,000
Less: fixed expenses
80,000
Net operating income
$

Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
RBCs margin of safety can be expressed as 20% of sales
($50,000 $250,000). This is also known as margin of
safety percentage or MoS%
McGrawHill Education (Asia)
Slide 86
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the margin of safety expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
McGrawHill Education (Asia)
Slide 87
Linking Margin of Safety % (to sales) and
Breakeven % (to sales)
Margin of safety in dollars = Total sales  Breakeven sales
Margin of safety in dollars
Total sales in dollars
= Margin of safety percentage (MoS%)
Total sales Breakeven sales
=
Total sales
Breakeven in dollars
=1
Total sales in dollars
= 1 Breakeven percentage
= 1 BE%
Therefore:
McGrawHill Education (Asia)
BE% = 1 MoS %
Slide 88
Calculate Breakeven given MOS (%)
RBCs margin of safety = 20% of sales
Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net operating income
Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
Breakeven sales of RBC = 1 20% = 80% of sales (or BE%)
= $250,000 x 80%
= $200,000
= Breakeven Sales on slide 86
McGrawHill Education (Asia)
Slide 89
3. Operating Leverage:
Cost Structure and Profit Stability
Cost structure refers to the relative proportion
of fixed and variable costs in an organization.
Managers often have some latitude in
determining their organizations cost structure.
McGrawHill Education (Asia)
Slide 90
3. Operating Leverage:
Cost Structure and Profit Stability
There are advantages and disadvantages to high fixed cost
(or low variable cost) and low fixed cost (or high variable
cost) structures.
An advantage of a high fixed
cost structure is that income A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies
will be lower in bad years
with lower proportion of
compared to companies
fixed costs.
with lower proportion of
fixed costs.
Companies with low fixed cost structures enjoy greater
stability in income across good and bad years.
McGrawHill Education (Asia)
Slide 91
3. Operating Leverage:
Managing fixed costs
Typical fixed costs: production facilities, rentals, employees
salaries and related benefits and utilities
Converting them into variable may reduce risk of financial commitment
and provide flexibility of capacity utilization
Outsourcing  switching to variable costs
Business with fast and regular change and/or large varieties of
products most likely will benefit from this approach e.g. Nike and
Apple
Noncore business functions with lower valueadd to majority
customers e.g. call centers for enquiries, 3rd party logistics, brokerdealers securities back office operations
Offshoring  reducing fixed costs
Honda and Toyota Thailand plants
HSBC back office functions in China
McGrawHill Education (Asia)
Slide 92
3. Operating Leverage
Operating leverage is a measure of how sensitive net
operating income is to percentage changes in sales.
It is a measure, at any given level of sales, of how a
percentage change in sales volume will affect profits.
Contributi on Margin
DOL Degree of Operating Leverage
Net Operating Income * *
** Profit Before Tax is a commonly used alternative to Net Operating
Income in the degree of operating leverage calculation
McGrawHill Education (Asia)
Slide 93
3. Operating Leverage
To illustrate, lets revisit the contribution income statement
for RBC.
Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income
Degree of
Operating
Leverage
McGrawHill Education (Asia)
Actual sales
500 Bikes
$ 250,000
150,000
100,000
80,000
$
20,000
Slide 94
3. Operating Leverage
With an operating leverage of 5, if RBC
increases its sales by 10%, net operating
income would increase by 50%.
Percent increase in sales
Degree of operating leverage
Percent increase in profits
10%
5
50%
Heres the verification!
McGrawHill Education (Asia)
Slide 95
3. Operating Leverage
Actual sales
(500)
Sales
$ 250,000
Less variable expenses
150,000
Contribution margin
100,000
Less fixed expenses
80,000
Net operating income
$
20,000
Increased
sales (550)
$ 275,000
165,000
110,000
80,000
$
30,000
10% increase in sales from
$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.
McGrawHill Education (Asia)
Slide 96
Quick Check 1
Coffee Klatch is an espresso stand in a
downtown office building. The average selling
price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average
fixed expense per month is $1,300. 2,100 cups
are sold each month on average. What is the
operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
McGrawHill Education (Asia)
Slide 97
Quick Check 2
At Coffee Klatch the average selling price of a cup of
coffee is $1.49, the average variable expense per cup
is $0.36, the average fixed expense per month is
$1,300 and an average of 2,100 cups are sold each
month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
McGrawHill Education (Asia)
Slide 98
What does higher value of Operating
Leverage mean?
High Operating Leverage ratio
signals the existence of high fixed costs.
increases risk of making loss in adverse market
conditions.
increases opportunity to make profit when higher
demand exists.
has lower margin of safety percentage (MoS%)
1
DOL
MoS%
McGrawHill Education (Asia)
Slide 99
Proof of Operating Leverage and Profit
Movement Relationship
Benchmark Co.
High F.C. Co.
$3,200,000
$3,200,000
$800
$800
($300)
($150)
Unit Contribution margin
$500
$650
Unit sales (Same)
4,000
4,000
$2,000,000
$2,600,000
($1,500,000)
($2,100,000)
(P)
500,000
500,000
Degree of operating leverage (CM/P)
4.0
5.2
Total Sales (Same)
Unit selling price (Same)
Unit variable costs
Contribution margin
(CM)
Fixed costs
Net Operating Profit (Same)
McGrawHill Education (Asia)
Slide 100
Proof of Operating Leverage and Profit
Movement Relationship
Benchmark Co.
High F.C. Co.
12.5%
12.5%
Degree of operating leverage
X 4.0
X 5.2
Increase in profits
50%
65%
Unit contribution margin
$500
$650
Unit change in sales (4,000 x 12.5%)
x 500
x 500
$250,000
$325,000
50%
65%
Increase in sales
Proof:
Change in profits
Percentage increase from the original
$500,000 profit
McGrawHill Education (Asia)
Slide 101
Proof of Operating Leverage and MoS%
Relationship
Benchmark Co.
High F.C. Co.
Total Sales (Same)
(S)
$3,200,000
$3,200,000
Contribution margin
(CM)
$2,000,000
$2,600,000
Fixed costs
(F)
($1,500,000)
($2,100,000)
Net Operating Profit (Same)
(P)
500,000
500,000
Degree of operating leverage (CM/P)
4.0
5.2
2,400,000
2,584,615
75%
80.77%
25%
19.23%
4.0
5.2
Breakeven Sales Dollars [F/(CM/S)]
Breakeven % (to sales)
MoS% = 1 BE%
1/MoS%
= Degree of operating leverage
McGrawHill Education (Asia)
Slide 102
4. The Concept of Sales Mix
Sales mix is the relative proportion in which a
companys products are sold.
Different products have different selling prices,
cost structures, and contribution margins.
When a company sells more than one product,
breakeven analysis becomes more complex as
the following example illustrates.
McGrawHill Education (Asia)
Slide 103
MultiProduct BreakEven Analysis
1. The BE% Method
Virtual Journeys Le Louvre and Le Vin sales and profit data are as follows:
Le Louvre (200)
Sales
$ 20,000
Variable expenses
15,000
Contribution margin
5,000
Fixed expenses
Net operating income
Sales
$ 20,000
Le Vin (400)
$ 80,000
40,000
40,000
$80,000
x
BE% = 60%
Breakeven sales
$12,000
$48,000
Total breakeven sales = $60,000
Breakeven units
120 units
240 units
Total
$ 100,000
55,000
45,000
27,000
$ 18,000
Contribution Margin
1
Net Operating Income MoS%
Net Operating Income
MoS%
Contribution Margin
18,000
MoS%
40%
45,000
MoS% 1 BE%
BE% 1 MoS% 1 40% 60%
DOL
Total breakeven units = 360 units
McGrawHill Education (Asia)
Slide 104
MultiProduct BreakEven Analysis
2. The WeightedAverage CM Ratio Method
Le Louvre comprises 20% of Virtual Journeys total sales
revenue and Le Vin comprises the remaining 80%. Virtual
Journey provides the following information:
Le Louvre (200 units)
Sales
$ 20,000
100%
Variable expenses
15,000
75%
Contribution margin
5,000
25.0%
Fixed expenses
Net operating income
Le Vin (400 units)
$
80,000
100%
40,000
50%
40,000
50%
Total
$ 100,000
100.0%
55,000
55.0%
45,000
45.0%
27,000
$ 18,000
Sales mix
$ 100,000
20,000
20%
Weightedaverage CM Ratio
= (20% x 25%) + (80% x 50%) OR
= 45%
McGrawHill Education (Asia)
80,000
80%
100%
Weightedaverage CM Ratio
= 45,000/100,000
= 45%
Slide 105
MultiProduct BreakEven Analysis
2. The WeightedAverage CM Ratio Method
Dollar sales to
Fixed expenses
=
break even
CM ratio
Dollar sales to
break even
$27,000
45%
= $60,000
Le Louvre (200 units)
Sales
$
12,000
100%
Variable expenses
9,000
75%
Contribution margin
3,000
25%
Fixed expenses
Net operating income
Le Vin (400 units)
$ 48,000
100%
24,000
50%
24,000
50%
Sales mix
McGrawHill Education (Asia)
12,000
20%
48,000
80%
Total
60,000
33,000
27,000
27,000

60,000
100.0%
55.0%
45.0%
100.0%
Slide 106
MultiProduct BreakEven Analysis
3. The WeightedAverage CM Method
Le Louvre comprises 33.33% of Virtual Journeys total unit
sales and Le Vin comprises the remaining 66.66%. Virtual
Journey provides the following information:
Le Louvre (200 units)
Sales
$ 20,000
100%
Variable expenses
15,000
75%
Contribution margin
5,000
25.0%
Fixed expenses
Net operating income
Unit CM
Sales mix (in units)
$25
200 units
33.33%
Le Vin (400 units)
$
80,000
100%
40,000
50%
40,000
50%
$100
400 units
66.66%
Total
$ 100,000
100.0%
55,000
55.0%
45,000
45.0%
27,000
$ 18,000
600 units
100%
Weightedaverage CM
= (1/3 x $25) + (2/3 x $100)
= $75
McGrawHill Education (Asia)
Slide 107
MultiProduct BreakEven Analysis
3. The WeightedAverage CM Method
Unit sales to
break even
Unit sales to
break even
Le Louvre (200 units)
Sales
$
12,000
100%
Variable expenses
9,000
75%
Contribution margin
3,000
25%
Fixed expenses
Net operating income
Sales mix (in units)
McGrawHill Education (Asia)
120 units
33%
Fixed expenses
Unit CM
$27,000
$75
= 360 units
Le Vin (400 units)
$ 48,000
100%
24,000
50%
24,000
50%
$
240 units
67%
Total
60,000
33,000
27,000
27,000
360 units
100.0%
55.0%
45.0%
100.0%
Slide 108
Key Assumptions of CVP Analysis
Selling price is constant.
Costs are linear and can be accurately divided into
variable (constant per unit) and fixed (constant in
total) elements.
In multiproduct companies, the sales mix is
constant.
In manufacturing companies, inventories do not
change (units produced = units sold).
McGrawHill Education (Asia)
Slide 109
Quick Check
McGrawHill Education (Asia)
Slide 110
Quick Check
McGrawHill Education (Asia)
Slide 111
Quick Check
McGrawHill Education (Asia)
Slide 112
Quick Check
McGrawHill Education (Asia)
Slide 113
End of Topic 3B
McGrawHill Education (Asia)
Slide 114