CHAPTER SIX

Cost Behavior Patterns & CVP Analysis

Learning Objectives:
After studying this chapter, you should be able to-
 Understand the behavioral patterns of costs
 Explain the relationship between operating income and net income.
 Understand the importance of CVP-Analysis.
 Illustrate how CVP can assist cost planning
 Illustrate how CVP can assist can incorporate income taxes.
 Explain how sensitivity analysis can help managers cope with
uncertainty

Cost Behavior Patterns

Management accounting systems record the cost of resources acquired and track
their subsequent usage. Costs may be classified according to functions – such as
manufacturing, administrative, general or selling – important for external
reporting.
Cost behavior refers to the classification of costs according to their behavioral
pattern, that is, the way costs change as volume of production output (activity0
changes.
The analytical study of the behavior of costs in relation to changes in volume of
production output reveals that:
 There are some items of costs which tend to vary directly with the volume
of output;
 Whereas there are others which remain an affected by variations in the
volume of output.
The former classes of costs represent the variable cost and the latter fixed costs.
Besides there are certain items of costs which are partly fixed and partly variable
and are known as semi-variable or semi-fixed or mixed costs.

(a) Fixed costs: also known as non-variable costs, stand-by costs, period
costs, or capacity costs are those costs which do not vary with change in
volume of output over a given period of time and within a relevant range of
activity.
Examples: Rent & Taxes of buildings, insurance charges & depreciation of plant,
machinery and buildings, salaries of foremen, workers, managers, permanent
staff and executives.
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There is an inverse relationship between volumes of output and fixed costs per
unit; whereas, remain constant in total per period. The equation for fixed costs is:

Fixed Costs (FC) = a

(b) Variable costs: are costs which fluctuate, in total, in direct proportion to
the volume of output or sales.
Examples include the costs of direct materials, direct labor, supplies and direct
expenses like sales commissions.
Variable costs are uniform (linear) incremental costs per unit of output. The
equation for Variable costs is:

Total Variable costs (TVC) = Unit variable costs x units (volume)

(c) Semi-Variable (Mixed) Costs: are a combination of fixed and variable costs
and are, thus, also known as “mixed costs.” Such costs are neither
perfectly variable nor absolutely fixed in relation to changes in the volume
of output. Examples: utility bills, such as power costs, telephone charges,
repairs and maintenance costs, etc.
The fixed component of such costs represents the cost of providing capacity and
the variable component is caused by using the capacity. For example, power
costs include a “fixed portion” a “minimum charge’ that will be charged even if
you do not consume power, and “variable charges” based on consumption of
power. The equation for mixed costs is:

Total Mixed cost (TMC) = Fixed Costs + UVC x units (volume)

Total Costs for the Organization

An organization’s total costs consist of the sum of its fixed costs, variable costs,
and mixed costs. The behavioral pattern for Total Cost is developed by combining
fixed, variable, and mixed costs.

The equation for total costs is:

Total Costs = Fixed Costs + Variable costs Per Unit X Units (volume)

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In the equation for total costs fixed costs and fixed element of fixed costs are
both included in the “Fixed Costs.” Likewise, variable costs and variable
elements of mixed costs are both included in “variable Costs.”

The equation for total costs corresponds to the general equation for a “straight-
line.”

Y = a + bx

The Importance of CVP Analysis

Cost-Volume-Profit (CVP) analysis is a technique used to analyze (examine) the
relationships between volume of output, total costs, total revenues, and profits.
CVP analysis can be used to examine how various alternatives that a decision
maker is considering affect operating income. The management of a company
wants reasonable correct answers to the following questions about future
operations:
(1) At what level of sales will the firm just cover all costs and expenses, i.e.
breakeven?
(2) If selling price is changed or if costs and expenses are changed, what will be
the effect on profits?
(3) In order to earn a certain dollar profit, how much sales will have to be?
The breakeven chart answers to these questions.
It is important to agree on the meaning of key terms in this chapter. This section
defines several terms central to understanding CVP analysis. We use the following
synonyms for the key terms:
Key term Synonym
Operating revenues Sales
Operating Costs Operating Expenses
Operating Income Operating Profit
In this chapter, operating costs are assumed to be made up of only two cost
categories – variable operating costs (variable with respect to production and
sales output units) and fixed operating costs.

Operating costs = variable operating costs + Fixed operating costs

Operating Income is operating revenues for the accounting period minus all
operating costs, including cost of goods sold:

Operating income = operating revenues - Operating costs

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Net Income is operating income plus non-operating revenues (such as interest
revenue) minus non-operating costs (such as interest costs) minus income taxes.
For simplicity, throughout this chapter non-operating revenues and non-
operating costs are assumed to be zero. Thus, the net income will be computed as
follows:

Net income = operating income – Income Taxes

In the example that follows, the measure of output is the number of units
manufactured or units sold.

Example:

The Small Business Specialities Company

Condensed Income Statement
For Year-Ending Dec. 31, 2015
Net sales (60,000 units @ $20 per unit) $1,200,000
Less: Costs and Expenses:
Variable Fixed
Direct material $195,000
Direct labor 215,000
Manufacturing Expenses 100,000 200,000
Selling Expenses 50,000 50,000
General & Administrative Expenses 160,000 50,000
Total $720,000 $400,000 1,120,000
Operating Profit $ 80,000

Break even Analysis

Q1. How many units must be sold to break even (BE)?
Solutions:

(a) Equation Method

The first approach for computing the breakeven point is the equation
method. Using the terminology in this chapter, the income statement can
be expressed in equation form as follows:

Revenues – Variable costs – Fixed Costs = operating income

This equation provides the most general and easy-to-remember approach

to any CVP situation. For the example above, let N = number of units sold
to break even.

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 Setting operating income equals to zero in the above equation:

$20N - $12N - $400,000 = $0

$8N = $400,000
N = $400,000 ÷ $8 = 50,000 units

If The Small Business Specialities Company sells fewer than 50,000

units she will have a loss, if she sells 50,000 units she will break even, and
if she sells more than 50,000 units she will make profit. This break even is
expressed in units. It can also be expressed in sales dollars: 50,000 units x
$20 selling price = $1,000,000.

(b) Contribution Margin Method

A second approach is the contribution margin method. Contribution
margin is equal to revenues minus all costs that vary (variable costs) with
respect to an output units.
This method uses the fact that:

Selling x Number – Unit variable x Number – Fixed costs = Operating income

Price of units costs of Units

Selling x Number – Unit variable x Number = Fixed costs + Operating income

Price of units costs of Units

Unit contribution x Number = Fixed costs + Operating income

margin of Units

Because at the break even number of units, operating income is by definition

zero, we obtain:
Unit contribution x Break even = Fixed costs
margin Number of Units

This gives us a general formula for a single product and based on output units:

Break even = Fixed costs_______

Number of Units Unit contribution margin

In our example, fixed costs are $400,000 and the unit contribution margin is $8:

Unit contribution = Selling - Unit variable

margin Price costs
$8 = $20 - $12
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 Therefore,

Break even = Fixed costs_______ = $400,000

Number of Units Unit contribution margin $8

= 50,000 units

If the calculations in the equation method and the contribution margin

method appear similar, it is because one is merely a restatement of the
other.
The following condensed contribution Income Statement can be used to
confirm the breakeven calculation:
Total
Revenues, $20 x 50,000 units $1,000,000
Variable costs, $12 x 50,000 600,000
Contribution margin, $8 x 50,000 400,000
Fixed costs 400,000
Operating Income $ 0

A contribution Income Statement groups individual line items to highlight the

contribution margin, which is the difference between revenues and all costs that
vary with respect to output units.

Target Operating Income

Q2. To earn before tax profit of $120,000, how many units must be sold?
Solutions:

Target volume = Fixed costs_+ Operating Income

(Number of Units) Unit contribution margin

Thus,
Target volume = $400,000 + $120,000
(Number of Units) $8

= $520,000
$8

= 65,000 units

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Role of Income Taxes
The only change in the equation method of CVP analysis is to modify the target
operating income to allow for taxes.

Revenues – Variable costs – Fixed Costs = operating income

We now introduce the income tax effects:

Target net Income = Operating Income – (operating income x Tax rate)

= Operating Income x (1 - Tax rate)

Thus,

Operating Income = Target Net Income

(1 - Tax rate)

So taking income taxes into account, the equation method yields:

Revenues – Variable costs – Fixed Costs = Target Net Income

(1 - Tax rate)

Q3. To earn an after tax profit of $48,000; how many units must be sold?
Small Business Specialities Company is subject to income tax rate of 40%.
Solutions:
Substituting numbers from our Small Business Specialities Company
example, the equation would now be:

$20N - $12N - $400,000 = Target Net Income

(1 - Tax rate)

$20N - $12N - $400,000 = $48,000

(1 – 0.40)

$20N - $12N - $400,000 = $48,000

0.60

$20N - $12N - $400,000 = $80,000

$8N = $480,000

N = 60,000units

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Proof:
Total
Revenues, $20 x 60,000 units $1,200,000
Variable costs, $12 x 60,000 720,000
Contribution margin, $8 x 60,000 480,000
Fixed costs 400,000
Operating Income $ 80,000
Income Taxes, $80,000 x 0.40 $ 32,000
Net Income $ 48,000

The presence of income taxes will not change the breakeven point. Why?
Because, by definition, operating income at the breakeven point is zero and
thus no income taxes will be paid.

In sum, CVP Analysis must be done carefully because one or more initial
assumptions may not hold. When the assumed conditions change; the
breakeven point and the expected operating income at various output levels also
change. Of course, the breakeven points are frequently incidental data. Instead,
the focus is on the effects on operating income under various production and
sales strategies.

Uncertainty & Sensitivity Analysis

Our CVP models often conveniently assume certainty regarding the levels of
variable costs, fixed costs, output and other factors. Obviously, our estimates and
predictions are subject to varying degrees of uncertainty; which is defined here
as the possibility that an actual amount will deviate from an expected amount.

How do we cope with uncertainty? There are many complex models available
that formally analyze expected values in conjunction with probability
distributions. But, the application of Sensitivity Analysis to an original solution
is the most widely used approach.

In the context of CVP, sensitivity analysis answers such questions as, what will
operating income be if the output levels decreases by 5% from the original
prediction? And what will operating income be if variable costs per unit increases
by 10%?

The sensitivity to various possible outcomes broaden managers’ perspectives as

too what might actually occur despite their well-laid plans.

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A tool of sensitivity analysis is the margin of safety (M.S.), which is the excess of
budgeted revenues over the breakeven revenues. The margin of safety is the
answer to the “what ... if’ question: If budgeted revenues are above breakeven
point and drop, how can they fall below budget before the breakeven point is
reached?

Assume Small Business Specialities Company has fixed costs $400,000, a

selling price of $20, and unit variable costs of $12. For 60,000 units sold the
budgeted revenue are $1,200,000 and the budgeted operating income is $80,000.

The breakeven revenue point for this set of assumptions is $1,000,000 or

50,000 units.

Here the margin of safety is $200,000 ($1,200,000 – $1,000,000) or 10,000

units (60,000 units – 50,000 units) is usually expressed as a percentage of
budgeted sales as follows:

Margin of Safety = Budgeted Sales – BE Sales x 100

In percentage Budgeted Sales

M.S. = $1,200,000 (or 60,000 units) - $1,000,000 (or 50,000 units) x 100
$1,200,000 (or 60,000 units)

M.S. = 16.7%

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