Cost behavior & terminology

COST BEHAVIOR &
TERMINOLOGY
ACCOUNTING & COST MANAGEMENT
TEM: 303
MD. GOLAM SAROWER RAYHAN
LECTURER, TEM, BUTEX

COST CLASSIFICATIONS IN MANUFACTURING
COMPANIES
Purpose of classification Cost classifications
Preparing an income statement
and balance sheet
• Product costs (Manufacturing cost)
• Direct materials
• Direct labor
• Manufacturing overhead
• Period costs (non manufacturing costs)
• Marketing and selling costs
• Administrative costs
Predicting changes in cost due to
changes in activity
• Variable costs
• Fixed costs
Assigning costs • Direct costs
• Indirect costs
Making decisions • Differential costs
• Sunk costs
• Opportunity costs

The Product
Direct
Materials
Direct
Labor
Manufacturing
Overhead
MANUFACTURING COSTS
Manufacturing costs are usually grouped into three main
categories: direct materials, direct labor, and
manufacturing overhead. These costs are incurred to make
a product.

DIRECT MATERIALS
Direct materials are raw materials that become an integral part
of the finished product and whose costs can be conveniently
traced to it.
Examples include the aircraft engines on a Boeing 777, the
Intel processing chip in a personal computer, the blank video
cassette in a pre-recorded video, and a radio in an
automobile.
Costing of Material:
Company A produced 1,000 tables. To produce 1,000 tables,
the company incurred costs of:
$12,000 on wood
$100 for a bag of nails to hold the tables together
Total material costs: $12,000 (direct material) [$100 (indirect
material)]

DIRECT LABOR
Direct labor consists of that portion of labor cost that can be
easily traced to a product. Direct labor is sometimes referred
to as “touch labor,” since it consists of the costs of workers
who “touch” the product as it is being made.
Examples include mechanics & worker work in manufacturing
a car engine, worker employed in assembly of electronic parts.
Costing of Labor:
Company A produced 1,000 tables. To produce 1,000 tables,
the company incurred costs of:
• $2,000 on wages for carpenters and $500 on wages for
security guards to overlook the manufacturing facility
Total labor costs: $2,000 (direct labor) [$500 (indirect labor)]
Per Unit Labor Cost= $2000/1000 tables= $2

MANUFACTURING OVERHEAD
Manufacturing overhead includes all manufacturing costs
except direct materials and direct labor. These costs cannot be
easily traced to specific units produced (also called indirect
manufacturing cost, factory overhead, and factory burden).
Manufacturing overhead= indirect material + indirect labor
Company A produced 1,000 tables. To produce 1,000 tables, the company incurred
costs of:
• $500 on wages for security guards to overlook the manufacturing facility
• $100 for a bag of nails to hold the tables together
• $500 for factory rent and utilities
• Total Manufacturing Overhead cost: $500 (Indirect Labor) + $ 100 (Indirect
Material) + $ 500 (rent & utility-other cost)= $1100
• Per Unit Manufacturing Overhead (OH) Cost= $ 1100/1000= $ 1.1

Indirect materials Indirect labor
Other Cost
Materials used to
support the
production process.
Examples: lubricants and
cleaning supplies used in
the automobile assembly
plant. Stationary
equipment used in a
factory
Wages paid to employees
who are not directly
involved in production
work.
Examples:
maintenance workers
and security guards.
Examples: Property
Tax, Depreciation cost,
insurance on
manufacturing facility,
factory rent.

Manufacturing Overhead (MOH) can be applicable to two segments:
• Machine Overhead Cost
• Labor Overhead Cost
• Machine Overhead Cost=
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐷𝑎𝑦 𝑋 𝑇𝑜𝑡𝑎𝑙 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝑤𝑜𝑟𝑘𝑖𝑛𝑔
• Labor Overhead Cost=
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐹𝑎𝑐𝑡𝑜𝑟𝑦 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐷𝑎𝑦 𝑋 𝑇𝑜𝑡𝑎𝑙 𝐿𝑎𝑏𝑜𝑟 𝑤𝑜𝑟𝑘𝑖𝑛𝑔
• If a firm has monthly expense $10000, total machine is 400 & total
labor is 200 person then
• M/C Overhead cost=
10000
= $0.96

NON-MANUFACTURING COST
Also called selling, general & administrative cost (SGA- cost)
Selling costs include all costs necessary to secure customer orders and get the
finished product into the hands of the customer. These costs are also referred to as
order-getting and order-filling costs.
Administrative costs include all executive, organizational, and clerical costs
associated with the general management of an organization.
Administrative
Costs
executive compensation,
general accounting,
secretarial, public relations,
and similar costs .
Selling
Costs
advertising, shipping, sales
travel, sales commissions,
sales salaries, and costs of
finished goods warehouses.

ANOTHER CLASSIFICATION OF COST
• Two more cost categories are often used in discussions of
manufacturing
• Prime cost is the sum of direct materials cost and direct labor cost
• Conversion cost is the sum of direct labor cost and manufacturing
overhead cost.
The term conversion cost is used to describe direct labor and
manufacturing overhead because these costs are incurred to convert
materials into the finished product.
Direct
Material
Direct
Labor
Manufacturin
g
Overhead
Prime
Cost
Conversio
n
Cost

MERCHANDISERS . .
.
BUY FINISHED
GOODS.
SELL FINISHED
GOODS.
MANUFACTURERS .
. .
BUY RAW
MATERIALS.
PRODUCE AND
SELL FINISHED
GOODS.
MegaLoMart
COMPARISON OF MERCHANDISING & MANUFACTURING

COST OF GOODS SOLD & COST OF GOODS
MANUFACTURED
• COST OF GOODS MANUFACTURED
(COGM)
• THE COST OF GOODS MANUFACTURED (COGM),
ALSO CALLED COST OF GOODS COMPLETED,
CALCULATES THE TOTAL VALUE OF INVENTORY
THAT WAS PRODUCED DURING THE PERIOD
AND IS READY FOR SALE
• COGM= BEGINNING WIP INVENTORY COST+
TOTAL MANUFACTURING COST- ENDING WIP
INVENTORY COST
• TOTAL MANUFACTURING COST= DIRECT
MATERIAL COST + DIRECT LABOR COST +
MANUFACTURING OVERHEAD COST
• COST OF GOODS SOLD (COGS)
• THE COST OF GOODS SOLD
CALCULATES THE TOTAL VALUE OF
INVENTORY THAT WAS PRODUCED
DURING THE PERIOD AND ALREADY
SOLD.
• COGS= BEGINNING FINISHED GOODS
INVENTORY COST + COST OF GOODS
MANUFACTURED (COGM) – ENDING
FINISHED GOODS INVENTORY
• MERCHANDISING COMPANIES ONLY
HAVE COGS BUT MANUFACTURING
COMPANIES MAY HAVE BOTH COGM &
COGS

COMPARISON OF MERCHANDISING & MANUFACTURING
COST OF GOODS SOLD FOR MANUFACTURERS DIFFERS ONLY
SLIGHTLY FROM COST OF GOODS SOLD FOR MERCHANDISERS.

BEGINNING RAW MATERIALS INVENTORY WAS $32,000. DURING THE MONTH, $276,000 OF
RAW MATERIAL WAS PURCHASED. A COUNT AT THE END OF THE MONTH REVEALED THAT
$28,000 OF RAW MATERIAL WAS STILL PRESENT. WHAT IS THE COST OF DIRECT MATERIAL
USED?
A. $276,000
B. $272,000
C. $280,000
D. $ 2,000

BEGINNING WORK IN PROCESS WAS $125,000. MANUFACTURING COSTS INCURRED FOR THE
MONTH WERE $835,000. THERE WERE $200,000 OF PARTIALLY FINISHED GOODS
REMAINING IN WORK IN PROCESS INVENTORY AT THE END OF THE MONTH. WHAT WAS THE
COST OF GOODS MANUFACTURED DURING THE MONTH?
A.$1,160,000
B.$ 910,000
C.$ 760,000
D.CANNOT BE DETERMINED.

BEGINNING FINISHED GOODS INVENTORY WAS $130,000. THE COST OF GOODS
MANUFACTURED FOR THE MONTH WAS $760,000. AND THE ENDING FINISHED GOODS
INVENTORY WAS $150,000. WHAT WAS THE COST OF GOODS SOLD FOR THE MONTH?
A. $ 20,000.
B. $740,000.
C. $780,000.
D. $760,000.
$130,000 + $760,000 = $890,000
$890,000 - $150,000 = $740,000

ASSIGNING COST TO COST OBJECTS
DIRECT COSTS
• COSTS THAT CAN BE
EASILY AND
CONVENIENTLY TRACED
TO A UNIT OF PRODUCT
OR OTHER COST OBJECT.
• EXAMPLES: DIRECT
MATERIAL AND DIRECT
LABOR
INDIRECT COSTS
• COSTS THAT CANNOT BE
EASILY AND
CONVENIENTLY TRACED
TO A UNIT OF PRODUCT
OR OTHER COST OBJECT.
• EXAMPLE:
MANUFACTURING
OVERHEAD

COST CLASSIFICATION FOR DECISION MAKING
It is important to realize that every decision
involves a choice between at least two
alternatives.
To make decisions, it is essential to have a
grasp on three concepts:
Differential costs,
Opportunity costs, and
Sunk costs.

DIFFERENTIAL COST AND REVENUE
DIFFERENTIAL COSTS (OR INCREMENTAL COSTS) IS A DIFFERENCE IN COST
BETWEEN ANY TWO ALTERNATIVES. DIFFERENTIAL COSTS CAN BE EITHER
FIXED OR VARIABLE. A DIFFERENCE IN REVENUE BETWEEN TWO
ALTERNATIVES IS CALLED DIFFERENTIAL REVENUE.
Example: You have a job paying $1,500 per month
in your hometown. You have a job offer in a
neighboring city that pays $2,000 per month. The
commuting cost to the city is $300 per month.
Differential revenue is:
$2,000 – $1,500 = $500
Differential cost is:
$300

OPPORTUNITY COST
THE POTENTIAL BENEFIT THAT IS GIVEN UP
WHEN ONE ALTERNATIVE IS SELECTED OVER
ANOTHER.
Example: If you were not attending college, you
could be earning $15,000 per year. Your
opportunity cost
of attending college for one year is $15,000.

SUNK COSTS
SUNK COSTS HAVE ALREADY BEEN INCURRED AND CANNOT
BE CHANGED NOW OR IN THE FUTURE.
THESE COSTS SHOULD BE IGNORED WHEN MAKING DECISIONS.
Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $10,000
cost.

IDLE TIME
The labor costs incurred during idle
time are ordinarily treated as
manufacturing overhead.
Machine
Breakdowns
Material
Shortages
Power
Failures
OVERTIME
The overtime premiums for all factory workers are
usually considered to be part of manufacturing
overhead.
This is done to avoid penalizing particular products or
customer orders simply because they happen to fall
on the tail end of the daily production schedule.

LABOR FRINGE BENEFITS
Labor fringe benefit costs are employment-related
costs paid by an employer, such as insurance
programs, retirement plans, and supplemental
unemployment programs.
They also include the employer’s share of Social
Security and Medicare, workers’ compensation, federal
employment tax, and state unemployment insurance.
These costs often add up to 30 to 40 percent of an
employee’s base pay.
Some companies
include all of
these costs in
manufacturing
overhead.
Other companies
treat fringe
benefit expenses
of direct laborers
as additional

COST ESTIMATING RELATIONSHIP METHODS
Mathematical equation in which a cost is expressed as
a dependent variable of one or more independent cost
driving (see cost driver) variables, or as a function of
one or more technical parameters.
• Parametric: The parametric technique uses regression or other statistical methods to develop
Cost Estimating Relationships (CERs). A CER is an equation used to estimate a given cost
element using an established relationship with one or more independent variables.
• Analogy: An analogy is a technique used to estimate a cost based on historical data for an
analogous system or subsystem. In this technique, a currently fielded system, similar in
design and operation to the proposed system, is used as a basis for the analogy.
• Engineering Estimate: With this technique, the system being costed is broken down into
lower-level components (such as parts or assemblies), each of which is costed separately for
direct labor, direct material, and other costs.
• Actual Costs: With this technique, actual cost experience or trends (from prototypes,
engineering development models, and/or early production items) are used to project
estimates of future costs for the same system. These projections may be made at various
levels of detail, depending on the availability of data.

• ECONOMIC & ACCOUNTING COST
• ECONOMIC COST: TOTAL COST INCLUDING BOTH
EXPLICIT AND IMPLICIT COSTS.
• ACCOUNTING COST: TOTAL COST INCLUDE ONLY
EXPLICIT COST
• EXPLICIT AND IMPLICIT COSTS
• A FIRM’S COST OF PRODUCTION INCLUDE EXPLICIT
COSTS AND IMPLICIT COSTS.
• EXPLICIT COSTS ARE INPUT COSTS THAT REQUIRE A
DIRECT OUTLAY OF MONEY BY THE FIRM. EX: TRAVEL
EXPENSES, THE COST OF A HOTEL ROOM, AND COSTS
RELATED TO ENTERTAINMENT.
• IMPLICIT COSTS ARE INPUT COSTS THAT DO NOT REQUIRE
AN OUTLAY OF MONEY BY THE FIRM. EX: NOT PAYING
RENT ON THE SELF-OWNED PROPERTY,

PRODUCT COSTING NEED KNOWLEDGE OF COST BEHAVIOR
COST BEHAVIOR PATTERN HELPS TO DETERMINE COST FOR DIFFERENT
MATERIALS
• COST BEHAVIOR PROVIDES PROPER DIRECTION OF FIXED & VARIABLE COST
ASSOCIATED WITH THE PRODUCT
• IN CASE OF MIXED COST THIS COST BEHAVIOR PROVIDES ACCURATE
PROPORTION OF FOXED & VARIABLE COST
• DURING PRODUCT COSTING WHAT WILL BE THE VARIABLE COST PER UNIT & HOW
MUCH IT SHOULD BE CHANGED IN RELATION TO OTHER COST THAT ARE
DETERMINED
• HOW FIXED COST IS AFFECTING THE EXISTING SELLING PRICE & PROFIT THAT
ALSO CAN BE OBSERVED BY COST BEHAVIOR

COST CLASSIFICATIONS FOR PREDICTING COST BEHAVIOR
HOW A COST WILL REACT
TO CHANGES IN THE
LEVEL OF ACTIVITY
WITHIN THE RELEVANT
RANGE.
– TOTAL VARIABLE COSTS
CHANGE WHEN ACTIVITY
CHANGES.
– TOTAL FIXED COSTS
REMAIN UNCHANGED
WHEN ACTIVITY CHANGES.
A manager may want to estimate the impact
that a 5% increase in sales would have on the
company’s total electric bill. Cost behavior
refers to how a cost will react to changes in the
level of activity within the relevant range.

VARIABLE COST
A VARIABLE COST VARIES IN DIRECT PROPORTION
TO CHANGES IN THE LEVEL OF ACTIVITY.
YOUR TOTAL TEXTING BILL IS BASED ON HOW MANY TEXTS YOU SEND.
Number of Texts
Sent
TotalTextingBill

VARIABLE COST PER UNIT
ALTHOUGH VARIABLE COSTS CHANGE IN TOTAL AS THE
ACTIVITY LEVEL RISES AND FALLS, VARIABLE COST PER
UNIT IS CONSTANT.
THE COST PER TEXT SENT IS CONSTANT AT 5 CENTS PER TEXT.
Number of Texts Sent
CostPerTextSent

EXAMPLES OF VARIABLE COSTS
Merchandising companies – cost of goods sold.
Manufacturing companies – direct materials,
direct labor, and variable overhead.
Merchandising and manufacturing companies –
commissions, shipping costs, and clerical costs,
such as invoicing.
Service companies – supplies, travel, and clerical.

Volume
Cost
TRUE VARIABLE COST
DIRECT MATERIALS IS A TRUE OR PROPORTIONATELY VARIABLE COST
BECAUSE THE AMOUNT USED DURING A PERIOD WILL VARY IN
DIRECT PROPORTION TO THE LEVEL OF PRODUCTION ACTIVITY.

STEP-VARIABLE COSTS
A resource that is obtainable only in large range
(such as maintenance workers) and whose costs
increase or decrease only in response to fairly wide
changes in activity is known as a step-variable cost.
Volume
Cost

STEP-VARIABLE COSTS
Small changes in the level of production are not
likely to have any effect on the number of
maintenance workers employed.
Volume
Cost

STEP-VARIABLE COSTS
Only fairly wide changes in the activity level will
cause a change in the number of maintenance
workers employed
Volume
Cost

FIXED COST
• A FIXED COST IS CONSTANT WITHIN THE RELEVANT RANGE. IN OTHER WORDS, FIXED COSTS
DO NOT CHANGE FOR CHANGES IN ACTIVITY THAT FALL WITHIN THE “RELEVANT RANGE.”
• FOR EXAMPLE, YOUR MONTHLY CONTRACT FEE FOR YOUR CELL PHONE IS A FIXED AMOUNT
FOR A CERTAIN NUMBER OF MINUTES. THE MONTHLY CONTRACT FEE DOES NOT CHANGE
BASED ON THE NUMBER OF CALLS YOU MAKE.
• OF COURSE, IF YOU GO OVER YOUR MONTHLY MINUTES ALLOTMENT, YOU HAVE EXCEED THE
RELEVANT RANGE FOR YOUR MONTHLY CONTRACT AND WILL BE CHARGED ABOVE AND
BEYOND YOUR MONTHLY CONTRACT FEE.
Number of Minutes Used
Within Monthly Plan
MonthlyCell
PhoneContract
Fee

FIXED COST PER UNIT
• A FIXED COST IS INVERSELY RELATED TO ACTIVITY—THE PER UNIT COST
DECREASES WHEN ACTIVITY RISES AND INCREASES WHEN ACTIVITY FALLS.
• FOR EXAMPLE, THE AVERAGE FIXED COST PER CELL PHONE CALL MADE
DECREASES AS MORE CALLS ARE MADE IN THE MONTH.
Number of Minutes Used
Within Monthly Plan
MonthlyCellPhone
ContractFee

Examples
Advertising and
Research and
Development
Examples
Depreciation on
Equipment and Real
Estate Taxes
TYPES OF FIXED COSTS
Discretionary
May be altered in the short-
term by current
managerial decisions
Committed
Long-term, cannot be
significantly reduced in the
short term.

COST CLASSIFICATIONS FOR
PREDICTING COST BEHAVIOR
Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit
Variable Total variable cost is Variable cost per unit remains
proportional to the activity the same over wide ranges
level within the relevant range. of activity.
Total fixed cost remains the
same even when the activity Fixed cost per unit goes
Fixed level changes within the down as activity level goes up.
relevant range.

Fixed Monthly
Utility Charge
Variable
Cost per KW
Activity (Kilowatt Hours)
TotalUtilityCost
X
Y
A mixed cost contains both variable and fixed
elements. Consider the example of utility cost.
MIXED COSTS (ALSO CALLED SEMI VARIABLE COSTS)

MIXED COSTS (ALSO CALLED SEMI VARIABLE COSTS)
The total mixed cost line can be expressed
as an equation: Y = a + bX
Where: Y = The total mixed cost.
a = The total fixed cost (the
vertical intercept of the line).
b = The variable cost per unit of
activity (the slope of the line).
X = The level of activity.
Fixed Monthly
Utility Charge
Variable
Cost per KW
Activity (Kilowatt Hours)
TotalUtilityCost
X
Y

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?
Y = a +
bXY = $40 + ($0.03 ×
2,000)Y = $100

THE HIGH-LOW METHOD-MIXED COST
ASSUME THE FOLLOWING HOURS OF MAINTENANCE
WORK AND THE TOTAL MAINTENANCE COSTS FOR
SIX MONTHS.

THE HIGH-LOW METHOD
The variable cost
per hour of
maintenance is
equal to the
change in cost
divided by the
change in hours.
= $8.00/hour$2,400
300

THE HIGH-LOW METHOD
The Cost Equation for Maintenance
Y = a + $8.00X

SALES SALARIES AND COMMISSIONS ARE
$10,000 WHEN 80,000 UNITS ARE SOLD, AND
$14,000 WHEN 120,000 UNITS ARE SOLD. USING
THE HIGH-LOW METHOD, WHAT IS THE FIXED
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
$4,000 ÷ 40,000 units
= $0.10 per unit
Units Cost
High level 120,000 14,000$
Low level 80,000 10,000
Change 40,000 4,000$

SALES SALARIES AND COMMISSIONS ARE
$10,000 WHEN 80,000 UNITS ARE SOLD, AND
$14,000 WHEN 120,000 UNITS ARE SOLD. USING
THE HIGH-LOW METHOD, WHAT IS THE FIXED
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
Total cost = Total fixed cost +
Total variable cost
$14,000 = Total fixed cost +
($0.10 × 120,000 units)
Total fixed cost = $14,000 - $12,000
Total fixed cost = $2,000

ABSORPTION AND VARIABLE COSTING
Absorption Costing/
Full Costing
Variable Costing/
marginal Costing
Product
Costs
Period
Costs
Direct Materials
Direct Labor
Variable Manufacturing Overhead
Fixed Manufacturing Overhead
Variable Selling and Administrative Expenses
Fixed Selling and Administrative Expenses
Product
Costs
Period
Costs

HARVEY COMPANY PRODUCES A SINGLE
PRODUCT
WITH THE FOLLOWING INFORMATION
AVAILABLE:
UNIT COST COMPUTATIONS

UNIT PRODUCT COST IS DETERMINED AS
FOLLOWS:
Under absorption costing, selling and administrative
expenses are
always treated as period expenses and deducted
from revenue as incurred.
UNIT COST COMPUTATIONS

CVP ANALYSIS
•COST-VOLUME-PROFIT (CVP) ANALYSIS IS THE STUDY OF THE EFFECTS OF
CHANGES OF COSTS AND VOLUME ON A COMPANY’S PROFITS.
•COST-VOLUME-PROFIT (CVP) ANALYSIS IS IMPORTANT IN PROFIT PLANNING.
•IT ALSO IS A CRITICAL FACTOR IN MANAGEMENT DECISIONS.
ASSUMPTION OF CVP ANALYSIS:
1. SELLING PRICE IS CONSTANT. THE PRICE OF A PRODUCT OR SERVICE
WILL NOT CHANGE AS VOLUME CHANGES.
2. COSTS ARE LINEAR AND CAN BE ACCURATELY DIVIDED INTO VARIABLE
AND FIXED ELEMENTS. THE VARIABLE ELEMENT IS CONSTANT PER UNIT,
AND THE FIXED ELEMENT IS CONSTANT IN TOTAL OVER THE ENTIRE
RELEVANT RANGE.
3. IN MULTIPRODUCT COMPANIES, THE SALES MIX IS CONSTANT.
4. IN MANUFACTURING COMPANIES, INVENTORIES DO NOT CHANGE. THE
NUMBER OF UNITS PRODUCED EQUALS THE NUMBER OF UNITS SOLD.

BASICS OF COST-VOLUME-PROFIT
ANALYSIS
Contribution Margin (CM) is the amount remaining from sales
revenue after variable expenses have been deducted.
• Let's look at a hypothetical contribution income statement for DBL Group.
The selling price of per unit product is $ 500. VARIABLE PRICE IS $300
• Notice the emphasis on cost behavior. Variable costs are separate from
fixed costs.

THE CONTRIBUTION APPROACH
SALES, VARIABLE EXPENSES, AND CONTRIBUTION
MARGIN CAN ALSO BE EXPRESSED ON A PER UNIT
BASIS. IF THIS COMPANY SELLS AN ADDITIONAL
UNIT, $200 ADDITIONAL CM WILL BE GENERATED
TO COVER FIXED EXPENSES AND PROFIT.

EACH MONTH, RACING MUST GENERATE AT LEAST
$80,000 IN TOTAL CM TO BREAK EVEN.

IF COMPANY SELLS 400 UNITS IN A MONTH, IT WILL BE
OPERATING AT THE BREAK-EVEN POINT.

IF COMPANY SELLS ONE MORE BIKE (401
BIKES), NET
OPERATING INCOME WILL INCREASE BY $200.

CVP RELATIONSHIPS IN GRAPHIC FORM
THE RELATIONSHIP AMONG REVENUE, COST, PROFIT AND VOLUME CAN BE EXPRESSED
GRAPHICALLY BY PREPARING A CVP GRAPH.
DBL DEVELOPED CONTRIBUTION MARGIN INCOME STATEMENTS AT 300, 400, AND 500
UNITS SOLD. WE WILL USE THIS INFORMATION TO PREPARE THE CVP GRAPH.

-
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
- 100 200 300 400 500 600 700 800
CVP GRAPH
Units
Fixed Expenses
Total Expenses

CVP GRAPH
-
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
- 100 200 300 400 500 600 700 800
Fixed Expenses
Total Expenses
Total Sales
Units

CVP GRAPH
-
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
- 100 200 300 400 500 600 700 800
Units
Break-even point
(400 units or $200,000 in sales)

CONTRIBUTION MARGIN RATIO
THE CONTRIBUTION MARGIN RATIO IS:
FOR THE COMPANY THE RATIO IS:
Total CM
Total sales
CM Ratio =
Each $1.00 increase in sales results in a
total contribution margin increase of 40¢.
= 40%
$80,000
$200,000

CONTRIBUTION MARGIN RATIO
OR, IN TERMS OF UNITS, THE CONTRIBUTION
MARGIN RATIO IS:
FOR THE COMPANY THE RATIO IS:
$200
$500
= 40%
Unit CM
Unit selling price
CM Ratio =

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
Unit contribution margin
Unit selling price
CM Ratio =
=
($1.49-$0.36)
$1.49
=
$1.13
$1.49
= 0.758

CHANGES IN FIXED COSTS AND SALES
VOLUME
WHAT IS THE PROFIT IMPACT IF COMPANY CAN INCREASE UNIT SALES
FROM 500 TO 540 BY INCREASING THE MONTHLY ADVERTISING
BUDGET BY $10,000?$80,000 + $10,000 advertising = $90,000
Sales increased by $20,000, but net operating
income decreased by $2,000.

What is the profit impact if COMPANY 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?
VOLUME
580 units × $310 variable cost/unit = $179,800
Sales increase by $40,000, and net operating income
increases by $10,200.

VOLUMEWhat is the profit impact if company (1) cuts its selling price $20
per unit, (2) increases its advertising budget by $15,000 per
month, and (3) increases sales from 500 to 650 units per
month?
Sales increase by $62,000, fixed costs increase by
$15,000, and net operating income increases by $2,000.

BREAK-EVEN ANALYSIS
BREAK-EVEN ANALYSIS CAN BE APPROACHED IN TWO WAYS:
1. EQUATION METHOD
2. CONTRIBUTION MARGIN METHOD
EQUATION METHOD
Profits = (Sales – Variable expenses) – Fixed expenses
Sales = Variable expenses + Fixed expenses + Profits
At the break-even point
profits equal zero
Total Per Unit Percent
Sales (500 bikes) 250,000$ 500$ 100%
Less: variable expenses 150,000 300 60%
Contribution margin 100,000$ 200$ 40%
Less: fixed expenses 80,000
Net operating income 20,000$

EQUATION METHOD
WE CALCULATE THE BREAK-EVEN POINT AS
FOLLOWS:
$500Q = $300Q + $80,000 + $0
Where:
Q = Number of bikes sold
$500 = Unit selling price
$300 = Unit variable expense
$80,000 = Total fixed expense

EQUATION METHOD
$500Q = $300Q + $80,000 + $0
$200Q = $80,000
Q = $80,000 ÷ $200 per bike
Q = 400 bikes
WE CALCULATE THE BREAK-EVEN POINT AS
FOLLOWS:Sales = Variable expenses + Fixed expenses + Profits

CONTRIBUTION MARGIN METHOD
THE CONTRIBUTION MARGIN METHOD
HAS TWO KEY EQUATIONS.
Fixed expenses
CM per unit
=
Break-even point
in units sold
Fixed expenses
CM ratio
=
Break-even point in
total sales dollars

CONTRIBUTION MARGIN METHOD
LET’S USE THE CONTRIBUTION MARGIN METHOD TO
CALCULATE THE BREAK-EVEN POINT IN TOTAL SALES
DOLLARS
Fixed expenses
CM ratio
=
Break-even point in
total sales dollars
$80,000
40%
= $200,000 break-even sales

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
BREAK-EVEN SALES IN UNITS?
a. 872 CUPS
B. 3,611 CUPS
C. 1,200 CUPS
D. 1,150 CUPS
Fixed expenses
CM per Unit
Break-even =
$1,300
$1.49/cup - $0.36/cup
= $1,300
$1.13/cup
= 1,150 cups
=

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 BREAK-
EVEN SALES IN DOLLARS?
A. $1,300
B. $1,715
C. $1,788
D. $3,129
Fixed expenses
CM Ratio
Break-even
sales
$1,300
0.758
= $1,715
=
=

TARGET PROFIT ANALYSIS
SUPPOSE RANOLD COMPANY WANTS TO KNOW HOW
MANY UNITS MUST BE SOLD TO EARN A PROFIT OF
$100,000.
CVP EQUATION METHOD
$500Q = $300Q + $80,000 + $100,000
$200Q = $180,000
Q = 900 bikes

CONTRIBUTION MARGIN
METHOD
Fixed expenses + Target profit
CM per unit
=
Unit sales to attain
the target profit
$80,000 + $100,000
$200/bike
= 900 bikes

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. 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
Fixed expenses + Target profit
Unit CM
Unit sales
to attain
target profit
= 3,363 cups
= $3,800
$1.13
$1,300 + $2,500
$1.49 - $0.36
=
=

MARGIN OF SAFETY
MARGIN OF SAFETY IS DEFINED AS THE DIFFERENCE BETWEEN
TOTAL SALES & BREAK-EVEN SALES.
TOTAL SALES – BREAK-EVEN SALESMARGIN OF SAFETY =
IN CASE OF PREV. EXAMPLE OF DBL GROUP, TOTAL SALES = 500 UNIT & BREAK EVEN
SALES = 400 UNIT
SO, MARGIN OF SAFETY= 500-400= 100 UNIT
MARGIN OF SAFETY PERCENTAGE = 100/500= 20%

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?
A. 3,250 CUPS
B. 950 CUPS
C. 1,150 CUPS
D. 2,100 CUPS
Margin of safety = Total sales – Break-even sales
= 950 cups
= 2,100 cups – 1,150 cups
or
950 cups
2,100 cups
Margin of safety
percentage
= = 45%

OPERATING LEVERAGE
A MEASURE OF HOW SENSITIVE NET OPERATING INCOME IS TO
PERCENTAGE CHANGES IN SALES.
Contribution margin
Net operating income
Degree of
operating leverage
=
Actual sales
500 Bikes
Sales 250,000$
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income 20,000$
$100,000
$20,000
= 5

MATH PRACTICE
VOLTAR COMPANY MANUFACTURES AND SELLS A SPECIALIZED
CORDLESS TELEPHONE FOR HIGH ELECTROMAGNETIC
RADIATION ENVIRONMENTS. THE COMPANY’S CONTRIBUTION
FORMAT INCOME STATEMENT FOR THE MOST RECENT YEAR IS
GIVEN BELOW:

Management is anxious to increase the company’s profit and has
asked for an analysis of a number of items.
Required:
1. Compute the company’s CM ratio and variable expense ratio.
2. Compute the company’s break-even point in both units and
sales dollars. Use the equation method.
3. Assume that sales increase by $400,000 next year. If cost
behavior patterns remain unchanged, by how
much will the company’s net operating income increase? Use the
CM ratio to compute your answer.
4. Refer to the original data. Assume that next year management
wants the company to earn a profit of at least $90,000. How many
units will have to be sold to meet this target profit?
5. Refer to the original data. Compute the company’s margin of
safety in both dollar and percentage form.

6. a. Compute the company’s degree of operating leverage at the present level of
sales.
b. Assume that through a more intense effort by the sales staff, the company’s
sales increase by 8% next year. By what percentage would you expect net
operating income to increase? Use the degree of operating leverage to obtain
your answer.
c. Verify your answer to ( b ) by preparing a new contribution format income
statement showing an 8% increase in sales.
7. In an effort to increase sales and profits, management is considering the use
of a higher- quality speaker. The higher-quality speaker would increase variable
costs by $3 per unit, but management could eliminate one quality inspector who
is paid a salary of $30,000 per year. The sales manager
estimates that the higher-quality speaker would increase annual sales by at least
20%.
a. Assuming that changes are made as described above, prepare a projected
contribution format
income statement for next year. Show data on a total, per unit, and percentage
basis.

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