Chapter 2

Introduction to Cost Behavior

and Cost-Volume Relationships

LEARNING OBJECTIVES:
When your students have finished studying this chapter, they should be able to:

1. Explain how cost drivers affect cost behavior.

2. Show how changes in cost-driver activity levels affect variable and fixed costs.

3. Calculate break-even sales volume in total dollars and total units.

4. Create a cost-volume-profit graph and understand the assumptions behind it.

5. Calculate sales volume in total dollars and total units to reach a target profit.

6. Distinguish between contribution margin and gross margin.

7. Explain the effects of sales mix on profits (APPENDIX 2A).

8. Compute cost-volume-profit relationships on an after-tax basis (APPENDIX 2B).

9. Understand how cost behavior and cost-volume-profit analyses are used by

managers.

18
CHAPTER 2: OVERVIEW

This chapter examines cost behavior and its impact on company profitability.

Section One: Discusses cost drivers.

Section Two: The behavior of variable and fixed costs is discussed. Variable costs
change in proportion to changes in the cost driver, whereas fixed costs are
unaffected by cost-driver activity.

Section Three: Covers the fundamentals of break-even and cost-volume-profit analysis.

The contribution margin and the equation techniques for solving for the
break-even point are illustrated. In addition, the graphical technique for
deriving the break-even point is shown. The break-even point (BEP) is
found in terms of units and sales dollars. The assumptions of CVP are
stated, changes in fixed expenses and contribution margin are discussed,
and solving for a target net profit is explained. At times, an incremental
approach is useful to evaluate changes in costs, revenues, and resulting
profit. Also, the effects of multiple changes in key factors and the use of
computer spreadsheets in evaluating alternatives are discussed.

Section Four: The trade-off between fixed and variable expenses and the use of
operating leverage are explained. Also, the distinction between gross
margin and contribution margin is highlighted.

Section Five: Shows how the concepts of break-even analysis can be applied to a
nonprofit situation.

Section Six: APPENDIX A covers the impact of shifts in the sales mix on profitability.

Section Seven: APPENDIX B covers the impact of income taxes on profitability.

19
CHAPTER 2: ASSIGNMENTS
COGNITIVE EXERCISES

24 Marketing Function of Value Chain and Cost Behavior

25 Production Function of Value Chain and Cost Behavior
26 Tenneco Automotive's Value Chain

EXERCISES

27 Identifying Cost Drivers

28 Basic Review Exercises
29 Basic Review Exercises
30 Basic Cost-Volume-Profit Graph
31 Basic Cost-Volume-Profit Graph
32 Hospital Costs and Pricing
33 Motel Rentals
34 Variable Cost to Break Even
35 Basic Relationships, Hotel
36 Sales-Mix Analysis
37 Income Taxes
38 Income Taxes and Cost-Volume-Profit Analysis

PROBLEMS

39 Fixed Costs and Relevant Range

40 Movie Manager
41 Promotion of a Rock Concert
42 Basic Relationships, Restaurant
43 Basic Relationships, Blockbuster
44 Cost-Volume-Profit Analysis, Barbering
45 CVP and Financial Statements
46 Bingo and Leverage
47 Adding a Product
48 Cost-Volume-Profit Relationships and a Dog Track
49 Traveling Expenses
50 Government Organization
51 Airline CVP
52 Gross Margin and Contribution Margin
53 Choosing Equipment for Different Volumes

20
 54 Boeing Break-Even (Business First)
55 Sales-Mix Analysis
56 Hospital Patient Mix
57 Income Taxes on Hotels
58 Tax Effects, Multiple Choice

CASES

59 Hospital Costs
60 CVP and Prediction of Income
61 CVP in a Modern Manufacturing Environment
62 Multi-product Break-Even in a Restaurant
63 Effects of Changes in Costs, Including Tax Effects

COLLABORATIVE LEARNING EXERCISE

64 CVP for a Small Business

INTERNET EXERCISE - Southwest Airlines

21
CHAPTER 2: OUTLINE
I. Activities, Costs, and Cost Drivers {L. O. 1}
Cost Drivers - Output measures of resources and activities.

Organizations can have many cost drivers. In this chapter, volume-based cost
drivers are used in order to examine cost behavior. See EXHIBIT 2-1 for
examples of costs and potential cost drivers for value-chain functions.

TEACHING TIP: Cause and Effect Relationships-What may cause a student to

perform poorly/well on an examination? An interview? There may be multiple
causes.

II. Comparison of Variable and Fixed Costs {L. O. 2}

Variable and fixed costs refer to how cost behaves with respect to changes in a
particular cost driver.

Variable Cost - a cost that changes in direct proportion to changes in the cost driver
(i.e., costs per unit do not change, total costs do change). Examples include the costs
of materials, merchandise, parts, supplies, commissions, and many types of labor.
See EXHIBIT 2-2 for a graph of variable cost behavior within a relevant range.

Fixed Cost - a cost that is not immediately affected by changes in the cost driver
(i.e., costs per unit do change, total costs do not change within the relevant range).
Examples include real estate taxes, real estate insurance, many executive salaries,
and space rentals.

TEACHING TIP: Fixed Costs and Time Period - All costs become variable as
the time period is expanded.

A. Relevant Range

Relevant Range - the limits (i.e., time period and/or activity) of cost-driver
activity within which a specific relationship between costs and the cost driver
is valid. See EXHIBIT 2-3 for a graph of fixed cost behavior within a
relevant range.

22
B. Differences in Classifying Costs

Costs may not act in a linear manner with volume-based cost drivers.
Examples: when learning affects the production time, and therefore the labor
cost, of units of product; some costs may be affected by more than one cost
driver; and whether costs are variable or fixed often depends on the decision
situation.

III. Cost-Volume-Profit Analysis {L. O. 3}

Cost-Volume-Profit (CVP) Analysis - the study of the effects of output volume on
revenue (sales), expenses (costs), and net income (net profit). The major simplifying
assumption is to classify costs as either variable or fixed with respect to the volume
of output activity. A CVP scenario follows.

A. Break-Even Point: Contribution Margin and Equation Techniques

Break-Even Point (BEP) - the level of sales at which revenues equals

expenses and net income is zero. One direct use of the BEP is to assess
possible risk. By comparing planned sales with the BEP, managers can
determine a Margin of Safety - how far sales can fall below the planned level
before losses occur.

Margin of Safety = planned unit sales - break-even unit sales

1. Contribution-Margin Technique. Contribution Margin (CM) Per

Unit - the sales price per unit minus the variable expenses per unit.
The BEP is reached when total contribution margin equals total fixed
costs. Dividing total fixed costs by the CM per unit gives the BEP in
number of units.

CM Percentage or Ratio - the portion of every sales dollar that

contributes to covering fixed costs and, hopefully, provides for profit
(divide total contribution margin by total sales). Dividing total fixed
costs by the CM percentage yields the sales dollars needed to break
even. The use of the CM percentage is necessary when a firm
produces more than one product.

23
2. Equation Technique. The basic income statement equation used for
CVP analysis is:

sales - variable expenses - fixed expenses = net income

This can be decomposed to:

unit sales price x number of units

- unit variable cost x number of units
- fixed expenses
net income

At the BEP, net income is zero. Let N = the number of units to be

sold to break even, put in values for the unit sales price, unit variable
cost and fixed expenses, and solve for N.

To compute the sales dollars needed to break even using the equation
technique, the variable expenses must be expressed as a proportion of
sales, which is called the Variable-Cost Ratio or Percentage. Then,
letting S = the sales dollars to break even, solve for S in the equation:

S - (variable-cost ratio x S) - fixed expenses = 0

Alternatively, if you have previously solved for the number of units

required to break even, you can multiply that result by the unit-selling
price to give the sales dollars needed to break even.

3. Relationship Between the Two Techniques. Both approaches result

in the following short-cut formulas:

break-even (units) = (fixed expenses)/(CM per unit)

break-even (dollars) = (fixed expenses)/(CM ratio)

24
B. Break-Even Point - Graphical Techniques {L. O. 4}
The BEP can also be found by graphing the cost and revenue relationships.
The process takes the following steps.

Step 1: Draw the axes. The horizontal axis = sales volume, and the
vertical axis = dollars of cost and revenue.

Step 2: Plot sales volume. Select a convenient sales volume and plot a
point for total sales dollars at that volume. Then draw a line
between the origin and the point.

Step 3: Plot the fixed expenses. It should be a horizontal line

intersecting the vertical axis at the level of fixed costs.

Step 4: Plot variable expenses. Determine the variable expenses at

some volume level. Add this amount to fixed expenses and
plot the point. Then draw a line from the intersection of the
vertical axis to this point. This line represents total expenses,
and the difference between the fixed expense line and this new
line represents the variable expenses.

Step 5: Locate the break-even point. The break-even point is where the
total expense line crosses the sales line.

See EXHIBIT 2-4 for an illustration of a CVP graph. CVP graphs show
profits over a wide volume range easier than numerical exhibits.

Almost all break-even graphs show revenue and cost lines extending back to
the vertical axis. This approach misleads because the relationships depicted
are only valid within the relevant range. See EXHIBIT 2-5 for the
conventional and modified break-even graphs.

25
 The assumptions used in constructing the typical break-even graph include
the following:

1. Expenses may be classified into variable and fixed categories.

2. The behavior of revenues and expenses is accurately portrayed and is

linear over the relevant range.

3. Efficiency and productivity will be unchanged.

4. Sales Mix (i.e., the relative proportions or combinations of quantities

of products that constitute total sales) is constant. [See APPENDIX
2A for more on sales mixes.]

5. The difference in inventory level at the beginning and end of a period

is insignificant.

C. Changes in Fixed Expenses

Increases (decreases) in fixed expenses increase (decrease) the BEP.

D. Changes in Contribution Margin per Unit.

Increases (decreases) in the CM per unit decrease (increase) the BEP.

E. Target Net Profit and an Incremental Approach. {L. O. 5}

CVP analysis can be used to determine the target sales, in units and dollars,
needed to earn a target profit. Using either the contribution margin or
equation techniques results in the following shortcut equations.

target sales volume in units = fixed expenses + target net income

CM per unit

target sales volume in dollars = fixed expenses + target net income

CM ratio

The Incremental Approach (i.e., the change in total results under a new
condition in comparison with some given or known condition) can be used.
Divide the target net income by the CM per unit and add the result to the unit
BEP to get the target sales volume in units. Likewise, divide the target net
income by the CM ratio and add the result to the dollar BEP to get the target
sales volume in dollars.

26
 F. Multiple Changes in Key Factors

Multiple factor changes can be demonstrated by constructing income

statements reflecting the changes and comparing before change and after
change results. Also, an incremental approach can be used to isolate just the
effects of the changes and eliminates irrelevant and potentially confusing
data.

G. CVP Analysis in the Computer Age

Numerous combinations of fixed expenses, selling prices, variable expenses,

and target income levels can be analyzed quickly using these computerized
spreadsheets. See EXHIBIT 2-6 for an example of spreadsheet analysis.

IV. Additional Uses of Cost-Volume Analysis

A. Best Cost Structure

Companies try to find their most desirable combination of fixed- and

variable-cost factors. Some choose to increase their CM ratios and fixed
costs by automating, while others may choose to lower their fixed costs and
lower their CM ratios by putting their sales force on commissions rather than
paying salaries.

When the CM percentage of sales is low, great increases in volume are

necessary before significant improvements in net profits are possible. As
sales exceed the BEP, a high CM percentage increases profits faster than a
low CM percentage.

B. Operating Leverage

Operating Leverage - the firm’s ratio of fixed and variable costs. In highly
leveraged firms (i.e., those with high fixed costs and low variable costs) small
changes in sales volume will result in large changes in net income. Less
leveraged firms show smaller changes in net income with changes in sales
volume. Above the BEP, net income increases faster for highly leveraged
firms. However, below the BEP, losses mount more rapidly. See EXHIBIT
2-7 for a graph comparing high versus low leverage.

C. Contribution Margin and Gross Margin {L. O. 6}

Gross Margin (or Gross Profit) - the excess of sales over the Cost of
Goods Sold (i.e., cost of the acquired or manufactured merchandise to be
sold). Contribution Margin is the excess of sales over all variable expenses.

27
V. Nonprofit Application

Nonprofit organizations, such as government agencies, can use the principles of CVP
analysis to determine how many individuals they can serve with limited budgets and
to assess the impact of changes in the level of funding and/or costs on their ability to
provide services.

VI. Appendix 2A: Sales-Mix Analysis {L. O. 7}

Sales Mix - the relative proportions or combinations of quantities of products that
comprise total sales. If the proportions of the mix change, the CVP relationships
may also change. Generally, selling a higher (lower) proportion of high CM
products than anticipated results in higher (lower) net income. Factors other than CM
per unit of product (e.g., CM per unit of time) can be useful in making sales mix
decisions (see Chapter 5 for further explanation).

VII. Appendix 2B: Impact of Income Taxes {L. O. 8}

The target sales equation can be altered to the following:

target sales - variable expenses - fixed expenses =

target after-tax income/ (1 - tax rate)

Letting N = the number of units of sales necessary to achieve the desired after-tax
income and substituting values for the selling price per unit, variable expenses per
unit, fixed expenses, target after-tax income, and the tax rate into the equation, N can
be solved. Alternatively, the following shortcut formula may be used:

change in net income =

(change in volume in units) x (CM per unit) x (1 - tax rate)

Each unit beyond the BEP adds to after-tax net profit at the unit CM multiplied by (1
- income tax rate).

When incorporating income taxes in CVP analysis, the BEP does not change
because the BEP is the point of zero profits. Therefore, there are no taxes on zero
profits.

28
CHAPTER 2: TRANSPARENCY MASTERS
The following exhibits are reproduced as transparency masters at the end of this manual:

Exhibit 2-1 Examples of Value-Chain Functions, Costs, and Cost Drivers

Exhibit 2-3 Fixed Costs and Relevant Range

Exhibit 2-4 Cost-Volume-Profit Graph

Exhibit 2-5 Conventional and Modified Break-Even Graphs

Exhibit 2-7 High Versus Low Leverage

29
CHAPTER 2: Quiz/Demonstration Exercises
Learning Objective 1

1. Cost drivers:

a. can be volume based

b. affect the total level of costs incurred by companies
c. are activities that cause costs to be incurred
d. all of these

2. Production is one of the value-chain functions. Which one of the following is not
an example of a cost driver for production costs:

a. labor hours
b. number of people supervised
c. sales dollars
d. machine hours

Learning Objective 2

3. Which of the following will remain constant, if the level of cost driver activity
increases within the relevant range?

a. variable cost per unit

b. total variable costs
c. total fixed costs
d. total costs
e. a., c.
f. b., c., d.

4. Fixed costs remain the same:

a. per unit produced

b. per unit sold
c. in total regardless of production or sales volume
d. in total provided production or sales remains within a relevant range

30
Learning Objective 3

Items 5 and 6 are based on the following data:

HardWood, Inc., produces and sells the finest quality golf tables in all of Madison
County, Iowa. The company expects the following sales and expense in 200x for
its tables:

Sales (1,000 tables @ $500 per table) $ 200,000

Variable expenses 200,000
Fixed expenses 60,000

5. How many tables must be sold in order for Hardwood, Inc., to break even?

a. 100 b. 200 c. 300 d. 400

6. What dollar amount of sales of tables is necessary to break even?

a. $50,000 b. $100,000 c. $150,000 d. $200,000

Learning Objective 4

7. Which of the following is not an assumption of cost-volume-profit analysis?

a. The behavior of revenues and expenses is accurately portrayed and is linear

over the relevant range.
b. Expenses can be classified into variable and fixed categories.
c. Sales mix will be constant.
d. Efficiency and productivity will both increase.
e. The inventory level at the end of the period will be insignificantly different
from that at the beginning.

8. Break-even is the point where:

a. revenue equals total manufacturing costs

b. revenue equals cost of goods sold
c. revenue equals total variable costs
d. revenue equals total variable costs plus total fixed costs

31
Learning Objective 5

Items 9 and 10 are based on the following data (ignore income taxes):

BOOM, Inc., manufactures and sells dynamite. A projected income statement for
the expected sales volume of 1,500,000 cases is as follows:

Sales $4,500,000
Variable expenses 1,000,000
Contribution margin $3,500,000
Fixed expenses 2,000,000
Before-tax profit $1,500,000

9. How many cases would need to be sold to have a before-tax profit of $2,150,000?

a. 1,100,000 cases d. 1,778,572 cases

b. 1,305,523 cases e. 1,933,842 cases
c. 1,589,331 cases f. none of the above

10. What dollar sales volume would be required to achieve $4,000,000 of before-tax
profit?

a. $6,845,100 b. $7,714,287 c. $9,354,006 d. $10,522,992

e. some other amount

Learning Objective 6

11. The difference between sales and total variable expenses is commonly called:

a. contribution margin. b. gross margin.

c. gross profit. d. excess sales.

12. If variable selling expenses increase, then gross margin (assuming all else constant)
must:

a. stay the same.

b. increase.
c. decrease.
d. need more information.

32
Learning Objective 7

13. TwinCo produces and sells two products. Product A sells for $8 and has variable
expenses of $3. Product B sells for $18 and has variable expenses of $10. It predicts
sales of 20,000 units of A and 10,000 units of B. Fixed expenses are $100,000 per
month. Assume that TwinCo hits its sales goal for February of $600,000, but falls
short of its expected before-tax profit of $70,000. What has happened?

a. TwinCo sold 40,000 units of product A and no product B.

b. TwinCo more of both products A and B than expected.
c. TwinCo sold more of product A and less of product B than expected.
d. TwinCo sold more of product B and less of product A than expected.

14. Break-even in units for a multi-product firm is calculated as fixed costs divided by:

a. the sum of the contribution margin percentages for each product

b. the weighted average contribution margin of all the products
c. the sum of the individual product contribution margins
d. it is not possible to calculate break-even in units for a multi-product firm

Learning Objective 8

15. Refer to the data provided for BOOM, Inc., in problems 9 and 10. Now assume
that BOOM, Inc. is subject to a 30% tax. How many cases must it sell to achieve an
after-tax income of $2,000,000?

a. 1,298,116 cases
b. 1,510,119 cases
c. 1,899,228 cases
d. 2,081,633 cases

16. Before-tax profit equals:

a. after-tax profit multiplied by the tax rate

b. after-tax profit multiplied by 1 minus the tax rate
c. after-tax profit divided by the tax rate
d. after-tax profit divided by 1 minus the tax rate

33
CHAPTER 2: Solutions to Quiz/Demonstration
Exercises

1. [d] 2. [c] 3. [e] 4. [d]

5. [b] The CM per unit must be computed. In this case, it is $300 ($500,000 -
$200,000)/1000 tables. Dividing the $60,000 fixed expenses by the $300 per
unit CM gives 200 sets.

6. [b] Either multiplying the unit BEP by the unit selling price or by dividing the
fixed expenses by the CM ratio. Using the first method, 200 tables multiplied
by a price of $500 per table gives $100,000 of sales to break even. With the
second method, $60,000 of fixed expenses divided by .60 ($300,000
CM/$500,000 Sales) also yields $100,000 to break even.

7. [d] 8. [d]

9. [d] Add the before-tax desired profit to the fixed expenses and dividing the result
by the CM per unit. In this case, $2,150,000 + $2,000,000 = $4,150,000 /
($3,500,000 / 1,500,000 cases) gives 1,778,572 cases.

10. [b] Divide the sum of the target before-tax income and the fixed expenses
by the CM percentage. In this case that is $6,000,000 [$4,000,000 +
$2,000,000] divided by .7777 [$3,500,000/$4,500,000] = $7,714,287.

11. [a] 12. [a]

13. [d] The CM ratios for the two products are 62.5% for A and 44.4% for B. When
the sales mix shifts to products with lower CM ratios, profits decrease.

14. [b]

15. [d] To solve this problem it is necessary to convert the after-tax income desired
to the before-tax income necessary. Dividing $2,000,000 by .70 (1 - tax rate)
gives $2,857,143 in before-tax income required. Adding this to the
$2,000,000 in fixed expenses yields a required contribution margin of
$4,857,143. Using the data provided for 1,500,000 cases, the selling price per
case is $3.00 and the variable expenses per case are $0.667. This gives a CM
per unit of $2.33, which can be divided into the $4,857,143 total contribution
margin to give 2,081,633 cases.

16. [d]

34
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37