Chapter 2
Introduction to Cost Behavior
and Cost-Volume Relationships
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Learning Objective 1
Explain how cost drivers
affect cost behavior.
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Cost Behavior
What is cost behavior?
It is how costs are related to, and affected
by, the activities of an organization.
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Cost Drivers
What are cost drivers?
Output measures of resources and
activities are called cost drivers.
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Cost Drivers
Production Example
Example costs:
Example cost drivers:
Labor wages
Labor hours
Supervisory salaries
No. of people supervised
Maintenance wages
No. of mechanic hours
Depreciation
No. of machine hours
Energy
Kilowatt hours
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Cost Drivers
How well the accountant does at identifying
the most appropriate cost drivers determines
how well managers understand cost behavior
and how well costs are controlled.
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Learning Objective 2
Show how changes in cost-driver
activity levels affect variable
and fixed costs.
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Comparison of
Variable and Fixed Costs
A variable cost is a cost that changes in direct
proportion to changes in the cost driver.
A fixed cost is not immediately affected
by changes in the cost driver.
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Rules of Thumb
Think of fixed costs as a total.
Total fixed costs remain unchanged
regardless of changes in cost-driver activity.
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Rules of Thumb
Think of variable costs on a per-unit basis.
The per-unit variable cost remains
unchanged regardless of changes
in the cost-driver activity.
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Relevant Range
This rule of thumb holds true only within
reasonable limits.
 The relevant range is the limit of cost-driver
activity within which a specific relationship
between costs and the cost driver is valid.

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Relevant Range
$12,000 –
Relevant Range
$8,000 –
–
0
–
$4,000
–
Fixed Costs
$16,000 –
500
1,000 1,500 2,000
Volume in Units
2,500
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Learning Objective 3
Calculate break-even sales
volume in total dollars
and total units.
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Cost-Volume-Profit
Analysis (CVP)
What is cost-volume-profit analysis?
It is the study of the effects of output
volume on revenue (sales), expenses
(costs), and net income (net profit).
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CVP Scenario
Selling price
Variable cost
Difference
Per Unit
$5
4
$1
Percentage
100
80
20
Total monthly fixed expenses = $8,000
Rent
$2,000
Labor
$5,500
Other
$ 500
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Break-Even Point

The break-even point is the level of sales
at which revenue equals expenses and net
income is zero.
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Margin of Safety

The margin of safety shows how far sales
can fall below the planned level before
losses occur.
Planned unit sales
–
Break-even unit sales
=
Margin of safety
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Break-Even Point
Techniques

1
2
There are two basic techniques for
computing break-even point:
Contribution margin
Equation
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Contribution Margin
Technique
Per Unit
Selling price
$5
Variable cost
4
Contribution margin
$1
$8,000 ÷ $1 = 8,000 units
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Contribution Margin
Technique
8,000 units × $5.00 = $40,000
$8,000 ÷ 20% = $40,000
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Equation Technique
Net income equals zero at the break-even point.
Sales
–
Variable expenses
–
Fixed expenses
= Zero net income (break-even point)
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Equation Technique
Let N = number of units to be sold to break even
$5N – $4N – $8,000 = 0
$1N = $8,000
N = $8,000 ÷ $1
N = 8,000 Units
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Equation Technique
Let S = sales in dollars needed to break even
S – 0.80S – $8,000 = 0
.20S = $8,000
S = $8,000 ÷ .20
S = $40,000
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Learning Objective 4
Create a cost-volume-profit
graph and understand the
assumptions behind it.
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Cost-Volume-Profit Graph
Break even sales point
8,000 units or $40,000
$50,000
Dollars
$40,000
$30,000
$20,000
Fixed expense line
$10,000
$0
0
2
4
6
8
10
12
Units (thousands)
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Learning Objective 5
Calculate sales volume in total
dollars and total units to reach
a target profit.
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Target Net Profit
Managers can also use CVP
analysis to determine the
total sales, in units and
dollars, needed to
reach a target
net profit.
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Target Net Profit
Contribution Margin Technique
Target sales volume in units =
Fixed expenses + Target net income
Contribution margin per unit
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Target Net Profit
Equation Technique
Target sales
– Variable expenses
– Fixed expenses
= Target net income
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Incremental Approach
to Target Net Profit

The incremental effect is the change in
total results (such as revenue, expenses,
or income) under a new condition in
comparison with some given or known
condition.
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Operating Leverage
The ratio of fixed to variable costs is called
operating leverage.
 In high leveraged companies, small changes
in sales volume result in large changes in
net income.
 Companies with less leverage are not
affected as much by changes in sales
volume.

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Learning Objective 6
Calculate contribution
margin and gross margin.
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Contribution Margin
and Gross Margin
Gross margin (which is also called gross profit)
is the excess of sales over the cost of goods sold.
Contribution margin is the excess of sales over
all variable costs.
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Learning Objective 7
Explain the effects of sales
mix on profits.
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Effects of Sales Mix
on Income

Sales mix is the combination of products
that a business sells.
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Effects of Sales Mix
on Income
Avisha’s Dresses Example
Selling price:
$90
Less variable cost:
32
Equals contribution margin per dress: $58
Fixed costs = $96,000
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Effects of Sales Mix
on Income
Assume that Avisha is considering selling
blouses.
 This will not require any additional fixed
costs.
 She expects to sell 2 blouses at $30 each for
every dress she sells.
 The variable cost per blouse is $19.
 What is the new breakeven point?

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Effects of Sales Mix
on Income
Contribution margin per blouse: $30 – $19 = $11
What is the contribution margin of the mix?
$58 + (2 × $11) =
$58 + $22 = $80
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Effects of Sales Mix
on Income
$96,000 fixed costs ÷ $80 = 1,200 packages
1,200 × 2 = 2,400 blouses
1,200 × 1 = 1,200 dresses
Total units = 3,600
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Effects of Sales Mix
on Income
What is the breakeven in dollars?
2,400 blouses × $30 =
1,200 dresses × $90 =
$ 72,000
108,000
$180,000
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Effects of Sales Mix
on Income
What is the weighted-average budgeted
contribution margin?
Dresses: 1 × $58
=
+
Blouses: 2 × $11
$80 ÷ 3 = $26.67
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Effects of Sales Mix
on Income
The break even point for the two products is:
$96,000 ÷ $26.667 = 3,600 units
3,600 × 1/3 = 1,200 dresses
3,600 × 2/3 = 2,400 blouses
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Effects of Sales Mix
on Income
Sales mix can be stated in sales dollars:
Dresses Blouses
Sales price
$90
$60
Variable costs
32
38
Contribution margin
$58
$22
Contribution margin ratio
64.4% 36.6%
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Effects of Sales Mix
on Income
Assume the sales mix in dollars is 60% dresses
and 40% blouses.
Weighted contribution would be:
64.4% × 60% = 38.64% dresses
36.6% × 40% = 14.64% blouses
53.28%
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Effects of Sales Mix
on Income
Break even sales dollars is $96,000 ÷ 53.28%
= $180,000 (rounding)
$180,000 × 60% = $108,000 dress sales
$180,000 × 40% = $ 72,000 blouse sales
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Learning Objective 8
Compute cost-volume-profit
relationships on an after-tax
basis.
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Target Net Income
and Income Taxes
Management of Avisha’s Dresses would
like to earn an after-tax income of $35,721.
 The tax rate is 30%.
 What is the target operating income?
 Target operating income
=
Target net income ÷ (1 – tax rate)
 TOI = $35,721 ÷ (1 – 0.30)
 TOI = $51,030

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Target Net Income
and Income Taxes
How many units must she sell?
 Revenues – Variable costs – Fixed costs
=
Target net income ÷ (1 – tax rate)
 $90Q – $32Q – $96,000 = $35,721 ÷ 0.70
 $58Q = $51,030 + $96,000
 Q = $147,030 ÷ $58
 Q = 2,535 dresses

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Target Net Income
and Income Taxes
Revenues (2,535 × $90)
Variable costs (2,535 × $32)
Contribution margin:
Fixed costs:
Operating income:
Income taxes: ($51,030 × .30)
Net income
$228,150
81,120
$147,030
96,000
$ 51,030
15,309
$ 35,721
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Learning Objective 9
Understand how cost behavior
and cost-volume-profit analysis
are used by managers.
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How Is Cost Behavior
Used By Managers ?
Understanding cost behavior is vital to
the manager’s decision-making role,
because one of the main goals of
management accounting is
controlling costs.
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End of Chapter 2
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