Part III: Tools to Analyze
Financial Operations
CHAPTER 7:
COST BEHAVIOR AND
BREAK-EVEN ANALYSIS
Fixed, Variable and
Semivariable Costs
Distinguishing between fixed, variable and
semivariable costs is important because this
knowledge is a basic working tool in
financial management.
Fixed, Variable and
Semivariable Costs
Fixed Costs are those costs that do
not vary in total when activity
levels (or volume) of operations
change.
Examine the examples in the chapter.
Fixed, Variable and
Semivariable Costs
Variable Costs are those costs that
vary in direct proportion when
activity levels (or volume) of
operations change.
Examine the examples in the chapter.
Fixed, Variable and
Semivariable Costs
Semivariable Costs vary when the
activity levels (or volume) of
operations change, but not in direct
proportion
The most frequent patters of
semivariable costs is the step
pattern.
Examine the examples in the chapter.
Analyze Mixed Costs
The Manager needs to know how
to analyze mixed costs because
they occur so often.
Analyze Mixed Costs by
Two Simple Methods
The Predominant Characteristics Method
— The manager judges whether the cost is
more fixed or more variable.
The Step Method — The manager
examines the “steps” in the step pattern of a
fixed cost and decides whether the pattern
appears to be more fixed or more variable.
Both of these methods are judgmental.
Analyze Mixed Costs Through
The High-Low Method
Cost is examined at its high level and its
low level.
Obtain the difference in cost between the
high and low levels; divide the amount of
change in the activity (or volume).
Examine the examples in the chapter.
Analyze Mixed Costs by the
Scatter Graph Method
The Scatter Graph finds the Mixed Cost’s
average rate of variability more accurately.
Use a graph to plot all points of data; cost
on vertical axis, volume on horizontal axis
of the graph. Fit a regression line to the
plotted points. The average fixed cost is
found at the point where the regression
line intersects with the cost axis.
Examine the examples in the chapter.
Understand Computation
Of the Contribution Margin
The Contribution Margin equals Variable
Cost deducted from net revenues. The
answer is the Contribution Margin.
(So called because it contributes to
fixed costs and profits.)
Examine the examples in the chapter.
Contribution Margin: Example
Examine Table 7-1 Page 53, which contains Operating Room Fixed and
Variable Costs. We can see that the total costs are $,1,217,756. Of this
amount, $600,822 is designated as variable cost and $616,934 is
designated as fixed ($529,556 + $87,378 = $616,934). For purposes
of our example, assume the Operating Room revenue amounts to
$1,260,000. The contribution margin is computed as follows:
Amount
Revenue
$1,260,000
Less Variable Cost
(600,822)
Contribution Margin
$ 659,178
Thus $659,178 is available to contribute to fixed costs and to profit. In this example
fixed costs are $616,934, so there is an amount left to contribute toward profit
Contribution Margin:
Practice
Assumptions: Greenside Clinic has revenue totaling $3,500,000.
Of this amount, 40 percent is variable cost and 60 percent is fixed cost.
Step 1. Divide costs into variable and fixed. In this case $3,450,000
times 40 percent equals $1,380,000 variable cost and $3,450,000
Times 60 percent equals $2,070,000fixed cost.
Step 2. Compute the contribution margin:
Revenue
Less Variable Costs
Contribution Margin
Less Fixed Costs
Operating Income
Amount
$3,500,000
(1,380,000)
$2,120,000
(2,070,000
$50,000
Contribution Margin:
Assignment
Assumptions: The Mental Health program for the Community Center
has just completed its fiscal year end. The Program Director determines
That his program has revenue for the year of $1,210,000. He believes
his variable expense amounts to $205,000 and he knows his fixed
expense amounts to $1,100,000.
Required: Compute the contribution margin for the Community Mental
Health program.
Computation:
Revenue
Less Variable Cost
Contribution Margin
Less Fixed Cost
Operating Profit (Loss)
$1,210,000
______________
($205,000)
______________
$1,005,000
______________
($1,100,000)
______________
($95,000)
______________
Contribution Margin:
Assignment
What does the result tell us about the program?
1. The contribution margin of $1,005,000 does not cover
the fixed costs of $1,100,000.
2. There is an overall loss in the program of $95,000.
3. The fixed cost is very high, making it imperative that
sufficient revenue levels be achieved.
The Cost-Volume-Profit (CVP)
Ratio or Breakeven Point
The Breakeven Point is the point when
the contribution margin equals the fixed
costs.
Loss equals a loss;
More equals a profit.
Thus, Breakeven Point.
Examine the examples in the chapter.
CVP Example
C o st - V olu m e - P rofit (C V P ) C ha rt
$ 5 00
Revenues (net)
Less: variable cost
Contribution margin
Less fixed cost
Operating income
4 00
$500,000
(350,000)
$150,000
(120,000)
$30,000
R ev enu e
Li n e
100%
70%
30%
Ne t
O p e ra t in g
In co m e
B re a k ev en
P o in t
V a ri ab le C ost
Li n e
3 00
2 00
Fi x ed C ost
Li n e
N et
L o ss
1 00
0
0
1000
2000
3000
N um ber of V is its
4000
5000
Compute the Profit-Volume
(PV) Ratio
If the contribution margin is expressed
as a percentage of net revenues, it is
often called the Profit-Volume Ratio
A PV chart needs only 2
lines to show the effect
of changes in volume.
See example and explanation in the chapter.
CVP-PV Practice
Revenues (net)
Less: variable cost
Contribution margin
Less fixed cost
Operating income
+10 0
+90
+80
+70
+60
+50
+40
+30
+20
100%
70%
30%
F ix e d C o st s
Re covered
B reakeven
Poin t
+10
0
-1 0
-2 0
-3 0
-4 0
-5 0
-6 0
-7 0
-8 0
-9 0
-1
-1
-1
-1
-1
-1
$500,000
(350,000)
$150,000
(120,000)
$30,000
N e t
In c o m e
P r o je c t e d
Re venu es
N e t L o s s
( du e to
u n re c o v e r e d
f ix e d c o s t s )
S a fe t y
C u s h io n
( be fo r e
b re a k e v e n )
00
10
20
30
40
50
0
10 0
20 0
30 0
40 0
50 0
R e v e n u e ( i n t h o u s a n d s o f d o ll a r s )
+10 0
+90
+80
+70
+60
+50
+40
+30
+20
+10
0
-1 0
-2 0
-3 0
-4 0
-5 0
-6 0
-7 0
-8 0
-9 0
-1
-1
-1
-1
-1
-1
60 0
70 0
00
10
20
30
40
50
CPV – PV Practice
Assumptions: The Mental Health program for the Community Center
has just completed its fiscal year end. The Program Director determines
That his program has revenue for the year of $1,210,000. He believes
his variable expense amounts to $205,000 and he knows his fixed
expense amounts to $1,100,000.
Amount
Revenue
Less variable cost
Contribution margin
Less fixed cost
Operating (loss)
$1,210,000
_________
_________
(205,000)
_________
$1,005,000
_________
(1,100,000)
_________
$95,000
_________
Percent
________
100.00%
________
16.94%
________
83.06% =PV or CM Ratio
________
90.91%
________
7.85%
________
Per-Visit
_______
$100.00
_______
16.94
_______
$83.06
_______
90.91
_______
$7.85
_______
CPV – PV Assignment
Assumptions: Greenside Clinic has revenue totaling $3,500,000.
Of this amount, 40 percent is variable cost and 60 percent is fixed
cost. The clinic had 35,000 visits.
Amount
Revenue
$3,510,000
_________
_________
Less variable cost
(1,380,000)
_________
Contribution margin
$2,120,000
_________
Less fixed cost
(2,
070,000)
_________
Operating profit (loss) _________
$50,000
Percent
________
100.00%
________
-39.43%
________
60.57% =PV or CM Ratio
________
-59.14%
________
1.43%
________
Per-Visit
_______
$100.00
_______
-39.43
_______
$60.57
_______
-59.14
_______
$1.43
_______
Understand Further Use of
The Contribution Margin
Contribution Margins are also
useful in showing measures of
profitability in a simple, easy-tounderstand manner.
(For example, see the DRG matrix in Figure 7-8.)