CHAPTER M5
Business Decisions
Using Cost Behavior
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Learning Objective 1:
Describe the differences
between a functional
income statement and a
contribution income
statement.
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Functional Income
Statements
 All financial income statements are functional
income statements.
 Expenses are grouped together according to
their function. More specifically, they are
grouped as either product costs (COGS) or
period costs (selling and administrative).
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Functional Format Review
 A CD Dealer buys and sells compact discs.
 Each CD is purchased at a cost of $6 and
sold for $15.
 Selling expenses last month were $10,000,
when 2,000 CDs were sold.
 Administrative expenses last month were
$6,000.
 Make an income statement for last month.
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Functional Income Statement
The CD Dealer
Functional Income Statement
For the Month Ended March 31, 2007
Sales (2,000 @ $15)
Cost of goods sold ($6 ea.)
$ 30,000
12,000
Gross profit
Operating expenses:
Selling expenses
Administrative expenses
$ 18,000
Operating income
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$ 10,000
6,000
16,000
$ 2,000
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Discussion Questions
 Using the functional income statement on the
previous slide, answer these questions:
How many units must they sell to break even?
 If sales increased by 10%, by what percentage
would income increase?
 If they were to sell 100 more units, how much
additional profit would there be?

 These questions are difficult to answer
without having more information.
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Contribution Income
Statement
 Managers find that the contribution income
statement can be more helpful when making
certain types of internal decisions.
 For the contribution format, expenses are
grouped together according to their cost
behavior. Variable expenses are reported
separately from fixed expenses.
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Purpose of the
Contribution Format
 The contribution income statement enables
the manager to answer questions like those
just asked about the CD Dealer.
 With expenses organized according to cost
behavior, managers find it much easier to
see the potential effect of changes they may
initiate in managing the business.
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Contribution Margin
 Sales revenue minus variable expenses
equals the contribution margin.
 To break even, a company needs to generate
a large enough contribution margin to cover
all of the fixed expenses.
 To make a profit, a company must generate
more contribution margin than its fixed
expenses.
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Learning Objective 2:
Determine per unit
amounts for sales,
variable costs, and the
contribution margin.
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Cost Behavior for CD Dealer
 Assume that the expenses for CD Dealer
have the following behavior patterns:
Cost of goods sold.......all variable
 Selling expenses…......$4,000 variable, $6,000
fixed
 Admin. Expenses...…$2,000 variable, $4,000
fixed

 Compute the per unit revenue and costs for
CD Dealer.
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Cost Behavior for CD Dealer
The CD Dealer
Per Unit Analysis
For the Month Ended March 31, 2007
Per Unit
Total
Sales (2,000 @ $15)
Variable Expenses:
Cost of goods sold ($6 ea.)
Selling expenses
Administrative expenses
Contribution Margin
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$
15.00
$ 30,000
$
6.00
2.00
1.00
6.00
12,000
4,000
2,000
$ 12,000
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Learning Objective 4:
Prepare and analyze a
contribution income
statement for a
merchandising firm.
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The CD Dealer
Contribution Income Statement
For the Month Ended March 31, 2007
Sales (2,000 @ $15)
Variable expenses:
Cost of goods sold
Selling expenses
Administrative expenses
Contribution margin
Fixed expenses:
Selling expenses
Administrative expenses
Operating income
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$ 30,000
12,000
4,000
2,000
18,000
$ 12,000
$ 6,000
4,000
10,000
$ 2,000
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Discussion Questions
 The CD Dealer made a $2,000 profit on
sales of 2,000 units. What profit would he
earn on sales of 4,000 units?
 If he does sell 4,000 units, would you expect
the fixed expenses to increase?
 If he does sell 4,000 units (double the
current sales), which other numbers on the
statement would you expect to double?
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Condensed Contribution Income Statement
The CD Dealer
Contribution Income Statement
For the Month Ended March 31, 2007
Total
Per Unit % of Sales
Sales (2,000 units)
Variable expenses
$ 30,000
18,000
$ 15.00
9.00
Contribution margin
Fixed expenses:
$ 12,000
10,000
$
Operating income
$ 2,000
6.00
100.0%
60.0%
40.0%
The condensed contribution income statement shown
above helps to answer the kind of questions posed
earlier.
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Using the Contribution Margin
 The condensed contribution income
statement clearly shows two very useful
pieces of information.
 The unit contribution margin (UCM) is a
key element in many management
decisions. For the CD Dealer, the UCM
equals $6.00. Thus, each additional unit
sold adds $6.00 to the monthly profit.
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Discussion Questions
 At the start business on the first day of a
month, is it fair to say that the CD Dealer
has a net loss of $10,000 for the month?
 What would be the net loss after the first
CD of the month is sold? What about after
the second? After the third?
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Learning Objective 3:
Determine the
contribution margin
ratio and explain its
importance as a
management tool.
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Using the Contribution Margin
 The second piece of useful information is
the contribution margin ratio (CMR).
 For the CD Dealer, the CMR is 40%. This
means that for any dollar increase in
sales, there should be an increase in
income equal to 40% of the dollar increase
in sales.
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Learning Objective 5:
Describe cost-volumeprofit (CVP) analysis
and explain its
importance as a
management tool.
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Cost-Volume-Profit
Analysis
 Cost-volume-profit analysis (CVP) is the
analysis of the relationship between cost and
volume and the effect of these relationships
on profit.
 CVP analysis can help determine the future
profitability prospects, or lack thereof, for
managers, owners, or potential owners of
businesses.
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Break-Even Point
 The most basic analysis in the CVP
toolbox is break-even analysis. The
break-even point is the sales volume
required to generate neither a profit nor a
loss.
 Using the contribution income statement,
the total contribution margin will equal the
total fixed expenses at the break-even
point.
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Break-even Points in
Units
Break-even Point (units) = Total Fixed Costs
UCM
For the CD Dealer =
=
$10,000
$6.00
1,667 Units
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Break-even Point in
Sales Dollars
Break-even Point ($) = Total Fixed Costs
CMR
For the CD Dealer =
=
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$10,000
.40
$25,000 of Sales
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Predicting Profits Using
CVP Analysis
 A natural extension of break-even analysis
is to calculate the amount of sales volume
needed to earn a certain level of profit.
 In order to earn a desired level of profit,
the total contribution margin must be equal
to the total fixed costs plus the desired
amount of profit.
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Learning Objective 6:
Use CVP analysis to
determine the amount
of sales required to
break even or to earn a
targeted profit.
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Required Sales in Units to
Meet Target Profits
Required Unit Sales = Fixed Costs + Target Profit
UCM
For the CD Dealer to earn $5,000 profit:
= $10,000 + $5,000
$6.00
= 2,500 Units
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Required Sales ($) to
Meet Target Profits
Required Sales ($) = Fixed Costs + Target Profit
CMR
For the CD Dealer to earn $5,000 profit:
= $10,000 + $5,000
.40
= $37,500 Sales
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CVP Graphing
 A CVP graph would be drawn as follows:
 The sales revenue line would start at the
origin and slope upward at a rate equal to the
selling price per unit.
 The total cost line would start at the amount of
fixed costs, and slope upward at a rate equal
to the variable cost per unit.
 The break-even point is that volume where
the revenue and cost lines intersect.
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CVP Graph
sa le s
Current Sales
= $30,000
Bre akeven =
$25,000 Sa le s
$ 30,000
total cost
$ 25,000
$ 20,000
$ 15,000
fixe d cost
$ 10,000
$ 5,000
500
1,000
1,500
Breakeven =
1,667 Units
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2,000
2,500
Current Sales
= 2,000 Units
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Learning Objective 7:
Use CVP to perform
sensitivity analysis.
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Sensitivity Analysis
 Sensitivity analysis is applied to assess the
changes in the CVP analysis when changes
are made in the basic parameters (price,
volume, etc.)
 It is also called what-if analysis. For
example: “What if we increased our fixed
costs by 10%, while lowering our variable
costs by 20%?”
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Change in Selling Price
 If the only change is in the selling price, then
the contribution margin also changes in the
same direction by the same amount.
 You would expect the break-even point and
target profit volumes to change in the
opposite direction of the change in selling
price. If the selling price decreases, the
break-even point increases.
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Change in Price Example
 Lets assume that the CD Dealer decreases
the price of CDs from $15 to $14. This
results in a decrease in the UCM from $6 to
$5, and a decrease in the CMR from 40% to
33.3%.
 New break-even point in units:
$10,000 / $5 = 2,000 units
 New breakeven in dollars:
$10,000 / .333 = $30,000
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Change in Variable Cost
 If the only change is in the variable cost, the
contribution margin also changes in the
opposite direction by the same amount.
 You would expect a change in the breakeven point and target profit volumes in the
same direction as the change in the variable
cost. If the variable cost increases, the
break-even point also increases.
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Change in Variable
Cost Example
 The CD Dealer experiences an increase in
variable costs from $9 to $11. This results in a
decrease in the UCM from $6 to $4, and a
decrease in the CMR from 40% to 26.7%.
 New break-even point in units:
$10,000 / $4 = 2,500 units
 New breakeven in dollars:
$10,000 / 26.7% = $37,500
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Change in Fixed Cost
 If the only change is in the fixed cost, then
there is no change in the contribution
margin.
 You would expect a change in the breakeven point and target profit volumes in the
same direction as the change in fixed cost.
If the fixed cost decreases, then the breakeven point also decreases.
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Change in Fixed Cost
Example
 The CD Dealer experiences a decrease in
fixed costs from $10,000 to $9,000. This
change has no affect on the UCM or CMR.
 New break-even point in units:
$9,000 / $6 = 1,500 units
 New breakeven in dollars:
$9,000 / .40 = $22,500
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Change in Both Costs
 If there are changes in both the fixed cost
and the variable cost, then there will be a
change in the contribution margin.
 There will most likely be a change in the
break-even point and target profit volumes,
but the direction of that change depends on
both the direction and relative magnitude of
the changes in the variable and fixed costs.
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Change in Both Costs
Example
 The CD Dealer lowers variable selling costs
by $1 per unit while increasing fixed selling
costs by $1,900. The new UCM is $7, the
new CMR is 46.7%, and the new fixed cost
is $11,900.
 Breakeven in units = $11,900 / $7 = 1,700
 Breakeven in $ = $11,900 / .467 = $25,500
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Multiple Products
 What would we do if the CD Dealer started
selling cassette tapes in addition to CDs?
 In a multiple product situation, we can
still perform the basic CVP calculations if
we use the total amounts, rather than the
per unit amounts.
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Multiple Products Example
 Assume that the CD Dealer has prepared a
contribution income statement using his
sales and costs expectations for the
average month in the future.
 Included in the sales and costs are the
amounts related to both the CDs and the
tapes. The statement is shown on the next
slide.
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The CD and DVD Dealer
Contribution Income Statement
For the Average Month
Total
% of Sales
Sales
Variable expenses
$
40,000
22,000
100.0%
55.0%
Contribution margin
Fixed expenses:
$
18,000
14,000
45.0%
Operating income
$
4,000
Notice that the average contribution margin is now
45%, compared to 40% previously. Also, fixed costs
have increased from $10,000 to $14,000.
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Discussion Questions
 Can you give examples of why the CD
Dealer might experience an increase in
monthly fixed costs when DVDs are added
to the inventory?
 Since the income statement shows a
doubling of profit from $2,000 to $4,000,
should the owner add DVDs without
question?
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Multiple Product
Break-Even Point
 For the CD and DVD Dealer, the break-
even point can now be calculated as
follows:
 Fixed cost =
Avg. CMR
$14,000 = $31,111
.45
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Multiple Product
Target Profit
 Prior to adding DVDs, the CD Dealer
earned a monthly profit of $2,000 on sales
of $30,000. What sales volume is now
required to earn that same $2,000 profit?
Fixed + Profit = $16,000 = $35,556
Avg. CMR
.45
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Discussion Questions
 The addition of DVDs caused the expected
profit to increase, but also caused the breakeven point to increase. Does this indicate a
greater risk of loss for the business?
 The target profit analysis shows that sales will
have to be $5,556 higher than the current level
of $30,000 just to earn the same $2,000
income that is currently earned. Does that
sound right? What would you do?
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Simplifying Assumptions
 The following five assumptions are made
when performing CVP analysis as described
in this chapter:
1. All costs are either fixed or variable.
2. Total fixed costs remain fixed throughout the
relevant range.

(continued on next slide)
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Simplifying Assumptions
3. Variable cost per unit remains stable
throughout the relevant range.
4. Selling prices remain stable throughout
the relevant range.
5. Average contribution margin ratio for
multiple products remains stable
throughout the relevant range.
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The End of Chapter M5
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