Chapter 6
Cost Behavior and Decision Making:
Cost, Volume, Profit Analysis
Topics
Introduction
The Contribution Margin Income Statement
The Contribution Margin and Its Uses
Introduction
Cost-Volume-Profit Analysis (CVP)
Focuses on the following factors:
The prices of products or services
The volume of products or services
produced and sold
The per-unit variable costs
The total fixed costs
The mix of products or services produced
The Contribution Margin Income
Statement
The Contribution Margin Income
Statement is structured by behavior
rather than by function.
Sales - All Variable Costs = Contribution
Margin
Contribution Margin - All Fixed Costs = Net
Income
Income Statements
TRADITIONAL
Sales
$1,000
Less: Cost of Goods Sold
Variable Costs
350
Fixed Costs
150
Total Costs of Goods Sold
$ 500
Gross Profit
$ 500
Less: S&A Costs
Variable Costs
$ 50
Fixed Costs
250
Total S&A Costs
$ 300
Net Income
$ 200
CONTRIBUTION MARGIN
Sales
Less: Variable Costs
Manuf. Costs
S&A Costs
Total Variable Costs
Contribution Margin
Less: Fixed Costs
Manuf. Costs
S&A Costs
Total Fixed Costs
Net Income
$1,000
$350
50
$400
$600
$150
250
$400
$200
The Contribution Margin Income
Statement
Key Concept
The contribution margin income
statement is structured to
emphasize cost behavior as
opposed to cost function.
Contribution Margin Per Unit
Sales (100,000 units)
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income
Total
Per Unit
$200,000
80,000
$120,000
40,000
$80,000
$2.00
.80
$1.20
Contribution Margin Per Unit
What if HD Inc. sold one more unit?
Total Per Unit
Sales (100,001 units)
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income
$200,002.00
80,000.80
$120,001.20
40,000.00
$80,001.20
$2.00
.80
$1.20
Contribution Margin Per Unit
Key Concept
For every unit change in
sales, contribution margin will
increase or decrease by the
contribution margin per unit
multiplied by the increase or
decrease in sales volume.
Contribution Margin Ratio
Contribution Margin Ratio
=
Contribution Margin (in $)
Sales (in $)
Contribution Margin Ratio
Sales (100,000 units)
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income
Total
Percent
$200,000
80,000
$120,000
40,000
$80,000
100%
40
60%
Contribution Margin Ratio
Key Concept
The contribution margin per
unit and the contribution margin
ratio will remain constant as
long as sales vary in direct
proportion with volume.
Contribution Margin Ratio
Key Concept
For every dollar change in
sales, contribution margin will
increase or decrease by the
contribution margin ratio
multiplied by the increase or
decrease in sales dollars.
Contribution Margin Ratio
Using either contribution margin per unit
or contribution margin ratio, calculate HD
Inc.’s net income (loss) when sales are
25,000 units or $50,000.
Answer:
25,000 units x $1.20 cm = $30,000 or
$50,000 x 60% = $30,000
The Contribution Margin and Its Uses
What would happen if sales increase?
Use the CM to determine the increase of
net income. Then consider what must
happen before sales increase. Lower
sales price? Increase incentives for
sales staff? Improve quality of product?
Increase advertising budget?
What-If Decisions Using CVP
Step 1: Define the Problem
Contribution margin is not
sufficient to cover fixed costs.
What-If Decisions Using CVP
Step 2: Identify Objectives
1. Increase net income
2. Maintain a high-quality
product
What-If Decisions Using CVP
Step 3:Identify and analyze available options
1. Reduce variable costs of
manufacturing the product
2.Increase sales through a
change in the sales incentive
structure or commissions (a
variable cost)
3. Increase sales through
increasing advertising (a fixed
cost)
What-If Options Using CVP
Option 1
When variable costs are reduced, contribution
margin will increase.
Find less expensive supplier of raw material
Reduce the amount of labor used
Use lower-wage employees
What would be the consequences of each?
What-If Options Using CVP
Total Option 1
Sales
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income (Loss)
$100,000 $100,000
72,000
64,800
$28,000 $35,200
35,000
35,000
$(7,000)
$200
What-If Options Using CVP
Option 2
Raise sales commissions on all sales
above the present level by 10 percent.
Sales will increase by $30,000 or 2,400
games. Additional sales commission will
be $3,000.
What-If Options Using CVP
Impact of increasing Sales Incentives, Sales = $130,000
Total Option 1
Sales
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income (Loss)
$100,000 $130,000
72,000
96,600
$28,000 $33,400
35,000
35,000
$(7,000) $(1,600)
What-If Options Using CVP
Option 2A
Increase net income by $5,400 by
increasing the sales commission by 10
percent on all sales of more than
$100,000.
The new variable costs = 72% of sales up
to $100,000 and 82% on all sales over
$100,000.
What-If Options Using CVP
Option 3
Spending an additional $10,000 on
advertising will increase sales by
$40,000 or 3,200 games.
What-If Options Using CVP
Impact of increasing Sales Incentives, Sales = $140,000
Total Option 3
Sales
Less: Variable Costs
Contribution Margin
Less: Fixed Costs
Net Income (Loss)
$100,000 $140,000
72,000 100,800
$28,000 $39,200
35,000
45,000
$(7,000) $(5800)
What-If Options Using CVP
Step 4: Select the best option
Option 1, NI = $200
Option 2, NI = $(1,600)
Option 2a, NI = $200
Option 3, NI = $(5,800)
Assess risk inherent in each option
Assess sensitivity of a decision to
changes in key assumptions
Changes in Price and Volume
If the manager changes the sales price
resulting in a change in sales volume, what
will be the impact on net income?
Raising the sales price may decrease sales
volume but the impact on total sales revenue
may be offset by the increase in sales price.
Decreasing the sales price may increase the
sales volume without increasing total sales
revenue.
Changes in Price and Volume
These business strategies decisions involve
individuals in many areas of an organization,
such as marketing, sales, production
management, and even human resources
personnel for hiring decisions. The
implications of a bad decision in this area
can affect the firm’s bottom line.
Changes in Cost, Price and Volume
Changes can be made to cost, price
and volume at the same time.
Changes in one almost always impact
one or both of the other variables.
Break-Even Analysis
Break-Even Point: the level of sales
where contribution margin just covers
fixed costs and consequently net
income is equal to zero.
Break-Even Analysis
Break-Even = Fixed Costs
(units)
Contribution Margin Per Unit
Break-Even = Fixed Costs
(Sales $)
Contribution Margin%
Break-Even Graph
Revenue
Break-Even Point
Income
Total Cost
$
Break-Even
Point
in $
Loss
Break-Even Point in Volume
Volume
Break-Even Calculations with
Multiple Products
The calculation of “average” contribution
margin is really a weighted average.
Fixed Costs
Break-Even Point
=
Weighted Average
Contribution Margin Ratio
Break-Even Calculations with
Multiple Products
Pause and Reflect
Imagine how difficult it is for large
retail stores such as Wal-Mart or
JCPenney to compute a breakeven point for the entire store or
company.
Break-Even Calculations with
Multiple Products
When using ABC, costs are classified as
unit, batch, product, or facility level
instead of variable or fixed.
Break-Even (units) =
Fixed Costs + Batch-level costs + Product-level costs
Contribution Margin Per Unit
Target Profit Analysis
(Before and After Tax)
To determine the sales units required to
achieve a Target Profit before taxes:
Sales (units) =
Fixed Costs + Target Profit (before taxes)
Contribution Margin Per Unit
Target Profit Analysis
(Before and After Tax)
Multiple Product formula to reach a
Target Profit:
Sales (units) =
Fixed Costs + Target Profit
Weighted Average Contribution Margin Per Unit
Target Profit Analysis
(Before and After Tax)
ABC Formula to reach a Target Income:
Sales (units) =
Fixed Costs + Batch-level Costs + Product-level
Costs + Target Profit
Contribution Margin Per Unit
The Impact of Taxes
If
After-Tax Profit = Before-Tax Profit (1-tax rate)
then
Before-Tax Profit = After-Tax Profit / (1-tax rate)
Therefore, to determine after-tax Target Income
Fixed costs + After-Tax Profit / (1-tax rate)
Sales in units =
Contribution Margin per unit
The Impact of Taxes
Key Concept
The payment of income tax is
an important variable in
target profit and other CVP
decisions.
The Impact of Taxes
Pause and reflect
What impact do income taxes
have on the calculation of the
break-even point?
Assumptions of CVP Analysis
Selling price is constant throughout the
relevant range.
Costs are linear throughout the relevant
range.
The sales mix used to calculate the weighted
average contribution margin is constant.
The amount of inventory is constant.
Cost Structure and Operating Leverage
Operating Leverage: The measure of
the proportion of fixed costs in a
company’s cost structure. It is used as
an indicator of how sensitive profit is to
changes in sales volume.
Cost Structure and Operating Leverage
Operating Leverage =
Contribution Margin
Net Income
Multiply OL x % increase in Sales = % increase in Net Income
Cost Structure and Operating Leverage
Company
A
B
C
Sales
$100,000
$200,000
$400,000
Cont. Margin
$ 60,000
$120,000
$240,000
Net Income
$ 20,000
$ 80,000
$200,000
60,000
20,000
120,000
80,000
240,000
200,000
3.0
1.5
1.2
30%
15%
12%
Operating
Leverage
=
10% Inc Sales
Cost Structure and Operating Leverage
Pause and Reflect
Unlike measures of contribution
margin, operating leverage
changes as sales change.
Cost Structure and Operating Leverage
Key Concept
A company operating near the
break-even point will have a high
level of operating leverage and
income will be very sensitive to
changes in sales volume.
Variable Costing for Decision Making
The only difference between absorption
and variable costing is the treatment of
fixed overhead.
Absorption Costing: FO is treated as
a product cost, and expensed when the
product is sold.
Variable Costing: FO is treated as a
period cost and expensed as incurred.
Variable Costing for Decision Making
Absorption Costing
Sales
$1,000
Less: Cost of Goods Sold
Variable Costs
350
Fixed Costs
150
Total Costs of Goods Sold
$ 500
Gross Profit
$ 500
Less: S&A Costs
Variable Costs
$ 50
Fixed Costs
250
Total S&A Costs
$ 300
Net Income
$ 200
Variable Costing
Sales
Less: Variable Costs
Manuf. Costs
S&A Costs
Total Variable Costs
Contribution Margin
Less: Fixed Costs
Manuf. Costs
S&A Costs
Total Fixed Costs
Net Income
$1,000
$350
50
$400
$600
$150
250
$400
$200
Variable Costing for Decision Making
Absorption Costing
Product Cost
Period Cost
Direct Material
Direct Labor
Variable Overhead
Fixed Overhead
Variable Costing
Product Cost
Period Cost
Direct Material
Direct Labor
Variable Overhead
Fixed Overhead
Sell. & Adm.
Fixed OH
Sell. & Adm.
Variable Costing for Decision Making
Product Costs
Absorption Costing
Direct Material
Direct Labor
Variable Overhead
Fixed Overhead
Total per unit
$.30
.35
.10
.30
Variable Costing
Direct Material
Direct Labor
Variable Overhead
$.30
.35
.10
Total per unit
$.75
$1.05
.30
Differences Between Absorption and
Variable Costing
When units sold equal units produced, net
income is the same under both costing
methods.
When units produced exceed units sold,
absorption costing will report higher net
income than variable costing.
When units sold exceeds units produced,
variable costing will report higher net
income than absorption costing.
Variable Costing for Decision Making
Key Concept
Variable costing is consistent with
CVP’s focus on differentiating fixed from
variable costs, and provides useful
information for decision making that is
often not apparent when using
absorption costing.
Variable Costing for Decision Making
I’m ready!
Bring on the
costs!