Cost Behavior: Analysis and Use

1. Variable Cost – varies proportionately in total but remains constant on a per unit
basis.
a. True variable costs – proportionately variable (ex. Raw material) amount
used directly increases as production increases by the same percentage.

b. Step variable costs – costs obtainable in large segments (ex. Labor costs of
maintenance workers) and that increase or decrease in response to fairly
wide changes in activity levels.

NOTE: these costs are constant for a certain activity level (relevant range)
and then vary in a step like fashion as volume increases.

2. Fixed Costs – remain constant in total but vary inversely on a per unit basis (if
production increases, then per unit cost decreases; if production decreases, then
per unit cost increases)

a. Committed fixed costs – relate to the investment in plant, equipment and

the basic organizational structure of the firm (ex. Depreciation of building
and equipment, real estate taxes, insurance, management salaries, etc.)
- are long term in nature
- cannot be reduced immediately over a short period of time
without seriously impairing either the profitability or the long run
goals of a firm.

b. Discretionary Fixed Costs (Managed Fixed Costs)

- arise form annual decisions by management to spend in certain
fixed costs areas (ex. Advertising, research, management
development programs)
- short term in nature, usually a single year
- possible to cut back on certain costs for short periods of time
with minimum disruptions to long term goals.

c. Semi variable or Mixed Costs – contains both variable and fixed costs
elements
- at certain levels of activity mixed costs display the same
characteristics as a fixed cost
- at certain levels they display same characteristic as a variable
cost
- (examples: electricity, heat, telephone, maintenance, car rental,
copy machine rental)

1
2
3
 3. Three Methods of breaking mixed costs down into their fixed and variable
elements

a. The High-Low Method

- costs involved are observed at the highest and lowest levels of
activity within the relevant range
- the difference in cost observed at the two extremes is divided by
the change in activity to determine the amount of variable cost.
NOTE: Since total fixed costs are constant regardless of activity, the
change in costs associated with activity is attributable to variable
cost behavior.

Variable Cost = Change in cost ÷ Change in activity

Then find fixed cost element as follows:

Fixed Cost Element = Total Cost (at high point) – Variable Cost Element

NOTE: You can also use the low point and arrive at the same fixed cost element.
Since fixed costs do not change in total within the relevant range of activity, this would
result in the same answer.

Graph Analysis
- cost is always plotted on the vertical axis and represented by the
letter “Y”
- cost is known as the dependent variable, since the amount of cost
incurred during a period depends upon the level of activity or
volume.

5. Comparison of Two Types of Income Statement

4
5
 a. Contribution Margin
(1) Sales – Variable Expenses = Contribution Margin
(2) The amount remaining from sales revenues after variable
expenses have been deducted that can be used to contribute
toward the recovery of fixed expenses and then toward profit for
the period.

b. Benefits of a JIT Inventory System

(1) reduce inventory levels, money can be spent elsewhere
(investment, plant expansion, etc)
(2) reduce storage space (turn into production space)
(3) total quality control (TQC) – reduces waste with zero deficits
(4) worker productivity is increases; machine set up time is
decreased.

6. Direct or Indirect Costs

a. Direct Costs – can be physically traced to the particular segment under

consideration (product line, sales territory, division, etc.)

b. Indirect Costs – must be allocated in order to be assigned to the segment

under consideration (indirect cost is manufacturing overhead).

NOTE: Indirect Costs are also called Common Costs.

7. Additional Cost Terms

a. Controllable Costs – if management at a certain level as the power to

authorize and influence the cost

b. Noncontrollable Costs – if management at a certain level is unable to

influence the incurrence of the cost.

c. Differential Cost – present under one alternative but is absent under an

alternative course of action.

NOTE: Differential costs are also known as incremental costs.

d. Opportunity Cost – potential benefit that is lost or sacrificed when

selecting one course of action makes it necessary to give up a different
course of action.
Opportunity cost is not recorded in the books of an organization, but is
considered in every decision.

e. Sunk Cost – already incurred and cannot be changed by any decision made
now or in the future. An irrelevant cost in decision-making.

6
 Cost – Volume – Profit (CVP) Analysis

1. CVP Analysis – study of interrelationship between

a. Prices of product
b. Volume of level of activity
c. Per unit variable cost
d. Total fixed costs
e. Mix of products sold

2. CVP key factor in decision making:

a. Choice of product lines
b. Pricing of products
c. Marketing strategy
d. Utilization of productive facilities

3. Contribution Margin Ratio (CM Ratio) / Profit Volume Ratio (P/V Ratio)

a. The percentage of contribution margin to total sales

CM Ratio = Contribution Margin ÷ Sales

4. Operating Leverage – measure of the extent to which fixed costs are being used in
an organization
a. If high operating leverage exists (a high proportion of fixed costs in
relation to variable costs) then profits will be very sensitive to changes in
sales

b. Therefore a small percentage increase (or decrease) in sales can yield a

large percentage increase (or decrease) in profits

c. Degree of operating leverage measured:

Contribution Margin ÷ Net Income = Degree of Operating Leverage

The degree of operating leverage will continue to decrease further the

company moves from its break-even point.

7
 5. Break Even Analysis

a. Break Even point – the point where the total sales revenue equals total
expenses (fixed and variable)

Or

The point where the total contribution margin equals the total fixed
expenses.

b. Two Methods of Break Even Analysis

(1) Equation Method

Sales = Variable Expenses + Fixed Expenses + Profits

NOTE: At the break-even point, the profits will be zero.

(2) Unit Contribution Method

Examines the relationship between contribution margin and total

fixed expenses.

Fixed Expenses ÷ (1) Unit Contribution Margin = Break Even Point (Units)
Or
Fixed Expenses ÷ (2) CM Ratio = Break Even Point (Dollars)

(1) Unit Contribution Margin = Unit Sales – Unit Variable Expense

(2) CM Ratio = Contribution Margin (sales – variable exp) ÷ Sales

8
9
 6. Target Net Profit Analysis

a. CVP Equation
Sales = Variable Expenses + Fixed Expenses + Profits

b. Unit Contribution Approach

(Fixed Expenses + Target Net Profit) ÷ Contribution Margin per unit = units sold to break
even

7. Margin of Safety

a. Excess of budgeted (or actual) sales over the break-even volume of sales

b. Indicates the range that sales can drop before losses are incurred.

c. Total Sales – Break even sales = Margin of Safety (MS)

Or
MS in dollars ÷ Total Sales = MS Percentage

8. Sales Mix – combination in which a company’s products are sold

If the sales mix changes so will the break-even point.

9. Limiting Assumptions in CVP Analysis

a. Revenues and cost behavior is linear through the relevant range
b. Costs are divided accurately between fixed and variable element
c. Sales mix is constant.
d. Inventories do not change (number of units produced = number of units
sold)
e. Worker and machine productivity do not change through the relevant
range
f. The value of a dollar does not change

10