IDENTIFYING COST BEHAVIOR PATTERNS

For each of the following situations, identify the graph that illustrates the cost behavior pattern involved:1. Cost of raw materials used2. Electricity Bill – a flat fixed charge, plus a variable cost after

a certain number of kilowatt hours are used.3. City water bill, which is computed as follows:

First 1,000,000 gallons or less $1,000 flat feeNext 10,000 gallons $0.003 per gallon usedNext 10,000 gallons $0.006 per gallon used

Next 10,000 gallons $0.009 per gallon used

Etc Etc

0 1,000,000 1,010,000 1,020,000 1,030,000$900

$950

$1,000

$1,050

$1,100

$1,150

$1,200

City Water Bill

City Water Bill

IDENTIFYING COST BEHAVIOR PATTERNS

• Rent on a factory building donated by the city, where the agreement calls for a fixed fee payment unless 200,000 labor-hours or more are worked, in which case no rent need be paid.

• Salaries of maintenance workers, where one maintenance worker is needed for every 1,000 hours of machine-hours or less (that is, 0 to 1,000 hours require one maintenance worker, 1,001 to 2,000 requires two maintenance workers, etc.)

CONTRIBUTION FORMAT VS. TRADITIONAL FORMAT OF INCOME STATEMENT

TRADITIONAL FORMAT CONTRIBUTION FORMAT

Sales Sales

- COGS - Variable expenses

= Gross Profit = Contribution Margin

- Selling & Administrative Expenses

- Fixed Expenses

= Net Income = Net Income

Marwick’s Pianos, Inc., purchases pianos from a large manufacturer and sells them at the retail level. The pianos cost, on the average, $2,450 each from the manufacturer. Marwick’s Pianos, Inc., sells the pianos to its customers at an average price of $3,125 each. The selling and administrative costs that the company incurs in a typical month are presented below:

During August, Marwick’s Pianos, sold and delivered 40 pianos.

SELLING COSTS ADMINISTRATIVE COSTS

Advertising…..$700 per month Executive salaries…..$2,500 per month

Sales salaries and commissions…..$950 per month, plus 8% of sales

Insurance…..$400 per month

Delivery of pianos to customers…$30/piano sold Clerical…..$1,000/month, plus $20/piano sold

Utilities…..$350 per month Depreciation of office equipment....$300/month

Depreciation of sales facilities…..$800/month

TRADITIONAL FORMAT

Sales $125,000Less: Cost of Goods Sold $98,000Gross Margin $27,000Less: Operating Expenses

Selling $14,000Administrative $5,000 $19,000

Net Income $8,000

CONTRIBUTION FORMAT INCOME STATEMENT

Sales $125,000Variable Expenses:

Variable production $98,000Variable selling $11,200Variable admin $800 $110,000

Contribution margin $15,000Fixed Expenses:

Fixed selling $2,800Fixed admin $4,200 $7,000

Net Operating Income $8,000

COST VOLUME PROFIT ANALYSIS

Cost-volume-profit analysis is based upon determining the breakeven point of cost and volume of goods.

CVP Analysis can help answer questions like: what products and services to offer and what prices to charge, etc.

It can be useful for managers making short-term economic decisions.

Running this analysis involves using several equations using price, cost and other variables and plotting them out on an economic graph.

COST VOLUME PROFIT ANALYSIS

• CVP analysis has following assumptions:– All cost can be categorized as variable or fixed.– Sales price per unit, variable cost per unit and

total fixed cost are constant.– All units produced are sold.

CONTRIBUTION INCOME STATEMENT FOR ABC COMPANY

Total Per UnitSales* $100,000 $250Variable Expenses $60,000 150Contribution margin $40,000 $100Fixed Expenses: $35,000Net Operating Income $5,000

*400 SPEAKERS SOLD

CONTRIBUTION INCOME STATEMENTIf 1 speakers is sold!!

Total Per UnitSales $250 $250Variable Expenses: $150 150Contribution margin $100 $100Fixed Expenses: $35,000Net Operating Income $(34,900)

CONTRIBUTION INCOME STATEMENTIf 2 speakers are sold!

Total Per UnitSales $500 $250Variable Expenses: $300 150Contribution margin $200 $100Fixed Expenses: $35,000Net Operating Income $(34,800)

CONTRIBUTION INCOME STATEMENTSales of 350 Speakers

Total Per UnitSales $87,500 $250Variable Expenses $52,500 150Contribution margin $35,000 $100Fixed Expenses: $35,000Net Operating Income $ 0

CONTRIBUTION INCOME STATEMENTSales of 351 Speakers

Total Per UnitSales $87,750 $250Variable Expenses $52,650 150Contribution margin $35,100 $100Fixed Expenses: $35,000Net Operating Income $ 100

“Once the break even point has been reached, net operating income will increase by the amount of the unit

contribution margin for each additional unit sold.”

Volume (400

speakers)

Sales Volume(425 speakers)

Difference(25

speakers)

Per Unit

Sales* $100,000 $106,250 $6,250 $250

Variable expenses**

60,000 63,750 3,750 150

Contribution Margin

40,000 42,500 2,500 $100

Fixed Expense 35,000 35,000 0

Net operating income

$5,000 $7,500 $2,500

*Sales= Price × Volume: $250 × 400 = $100,000**Variable expense = Variable expense per speaker × Volume: $150 × 400 = $60,000

SUMMARY

• If sales are zero, loss would equal fixed expenses.• Each unit sold reduces the loss by the amount of

unit contribution margin.• After reaching break-even point, each additional

unit sold increases the company's profit by the amount of the unit contribution margin.

CVP RELATIONSHIPS IN GRAPHIC FORM

0 100 200 300 400 500 600 700 800$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

$160,000

Fixed ExpenseTotal Sales RevenueTotal Expense

CONTRIBUTION MARGIN RATIO

CM Ratio = Total Contribution MarginTotal Sales

OR

CM Ratio = Unit Contribution MarginUnit selling price

CONTRIBUTION MARGIN RATIO

Total Per Unit % of salesSales* $100,000 $250 100%Variable Expenses $60,000 150 60%Contribution margin $40,000 $100 40%Fixed Expenses: $35,000Net Operating Income $5,000

*400 SPEAKERS SOLD

$30,000 increase in sales?

Present Expected Increase % of sales

Sales $100,000* $130,000 $30,000 100%Variable expenses

60,000** 78,000 18,000 60%

Contribution Margin

40,000 52,000 12,000 40%

Fixed Expense 35,000 35,000 0Net operating income

$5,000 $17,000 $12,000

*Sales= Price × Volume: $250 × 400 = $100,000**Variable expense = Variable expense per speaker × Volume: $150 × 400 = $60,000 OR 60% of sales

APPLICATIONS OF CVP CONCEPTS

Changes in Fixed Cost & Sales Volume Change in Variable Costs & Sales Volume Changes in Fixed Cost, Sales Price, & Sales

Volume Changes in Variable Cost, Fixed Cost, and Sales

Volume Change in Selling Price

CHANGES IN FIXED COST & SALES VOLUME

Current Sales

Sales with Additional

Advertising Budget

Difference % of Sales

Sales $100,000 $130,000 $30,000 100%Variable Expenses

(60,000) 78,000* 18,000 60%

Contribution Margin

40,000 52,000 12,000 40%

Fixed Expenses

(35,000) 45,000** 10,000

Net Operating Income

$5,000 7,000 2,000

*520 units × $150 per unit = $78,000**35,000 + additional $10,000 monthly advertising budget = $45,000.

ALTERNATIVE SOLUTION 1

Expected total contribution margin: $130,000 × 40% CM ratio

$52,000

Present total contribution margin $100,000 × 40% CM ratio

40,000

Incremental contribution margin 12,000

Change in fixed expenses Less incremental advertising expense

10,000

Increased net operating income $2,000

ALTERNATIVE SOLUTION 2

Incremental contribution margin:$30,000 × 40% CM ratio…………………. $12,000

Less Incremental advertising expense………. 10,000Increased net operating margin……………….. $ 2,000