COST BEHAVIOR

I. The Nature of Fixed and Variable Costs

A. Short Run Versus Long Run

1. Variable Costs change in total as the level of activity changes.

2. Fixed Costs do not change in total with changes in activity levels – in the short
run. In the long run no costs are fixed because changes can be made.

The concepts of variable and fixed costs are short run in nature. They usually apply
to a particular period and/or relate to a particular level of activity.

In the long run, all costs change and are not strictly variable or fixed. Fixed costs
are only fixed in the short run.

B. Relevant Range

This is the range (or band) of activity levels over which cost behaviors are
expected to be consistent. This means the behaviors are “relevant” only to such
range/band of activity levels.

Variable or fixed cost behaviors apply only if the specified activity level lies within
the relevant range. If the alternative level of activity is outside the relevant range,
the breakdown of fixed and variable costs requires a new computation.

Operating below the relevant range means being out of business because the total
fixed costs cannot be recovered, and capacity must be expanded in operating
above the relevant range.

II. Fixed costs can be classified to explain the relationship between current capacity and
fixed costs

A. Capacity Costs

Capacity costs provide a firm with the ability to produce and/or sell.

Also known as committed costs, these costs will be incurred even if the firm
temporarily shuts down operations. These costs result from ownership of facilities
and the firm’s basic organization structure.

Committed costs typically exist only in the short or medium run. Over the long
run, for example, the firm can get out of a long-term lease or sell assets no longer
needed.

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 B. Discretionary Costs

Sometimes called programmed costs, these do not need to be incurred in the short
run for the firm to operate. They are usually essential to achieve long run goals.
They reflect top management policies and commitments to particular programs.
Examples include research and development cost, and advertising cost.

III. Simplifying Cost Analysis

Costs vary with the volume or activity level in several ways. Some do not vary in
the short run (i.e., fixed costs); others vary with volume or activity level (variable
costs.

To simplify analysis, decision-makers assume costs to be strictly fixed or linearly

variable. This is done because the additional costs of analyzing complex data (semi-
or mixed types) often exceed the added benefits of doing so.

IV. The CVP Model

This basic financial model summarizes the effect of volume changes on costs,
revenues, and income. The user can extend the analysis to effect on profit of changes
in selling price, costs, income tax, and mix of products.

A. Break-Even Point is the volume of activity that produces equal revenues and total
costs. At this revenue level, neither profit nor loss results.

B. Contribution-margin approach

Contribution margin/unit = Selling price/unit – Variable costs/unit

Break-even volume = Fixed Costs ÷ Contribution margin/unit.

Contribution margin is that which remains after the variable costs of the sale are
considered or recovered. (Contribution margin conceptually covers fixed costs
first, and then contributes to the profitability.)

C. Equation approach

Operating profit = Sales revenue – Total Costs

Operating profit = Sales revenue – Variable cost – Fixed cost

Operating profit = (Selling Price/Unit * Sales Volume) – (Variable Cost/Unit *

Sales Volume) – Fixed Costs

Operating profit = [(Selling Price/Unit - Variable Cost/Unit) * Sales Volume] –

Fixed Costs

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 Setting Operating profit = 0 (break-even) and solving for Sales volume:

Sales volume = Fixed costs ÷ Contribution margin/Unit.

D. Target profit

Target-profit analysis helps determine sales volume to generate a desired profit.

This is merely an extension of the break-even case where profit was zero.

1. Contribution-Margin Approach

Target Profit Volume = (Fixed Costs + Target Profit) / Contribution Margin/Unit

2. Equation Approach

Operating profit = Sales revenue – Variable cost – Fixed cost

E. Margin of Safety

Margin of Safety, the excess of sales (projected or actual) beyond the breakeven
sales level, can be computed in units or amounts.

The calculation is:

Sales Units – Break-Even Sales Units = Margin of Safety in units, or

Sales Amount – Break-Even Sales Amount = Margin of Safety in sales amount

F. Cost Structure and Operating Leverage

Cost structure, the proportion of fixed and variable costs to total costs, has a
significant effect on the sensitivity of profit to volume changes.

The extent to which cost structure is made up of fixed costs is called operating
leverage. Operating leverage is high in firms with a high proportion of fixed costs,
a small proportion of variable costs, and the resulting high contribution margin per
unit.

G. Using Sales Amount as a Measure of Volume

Break-Even Sales Amount = Fixed Costs / Contribution Margin Ratio

Contribution margin ratio is the contribution margin divided by sales.

H. Income Tax

The effect of income tax can be incorporated in the model by substituting after-tax
profit for before-tax profit using the relationship

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 After-Tax Profit = Before-Tax Profit * (1 – t), where t = Income-Tax Rate, or

Before-Tax Profit = After-Tax Profit / (1 – t)

I. Multiple Products Financial Modeling

In multiple-product firms, it is more useful to perform breakeven analysis using

contribution margin ratio.

Breakeven Sales Amount = Fixed Costs ÷ Contribution Margin Ratio

Multiple-product firms have to deal with several alternatives:

1. Assume the Same Contribution Margin where the products can often be
grouped such that they have equal or nearly equal contribution margins.

2. Assume a Weighted-Average Contribution Margin, where break-even point is:

Break-Even Units = Fixed Costs ÷ Weighted-Average Contribution Margin/Unit.

3. Treat Each Product Line as a Separate Entity, where allocating fixed or common
costs could be an issue.

V. Simplifications and assumptions “operationalize” CVP analysis in the real world setting.

A. Total costs can be separated into the fixed and variable components.

B. Cost and revenue behavior is linear. (This means fixed costs do not change in total,
variable costs/unit remains constant, and the selling price/unit remains constant are
assumptions that may be acceptable within the relevant range of activity; thus, this
can also be called the relevant-range assumption.)

C. The product mix remains constant.

This is another situation where accuracy vs. usefulness is a key issue.