Central Luzon State University

Science City of Muñoz 3120

Nueva Ecija, Philippines

Instructional Module for the Course

ACCTG 1103 Accounting for Manufacturing Operations

Lesson 02 Cost Behavior and Contribution Margin Income Statement

Objectives
After studying this material, you should be able to:
1. Define basic cost behaviors, including fixed, variable, semi variable, and step costs.
2. Identify the components of a product’s cost.
3. Understand the distinction between financial and contribution margin income statements.

II. Learning Activities

Cost behavior deals with the way costs respond to changes in activity levels. A cost driver is a factor
that causes, or “drives,” costs. For example, the cost driver for the cost of lumber for the activity of building a
house could be the number of board feet of lumber used or the size of the house in square feet. The cost
driver for direct labor costs could be the number of labor-hours worked.

Managers need to know how costs behave to make informed decisions about products, to plan, and to
evaluate performance. We classify the behavior of costs as being in one of four basic categories: fixed,
variable, semi variable, and step costs, as discussed next.

Fixed versus Variable Costs

Variable cost are costs that change in direct proportion with a change in volume within the relevant
range of activity. If the activity is producing units, variable manufacturing costs typically include direct
materials, certain manufacturing overhead (for example, indirect materials, materials-handling labor, energy
costs), and direct labor in some cases (such as temporary workers). Certain nonmanufacturing costs such
as distribution costs and sales commissions are typically variable. Much of manufacturing overhead and
many nonmanufacturing costs are typically fixed costs.
Although labor has traditionally been considered a variable cost, today the production process at
many fi rms is capital intensive and the amount of labor required is not sensitive to the amount produced. In
a setting in which a fixed amount of labor is needed only to keep machines operating, labor is probably best
considered to be a fixed cost.
In merchandising, variable costs include the cost of the product and some marketing and
administrative costs. All of a merchant’s product costs are variable. In manufacturing, a portion of the product
cost is fixed. In service organizations, variable costs typically include certain types of labor (such as temporary
employees), supplies, and copying and printing costs.
 ACCTG 1103 | Accounting for Manufacturing

Exhibit 1 Four Cost Behavior Patterns

Exhibit 1. depicts variable cost behavior— (a), and fixed cost behavior— (b). Note in the graph that
volume is on the horizontal axis, and total costs (measured in dollars) are on the vertical axis. Item (a) shows
that total variable costs increase in direct proportion to changes in volume. Thus, if volume doubles, total
variable costs also double. Item (b) shows that fixed costs are at a particular level and do not increase as
volume increases.
The identification of a cost as fixed or variable is valid only within a certain range of activity. For
example, the manager of a restaurant in a shopping mall increased the capacity from 150 to 250 seats,
requiring an increase in rent costs, utilities, and many other costs. Although these costs are usually thought
of as fixed, they change when activity moves beyond a certain range. This range within which the total fixed
costs and unit variable costs do not change is called the relevant range.
Four aspects of cost behavior complicate the task of classifying costs into fixed and variable
categories. First, not all costs are strictly fixed or variable. For example, electric utility costs may be based
on a fixed minimum monthly charge plus a variable cost for each kilowatt-hour. Such a semi variable cost
has both fixed and variable components. Semi variable costs, also called mixed costs, are depicted in Exhibit
1 (c).
Second, some costs increase with volume in “steps.” Step costs, also called semi- fixed costs,
increase in steps as shown in Exhibit 1 (d). For example, one supervisor might be needed for up to four fire
fighters in a fire station, two supervisors for five to eight, and so forth as the number of fire fighters increases.
The supervisors’ salaries represent a step cost.
Third, as previously indicated, the cost relations are valid only within a relevant range of activity. In
particular, costs that are fixed over a small range of activity are likely to increase over a larger range of
activity.
Finally, the classification of costs as fixed or variable depends on the measure of activity used. For
example, at Jackson Chip, part of the production cost is setting up the machines to run a specific part. Plant
engineers have to calibrate the machine for each production run, but each run can produce up to 4,000 socs
(system on a chip). If production volume is the activity measure, then the plant engineer costs are a step

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cost. However, if the number of production runs is the activity measure, then the plant engineer costs are
variable; they spend the same amount of time for each run.
Understanding cost behavior is an important part of using cost accounting information wisely for decisions.
Consider a recent example at Jackson Chip. Moto Company, a longtime customer of Jackson, has requested
a price quotation from Jackson for a modified version of a common chip. The modified toy is the J12. Moto
wants the quotation to cover a volume of J12 Chip from 2,000 to 6,000, because it is not sure of its final
requirement.
Maggie, the plant cost analyst, has prepared the preliminary cost data in Exhibit 2 Cost Data (see exhibit
below) for Sandy, the Jackson sales representative for Moto. The cost for developing production
specifications is fixed. It does not depend on the volume of gears actually produced. The direct materials and
the direct labor costs are variable. They increase proportionately with volume.
Exhibit 2. Cost Data
Cost Item Amount Notes Type
This is a one-time expenditure for
Develop Production Specification for J12 Chip $ 2,000 F
drawings.

Direct materials 10 This is the cost per chip. V

Direct Labor 2 This is the cost per chip. V

Up to 4,000 chips can be produced in a

Set up machinery 1,000 S
single production run.

Chip Inspection: Equipment 500 A new measuring device is required. SV

Labor .25 Per gear. SV

F – Fixed; V – Variable; S – Step or Semi Fixed; SV - Semi variable

The cost for setting up the machinery is neither fixed nor variable with respect to volume. The setup costs
are semifixed—they are incurred to set up the initial production run, and then they are not affected by
production until 4,000 gears have been produced. To produce more than 4,000 gears, another fixed amount
must be spent.
The inspection costs are semi variable. The new measuring device is a fixed cost and the $0.25 per chip is
variable.

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 ACCTG 1103 | Accounting for Manufacturing

Components of Product Costs

Full Cost - Sum of all costs of manufacturing and selling a unit of product (includes both fixed and variable
costs).
Full absorption cost - All variable and fixed manufacturing costs; used to compute a product’s inventory
value under GAAP.
Exhibit 3.0 Product Cost Components—Jackson Chips

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Starting with Exhibit 3, assume that Jackson Chips estimates the cost to produce a specialized soc
for android phones during year 3. The full cost to manufacture and sell one gear is estimated to be $40, as
shown on the left side of Exhibit 2. The unit cost of manufacturing the gear is $29, also shown on the left
side of the exhibit. (One unit is 1 gear.) This full cost of manufacturing the one unit is known as the full
absorption cost. It is the amount of inventoriable cost for external financial reporting according to GAAP.
The full absorption cost “fully absorbs” the variable and fixed costs of manufacturing a product.
The full absorption cost excludes nonmanufacturing costs, however, so marketing and administrative
costs are not inventoriable costs. These nonmanufacturing costs equal $11 per unit, which is the sum of the
two blocks at the bottom of Exhibit 3.
The variable costs to make and sell the product are variable manufacturing costs, $23 per unit, and
variable nonmanufacturing costs, $4 per unit. Variable nonmanufacturing costs could, in general, be either
administrative or marketing costs. For Jackson Chips, variable nonmanufacturing costs are primarily selling
costs. In other cases, variable administrative costs could include costs of data processing, accounting, or any
administrative activity that is affected by volume.
Exhibit 3 also includes unit fixed costs. The unit fixed costs are valid only at one volume—2,000 units
(of this gear) per year—for Jackson Chips. By definition, total fixed costs do not change as volume changes
(within the relevant range, of course). Therefore, a change in volume results in a change in the unit fixed cost
as discussed above.

Gross Margin per Unit—Jackson Chips

Exhibits 4 below are designed to clarify definitions of gross margin, contribution margin, and operating profit.
You may recall from your study of financial accounting statements that the gross margin appears on external
financial statements as the difference between revenue and cost of goods sold. We refer to this format as a
traditional income statement. Cost of goods sold is simply the full absorption cost per unit times the number
of units sold. Exhibit 4 presents the gross margin per unit for the gears that Jackson Chips produces and
sells for $45 each.
Recall from Exhibit 3 that each chip is estimated to have a $29 full absorption cost. Therefore, the gross
margin per unit is $16 ($45 - $29). The operating profit per unit is the difference between the sales price and
the full cost of making and selling the product. For Jackson Chips, Exhibit 4 shows the operating profit per
unit to be $5 ( $45 sales price - $40 full cost).
Exhibit 4 below also shows the contribution margin per unit. On a per unit basis, the contribution margin
is the difference between the sales price and the variable cost per unit. Think of the contribution margin as
the amount available to cover fixed costs and earn a profit.

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Exhibit 4. Contribution Margin per Unit—Jackson Chips

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The contribution margin is important information for managers because it allows them to assess the
profitability of products before factoring in fixed costs (which tend to be more difficult to change in the short
run). For example, a coffee shop sells both drip coffee and espresso drinks. A cup of drip coffee sells for
$1.50 and a cappuccino sells for $2.50. Which product contributes more per unit to profits? Answer: We don’t
know until we know the contribution margin per unit for each product. Suppose that the variable cost per cup
is $0.25 for drip coffee and $1.50 for cappuccino. Then the contribution margins (per unit) are as follows:
CM per Unit Sales Price Variable Cost per Unit

Drip Coffee 1.25 1.50 0.25

Cappuccino 1.00 2.50 1.50
Although the cappuccino sells for more, the drip coffee provides a higher contribution per unit toward covering
fixed costs and earning a profit.

How to Make Cost Information More Useful for Managers

As discussed earlier, cost accountants divide costs into product or period categories. In general, product
costs are more easily attributed to products; period costs are more easily attributed to time intervals. Once
product costs are defined, all other costs are assumed to be period costs. It is important to note, however,
that the determination of product costs varies, depending on the approach used. Two (2) common
approaches are outlined here:
• Full absorption costing (traditional income statement). Under this approach required by GAAP, all
fixed and variable manufacturing costs are product costs. All other costs are period costs.
• Variable costing (contribution margin income statement). Using this approach, only variable
manufacturing costs are product costs. All other costs are period costs

Gross Margin versus Contribution Margin Income Statements

A traditional income statement using full absorption costing (the first approach in the list) and a contribution
margin income statement using variable costing (the second approach) for the special order of chips are
shown in Exhibit 5 below. The data come from Exhibits 4 and 5, but unit costs are multiplied by 2,000 gears
to give total amounts for year 3. Operating profit is the same for each approach because total units produced
equal total units sold, but note the difference in product costs on each statement.

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Exhibit 5.0 Gross Margin versus Contribution Margin Income Statements

Developing Financial Statements for Decision Making

While the gross margin and contribution margin statements illustrated in Exhibit 5 are common, there is no
reason to restrict managers to these statements. The goal of the cost accounting system is to provide
managers with information useful for decision making. In designing the cost accounting system, we determine
the information that managers use in making decisions and then provide it to them in ways that support their
work.
For example, many firms are concerned with ensuring that the activities they undertake add value to their
product or service. If this is important to managers for making decisions, we can develop financial statements
that classify costs into value-added or nonvalue-added categories. By classifying activities as value added
or nonvalue added, managers are better able to reduce or eliminate nonvalue-added activities and therefore
reduce costs.
Suppose that Jobert, the plant manager of Jackson Chips, wants to know which costs add value. The
controller reviews production activities and related costs in detail and prepares the value income statement
shown in Exhibit 6. The data come from Exhibit 5. However, costs are shown in greater detail and separated
into nonvalue-added and value-added categories. For example, variable marketing and administrative costs
of $8,000 from Exhibit 5 are shown as two-line items under variable marketing and administrative costs in
Exhibit 6: marketing and administrative services used to sell products totaling $6,000 and marketing and
administrative services used to process returned products totaling $2,000. The value income statement
outlines costs linked to three segments of the value chain: production, marketing, and distribution. Remember
that the primary idea of the value chain is that value is added to the product in each business function. The
goal is to maximize value-added activities and minimize nonvalue-added activities.

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Exhibit 6. Value Income Statement

JACKSON CHIPS

The controller identifies nonvalue-added activities associated with two areas, mate- rials waste and
reworked products. Materials waste refers to material that was thrown away because of incorrect cuts or
defective material. Reworked products consist of products that have been manufactured incorrectly and
have to be fixed (or reworked). Costs to rework products are generally incurred by the production, marketing,
and administration departments. Marketing gets involved because failure detection sometimes does not
occur until the customer returns the goods. Thus, nonvalue-added activities are not limited to production.
Assume that the company sold 2,000 units in year 3, and the controller uses the per unit costs
outlined in Exhibit 3. The controller’s value income statement shows total nonvalue-added activities to be
$8,000. This amount is only 10 percent of total costs but is 80 percent of operating profit. Clearly, reducing
nonvalue-added activities could significantly increase profits.
Reducing nonvalue-added activities is not a simple task. For example, how should the production
process be changed to reduce materials waste? Should higher quality materials be purchased, resulting in
higher direct materials costs? Or should production personnel be trained and evaluated based on materials
wasted? However, providing the information highlights the problem and the potential effect that changes
could have on firm performance. Depending on the business and strategic environment of the firm, we could
construct financial statements around activities related to quality, environmental compliance, or new product
development.

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References

Aliling, L. E., & Anastacio, M. L. (2015). Management Accounting 1. Manila: Rex Books
Store.
Drury, C. (2014). Management and Cost Accounting. Cengage Learning Asia Pte Ltd.
Flores, M. O. (2016). Integrated Cost Accounting - Principles and Applications. Quezon
City: Rex Printing Company Inc.
Lanen, W. N., Anderson, S. W., & Maher, M. W. (2014). Fundamentals of Cost
Accounting. New York: McGraw-Hill/Irwin.

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Lumibao