Cost Volume Profit Analysis

Lecture # 18

COST-VOLUME-PROFIT (CVP)
ANALYSIS

Technique that uses the degrees of cost

variability for measuring the effect of
changes in volume on resulting profits.
It is assumed that fixed costs will
remain the same in total within a range
of production volume in which the firm
expects to operate.

LIMITATIONS OF CVP ANALYSIS

CVP analysis assures that all factors except

volume will remain constant for a given period
of time.
In some cases, costs are relatively
unpredictable except over very limited ranges
of activity.
Anticipated results depend on the stability of
the CVP relationships as they have been
established.

BREAK-EVEN ANALYSIS

The break-even point is the point at

which sales revenue covers all costs to
manufacture and sell the product, but
there is no profit.
Costs must be segregated according to
their degree of variability.

COMPUTING BREAK-EVEN POINT

Sales Revenue (2,000 units)
Less: Variable costs
Contribution margin
Less: Fixed costs
Operating income

Total
$ 100,000
60,000
$ 40,000
30,000
$ 10,000

Unit
$ 50
30
$ 20

How
much
contribution
margin
must
this
company
have
to
cover
its
fixed
How
much
contribution
margin
must
this
company
have
to
cover
its
fixed
Contribution
margin
is
amount
by
which
revenue
exceeds
the
variable
Contribution
margin
is
amount
by
which
revenue
exceeds
the
variable
How
much
contribution
margin
must
this
company
have
to
cover
its
fixed
How
many
units
must
this
company
sell
to
cover
How
many
units
must
this
company
How
many
units
must
this
company
sell
to
cover
costs
(break
even)?
costs
of
the
(break
costs costs
of producing
producing
the revenue.
revenue.
costs
(break even)?
even)?
its
costs
(break
its fixed
fixed
costs
(break
even)?
Answer:
$30,000
sell
to cover
its
fixedeven)?
costs
Answer:
$30,000

(break
Answer:
$20
per
Answer: $30,000
$30,000
$20even)?
per unit
unit == 1,500
1,500 units
units

BREAK-EVEN POINT CALCULATIONS

Sales revenue (to break even) = Cost to

manufacture + Selling and
Administrative Costs
Sales revenue (to break even) = Fixed
manufacturing and selling and
administrative costs + Variable
manufacturing and selling and
administrative costs

BREAK-EVEN POINT CALCULATIONS

(CONT.)

Break-even sales volume (dollars) =

Total fixed costs / Contribution margin
ratio
Break-even volume (dollars) = Total fixed
costs / 1 (Variable costs/Sales revenue)
Break-even sales volume = Total fixed
cost / Unit contribution margin

COMPUTING BREAK-EVEN SALES

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf fixed
fixed
costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs are
are $3.00
$3.00 per
per
unit,
unit, how
how many
many units
units must
must be
be sold
sold to
to break
break even?
even?
a.
a.
b.
b.
c.
c.
d.
d.

100,000
100,000 units
units
40,000
40,000 units
units
200,000
200,000 units
units
66,667
66,667 units
units

COMPUTING BREAK-EVEN SALES

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf fixed
fixed
costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs are
are $3.00
$3.00 per
per
unit,
unit, how
how many
many units
units must
must be
be sold
sold to
to break
break even?
even?
a.
a.
b.
b.
c.
c.
d.
d.

100,000
100,000 units
units
40,000
40,000 units
units
200,000
200,000 units
units
Unit contribution = $5.00 - $3.00 = $2.00
66,667
66,667 units
unitsFixed costs
Unit contribution

$200,000
$2.00 per unit

= 100,000 units

COMPUTING BREAK-EVEN SALES

Use
Use the
the contribution
contribution margin
margin ratio
ratio formula
formula to
to
determine
determine the
the amount
amount of
of sales
sales revenue
revenue ABC
ABC must
must
have
have to
to break
break even.
even. All
All information
information remains
remains
unchanged:
unchanged: fixed
fixed costs
costs are
are $200,000;
$200,000; unit
unit sales
sales
price
price is
is $5.00;
$5.00; and
and unit
unit variable
variable cost
cost is
is $3.00.
$3.00.
a.
a.
b.
b.
c.
c.
d.
d.

$200,000
$200,000
$300,000
$300,000
$400,000
$400,000
$500,000
$500,000

COMPUTING BREAK-EVEN SALES

Use
Use the
the contribution
contribution margin
margin ratio
ratio formula
formula to
to
determine
determine the
the amount
amount of
of sales
sales revenue
revenue ABC
ABC must
must
have
have to
to break
break even.
even. All
All information
information remains
remains
unchanged:
unchanged: fixed
fixed costs
costs are
are $200,000;
$200,000; unit
unit sales
sales
price
price is
is $5.00;
$5.00; and
and unit
unit variable
variable cost
cost is
is $3.00.
$3.00.
a.
a.
b.
b.
c.
c.
d.
d.

Unit
Unit contribution
contribution == $5.00
$5.00 -- $3.00
$3.00 == $2.00
$2.00
$200,000
$200,000
Contribution
Contribution margin
margin ratio
ratio == $2.00
$2.00 $5.00
$5.00 == .40
.40
Break-even
Break-even revenue
revenue == $200,000
$200,000 .4
.4 == $500,000
$500,000
$300,000
$300,000
$400,000
$400,000
$500,000
$500,000

PREPARING A CVP GRAPH

Starting at the origin, draw the total revenue

Costs and Revenue

in Dollars

line with a slope equal to the unit sales price.

Revenue

Total fixed cost

extends horizontally
from the vertical axis.

Total fixed cost

Volume in Units

PREPARING A CVP GRAPH

Revenue

Draw the total cost line with a slope

Costs and Revenue

in Dollars

equal to the unit variable cost.

Break-even
Point

Profit
Total cost

Loss
Total fixed cost
Volume in Units

COMPUTING SALES NEEDED TO ACHIEVE TARGET

OPERATING INCOME

Break-even formulas may be adjusted to

show the sales volume needed to earn
any amount of operating income.
Unit sales =

Dollar sales =

Fixed costs + Target income

Contribution margin per unit

Fixed costs + Target income

Contribution margin ratio

COMPUTING SALES NEEDED TO ACHIEVE TARGET

OPERATING INCOME

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf
fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs
are
are $3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must be
be
sold
sold to
to earn
earn operating
operating income
income of
of $40,000?
$40,000?
a.
a.
b.
b.
c.
c.
d.
d.

100,000
100,000 units
units
120,000
120,000 units
units
80,000
80,000 units
units
200,000
200,000 units
units

COMPUTING SALES NEEDED TO ACHIEVE TARGET

OPERATING INCOME

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf
fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs
are
are $3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must be
be
sold
sold to
to earn
earn operating
operating income
income of
of $40,000?
$40,000?
a.
a.
b.
b.
c.
c.
d.
d.

Unit contribution = $5.00 - $3.00 = $2.00

100,000
units
100,000 units
Fixed costs + Target income
120,000
120,000 units
units
Unit contribution
80,000
80,000 units
units
$200,000 + $40,000
= 120,000 units
$2.00
per
unit
200,000
units
200,000 units

CVP ANALYSIS WHEN A COMPANY SELLS MANY

PRODUCTS

Speedo provides us with the following information:

Sales
$
Var. exp.
Contrib. margin $
Fixed exp.
Net income

Bikes
250,000 100%
150,000 60%
100,000 40%

Carts
$ 300,000 100%
135,000 45%
$ 165,000 55%

Total
$ 550,000 100%
285,000 52%
$ 265,000 48%
170,000
$ 95,000

CVP ANALYSIS WHEN A COMPANY SELLS MANY

PRODUCTS

The overall contribution margin ratio is:

Sales
$
Var. exp.
Contrib. margin $
Fixed exp.
Net income

Bikes
250,000 100%
150,000 60%
100,000 40%

$265,000
$550,000

Carts
$ 300,000 100%
135,000 45%
$ 165,000 55%

Total
$ 550,000 100%
285,000 52%
$ 265,000 48%
170,000
$ 95,000

= 48% (rounded)

CVP ANALYSIS WHEN A COMPANY SELLS MANY

PRODUCTS

Break-even in sales dollars is:

Sales
$
Var. exp.
Contrib. margin $
Fixed exp.
Operating income

Bikes
250,000 100%
150,000 60%
100,000 40%

$170,000
.48

Carts
$ 300,000 100%
135,000 45%
$ 165,000 55%

Total
$ 550,000 100%
285,000 52%
$ 265,000 48%
170,000
$ 95,000

= $354,167 (rounded)

WHAT IS OUR MARGIN OF SAFETY?

Margin of safety is the amount by
which sales may decline before
reaching break-even sales:
Margin of safety = Actual sales - Break-even sales

Margin of safety provides a quick means

of estimating operating income at any
level of sales:
Operating
Income

Margin
of safety

Contribution
margin ratio

WHAT IS OUR MARGIN OF SAFETY?

ADM contribution margin ratio is 40
percent. If sales are $100,000 and
break-even sales are $80,000, what is
operating income?
Operating =
Income

Operating
Income

Margin
of safety

Contribution
margin ratio

= $20,000 .40 = $8,000

WHAT CHANGE IN OPERATING INCOME DO WE

ANTICIPATE?

Once break-even is reached, every additional

dollar of contribution margin becomes operating
income:

Change in
operating income

Change in
sales volume

Contribution
margin ratio

ADM expects sales to increase by $15,000 and has

a contribution margin ratio of 40%. How much
will operating income increase?
Change in
operating income

$15,000 .40

$6,000

BUSINESS APPLICATIONS OF CVP

Consider the following information
developed by the accountant at
Speedo, a bicycle retailer:
Total
Sales (500 bikes)
$ 250,000
Less: variable expenses
150,000
Contribution margin
$ 100,000
Less: fixed expenses
80,000
Operating income
$ 20,000

Per Unit
$
500
300
$
200

Percent
100%
60%
40%

BUSINESS APPLICATIONS OF CVP

Should Speedo spend $12,000 on
advertising to increase sales by 10
percent?
Total
Sales (500 bikes)
$ 250,000
Less: variable expenses
150,000
Contribution margin
$ 100,000
Less: fixed expenses
80,000
Operating income
$ 20,000

Per Unit
$
500
300
$
200

Percent
100%
60%
40%

BUSINESS APPLICATIONS OF CVP

Should Speedo spend $12,000 on advertising
to increase sales by 10 percent?
500
Bikes
Sales
$ 250,000
Less: variable expenses
150,000
Contribution margin
$ 100,000
Less: fixed expenses
80,000
Operating income
$ 20,000

550 $500
550 $300
$80K + $12K

No, income is decreased.

550
Bikes
$ 275,000
165,000
$ 110,000
92,000
$ 18,000

BUSINESS APPLICATIONS OF CVP

Now, in combination with the advertising,
Speedo is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?

500
Bikes
Sales
$ 250,000
Less: variable expenses
150,000
Contribution margin
$ 100,000
Less: fixed expenses
80,000
Operating income
$ 20,000

BUSINESS APPLICATIONS OF CVP

Now, in combination with the advertising,
Speedo is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?

500
Bikes
Sales
$ 250,000
Less: variable expenses
150,000
Contribution margin
$ 100,000
Less: fixed expenses
80,000
Operating income
$ 20,000

1.25 500
625 $450
625 $300
$80K + $12K

Income is decreased even more.

625
Bikes
$ 281,250
187,500
$ 93,750
92,000
$
1,750

BUSINESS APPLICATIONS OF CVP

Now, in combination with advertising and a price cut, Speedo
will replace $50,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?

500
Bikes
Sales
$ 250,000
Less: variable expenses
150,000
Contribution margin
$ 100,000
Less: fixed expenses
80,000
Operating income
$ 20,000

BUSINESS APPLICATIONS OF CVP

Now, in combination with advertising and a price cut, Speedo
will replace $50,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?

1.5 500

500
Bikes
Sales
$ 250,000
Less: variable expenses
150,000
Contribution margin
$ 100,000
Less: fixed expenses
80,000
Operating income
$ 20,000

750 $450
750 $325
$92K - $50K

750
Bikes
$ 337,500
243,750
$ 93,750
42,000
$ 51,750

The combination of advertising, a price cut,

and change in compensation increases income.

DIFFERENTIAL ANALYSIS

Differential analysis is a study that highlights the

significant cost and revenue data alternatives.
The designated purpose for which a cost
measurement is to be made should be included in
the cost analysis.
Where there is excess capacity, only the differential
costs per unit should be considered in producing
additional units.
Differential costs do not include fixed factory
overhead costs.
May be used in make-or-buy decisions.

ACCEPT OR REJECT A SPECIAL

ORDER

Many companies follow a practice of

contribution pricing, meaning accepting
a selling price as long as it exceeds
variable cost, thus contributing some
positive contribution margin in times of
excess capacity.

OPERATING LEVERAGE

Operating Leverage refers to the ability

of the firm to generate an increase in net
income when sales revenue increases
Operating Leverage Factor = Contribution
Margin
Net Income

Percentage change in Net Income =

Percentage Increase in Sales Revenue x Operating
Leverage
Factor