Cost-Volume-Profit

Relationships
 Learning Objectives

• Explain the purpose of cost-volume-profit (CVP) analysis

• Explain the contribution margin (CM) concept
• Compute the break-even (BE) point by using graph,
equation, and contribution margin methods
• Compute profit (income) at a given level of sales and also
target sales by using the methods above
• Calculate the effect on profit of changes in variable costs,
fixed costs, selling price, and volume
• Perform CVP analysis for a multi-product company
• Compute the margin of safety and operating leverage and
explain their significance
 Cost-Volume-Profit (CVP) Analysis

• CVP analysis is an analysis of the relationships

among activity level, revenue, costs and profit.
• Classification of cost items into fixed and variable
is paramount in CVP analysis.
• Contribution margin (CM) concept facilitates CVP
analysis.
 The CM Concept

• Assume the following budgeted (expected) annual

data for ABC, a single-product company.
Total Per Unit Percent
Sales (500 units) $10,000 20 100%
-Variable costs 6,000 12 60%
Contribution margin $ 4,000 8 40%
-Fixed costs 3,000
Net income $ 1,000
 The CM Concept

• Assume the following budgeted (expected) annual

data for ABC, a single-product company.
Total Per Unit Percent
Sales (500 units) $10,000 20 100%
-Variable costs 6,000 12 60%
Contribution margin $ 4,000 8 40%
-Fixed costs
Contribution 3,000(CM) is the amount
Margin
Net income from sales
remaining $ 1,000
revenue after variable
costs have been deducted.
 The CM Concept

• Assume the following budgeted (expected) annual

data for ABC, a single-product company.
Total Per Unit Percent
Sales (500 units) $10,000 20 100%
-Variable costs 6,000 12 60%
Contribution margin $ 4,000 8 40%
-Fixed costs 3,000
Net income $ 1,000fixed costs.
CM goes to cover
 The CM Concept
• Assume the following budgeted (expected) annual
data for ABC, a single-product company.
Total Per Unit Percent
Sales (500 units) $10,000 20 100%
-Variable costs 6,000 12 60%
Contribution margin $ 4,000 8 40%
-Fixed costs 3,000
Net income $ 1,000
After covering fixed costs, any remaining CM
contributes to profit.
 The CM Concept

• Assume the following budgeted (expected) annual

data for ABC, a single-product company.
Total Per Unit Percent
Sales (500 units) $10,000 20 100%
-Variable costs 6,000 12 60%
Contribution margin $ 4,000 8 40%
-Fixed
CM percosts 3,000
unit is the amount that each unit contributes to
Net income fixed$costs
1,000and profit.
CM Per unit therefore measures the change in profit as a
result of a one unit change in sales.
 The CM Concept

• Assume the following budgeted (expected) annual

data for ABC, a single-product company.
Total Per Unit Percent
Sales (500 units) $10,000 20 100%
-Variable costs 6,000 12 60%
Contribution margin $ 4,000 8 40%
-Fixed costs
CM percentage 3,000 that each dollar of sales
is the amount
Net incomecontributes to$fixed
1,000costs and profit.
CM percentage therefore measures the change in profit as a
result of a one dollar change in sales.
 Quick Test

Carver Company produces a product which sells for $30.

Variable manufacturing costs are $15 per unit. Fixed
manufacturing costs are $5 per unit based on the current level
of activity, and fixed selling and administrative costs are $4
per unit. A sales commission of 10% of the selling price is
paid on each unit sold. The contribution margin per unit is:
a. $ 3
b. $15
c. $ 8
d. $12
 Quick Test

Carver Company produces a product which sells for $30.

Variable manufacturing costs are $15 per unit. Fixed
manufacturing costs are $5 per unit based on the current level
of activity, and fixed selling and administrative costs are $4
per unit. A sales commission of 10% of the selling price is
paid on each unit sold. The contribution margin per unit is:
a. $ 3
b. $15
c. $ 8
d. $12
 Applications of CVP Analysis

• Break-even analysis (calculation)

• Profit at a given level of sales
• Target sales
• The effect on profit of changes in cost structure
• The effect on profit of changes in selling price
• The effect on profit of changes in costs and selling
price
• The effect on profit of changes in sales mix (for a
multi-product company)
 Break-even (BE) Analysis

• The objective of BE analysis is to determine the

quantity or dollar amount of sales that generates
zero profit.
• There are basically three methods for BE analysis:
– Graph
– Equation
– Contribution margin
 BE Analysis – Graphic Method
$, Y

VC/unit

VC/unit

Total FC ($3,000)
FC

# of units produced
0
and sold, X
 BE Analysis – Graphic Method
$, Y

BE in $
(7,500)
FC

# of units produced
0 BE in units and sold, X
(375)
 BE Analysis – Equation Method
Revenue = (Unit SP) * Volume
Total cost = (Unit VC) * Volume + Total FC
Profit = Revenue - Total cost
= (Unit SP) * Volume - (Unit VC) * Volume -
Total FC
= (Unit SP - Unit VC) * Volume - Total FC
At break-even, profit is zero. Thus:
Volumebe = (Total FC) / (Unit SP - Unit VC)
Dollarbe = Volumebe * Unit SP
 BE Analysis – CM Method

• CM per unit (CM ratio) is the amount that each unit

(dollar of sales) contributes toward recovering
fixed costs and then toward earning a profit for the
period.
• The volume and dollar sales at break-even then are:
Volumebe = (Total FC) / (Unit CM) = $3,000 / $ 8
Dollarbe = (Total FC) / (CM ratio) = $3,000 / .40
• CM formulas can be derived from the equation
method.
 Profit at a Given Level of Sales
• The same three methods as in BE analysis can be
used. See next slide for graphic solution.
• Using equation method,
Profit = Revenue - Total cost
= (Unit SP) * Volume - (Unit VC) * Volume -
Total FC
= (Unit SP - Unit VC) * Volume - Total FC
• Using CM method,
Profit = (CM/unit) * Volume - Total FC
or, (CM ratio) * Revenue - Total FC
 Profit Calculation – Graphic Method
$, Y

Pretax profit=Total revenue

minus Total cost
CM/unit
FC

# of units produced
0 and sold, X

-FC
 Target Sales
• The objective here is to determine the level of
sales that has to be achieved to make a given
amount of profit.
• The same three methods as in BE analysis can be
used. Using contribution margin method:
Volumets = (Fixed cost + Profit) / (Unit CM)
Dollarts = (Fixed cost + Profit) / (CM ratio)

Assuming ABC desires a profit of $1,000, then

Volumets = ($3,000 + $1,000) / $8 = 500 units
The Effect of Changes in Parameters

• Selling price and costs in the computations above

are estimates and thus may not materialize.
• It may also be possible to change the proportions
of fixed and variable costs, e.g., through
automation or use of higher quality material.
• Thus, managers often perform an (a sensitivity)
analysis to determine the impact of changes in
estimates or cost components on BE point and
profit.
The Effect of Change in Cost Elements
• For example, NBC produces a surge protector.
• SP = $30; VC = $18; total FC = $15,000; and
sales volume = 2,000.
• A proposed automation decreases VC by $3 per
unit, but increases FC by $5,000.
• What is the impact on profit?
Increase in CM ($3 * 2,000) $ 6,000
Increase in FC (5,000)
Net effect on profit $ 1,000
 The Effect of Change in Selling Price
• For example, XYZ produces a spray paint.
• SP = $20; VC = $8; total FC = $10,000; and sales
volume = 1,000.
• Sales people insist that reducing the selling price
by $4 per unit increases sales volume by 20%.
• What is the impact on profit?
Proposed CM (8 * 1,200) $ 9,600
Current CM (12 * 1,000) 12,000
Net effect on profit $(2,400)
The Effect of Change in Sales Volume
and Costs
• For example, XYZ produces a spray paint.
• SP = $20; VC = $8; total FC = $10,000; and sales
volume = 1,000.
• An advertising campaign costing $3,000 increases
sales volume by 20%.
• What is the impact on income?
Increase in CM (12 * 200) $ 2,400
Increase in FC (3,000)
Net change in profit $ (600)
 Multi-Product Case
• A multi-product case can be converted into a single-product
case by use of the weighted-average CM per unit or a
composite unit.
• Example: Sam Corp. sells two products with the following SP
and VC:
A B
SP/unit $ 12 $ 20
VC/unit 5 8
• Sam has been selling two units of A for every three units of B.
• Total FC is $ 20,000.
• What is the BE point?
 Multi-Product – WA Approach

• W.A. CM/unit = 2/5 * $7 + 3/5 * $12 = $ 10

• Now we can assume that we have one product
with a CM of $ 10 per unit.
• BE in units = total FC / CM per unit
= $20,000 / $10 = 2,000 units
• Units of A to be sold = 2/5 * 2,000 = 800
• Units of B to be sold = 3/5 * 2,000 = 1,200
 Multi-Product – Composite Unit
• We introduce a composite unit, Z, consisting of 2
units of A and 3 units of B.
• CM per unit of Z = 2 * $7 + 3 * $12 = $ 50
• Now we can assume that we have one product (Z)
with CM of $ 50 per unit.
• BE in units = total FC / CM per unit
= $20,000 / $50 = 400 units of Z
• Units of A to be sold = 2 * 400 = 800
• Units of B to be sold = 3 * 400 = 1,200
 Assumptions in CVP Analysis
• Linearity of revenues and costs, i.e., efficiency,
productivity, and selling price do not change
• Accurate classification of costs into variable and
fixed (i.e., only one cost driver, unit)
• Constancy of sales and production mix
• Constancy of the inventory level, i.e., sales =
production
• Equality of revenues and expenses with cash flows
• Ignoring time value of money and non-
quantitative information
 Margin of Safety

• Margin of safety is the excess of budgeted sales

over the break-even sales. It is the amount by
which sales can drop before losses are incurred.

Margin of safety = Budgeted sales - Break-even sales

Let’s calculate the margin of safety for ABC.

 Margin of Safety

• ABC has a break-even sales of $7,500; budgeted

sales are $10,000. The margin of safety is $2,500.

Budgeted BE Sales
Sales $10,000 $7,500
-Variable costs 6,000 4,500
Contribution margin $ 4,000 $3,000
-Fixed costs 3,000 3,000
Net income $ 1,000 $ 0
 Margin of Safety
• The margin of safety can be expressed as 25
percent of sales.
($2,500 ÷ $10,000)
Budgeted BE Sales
Sales $10,000 $7,500
-Variable costs 6,000 4,500
Contribution margin $ 4,000 $3,000
-Fixed costs 3,000 3,000
Net income $ 1,000 $ 0
 Operating Leverage
• Operating leverage measures the percentage change
in current profit as a result of a given percentage
change in sales.
• It is a measure of how sensitive net income is to
change in sales.

Degree of Contribution margin

operating leverage = Net income
 Operating Leverage

Budgeted Sales
Sales $10,000
-Variable costs 6,000
Contribution margin $ 4,000
-Fixed costs 3,000
Net income $ 1,000

$4,000 = 4
$1,000
 Operating Leverage

• With an operating leverage of 4, if ABC increases

its sales by 10%, net income would increase by
40%.

Percent increase in sales 10%

Degree of operating leverage × 4
Percent increase in profit 40%
 Mixed Costs – Definition
• Mixed costs are costs that contain both variable and
fixed components, e.g., utilities.
– Costs aggregated in various ways are also mixed,
e.g., overhead or machining.
• The fixed component represents the minimum cost
of having a service available for use; the variable
component represents the cost of actual
consumption.
• Graphically, a mixed cost is represented by a
straight line that intersects the vertical (Y) axis.
 Mixed Costs

350
300
Total utility cost

250
200 Variable
150
Utility charge
100
50
Fixed
Utility charge
0
0 50 100 150 200 250
Kilowatts used
 Mixed Costs
The total mixed cost line can be expressed
as an equation: Y = a + bX
350
Where: Y = the total mixed cost
300
Total utility cost

a = the total fixed cost (the

250 vertical intercept of the line)
200 Variable
b = the variable cost per unit of

150
Utility charge
activity (the slope of the line)
X = the level of activity
100
50
Fixed
Utility charge
0
0 50 100 150 200 250
Kilowatts used
 Analysis of Mixed Costs
(Cost Estimation)
• Involves estimating the fixed and the variable
components of a mixed (or total) cost, i.e., generally
estimating a linear cost formula Y= a + bX that can
be used to estimate cost at various levels of activity.
• Y is the total mixed cost (the dependent variable – it
is affected by the level of activity).
• a is the total fixed cost (the constant).
• b is the variable cost per unit (the multiplier for X).
• X is the level of activity (the independent variable).
 Methods of Cost Estimation

• Engineering Method
– It is based on a study of input-output relationship.
– The cost of all inputs are added to estimate the
cost of the output.
– This method is used only when input-output
relationship remains stable over-time and indirect
costs are a small portion of total cost; it is also
used when there is no past data to analyze.
• Analysis of Past Data
 Analysis of Past Data

• Analysis of Past Data

– High-low Method
– Scatter-graph
– Simple Ordinary Least-Square (OLS)
Regression
• Note: all of these methods assume linearity and
one independent variable (one cost driver).
 Cost Estimation Example

• Wise Co. recorded the following machine hours

and Overhead cost for the last six months.
Machine Hours Overhead Cost
10 23
15 37
8 19
20 48
22 49
18 40
 High-low Method
• Graphically, a line that connects the observations with
the highest and lowest value for the dependent variable.
 High-low Method

• Mathematically, choose the observations with the

highest and lowest value for the dependent variable
to estimate a and b in the cost formula Y = a + bX
• b = rise/run = change in cost / change in activity
= (49 - 19) / (22 - 8) = 2.14
• Go to the high or low observation only:
• Y = a + bX a = Y - bX
• a = 49 - 2.14 * 22 a = 1.92
• Cost formula: Y = 1.92 + 2.14X
 Notes on High-low Method

• The 1.92 is not the estimated fixed overhead at

zero level of activity. It is the estimated fixed
overhead within the relevant range. Similarly, 2.14
is the estimated variable overhead per machine
hour within the relevant range.
• The method ignores all but two extreme
observations. Thus, the accuracy of cost estimates
depends on how representative the two points are
of the entire set of observations.
 Scatter-graph
• Plot the data points on a graph and draw a line
through those points that best fits the data.
60
50
Overhead Cost

40
30
20
10
0
0 5 10 15 20 25
Machine hours
 Scatter-graph

• To estimate a and b in the cost formula:

– Read the intercept and the slope from the graph.
– Alternatively, use the coordinates of any two
points on the line and the formulas as in the
high-low method.
• The method uses all the observations, but it is
subjective (thus the reason for low usage and the
quick-and-dirty label).
 Simple Ordinary Least-Squares
Regression
• Estimate a and b in the cost formula in such a way
that the sum of the squared errors (vertical
distances between observations and regression
line) is minimized.
• Regression analysis is more appealing because we
can measure the goodness of fit of the regression
equation, and more importantly, because we can
make probability statements about the estimated
coefficient (b) and the estimated costs (Y).
 Simple Ordinary Least-Squares
Regression
• Many computer programs provide estimates of a
and b in the cost formula and regression related
statistics; one only needs to understand the output.
• Alternatively, for a simple regression, you can
solve the following system of equations:
 Y = na + b  X
 XY = a  X + b  X2
where, n is the number of observations
 Measures of Goodness of Fit for OLS

• R2 , the % of variation in Y that is explained by X.

R2 is between 0 and 1.
• Standard error of regression (standard error of Y
estimate), S(e), is an estimate of the standard
deviation of the error term.
– Note that the regression equation is
Y = a + bX + e (e is the random variation, error
term), and the estimated regression equation is:
Y = a + bX
 Measures of Goodness of Fit for OLS

• Standard error of b, S(b), is an estimate of the

standard deviation of b.
• t = b/S(b)
– As a rule of thumb, if t > 2, the estimated
coefficient (b) is significantly different from
zero, i.e., X explains a significant portion of the
variation in Y.
– Computer programs report the p-value, i.e., the
significance level, for each variable.
Cost Estimation Example – Summary
Fixed Cost Variable Cost
per period (a) per unit (b)
High-Low 1.92 2.14
Scatter-graph 2.00 2.12
Regression 1.41 2.23
Estimated cost for the next month at 17 MH:
High-Low = $1.92 + $2.14 * 17 = $38.30
Scatter-graph = $2.00 + $2.12 * 17 = $38.04
Regression = $1.41 + $2.23 * 17 = $39.32
 Data Analysis Steps

• Before using any of the three methods above, a few

data analysis steps should be taken.
– Review alternative activity bases
• activity base chosen should be closely related to cost
item (Y)
– Plot the data
• catch outliers and omit them
– Examine data correspondence and period of
accumulation
– Examine the constancy of production process