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Cost Volume Profit is a powerful tool that helps managers understand the relationships among cost, volume

and profit. CVP focuses on how profits are affected by the following five elements:

1. Prices of products.
2. Volume or level of activity.
3. Per unit variable costs.
4. Total fixed costs.
5. Mix of products sold.

Contribution income statement emphasizes the behavior of costs and is prepared for management use and is not
ordinarily available to those outside the company.

Contribution Margin

Contribution Margin: the amount remaining


from sales revenue after variable expenses
have been deducted.
- The amount that is available to cover
fixed expenses and then then to
provide profits for the period.
- To break even, the total CM in
dollars must equal the fixed costs.

- If each unit sold provides $100 in CM then, The number of units needed to break even = Fixed -
Expenses/ CM per unit
- Once the break-even point is reached, operating income will increase by the unit CM for each
additional unit sold
- To summarize, if sales are zero, the companys operating loss equals its fixed expenses. Each unit that is
sold reduces the loss by the amount of the unit CM. Once the break-even point has been reached, each
additional unit sold increases the companys operating profit by the amount of the unit CM.

CVP Graph (aka Break Even Chart)

- The relationships among revenues, costs, and level of


activity presented in graphic form.
- 3 Steps:
1. Plot the line parallel to the volume axis that
represents total fixed expenses. For Acoustic
Concepts, total fixed expenses are $35,000.
2. Plot the line representing total expenses (fixed
plus variable) at various activity levels. For
example, in Exhibit 41, total expenses at an
activity level of 600 speakers are calculated as
follows: Total expenses at other activity levels
are calculated using this approach.
3. Plot the line representing total sales dollars at
various activity levels. For example, in Exhibit
41, sales at an activity level of 600 speakers
are $150,000 (600 speakers $250 per
speaker). Total sales at other activity levels are
calculated using this approach.
4. The anticipated profit or loss at any given level
of sales is measured by the vertical distance
between the total revenue line (sales) and the
total expenses line (variable expenses plus
fixed expenses).
5. The break-even point is where the total
revenue and total expenses lines intersect.

A simpler form of the CVP graph, called a profit graph. That


graph is based on the following equation: (graph pic not shown here but its just an upward sloping vertical line)

Profit = Unit CM Q Fixed expenses

Rearrange the above equation to isolate Q and let profit = 0, to determine the break even number of units.

Contribution Margin Ratio

The CM expressed as a
percentage of total sales is
referred to as the contribution
margin (CM) ratio. This ratio is
computed as follows:

- The CM ratio shows how the CM is affected by a change in total sales.


- Change in CM = CM ratio Change in sales
- Operating income will also increase by the amount of change in the CM assuming FC remain the same.
- The effect on operating income of any dollar change in total sales can be computed by simply applying
the CM ratio to the dollar change.

Key Formulas for Contribution Format Income Statements


Variable expense ratio is the ratio of variable expenses to sales.

This leads to a useful equation that relates the CM ratio to the variable expense ratio as follows:

Change in Fixed Cost and Sales Volume

Incremental Analysis; An analytical approach that focuses only on those items of revenue, cost, and volume
that will change as a result of a decision.

Suppose the sales manager thinks that a $10,000 increase in the monthly advertising budget (FC) would
increase monthly sales by $30,000. Should the advertising budget be increased?

Alternative Solution 1 and 2 for the incremental analysis;

Assuming no other factors need to


be considered, the increase in the
advertising budget should be
approved since it would lead to an
increase in operating income of
$2,000.

Since in this case only the fixed


costs and the sales volume
change, the solution can be
presented in an even shorter
format, as follows
Change in Variable Costs and Sales Volume
Suppose management wants to increase variable costs by $10 to increase overall quality of products and expects
sales to increase from 400 units to 480 units.
- If variable costs go up, the CM per unit decreases from $100 to $90
- Higher quality
parts should be
used.

Change in Fixed Costs, Selling Price, and Sales Volume


Suppose management wants to decrease selling price by $20 and increase the advertising budget by $15,000 to
increase sales by 50% from 400 units to 600 units.

Changes should not be


made as per the
incremental analysis to
the left.

$700 decrease in
operating income can be
verified by creating a
contribution income
statement as the one in
the left.

Change in Cariable Cost, Fixed Cost, and Sales Volume


Pay sales commission by $15 per unit sold, rather than pay flat wages of $6000. We expect sales to increase by
15% to 460 units from the current 400.
Changing the sales staff from
a salaried basis to a
commission basis will affect
both fixed and variable costs.
Fixed costs will decrease by
$6,000, from $35,000 to
$29,000. Variable costs per
unit will increase by $15,
from $150 to $165, and the
unit CM will decrease from
$100 to $85:

Change in Regular Selling Price


Can sell in bulk 150 speaker to a wholesaler if a price is worked out.
If the company wants to increase profits by $3,000, what should the sale price be per unit.

- No fixed expenses are included in the computation. This is because fixed expenses are not affected by
the bulk sale, so all of the additional revenue that is in excess of variable costs goes to increasing the
profits of the company.

Break Even Computations


The break-even point can be computed using either the equation method or the formula methodthe two
methods are equivalent.

Equation Method:

Sales = Variable expenses + Fixed expenses + Profits

- $250Q = $150Q + $35,000 + $0


The break-even point in sales dollars can be computed by multiplying the break- even level of unit sales by the
selling price per unit 350 speakers $250 = $87,500

The break-even point in total sales dollars, X, can also be directly computed as follows:

Sales = Variable expenses + Fixed expenses + Profits

X = 0.60X + $35,000 + $0
X = $87,500

$87,500 $250 = 350 speakers

Note: In Break Even Analysis, the numbers should always be rounded up for sales level and units.

The Formula Method: The approach centers on the idea discussed earlier that each unit sold provides a certain
amount of CM that goes toward covering fixed costs.

To find how many units must be sold to


break even, we simply rearrange the profit
equation to divide total fixed costs by the unit
CM.

A variation of this method uses the CM ratio instead of the unit CM. The result is the break-even in total sales
dollars rather than in total units sold:

Target Operating Profit Analysis


Suppose management wants to earn a target net income of $40,000. How many speakers have to be sold.

The Equation Method:


Sales = Variable expenses + Fixed expenses + Profits
$250Q = $150Q + $35,000 + $40,000
Q = 750 speakers

Thus, the target operating profit can be achieved by selling 750 speakers per month, which represents $187,500
in total sales ($250 750 speakers).

The Formula Method: The second approach involves expanding the formula used to determine break-even
units to include the target operating profit as follows:
The dollar sales needed to attain the target operating profit can be computed as follows:

After Tax Analysis:


In general, operating profit after taxes can be computed as a fixed percentage of income before taxes. To
calculate income taxes, we multiply the tax rate (t) by the operating profit before taxes (B). Therefore, after-tax
profit is equal to profit before taxes (1 t) and is derived as follows:

Whenever target operating profit is


expressed on an after-tax basis, the
equation method can be used as
described earlier, except that target
operating profit must be restated to a
pre-tax basis.
Margin of Safety: The excess of budgeted (or actual) sales over the break- even volume of sales.
It states the amount by which sales can drop before losses begin to be incurred.

Margin of safety = Total budgeted (or actual) sales Break-even sales

Cost Structure: The relative proportion of fixed and variable costs in an organization.

Cost Structure and Profit Stability:


- Comparing high fixed cost oriented companies vs. high variable cost oriented companies.
- Bogside farm has a high variable cost, and sterling farm has a high fixed costs.

If sales are expected to be greater than $100,000 then sterling farms (low VC) is better because it has a
higher CM and its operating income will therefore increase more rapidly as sales increase.

What if sales drop below $100,000.

Bogside Farm is less vulnerable to downturns than Sterling Farm for two reasons.
- First, due to its lower fixed expenses, Bogside Farm has a lower break-even point and a higher margin of
safety, as shown by the computations above. Therefore, it will not incur losses as quickly as Sterling
Farm in periods of sharply declining sales.
- Second, due to its lower CM ratio, Bogside Farm will not lose CM as rapidly as Sterling Farm when
sales fall off. Thus, Bogside Farms income will be less volatile.
Operating Leverage: a measure of how sensitive operating income is to percentage changes in sales. Operating
leverage acts as a multiplier.

- If operating leverage is high, a small percentage increase in sales can produce a much larger percentage
increase in operating income.

The degree of operating leverage is a measure, at a given level of sales, of how a percentage change in sales
volume will affect profits. It is computed by the following formula:

Bogside = 4
Sterling = 7

In general, this relation between the percentage change in operating income is given by the following formula:

Percentage change in operating income = Degree of operating leverage Percentage change in sales

- If two companies have the same total revenue and same total expense but different cost structures, then
the company with the higher proportion of fixed costs in its cost structure will have higher operating
leverage.
- The degree of operating leverage is greatest at sales levels near the break-even point and decreases as
sales and profits rise.
o Because as you get closer to the break even point, net income which is the denominator of the
degree of operating leverage formula, approaches 0.

Indifference Analysis: At which point will a company be indifferent between using a Labour intensive
program (high VC and low fixed) and a Capital intensive production system (high FC and low VC) assuming
the quality is the same.

We can calculate the point at which Goodwin will be indifferent about using a LIP system versus a CIP system
as follows:
1. Determine the unit CM multiplied by the number of units (Q) minus the total fixed costs of each
alternative.
2. Set up an equation with each alternative on opposite sides of the equal sign.
3. Solve for Q, the indifference point:
$12Q $1,800,000 = $18Q $3,600,000
$6Q = $1,800,000
Q = 300,000 units
Shortcut:

The Definition of Sales Mix


Sales Mix: the relative proportions in which a companys products are sold.
- Profits will be greater if high-margin rather than low-margin items make up a relatively large proportion
of total sales.
- A shift in the sales mix from high-margin items to low-margin items can cause total profits to decrease
even though total sales may increase.
- Conversely, a shift in the sales mix from low-margin items to high-margin items can cause the opposite
effecttotal profits may increase even though total sales decrease.
Sales Mix and Break-Even Analysis:
The break-even point is $X in sales, which was computed by dividing the fixed costs by the companys overall
CM ratio.

Calculating the break-even point in units when a company sells more than one product. The approach is based
on calculating a weighted-average CM per unit for the multiple products based on the existing unit sales mix
and the individual CM per unit for each product.

Note that the sales mix percentages are based on the unit sales of each product as a percentage of total sales.

The final step is to divide total fixed costs by the weighted-average CM per unit.
Assumptions of the CVP Analysis

A number of assumptions typically underlie CVP analysis:


1. Selling price is constant throughout the entire relevant range. The price of a product or service does not
change as volume changes.
2. Costs are linear throughout the entire relevant range, and they can accurately be divided into variable
and fixed elements. The variable element is constant per unit, and the fixed element is constant in total
over the entire relevant range.
3. In multi-product companies, the sales mix is constant.
4. In manufacturing companies, inventories do not change. The number of units produced equals the
number of units sold (this assumption is considered further in Chapter 8).

SUMMARY

1. Costvolumeprofit (CVP) analysis is based on a simple model of how contribution margin (CM) and
operating income respond to changes in selling prices, costs, and vol- ume. The analysis is based on the
contribution income statement approach and requires a detailed understanding of cost behaviour. [LO1]
2. A CVP graph depicts the relationships between sales volume in units and fixed expenses, variable
expenses, total expenses, total sales, and profits. The CVP graph is useful for de- veloping intuition
about how costs and profits respond to changes in sales volume. [LO2]
3. The CM ratio is the ratio of the total CM to total sales. This ratio can be used to estimate the effect of a
change in total sales on operating income. [LO3]
4. The techniques of CVP analysis can be used to estimate the effects on CM and operating profit of
changes to sales volume, fixed costs, variable costs per unit, and selling prices. A useful aspect of the
analysis is that managers can evaluate the profit impact of the trade- offs inherent to many operating
decisions, such as increasing advertising costs to boost sales volumes. [LO4]
5. The break-even point is the level of sales (in units or in dollars) at which the company generates zero
profits. The break-even point can be computed using several different tech- niques that are all based on
the simple profit equation. [LO5]
6. The profit equation can also be used to compute the level of sales required to attain a target profit. [LO6]
7. The margin of safety is the amount by which the companys current sales exceed break- even sales.
[LO7]
8. The degree of operating leverage measures the effect of a percentage change in sales on the companys
operating income. The higher the degree of operating leverage, the more sensitive operating income will
be to a change in sales. The degree of operating leverage is not constantit depends on the companys
current level of sales. [LO8]
9. The profits of a multi-product company are affected by its sales mix. Changes in the sales mix can affect
the break-even point, margin of safety, and other critical measures. [LO9]