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Chapter 3

Cost-Volume-Profit Analysis

Introduction
• Feature story:
• Mary Frost sells Do-All software, a home-office
software package, at booths rented at software
conventions.
• There’s a new computer convention coming up that
she views as critical for exposure to new clients
and growth.
• The convention organizer has different booth-rental
plan.
– Pay a fixed amount.
– Pay nothing up front and then pay a fixed percentage on
whatever revenues she earn.
• The management accountant recommends doing
Cost-Volume-Profit (CVP) analysis to help evaluate
the risks and rewards of the options. 2

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Introduction

• Cost-volume-Profit (CVP) analysis examines the

behavior of total revenues, total costs, and operating
income as changes occur in the output level (the
volume), the selling price, the variable cost per unit,
or the fixed costs of the product.
• An important feature of CVP analysis is distinguishing
fixed from variable costs.

Basic Assumptions
• Changes in production/sales volume are the
sole cause for cost and revenue changes.
• Total costs consist of fixed costs and variable
costs.
• Revenue and costs behave and can be graphed
as a linear function (a straight line) with volume.
• Selling price, variable cost per unit, and fixed
costs are all known and constant.
• In many cases only a single product will be
analyzed. If multiple products are studied, their
relative sales proportions are known and
constant.
• The time value of money (interest) is ignored. 4

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Basic Formulae

Total Cost Pretax

Operating Revenues of Operating
Income = from Goods Expenses
Operations Sold

Net Operating Income

Income = Income Taxes

Essentials of CVP analysis

• Example:
• Mary Frost is considering selling Do-All software at a new
computer convention.
• Mary can purchase this software at $120 per package (with
privilege of returning unsold packages).
• The packages would be sold at $200 each
• She would pay a fixed rental cost: $2,000. Assume no other
costs.
• Mary is uncertain about how many packages she would be
able to sell.
• She wants to know what profits she would make for different
quantities of packages that she might sell.
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Example (contd.) Contribution income statement

• The only numbers that change from selling different

quantities of packages are total revenues and total variable
costs.
• The difference between total revenues and total variable
costs is called contribution margin.
• contribution margin per unit is the difference between
selling price and variable cost per unit. ($200-$120=$80)
• contribution margin percentage = contribution margin per
unit divided by selling price ($80/$200 = 0.40, or 40%) 7

Methods to Express CVP Relationships

• Equation Method:

Revenues _ Variable _ Fixed =

Operating
Costs Cost income

Selling X Quantity _ Varaible cost X Quantity _ Fixed Operating

[ Price of output ] [ per unit of output ] Cost
=
income
units sold units sold

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Methods to Express CVP Relationships

(contd.)
• Contribution Margin Method:

Selling _ Varaible cost Quantity _ Fixed Operating

[ Price per unit ]X [ of output ] Cost
=
income
units sold
Contribution Margin
Per unit

Contribution Quantity _ Fixed Operating

[ margin per unit ] X [ of output ] Cost
=
income
units sold

Methods to Express CVP Relationships (contd.)

• Graph Method:

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Breakeven Point
• The breakeven point (BEP) is that quantity of
output sold at which total revenues equal total
costs – that is the quantity of output sold at
which the operating income is $0.
• Recall the equation method:
Selling X Quantity _ Varaible cost X Quantity _ Fixed Operating
[ Price of output ] [ per unit of output ] Cost
=
income
units sold units sold

• Using Do-All software data: the breakeven point (Q)

when operating income is zero.
• [$200 X Q] – [$120 X Q ] – [$2,000] = $0
$80 X Q = $2,000
Q = 25 units
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Breakeven Point (contd.)

• Breakeven point can also be expressed in terms of
Revenues:
• Breakeven revenue = Breakeven point X selling price
• Do-All software example:
• Breakeven revenue = 25 units X $200 = $5,000

• Also Contribution margin method can be used:

Contribution Quantity _ Fixed Operating
[ margin per unit ] X [ of output ] Cost
=
income
units sold
• Contribution margin per unit X Breakeven point = Fixed cost
Breakeven point = Fixed cost/ Contribution margin per unit
= $2,000/ $80 per unit = 25 unit
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Target Operating Income

• How many units must Do-All software sell to
earn an operating income of $1,200?
• Using equation method:
Selling X Quantity _ Varaible cost X Quantity _ Fixed Operating
[ Price of output ] [ per unit of output ] Cost
=
income
units sold units sold

• [$200 X Q] – [$120 X Q ] – [$2,000] = $1,200

$80 X Q = $2,000 + $1,200 = $3,200
Q = 40 units
• The revenue needed to earn $1,200 =
40 X $200 = $8,000
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Profit-Volume Graph
• PV graph shows how change in volume affect operating
income.

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Using CVP analysis for Decision Making

• “What if” theme.
– Introduce additional features for existing product
– Advertise
– Expand into new market
– Reducing selling price
• CVP analysis helps managers make decisions by
estimating the expected profitability of these
choices, and evaluating the risk.
• Example: Do-All software :
– Decision to advertise
– Decision to reduce selling price
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Using CVP analysis for Decision Making

(contd.)
• Decision to Advertise:
– Suppose Mary anticipates selling 40 units.
Operating income would be $1,200.
– Mary is considering placing an
advertisements.
– Advertisements cost is $500 (fixed cost)
– She anticipate that the advertising will
increase sales by 10% to 44 packages.
– Should Mary Advertise?

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Using CVP analysis for Decision Making

(contd.)

40 packages sold 44 packages sold Difference

with No advertising with advertising

Revenues $8,000 $8,800 $800

($200 X…)
Variable costs 4,800 5,280 480
($120 X…)
Contribution 3,200 3,520 320
margin ($80 X..)
Fixed cost 2,000 2,500 500

Operating $1,200 $1,020 $(180)

income
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Using CVP analysis for Decision Making

(contd.)
• Decision to Reduce Selling Price:
– Mary is contemplating whether to reduce the
selling price to $175.
– At this price, she thinks she will sell 50 units.
– At this quantity, the software wholesaler will
sell the packages to Mary for $115 per unit
instead of $120.
– Should Mary reduce the selling price?

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Using CVP analysis for Decision Making

(contd.)

Lowering price to Maintaining price Difference

$175, 50 packages ,40 packages sold
sold
Revenues $8,750 $8,000 $750

Variable costs $5,750 $4,800 $950

Contribution $3,000 $3,200 $200

Fixed cost $2,000 $2,000 0

Operating $1,000 $1,200 $(200)

income

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Using CVP analysis for Decision Making

(contd.)
• Mary could also ask “ At what price can I sell 50
units (purchased at $115 per unit) and continue
to earn an operating income of $1,200?
• The answer is $179.
– Target operating income $1,200
– Add fixed cost $2,000
– Target contribution margin $ 3,200
– Divided by number of units sold ÷ 50 units
– Target contribution margin/unit $64
– Add variable cost/unit $115
– Target selling price $179

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Sensitivity Analysis
• Sensitivity analysis is a “what-if” technique that
managers use to examine how an outcome will
change if the original predicted data are not
achieved or if an underlying assumption changes.
• “What” happens to profit (operating income) “if”:
– Selling price changes
– Volume changes
– Cost structure changes
• Variable cost per unit changes
• Fixed cost changes
• Spreadsheets, such as Excel, enable managers to
conduct CVP-based sensitivity analysis in a
systematic and efficient way.
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Sensitivity Analysis (contd.)

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Margin of Safety
• One indicator of risk
• The amount by which budgeted (or actual ) revenues
exceed breakeven revenues.

• Margin of safety = Budgeted Revenue – Breakeven Revenue

• Expressed in units, margin of safety is the sales

quantity minus the breakeven quantity.
• The higher margin of safety gives the company
confidence that it is unlikely to suffer a loss.

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Alternative Fixed-Cost / Variable-Cost

Structures
• CVP-based sensitivity analysis highlights the risks
and returns as fixed costs are substituted for variable
costs in a company’s cost structure.
• Suppose Computer Convention offers Mary three
rental alternatives:
– Option 1: $2,000 fixed fee
– Option 2: $800 fixed fee plus 15% of revenues
– Option 3: no fixed fee with 25% of revenues.
• Mary interested in how her choice of a rental
agreement will affect the income she earns and the
risks she faces.
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Alternative Fixed-Cost / Variable-Cost

Structures (contd.)

Fixed cost Contribution margin /unit

(Selling price – Variable costs per unit)
Option 1 $2,000 $80
($200 - $120)
Option 2 $800 $50
($200 - $120 – (0.15 X $200))
Option 3 $0 $30
($200 - $120 – (0.25 X $200))

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Alternative Fixed-Cost / Variable-Cost

Structures (contd.)
• If Mary sells 40 units, she should be indifferent across the
three options. Each option results in operating income of
$1,200.(see Exhibit 3-5)
• Option 1 has the higher risk of loss because of its higher
fixed cost which result in a higher breakeven point (25
units) an a lower margin of safety (40-25=15 units) relative
to other options.
• Also, option 1 has the higher contribution margin per unit
($80) because of its low variable costs.
• At low demand levels option 3 is preferable.
• At high levels of demand option 1 is preferable.
• Mary choice will depend on her attitude to accept risk.
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Alternative Fixed-Cost / Variable-Cost

Structures (contd.)

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Effects of Sales-Mix on CVP

• The formulae presented to this point have

assumed a single product is produced and sold
• A more realistic scenario involves multiple
products sold, in different volumes, with different
costs
• For simplicity’s sake, only two products will be
presented, but this could easily be extended to
even more products

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Effects of Sales-Mix on CVP (contd.)

• A weighted-average CM must be calculated (in

this case, for two products)
Weighted ( Product #1 CMu x Product #1 Q ) + ( Product #2 CMu x Product #2 Q )
Average =
CMu Total Units Sold (Q) for Both Products

• This new CM would be used in CVP equations

Multi- Fixed Costs

Product = Weighted Average CM per unit

BE

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Effects of Sales-Mix on CVP (contd.)

• Mary plans to sell two different software products: Do-All
and Superword.
• We assume the budgeted sales mix ( 3 units of Do-All sold
for every 2 units of Superword sold) will not change.

Do-All Superword Total

Units sold 60 40 100
Revenues ($200, and $100/unit) $12,000 $4,000 $16,000
Variable costs ($120, and $70) 7,200 2,800 10,000
Contribution margin ($80,$30) $4,800 $1,200 6,000
Fixed costs 4,500
Operating income $1,500

• What is the breakeven point?

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Effects of Sales-Mix on CVP (contd.)

• WA contribution margin =( [$80 X 60] + [$30 X 40]) / (60 + 40) = $ 60 /unit
• Breakeven point = Fixed costs/ WA contribution margin per unit
= $4,500/ $60 = 75 unit
• Because the ratio of Do-All sales to Superword sales is 3:2
(60:40), the breakeven point is 45 units of Do-All and 30 units
of Superword.
• Try to find the Breakeven revenue. How you split the total
breakeven revenue between the different products?

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Multiple Cost Drivers

• Variable costs may arise from multiple cost drivers or
activities. A separate variable cost needs to be calculated
for each driver.
• Suppose Mary will incur a variable cost of $10 for
preparing documents for each customer who buys Do-All
software.
• Operating income = Revenues – (cost of each package X
Number of packages) – (Cost of preparing doc. X
number of customers) – Fixed costs.
• If Mary sells 40 packages to 15 customer, then OI= $1,050
• If Mary sells 40 packages to 40 customer, then OI= $800
• No unique breakeven point. Mary will breakeven if she
sells 26 packages to 8 customers, or 27 packages to 16
customer.
• The simple formula cannot be used.
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