Financial and Managerial

Accounting (MBA 521)

Chapter Three
Cost – Volume – Profit Analysis
Instructor: Habtamu B. Abera [PhD]
LO-1 Perform cost-volume-profit (CVP)
analysis.
LO-2 Define breakeven point, and use
contribution margin to determine a
company’s breakeven
LO–3 Decision relevance of Breakeven point
LO-2 Perform cost-volume-profit (CVP) analysis
 CVP analysis is a study of the relationships between the sale
volume, expenses, revenue and profit.
 Managers use CVP analysis to help answer questions such as:

 How changes in output (volume) affect total revenues and total

costs?
• Also, it provides answers to questions such as:
– How many units must be sold to break-even?
– What would be the effect on profits if we reduce our selling price
and sell more units?
– What sales volume is required to meet the additional fixed
charges arising from an advertising campaign, if any?
– Should we pay our sales people on the basis of a salary only, or
on the basis of a commission only, or by a combination of the
two?
CVP analysis assumptions
 Changes in the levels of revenues and costs arise only
because of changes in the number of product (service)
units produced and sold.
 Total cost can be separated into two: FC & VC (both can
be direct and indirect)
 Within a relevant range, total revenue and total cost
have a linear relationship with the level of output.
 Selling price, FC, and VC per unit are known and
constant.
 The analysis either covers a single product or assumes
that the proportion of different products when multiple
products are sold will remain constant as the level
of total units sold changes.
Essentials of CVP Analysis
 Contribution Margin:
 Is the difference between total revenues and total
variable costs
 It indicates why operating income changes as the
number of units change.
C M = Tot al revenue - Total variable C o s t

 Contribution margin per unit:

 Is a useful tool to calculate contribution margin

 Is the difference between the selling price and the

variable cost per unit.

U C M = U n i t S e l l i n g P r i c e - U n i t Va r i a b l e C o s t
Essentials of CVP …
 Contribution Margin Ratio (CMR)
 Is contribution margin per unit divided by selling price.
𝑈𝑛𝑖𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
 CMR =
𝑈𝑛𝑖𝑡 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒

Typical decision-making situations requiring CVP analysis

would be:
 accepting a special order to use up spare capacity
 abandoning a line of business
 the existence of a limiting factor
 carrying out an activity in-house rather than buying in a
service under contract.
Exercise
• Fixed costs are Br. 15,000. Variable cost per unit is
Br. 30.00 and the unit selling price is Br. 55.50.
• Compute:
– Unit contribution margin
– The contribution margin ratio
• Answer:
– UCM = Br. 55.50/unit – Br. 30.00/unit
– UCM = Br. 25.50/unit
– CMR = Br. 25.50/unit ÷ Br.55.50/unit
– CMR= 0.4594 or 45.94%
LO-3 Define breakeven point, and use
contribution margin to determine a
company’s breakeven

71
 Breakeven Analysis
• CVP analysis can be used to examine how various ‘what
if’ alternatives being considered by a decision maker
affect operating profit.

• Break even point is one of the point of interest in this

analysis.

• Break-even point is the quantity of output sold or the

number of customers served at which total revenues
equal total costs.
• Managers are interested in BEP as they want to avoid
operating losses. BEP tells them how much output they
must sell to avoid a loss.
Example
• Sheger Plc. plans to sell Do-All Software, a soft ware
package, at a heavily attended two day computer
convention. The Plc can purchase this software from a
computer wholesaler Br. 120 per package with the
privilege of returning all unsold units and receiving a full
Br. 120 per package. The packages will be sold at Br. 200
each. Sheger has already paid to Computer Conventions
Ltd. Br. 2,000 for the two days rental.

• Compute the breakeven quantity and sales revenue for

Shager Plc
Solution:
• Equation Method:
Revenue–variable costs–Fixed costs = Operating Income (Profit)
[USP x Q] – [UVC x Q] – FC = OI
Then, substitute the given values in the equation. Since at breakeven OI
is zero, hence,
[Br. 200 x Q] – [Br. 120 x Q] – Br. 2,000 = 0
Br. 200Q – Br. 120Q – Br. 2,000=0
Br. 80Q – Br. 2000=0
Br. 80Q= Br. 2,000
𝐵𝑟.80𝑄 𝐵𝑟.2,000
=
𝐵𝑟.80 𝐵𝑟.80

Q = 25.
Therefore the breakeven quantity is 25 packages.
The breakeven sales revenue is equal to:
USP x Q => Br. 200/package x 25 packages
Breakeven sale revenue is Br. 5,000
Solution:
• Contribution Margin Method:
Is simply an algebraic manipulation of the equation method. Contribution
margin is equal to Revenue–variable costs. The method uses this fact:
[USP x Q] – [UVC x Q] – FC = OI

[USP –UVC] x Q = FC + OI

UCM x Q = FC + OI
𝐹𝐶+𝑂𝐼
Q= since, at breakeven OI is zero, breakeven quantity is;
𝑈𝐶𝑀
𝐹𝐶
Q= so, Breakeven quantity is computed as:
𝑈𝐶𝑀
𝐵𝑟.2,000
Q= = > Q = 25
𝐵𝑟.200 −𝐵𝑟.120
Sales revenue at breakeven point remains the same but can also be
computed using
𝐹𝐶 𝐵𝑟.2000
S= = = Br. 5,000
𝐶𝑀𝑅 0.4
Solution:
• Graph Method:
• Two equations are required:
 Total Cost Function: TC = TVC + FC => TC= [UVC x Q] + FC
 TC = Br. 120Q + Br. 2000
 Total Revenue function: TR = USP x Q
 TR = Br. 200Q
 Break-Even (Quantity) Point
The sales volume required so that total revenues and
total costs are equal; may be in units or in sales birrs.
 How to find the quantity break-even point?
EBIT = P(Q) - V(Q) FC
EBIT = Q(P - V) - FC
EBIT = Earnings Before Interest and Tax

P = Price per unit V = Variable costs per unit

FC = Fixed costs Q = Quantity (units)
produced and sold
 Break-Even (Quantity) Point

 Breakeven occurs when EBIT = 0

Q (P - V) - FC = EBIT
QBE (P - V) - FC = 0
QBE (P - V) = FC
QBE = FC / (P - V)

Unit Contribution Margin

 Break-Even (in Birr Sales) Point
How to find the sales break-even point:
SBE = FC + (Total Variable Cost BE)
FC = QBE (Unit Selling Price-Unit Variable Cost)
FC = QBE (Unit Contribution Margin)
SBE = FC /CM ratio
SBE = FC /(unit contribution margin/unit selling price)
SBE * = FC / [1 - (VC / SP) ]
 Break-Even Point Example
BMW wants to determine both the quantity and sales
revenue at break-even points when:
 Fixed costs are Br.100,000,000
 No. SUV cars sold for Br.437,500 each
 Variable costs are Br.187,500 per unit

Compute:
a. The break-even quantity and break-even sales revenue
b. Prepare contribution Income statement
 Break-Even Point (s)
Breakeven occurs when:
QBE = FC / (P - V)
QBE = Br.100,000,000 / (Br.437,500- Br.187,500)
QBE = 400 Units
SBE = (QBE )(V) + FC
SBE = (400 )(Br.187,500) + Br.100,000,000
SBE = Br.175,000,000
 Contribution Income Statement
• Revenue, Br. 437,500 x 400 cars ……..….. Br. 175,000,000
• Less: Variable costs, Br. 187,500 x 400 cars… 75,000,000
• Contribution margin, Br. 250,000 x 400cars… 100,000,000
• Less: Fixed Costs ………………………………………. 100,000,000
• Operating Income …………………………………..Br. 0____
 Break-Even Chart /Graph/

Total Revenues
Profits
REVENUES AND COSTS

250
(Br. Millions)

Total Costs
175

Fixed Costs
100
Losses
Variable Costs
50

0 100 200 300 400 500 600 700

QUANTITY PRODUCED AND SOLD
 Margin of Safety
• The margin of safety indicates by how much
sales may decrease before a loss occurs.

• Formula:
• Margin of safety = Expected sales – Breakeven sales

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 −𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑠𝑎𝑙𝑒𝑠

• % margin of safety =
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑠𝑎𝑙𝑒𝑠

Profit = CMR x Sales Revenue – Fixed Costs

Example
• If unit selling price and variable cost were Br. 20/unit and
Br. 10/unit respectively and fixed costs were Br. 60,000,
compute:
a) Breakeven sales
b) Expected sales at 8000 unit
c) The margin of safety [in units & sales revenue]
d) The percentage of margin of safety.
• Solution:
a) 6,000 units
b) Br. 160,000
c) 2,000 units or Br. 40,000
d) 25%
 Target Operating Income
 Break even formula may be adjusted to show
the sales volume needed to earn any amount
of operating income.
Fixed Cost  Target Income
Unit Sales 
Unit Contribuion Margin
Fixed Cost  Target Income
Birr Sales 
Contribution Margin Ratio
Income Tax Rate

Exercise I
 Shebele Restaurant has fixed costs of Br. 660,000,
variable costs of Br. 15 per unit, and a contribution margin
ratio of 40 percent.

Compute the following:

a. Unit sales price and unit contribution margin for the
above product.
b.The sales volume in units required for Shebele.
Corporation to earn an operating income of Br. 300,000.
c.The birr sales volume required for Shebele Corporation to
earn a Net Income of Br. 300,000 at 40% tax rate
Exercise
 Assume Ethiopia Hotel charges Br. 200 a single
night with full breakfast in the morning. The Hotel
estimated that the variable expense per person is Br.
120 which include expenses for food, maid and utilities.
If the annual fixed expenses total Br. 480,000.
 compute
a) the breakeven: in number of customers to be served and sales
revenue
b) sales in number of customers and birr sales if the target
operating income (profit) is Br. 56,000.
c) sales in number of customers and birr sales if the target NI is
Br. 42,000 at a tax rate of 30%.
Ans.
A] 6,000 & Br. 1,200,00
B] 6,700 & Br. 1,340,000
C] 6,750 & Br. 1,350,000
Solution
a. Breakeven:
i. No. of persons served Sales = 6,000 persons
ii. Sales Revenue= Br. 1,200,000
b. When Target Operating Income is Br. 56,000
i. No. of persons served= 6,700 persons
ii. Birr sales = Br. 1,340,000
c. When Target NI is Br. 42,000 at 30% tax rate
i. No. of persons served = 6,750 persons
ii. Birr sales = Br. 1,350,000
 Exercise
1. MC Corp. has fixed costs of Br. 180,000 and variable costs of
Br. 8.90 per unit. It has a target income of Br. 264,000. How
many units must be sold if selling price is Br. 12 per unit to
achieve its target net income (assume tax rate of 40%).
a. 200,000 b. 58,064.5 c. 143,225. d. none

2. The following information is available for CHS Co. Sales, Br.

350,000, CGS, Br. 120,000, Total fixed expenses, Br. 60,000,
and Total variable expenses, Br. 100,000. Which amount
would you find on CHS’s CVP income statement?
a) CM of Br. 250,000
b) CM of Br. 190,000
c) Gross profit of Br. 230,000
d) Gross profit of Br. 190,000
LO – 3 Decision relevance of
Breakeven point
Using Breakeven Analysis for Decision Making

 Decision to advertise:
 Givens:
 Selling price = Br. 80 per unit
 Variable cost = Br. 60 per unit
 Fixed cost = Br. 16,000

Suppose the firm anticipates selling 900 units and

generate Br. 2,000 operating income. The firm is
considering placing an advertisement which will cost Br.
1,500 and will remain fixed regardless of the number of
units the firm sells. The decision will advertise will increase
sales by 10%. Should the firm advertise?
 Using CVP …
 Advertisement:

No Ad With Ad Difference

CM (Br. 20 * 900; Br. 20 * 990) Br. 18,000 Br. 19,800 Br. 1,800

Fixed costs 16,000 17,500 1,500

Operating Income Br. 2,000 Br. 2,300 Br. 300

 Using CVP…
 Decision to Reduce Selling Price
 Consider the given information above as it is and
further assume that the firm plans to reduce selling
price by 10%, in order to increase sales to 1300 units.
Should the price be reduced?

CM from lowering price (Br. 72 – 60) * 1300 Br. 15,600

CM from maintaining price (Br. 80 – 60) * 900 18,000

Change in CM from lowering price Br. (2,400)

Effects of Sales Mix on Income
 Effects of sales mix…
 Sales mix is the quantities of various products (or
services) that constitute total unit sales of a company.
 Given:

Product X Product Y Total

Units sold 60 40 100
Revenue, Br.200;Br.100 Br. 12,000 Br.4,000 Br.16,000
VC, Br.120; Br. 70 7,200 2,800 10,000
CM, Br. 80; Br. 30 Br. 4,800 Br.1,200 Br. 6,000
Fixed Costs 4,500
Operating Income Br. 1,500
Required: Compute Breakeven Units
 Effects of sales mix…
 Ratio of sales units: (Method I)
 No of Product X : No of Product Y
 60 : 40
 3:2 (let H represents the breakeven quantity)
 Revenue – variable costs – Fixed Cost = 0
[(Br. 200 x 3H) + (Br. 100 x 2H)] – [(Br. 120 x 3H) + (Br. 70 x 2H) – Br. 4,500=0
[Br. 600 H + Br. 200H] – [Br. 360H + Br. 140H] – Br. 4,500=0
[Br. 800H – Br. 500H] – Br. 4,500=0
Br. 300H – Br. 4,500= 0
Br. 300 H = Br. 4,500
H = 15 Hence, Quantity of Product x = 3 x 15= 45 and
Quantity of Product Y= 2 x 15 =30
Effects of sales mix…
• Method II
𝑇𝑜𝑡𝑎𝑙 𝐶𝑀
• Step I : Calculate combined CM Ratio=
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝐵𝑟. 6,000
– Combined CM Ratio = 𝐵𝑟.16,000 = 0.375 or 37.5%

• Step II: Compute Overall sales revenue at breakeven

𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 𝐵𝑟.4,500
– Overall Sales Revenue at BE = = = Br. 12,000
𝑂𝑣𝑒𝑟𝑎𝑙𝑙 𝐶𝑀𝑅 0.375
• Step III: Allocate the overall BE Sales to the products based on
their ratio in revenue
– X : Y => 12,000 : 4,000 => 3 : 1
– To Product X = Br. 12,000 x 3/4 = Br. 9,000
– To Product Y = Br. 12,000 x 1/4 = Br. 3,000
• Compute the units to be produced and sold from each product
– From Product X => Br. 9,000/Br. 200 per unit = 45 units
– From Product Y => Br. 3,000/Br. 100 per unit = 30 units
Activity
Particulars Product I Product II Total
Amount % Amount % Amount %
Sales Br. 20,000 100 Br.80,000 100 Br. 100,000 100
- Variable Cost 15,000 75 40,000 50 55,000 55
Contribution Margin Br. 5,000 25 Br. 40,000 50 Br. 45,000 45
- Fixed Costs 27,000
Operating Profit Br. 18,000

Compute:
a) The combined breakeven sales
b) The breakeven sales of each product
c) Prepare the contribution Income Statement
Activity - Solution
• Contribution Income Statement
Product I Product II Total
Particular
Amount % Amount % Amount %

Sales Br. 12,000 100 Br. 48,000 Br. 60,000 100

Variable Costs 9,000 75 24,000 33,000 55

Contribution Margin Br. 3,000 25 Br. 24,000 Br. 27,000 45

Fixed Costs 27,000

Operating Profit 0
End of Chapter Three
Incremental Analysis
The Concept of Relevant
Information
Some cost concepts
 Common costs:
 Are costs which will be identical for all alternatives.
e.g. rent or rates on a factory.
 Sunk costs:
 Also called past costs. e.g. dedicated fixed assets,
development costs already incurred.
 Committed costs:
 Is a future cash outflow that will be incurred anyway,
whatever decision is taken now. e.g. contracts already
entered into which cannot be altered.
 Which of these costs are relevant costs?
What makes information relevant to
a decision problem?
 Two/three criteria are important:
 Bearing on the future:
 The consequence of the decisions are born
in the future, not in the past.
 Different under competing alternatives
 Must involve costs or benefits that differ
among the alternatives
 Cash Flow
 Must be a cash expense/revenue.
Incremental Analysis to Common
Business Decisions
 Special Orders Decisions:
• XYZ Co. has received a one-time offer for 500 prints
at a special price of Br. 0.40 per print (Br.200).

• The regular price is Br. 0.50. should the offer be accepted

or rejected.

Sales for the week (5,000 prints at Br. 0.50) Br.2,500

Less: Variable costs, including paper, maintenance,
and etc (5,000 copies at Br. 0.20) 1,000
Total contribution margin Br. 1,500
Less: Fixed costs (supplies, plus allocated costs
of the print shop) 1,200
Operating profit for the week Br. 300
 Special Orders Decisions
Condition I: Analysis of Special Order: Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special Difference
Offer) Offer) (Af – Bf)
Comparison of Totals
Sales revenue Br.2,500 Br.2,700 Br.200
Variable costs (1,000) (1,100) (100)
Total contribution Br.1,500 Br.1,600 Br.100
Fixed costs (1,200) (1,200) -0-
Operating profit Br. 300 Br. 400 Br.100

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. 0.40 Br. 200
Less: Differential costs, 500 at Br. 0.20 100
Differential operating profit (before taxes) Br. 100

The special order should be accepted

 Special Orders Decisions
Condition II: Analysis of Special Order: No Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special
Offer) Offer) Difference
Comparison of Totals
Sales revenue Br.2,500 Br.2,450 Br.(50)
Less: Variable costs 1,000 1,000 -0-
Total contribution Br.1,500 Br.1,450 Br.(50)
Less: Fixed costs 1,200 1,200 -0-
Operating profit Br. 300 Br. 250 Br.(50)

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. (0.10) Br. (50)
Less: Differential costs, -0-
Differential operating profit (before taxes) Br. (50)

The special order should be rejected

 Use of Differential Analysis for Production
Decision

Understand how to apply differential analysis to production

decisions.

Decision to make goods or services

Make or buy
internally or purchase them externally

Add or drop Decision to add or drop a product

a segment line or close a business unit

Product Decision on what products or

choice services to offer (product mix)
 Make-or-Buy Decisions
XYZ company’s current costs of developing prints:

100,000
Per unit prints
Costs directly traceable:
Direct materials Br.0.05 Br. 5,000
Direct labor 0.12 12,000
Variable manufacturing overhead 0.03 3,000
Fixed manufacturing overhead 4,000
Common costs allocated to this product line 10,000
Total costs Br.34,000

This year’s expected volume is 100,000 prints, so the full cost of

processing a print is:
Br. 34,000 ÷ 100,000 = Br. 0.34
Make-or-Buy Decisions
The Co. has received an offer from an outside
developer to process any number of prints for Br. 0.25
each.

Should XYZ Co. accept this offer?

The accounting department

prepared cost analyses at volume
levels of 50,000 and 100,000 prints
per year.
Add or Drop a product/service
 Add or Drop Decisions Should the prints
segment be
dropped?
XYZ Co.
Product Line Income Statement

Total Prints Cameras Frames

Sales revenue Br.80,000 Br.10,000 Br.50,000 Br.20,000

Cost of sales (all variable) 53,000 8,000 30,000 15,000
Contribution margin Br.27,000 Br. 2,000 Br.20,000 Br. 5,000
Less fixed costs:
Rent 4,000 1,000 2,000 1,000
Salaries 5,000 1,000 2,500 1,500
Marketing and administrative* 3,000 500 1,500 1,000
Operating profit (loss) Br.15,000 Br. (500) Br.14,000 Br. 1,500

*Half of the Marketing and Administrative cost is fixed.

Product Choice Decisions
Product Choice Decisions
Constraints
Activities, resources, or policies that limit the
attainment of an objective are called constraints.

Contribution Margin per Unit of Scarce

Resource
Contribution margin per unit of a particular input
with limited availability.
Product Choice Decisions
XYZ Co
Revenue and Cost Information
Metal Wood
frames frames
Price
Less: Variable costs per unit Br.50 Br.80
Material 8 22
Labor 8 24
Overhead 4 4
Contribution margin per unit Br.30 Br.30
Fixed costs
Manufacturing Br.3,000
Marketing and administrative 1,500
Total Br.4,500
Product Choice Decisions
XYZ Co.
Revenue and Cost Information
Metal Wood
frames frames

Per unit:
Contribution margin Br. 30 Br. 30
Machine hours required ÷ 0.5 ÷ 1.0
Contribution margin per machine hour Br. 60 Br. 30

Metal Frames have a higher contribution margin

per machine hour.
Product Choice Decisions
Suppose XYZ Co. has 200 machine hours per
month available.
Metal Wood
frames frames
Capacity 400 200
Contribution margin per unit × Br.30 × Br.30
Total contribution margin Br.12,000 Br.6,000
Less: Fixed manufacturing costs 3,000 3,000
Less: Fixed marketing and admin. costs 1,500 1,500
Operating profit Br. 7,500 Br.1,500

Selling metal frames will result in higher profits than

selling wooden frames.
Joint Product Decisions
 Joint Product Decisions
Two or more products produced from a
common input are called joint products.

Product A
Joint costs are
the costs of
Joint Costs Product B processing prior to
the split-off point.

Product C
The split-off point is the point in a process where
joint products can be recognized as separate products.
Joint Product Decisions
Firms are often faced with the
decision to sell partially completed
products at the split-off point or to
process them to completion.

General rule:
Process further only if
incremental revenues > incremental costs
 Joint Product Decisions
Addis Mfg Co. produces two products, X and Y, from this process.

Further Final
OIL X Revenue
Revenue
Br.
Br.80,000
80,000 Processing Sale
Br. 50,000 Br.120,000

Joint Common
Cost Joint
Production
Br. 120,000 Product
Process

CHEMICALS Y Revenue Further Final

Br. 70,000 Processing Sale
Br. 40,000 Br.115,000
Split-Off
Point

Should the products be sold at split-off or processed further?

 Joint Product Decisions
Incremental Incremental
Product Revenue Cost Difference
X Br. 40,000 Br. 50,000 Br.(10,000)
Y 45,000 40,000 5,000

Product X incremental revenue = Br. 120,000 - 80,000

Product Y incremental revenue = Br. 115,000 - 70,000

Decision:
Process product Y, but sell product X at the split-off point.
Note that the Br.120,000 joint cost is irrelevant to the
processing decision.
 Joint Product Decisions
Joint costs are not relevant
in decisions regarding what to do with
• a product after the split-off point.
• As a general rule . . .
• It is always profitable to continue processing
a joint product after the split-off point so
long as the incremental revenue exceeds the
incremental processing costs.
End of Chapter VII

• Wish You Good

Work and Luck!!
 Financial and Managerial
Accounting (MBA 521)

End of Chapter Three