CHAPTER – ONE

Cost-Volume-Profit Analysis
Cost-volume profit (CVP) analysis examines the behavior of total revenues, total cost and
operating income as changes occur in the output level, selling price, variable costs per unit or
fixed costs.
Managers often classify costs as fixed or variable when making decisions that affect the volume
of output. The managers want to know how such decision will affect costs and revenues. They
realize that many factors in addition to the volume of output will affect cost. Yet, a useful
starting point in their decision process is to specify the relationship between the volume of out
puts and costs and revenues.
The mangers of profit-seeking organizations usually study the effects of output volume on
revenue (sales), expenses (costs) and net income (net profit). This study is commonly called cost-
volume-profit (CVP) analysis. The mangers of nonprofit organizations also benefit from the
study of CVP relationships. Why? No organization has unlimited resources, and knowledge of
how cost fluctuate as volume changes helps managers to understand how to control costs. For
example, administrators of nonprofit hospitals are constantly concerned about the behavior of
costs as the volume of patients fluctuates.

To apply CVP analysis, mangers usually resort to some simplifying assumptions. The major
simplification is to classify costs as either variable or fixed with respect to a measure of the
volume of output activity. That is, all costs must be classified as either fixed or variable with
respect to production or sales volume before CVP analysis can be used.
CVP analysis can be used to develop predictions of what can happen under alternative strategies
concerning sales volume, selling price, variable costs or fixed costs. Applications include “what
if” analysis. For example, how will revenues and cost be affected if we sell 1,000 more units? If
we raise or lower our selling prices?, If we expand business in to overseas markets? By
examining various possibilities and alternatives, CVP analysis illustrates various decision
outcomes and thus serves as an invaluable aid in the planning process.

Cost and Management Accounting II; BY Lakachew A. Page 1

 THE OBJECTIVE OF CVP ANALYSIS

CVP analysis looks primarily at the effects of differing levels of activity on the financial results
of a business. The reason for the particular focus on sales volume is because, in the short-run,
sales price, and the cost of materials and labor, are usually known with a degree of accuracy.
Sales volume, however, is not usually so predictable and therefore, in the short-run, profitability
often hinges  upon it. For example, Company A may know that the sales price for product x in a
particular year is going to be in the region of $50 and its variable costs are approximately $30.

It can, therefore, say with some degree of certainty that the contribution per unit (sales price less
variable costs) is $20. Company A may also have fixed costs of $200,000 per annum, which
again, are fairly easy to predict. However, when we ask the question: ‘Will the company make a
profit in that year?’, the answer is ‘We don’t know’. We don’t know because we don’t know the
sales volume for the year. However, we can work out how many sales the business needs to
make in order to make a profit and this is where CVP analysis begins.

For example, CVP analysis helps to answer the following questions:

 How much does a firm have to sell just to cover its total costs?

 How much does a firm have to sell to reach its target profit?

 How will a change in a firm’s fixed cost affect its net income?

 How much will a firm’s sales need to increase so as to cover a planned increase in
advertising budget?

 What price should a firm change to cover its cost and provide for its planned amount of
profit?

 How much should a firm actual or budgeted sales decline before it suffers a loss?

Cost-Volume Profit Assumptions

Cost-Volume- Profit (CVP) analysis is based on several assumptions.

Cost and Management Accounting II; BY Lakachew A. Page 2

 1. Changes in the level of revenues and costs arise only because of changes in the number of
product (service) units produced and sold-for example the number of television sets
produced and sold by Sony corporations.
2. Total costs can be divided in to a fixed component and a component that is variable with
respect to the level of output.
3. The behavior of total cost and total revenue is linear in relation to output units within the
relevant range and time period.
4. The unit selling price, unit variable costs, and fixed costs are known and constant.
5. The analysis either cover a single product or assumes that the sales mix when multiple
products are sold will remain constant as the level of total units sold changes.
6. Time value of money is not considered.
A cost behavior is described in terms of how its amount changes in relation to production and
sales volume changes. Total fixed costs remain constant to changes in sales volume. Total
variable costs change in direct proportion to sales volume changes. Mixed costs display the
effects of both fixed and variable components. Step costs remains the same over various ranges
of the level of activity, but the cost increases by discrete amounts (that is, in steps) as the level of
activity changes from one range to the next. Curvilinear costs change in a non-linear relation to
volume changes.
CVP1. The Breakeven point
The breakeven point is that quantity of output where total revenues equal total cost- that is,
where the operating income is zero. Why would mangers be interested in the breakeven point?
Mainly because they want to avoid operating losses, and the breakeven point tells them what
level of sales they must generate to avoid a loss. Breakeven point can be determined by using:
the equation method, the contribution margin method and the graph method.
The following abbreviations are useful in subsequent analysis.
USP= Unit selling price
UVC= Unit variable costs
UCM= Unit contribution margin (USP-UVC)
CM % = Contribution margin percentage (UCM/USP)
FC = Fixed costs
Q = Quantity of outputs units sold (and manufactured)

Cost and Management Accounting II; BY Lakachew A. Page 3

 OI = Operating income
TOI= Target operating income
TNI = Target net income

Example 1:
ABC Company manufactures and sells pens. Currently, 5,000,000 units are sold per year at a
selling price of $ 0.50 per unit. Fixed costs are $ 900,000 per year. Variable costs are $ 0.30 per
unit. Determine the break even quantity.
A) Equation method
Revenues –Variable cost- Fixed cost = Operating income
(USP x Q) – (UVC x Q) – FC = 0
0.5 Q – 0.3 Q – 900,000 – 0
0.2Q 900 ,000
=
0.2 0.2
Q=4,500 ,000
If ABC sells fewer than 4,500,000 units, it will have a loss, if it sells 4,500,000 it will
break even; and if it sells more that 4,500,000 it will mark a profit. The break even can be
expressed in revenue (birr) as:
Break even quantity x selling price per unit
=4,500,000 X $0.5 selling price = $2,250,000
B) Contribution margin method
Operating income = ((USP – UVC) X Quantity of units sold)) - FC
0 (at breakeven point) = UCM x Q-FC
FC Fixed cost
Q= =
UCM Unit cot riibutionm arg in
* Breakeven point in Birr = BEP in Q X USP
FCXUSP
OR= UCM
FC
OR = CM % , Where CM% = UCM/USP

Cost and Management Accounting II; BY Lakachew A. Page 4

 C) Graph method
Plot a line of total costs and a line of total revenues. Their point of intersection is breakeven
point. The graph also shows the profit or loss outlook for a wide range of output levels beside the
breakeven point.

Profit
Total revenue line

3000, 000
Total cost line
2,000,000
1,000,000 Breakeven point = 4,500,000
900,000

Fixed cost Loss

Fixed cost

Units sold (in millions) 0 1 2 3 4 5 6

CVP2. Target operating income

CVP analysis may use to determine the total sales, in units and dollars needed to reach a target
profit.

Cost and Management Accounting II; BY Lakachew A. Page 5

Target Revenue – Target Variable cost – Fixed cost= Target operating income
FC+TOI
Target Q = UCM

Eg. Company A wants to achieve a target profit of $300,000. The selling price per unit is $ 50,
Variable costs are $ 30 per unit and Fixed costs are $ 200,000 per year. The sales volume
necessary in order to achieve this profit can be ascertained using any of the three methods
outlined above. If the equation method is used, the profit of $300,000 is put into the equation
rather than the profit of $0:

(50Q) – (30Q) – 200,000 = 300,000

20Q – 200,000 = 300,000
20Q = 500,000
Q = 25,000 units.

Alternatively, the contribution method can be used:

UCM = 20, FC = 200,000 and P = 300,000.

Q = FC + P
        UCM
Q = 200,000 + 300,000
                  20

Therefore Q = 25,000 units.

Finally, the answer can be read from the graph, although this method becomes clumsier than the
previous two. The profit will be $300,000 where the gap between the total revenue and total cost
line is $300,000, since the gap represents profit (after the break-even point) or loss (before the
break-even point.)

CVP3. Target Net income and Income taxes

Thus far, we have ignored the effect of income taxes in our CVP analysis. At times, managers
want to know the effect of their decisions on income after taxes. Net income is operating income
minus income taxes. CVP calculations for target income must then be stated in terms of target
net income instead of target operating income.

Cost and Management Accounting II; BY Lakachew A. Page 6

Revenues – Variable cost- Fixed cost = Target operating income
Furthermore,

Target net income = (Target operating income) – (Target operating X tax rate
Income

T arget net income

Target operating income = 1−Taxrate

TNI
FC +
1−TR
Q=
UCM
TNI
FC+
1−TR
Target revenue= CM %
CVP4. Margin of Safety (MOS)
The margin of safety is the difference between budgeted/actual sales volume and break-even
sales volume; it indicates the vulnerability of a business to a fall in demand. It is often expressed
as a percentage of budgeted sales
Budgeted sales – Break-even sales = Margin of safety
MOS ratio = MOS x 100 %
Budgeted/actual Sales
Example: Based on the following information, calculate margin of safety, margin of safety ratio
Budgeted Sales 700 units x $ 8 = $5,600
Variable cost 700 units x $ 6 = $4,200
Fixed cost = $1,000
CVP5. Sales Mix Analysis
Sales mix is the relative combination of quantities of various products (or services) that
constitutes total unit sales. If the proportions of the mix change, the cost volume profits
relationships also change.

Cost and Management Accounting II; BY Lakachew A. Page 7

 Unlike in the single product (or service) situation, there is no unique breakeven number of units
for a multiple- product situation. The breakeven quantity depends on the sales mix. One possible
assumption is that the budgeted sales mix will change at different levels of total unit sales.
Breakeven point (in units) for multiproduct companies is computed using the following formula:
FC
QBEP =
WACM
Illustration on computation of BEP for multiple product company (sales mix and breakeven point)
Given the following data work out the requirements
Given
Name of company:- SS company
Number of types of products: - Two
Types of products: - LL CD and VV CD
Additional information: - sales in the current month;
LL CD VV CD Total
Item Amount Percent Amount Percent Amount Percent
Sales Br.20000 100% Br.80000 100% Br100000 100%
Less var. cost Br.15000 75% Br.40000 50% Br.55000 55%
CM Br.5000 25% Br.40000 50% Br.45000 45%
Fixed Expenses Br.27000
Required: Compute the overall break- even point sales in Birr and for each product at the breakeven
point at the given sales mix. (Remember the BEP in units can be computed if and only if the data
provided is in units).
Solution
Overall BEP=Fixed cost/overall CM-ratio=Br. 27,000/0.45=Br. 60,000 and at this BEP, sales of
LL CD and VV CD should be Br. 12,000 and Br.48,000 respectively.

Example 2
Suppose Ramos Company has two products, wallets (W) and Belt (B). The income budget is as
follows:
Wallets (W) Belt ( B) Total
Sales in units 300,000 75,000 375,000
Sales @ $ 8, and $ 5 2,400,000 375,000 2,775,000
Variable expenses @ $ 7 and $ 3 2,100,000 225,000 2,325,000
Contribution margin @ $ 1 and $ 2 300,000 150,000 450,000

Cost and Management Accounting II; BY Lakachew A. Page 8

Fixed costs 180,000
Net income $270,000

Required: Calculate the breakeven point. Assume that there is no change in sales mix and ignore
income taxes.
 Since the sales mix will not be changed there is a constant mix of 4 units of W, for every
unit of B i.e. 300,000: 75,000 or 4: 1 or 80%: 20%. Therefore W= 4B.
Solution
Method 1 = [(8W – 7W) + (5B – 3B)] – 180,000 = 0
= (32B – 28B) + (5B – 3B) - 180,000 = 0
B = 30,000 units
W = 4B = 4 (30,000 units) = 120,000 units
Method 2 = we have to calculate the weighted-average contribution margin per unit for the two
products together at the sales mix.

WACM per unit = Wallets (W) CM per unit X Q of W sold + Belt (B) CM per unit X Q of B
sold
Number of Q of W sold + number Q of B sold
= $1 per unit X 300,000 units + $2 per unit X 75,000 units = $1.2 per unit
300,000 + 75,000
We have then BEP = FC
CM per unit
= $180,000 = 150,000 units
$1.2
Because the ratio of Wallet sales to Belt sales is 300,000:75,000, or 4:1, the breakeven point is
120,000 units (0.8*150,000) of wallets and 30,000units (0.20*150,000) of Belt. At this mix, the
contribution margin of $180,000 i.e. 120,000 units wallet X $1 per units = $120,000 and 30,000
units of Belt X $2 per units = $60,000 equals with the fixed costs of $180,000.

We can also calculate the breakeven point revenues for the multiproduct situation using the
WACM percentage.

Cost and Management Accounting II; BY Lakachew A. Page 9

WACM% = Total contribution margin =450,000 =0.1621621621621622
=16.21621621621622%
Total revenues 2,775,000
Total revenues to require at BEP = FC = $180,000 = 1,110,000
WACM% 0.1621621621621622
The total revenues of $2,775,000 are in the ratio of 2,400,000:375,000 or 86.5%: 13.5%.
Hence the breakeven revenues of $1,110,000 should be split in the same ratio, 86.5%:13.5%.
Managers usually want to maximize the sales of all their products. Faced with limited resource
and time, however, executive prefer to generate the most profitable sales mix achievable.
Profitability of a given product helps guide executive who must decide to emphasize or de-
emphasize particular products. For example given limited production facilities or limited time of
sales personnel, should we emphasize wallets or ray cases? These decisions may be affected by
other factors beyond the contribution margin per unit of product.
In general, other things being equal, for any given total quantity of units sold, if the sales mix
shifts toward unit with higher contribution margins operating income will be higher.
CVP Analysis in service and non-profit organizations
CVP analysis can be applied in service and NFP organizations in measuring their output.
Examples of output measures in venous service and not profit industries follow:

Industry Measure of out put

Air lines Passenger-miles
Hotels / Motels Room-nights occupied
Hospitals Patient- days
Universities Student credit-hours
Example 3
Samara University has annual budget of $10,000,000 for MSC scholarship, $ 30,000 per student
per year. Fixed cost of the programmed is $1,000,000.
Required: -
1. How many students can get the scholarship?
2. Suppose total budget for the next year is reduced by 30% calculate the number of MSC
scholarship that SU can offer next year.

Cost and Management Accounting II; BY Lakachew A. Page 10

Solution:
1. Revenue – variable cost – FC = 10,000,000- 30,000 Q –1,000,000 = 0
9 , 000 , 000
Q= =300 students
30 , 000
6 , 000 , 000
Q= =200 students
2. 10,000,000 (0.7) – 30,000 Q – 1,000,000 = 0 = 30 , 000
Example 4: Consider an agency of the Massachusetts Department of Social Welfare with a
$900,000 budget appropriation (its revenues) for 2011. This nonprofit agency’s purposes to
assist handicapped people seeking employment. On average, the agency supplements each
person’s income by $5,000 annually. The agencies only other costs are fixed costs of rent and
administrative salaries equal to $270,000.
Required: How many people could be assisted in 2011? Final figure (Answer): 126 people

Contribution Margin Vs Gross Margin

Contribution margin refers to the difference between revenues and all variable costs.
Gross margin refers to the difference between revenue and the costs of goods sold.
Some organizations may prepare contribution income statement for managerial analysis purpose.
The following illustration shows the difference between contribution income statement and
financial accounting income statement.

Contribution income statement

(Emphasizing on Contribution Margin)
Revenues xx
Variable Costs xx
Contribution Margin xx
Fixed costs xx
Operating Income xx

Financial Accounting Income Statement

(Emphasizing on Gross Profit)
Revenue xx
Cost of goods sold xx
Gross Profit xx
Operating Expenses xx
Operating Income xx

Cost and Management Accounting II; BY Lakachew A. Page 11

 Illustration
Given the following data, prepare the contribution income statement and financial accounting
income statement.
Revenue Br. 1,000,000
Variable Manufacturing costs 250,000
Variable non Manufacturing costs 270,000
Fixed Manufacturing costs 160,000
Fixed non Manufacturing costs 138,000

Solution

Contribution Income Statement

(Emphasizing on Contribution Margin)
Revenues 1,000,000
Variable Mfg Costs 250,000
Variable non Mfg Costs 270,000 520,000
Contribution Margin 480,000
Fixed Mfg costs 160,000
Fixed Non Mfg Costs 138,000 298,000
Operating Income 182,000
Financial Accounting Income Statement
(Emphasizing on Gross Profit)
Revenue 1,000,000
Cost of goods sold 410,000
Gross Profit 590,000
Operating Expenses 408,000
Operating Income 182,000

1.8. Limitations of CVP Analysis - The CVP analysis is generally made under certain limitations
and with certain assumed conditions, some of which may not occur in practice. Following are the
main limitations and assumptions in the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit
analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction
of capacity takes place.
2. In case where a variety of products with varying margins of profit are manufactured, it is difficult
to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly constant which in
reality is difficult to find. Thus, if a cost reduction program is undertaken or selling price is changed,
the relationship between cost and profit will not be accurately depicted.

Cost and Management Accounting II; BY Lakachew A. Page 12

4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely
variable at all levels of activity and fixed cost remains constant throughout the range of volume being
considered. However, such situations may not arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant, though
sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing
stock carried over to the next financial year does not contain any component of fixed cost. Inventory
should be valued at full cost in reality.

Worksheet for CVP analysis

1. LA Motors is a small car dealership. On average, it sells a car for $27,000, which it
purchases from the manufacturer for $23,000. Each month, LA Motors pays $48,200 in rent and
utilities and $68,000 for salespeople’s salaries. In addition to their salaries, salespeople are paid a
commission of $600 for each car they sell. LA Motors also spends $13,000 each month for local
advertisements. Its tax rate is 40%.
Required
1. How many cars must LA Motors sell each month to break even?
2. LA Motors has a target monthly net income of $51,000. What is its target monthly operating
income? How many cars must be sold each month to reach the target monthly net income of
$51,000?

2. The Express Banquet has two restaurants that are open 24-hours a day. Fixed costs for the
two restaurants together total $459,000 per year. Service varies from a cup of coffee to full
meals. The average sales check per customer is $8.50. The average cost of food and other
variable costs for each customer is $3.40. The income tax rate is 30%. Target net income is
$107,100.
Required
1. Compute the revenues needed to earn the target net income.
2. How many customers are needed to break even? To earn net income of $107,100?
3. Compute net income if the number of customers is 170,000.

Cost and Management Accounting II; BY Lakachew A. Page 13