Chapter 7 Notes – Cost-Volume-Profit Analysis

What is Cost-Volume-Profit Analysis?

Cost-Volume-Profit (CVP) analysis summarizes the effects of changes in an organization’s volume of

activity on its costs, revenue and profit.

What is Contribution Margin?

Revenue – Variable Costs – Fixed Costs = Operating Income

Contribution Margin = Revenue – Variable Costs i.e.

Operating Income = Contribution Margin – Fixed Costs

In the short run, when a change in revenue doesn’t affect fixed costs , changes in operating income are
completely driven by changes in contribution margin.

What are the two different ways to operationalize contribution margin for CVP analysis?

Contribution margin per unit = Selling price per unit – Variable costs per unit

Contribution margin ratio = (Selling price per unit – Variable costs per unit) / Selling price per unit

= (Revenue – Total variable costs) / Revenue

How’s Contribution margin different from Gross margin?

What is the break-even point and how to compute it?

Break-even point is the volume of activity where the organization’s revenues and expenses are equal.

Two different ways to think about Break-even level of activity:

1) The activity level where the total contribution margin $ = Total fixed expenses
2) The activity level where Revenue = Total variable expenses + Total fixed expenses

Formally,

1) Contribution Margin approach

 Using Contribution per unit
 Compute the contribution per unit by subtracting the variable costs from the
selling price.
 Use the formula (¿ Costs)/(Contribution per unit ) to compute the break-
even point in units.

o Using Contribution Margin

 Compute the contribution margin ratio i.e.
(Contribution per unit)/(Sales Price per unit).
 Use the formula (¿ Costs) /(Contribution Margin Ratio) to compute the
break-even point in dollars.

2) Equation Approach
a. At the break-even point, Sales−Variable Expenses−¿ Expenses=0
b. If x is the volume produced to break-even, the equation can be written as
Sale Price∗x −Variable Cost per unit∗x−¿ Costs=0, and solve for x .

How to apply the CVP analysis to figure out the level of activity needed to achieve a certain level of
operating profit?

We can easily modify the break-even point calculations to include the profit to be earned and find the
activity level to attain that target profit.

This involves simply replacing

1) Fixed Costs with (Fixed Costs + Target profit) In the Contribution Margin approach
2) 0 on the RHS with Target profit when using the Equation Approach

How to apply the CVP analysis to figure out the level of activity needed to achieve a certain level of
after-tax profit?

First calculate: Target operating profit = Target after-tax profit ÷ (1 – Tax rate)

Then use the approach outlined just above to determine the activity level needed to achieve the desired
operating profit.
How can CVP analysis be applied to analyze the effects of short-term pricing, production, sourcing and
spending decisions on operating income?

Pricing, production, sourcing and spending decisions affect some or all of the following:

a) Selling price
b) Sales Volume
c) Variable costs
d) Fixed costs

The incremental profit arising from choosing a specific set of decisions say A, instead of a competing set
say B, can be easily calculated as

Change in $ contribution margin – Change in Fixed Costs.

If incremental profit is positive A is better than B. We can always have B as “status-quo” to compare a
proposed change with the current set up.

Question:

In the Hydro Systems Engineering Example, let’s say that the company is evaluating the idea of providing
a modified portfolio of consulting services in the future that would lead to total annual revenues of
$1,000,000, a revised contribution margin of 25% and annual fixed costs of $170,000. By how much
would the operating profit change if the new portfolio of services are offered instead of the current
services?

How can CVP analysis be used by management to get a “feel” for how far away the current business
activity level is from a “loss” territory?

Simply calculate a Safety Margin Ratio defined as

= (Current Revenue – Break-even Revenue) / Current Revenue

How does the CVP analysis change if the company produces multiple products?

Most organizations have more than one product line, and CVP analysis may be adapted for these firms.
The same basic equations are used; however, the contribution margin must be weighted by the sales
mix.

A weighted-average unit contribution margin is calculated by multiplying a product's contribution

margin by its sales mix percentage, and then summing the results for individual products.

The result is divided into fixed expenses (as before) to arrive at the break-even point in "units." These
"units" are really a commingled market basket of goods.

As a final step, the sales-mix percentages are multiplied by the number of "units" to calculate individual
product sales to break even.
What is Operating Leverage Factor (OLF) and how exactly does a company’s cost structure related to
its OLF?

A firm's cost structure has a significant effect on the way that profits fluctuate in response to changes in
sales volume. The greater the proportion of fixed costs, the greater the impact on profit from a given
percentage change in sales revenue.

The extent to which an organization uses fixed costs in its cost structure is called operating leverage.

A company with a high proportion of fixed costs and a low proportion of variable costs has high
operating leverage and the ability to greatly increase net income from an increase in sales revenue.

Operating leverage factor = Contribution margin ÷ Operating income

This factor, when multiplied by the percentage change in sales revenue, will equal the percentage
change in operating income.

In class exercise:

Investopedia had an annual revenue of $1,000,000, variable costs of $500,000 and fixed costs of $400,000.

a) What is Investopedia’s safety margin ratio at this level of revenue?

b) What is Investopedia’s Operating Leverage Factor at this level of revenue?

c) What percentage change in operating income would result from a 10% change in sales revenue?

d) Assume that Investopedia is contemplating a different cost structure, variable costs of $400,000
and fixed costs of $500,000 that would generate the same revenue of $1,000,000. What
percentage change in operating income would result from a 10% change in sales revenue?

e) If you are the owner of Investopedia and if both a 10% increase and a 10% decrease in sales
revenue are equally likely which of the two cost structures would you pursue? Why?