CHAPTER 1 COST-VOLUME-PROFIT RELATIONSHIPS

Cost-Volume-Profit (CVP) Analysis

It examines the behavior and relationship of total revenues, total costs and operating profit as changes occur in the output
level (unit sold), selling price, variable cost per unit, or the fixed costs of a product. Simply it is also called break-even
analysis. (CVP) Analysis is a powerful tool for planning and a short-run decision making. It helps managers understand the
relationships among cost, volume, and profit by focusing on interactions among the following five elements/components of
CVP analysis:
1) Prices of products.
2) Volume or level of activity.
3) Per unit variable costs.
4) Total fixed costs.
5) Mix of products sold or sales mix.

Key Assumptions of CVP Analysis

For any CVP analysis to be valid, the following important assumptions must be reasonably satisfied
within the relevant range.

1. Selling price is constant and linear within the relevant range. The unit price of a product or service will not change as
volume changes.
2. Costs are linear (straight-line) and can be accurately 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. Total contribution margin (total revenue - total variable costs) is linear within the relevant range and increases
proportionally with output.
4. In manufacturing companies, inventories do not change. The number of units produced equals the number of units
sold. (Sales and production are equal). Thus, there is no material fluctuation in inventory levels. This assumption is
necessary because of the allocation of fixed costs to inventory at potentially different rates each year.
5. All revenues and costs can be added or compared without taking into account the time value of money (i.e., either no
inflation)
6. The only revenue and cost driver is volume of production. (Changes in activity are the only factors that affect revenue
and costs).
7. There will be no capacity additions during the period under consideration. If such additions were made, fixed (and,
possibly, variable) costs would change.
8. Labor productivity, production technology, and market conditions will not change. If any of these changes occur,
costs would change correspondingly and selling prices might change.
9. In a multiproduct firm, the sales mix will remain 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.) If this assumption were not made, no weighted average contribution margin could be computed for
the company.
Cost Behavior Analysis
It is the study of how specific costs respond to changes in the level of business activity (output).
It allows costs to be classified as variable and fixed cost.
1) Variable Costs
Costs that vary in total directly and proportionately with changes in the activity level.
Example: If the activity level increases 10 percent, total variable costs increase 10 percent.
Example: If the activity level decreases by 25 percent, total variable costs decrease by 25 percent.
Variable costs remain the same per unit at every level of activity.

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Example: CGS, direct material, direct labor, variable MOH, variable Non MOH

2) Fixed Costs
Costs that remain the same in total regardless of changes in the activity level.
Per unit cost varies inversely with activity: As volume increases, unit cost declines, and vice versa
Examples: Property taxes
Insurance
Rent
Depreciation on buildings and equipment

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 The Linearity Assumption and the Relevant Range
Although many costs are not strictly linear when plotted as a function of volume, a curvilinear cost can be satisfactorily
approximated with a straight line within a narrow band of activity known as the relevant range. The relevant range is that
range of activity within which the assumptions made about cost behavior are valid. (i.e., per unit variable cost and total fixed
cost remain constant (straight line/linear).

The Basics of Cost-Volume-Profit (CVP) Analysis

The contribution income statement emphasizes the behavior of costs and therefore is extremely helpful to a manager
(internal purpose) in judging the impact on profits of changes in selling price, cost, or volume. While, the traditional
approach organizes costs in a functional format. Costs relating to production, administration, and sales are grouped
together without regard to their cost behavior. The traditional approach is used primarily for external reporting purposes
whereas the contribution approach used primarily by management.

Comparison of the Contribution Income Statement with the traditional Income Statement

Comparison of the Contribution Income Statement

with the Traditional Income Statement

Traditional Approach Contribution Approach

(costs organized by function) (costs organized by behavior)

Sales $ 100,000 Sales $ 100,000

Less cost of goods sold 70,000 Less variable expenses 60,000
Gross margin $ 30,000 Contribution margin $ 40,000
Less operating expenses 20,000 Less fixed expenses 30,000
Net operating income $ 10,000 Net operating income $ 10,000

Explain how changes in activity affect contribution margin and net operating income.

Contribution Margin
The contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus, it is
the amount available to cover fixed expenses and then to provide profits for the period. Notice the sequence here—
contribution margin is used first to cover the fixed expenses, and then whatever remains goes toward profits. If the
contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period. To illustrate with an
extreme example, assume that ABC Company sells only one speaker during a particular month. The company’s income
statement would appear as follows:

ABC Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (1 speaker) $250 $250
Less variable expenses 150 150
Contribution margin $100 $100
Less fixed expenses 35,000
Net operating loss $ (34,900)

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Notice that sales, variable expenses and contribution margin are expressed on a per unit basis as well as in total on this
contribution income statement. The per unit figures will be very helpful in the work we will be doing in the following
pages. Note that this contribution income statement has been prepared for management’s use inside the company and would
not ordinarily be made available to those outside the company.

ABC Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (400 speakers) $100,000 $250
Less variable expenses 60,000 150
Contribution margin 40,000 $100
Less fixed expenses 35,000
Net operating income $ 5,000

If enough speakers can be sold to generate $35,000 in contribution margin, then all of the fixed expenses will be covered
and the company will break even for the month—that is, it will show neither profit nor loss but just cover all of its costs. To
reach the breakeven point, the company will have to sell 350 speakers in a month, since each speaker sold yields $100 in
contribution margin:
ABC Company
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (350 speakers) $87,500 $250
Less variable expenses 52,500 150
Contribution margin $35,000 $100
Less fixed expenses 35,000
Net operating income $ 0

Break-Even Analysis
Earlier in the chapter we defined the break-even point as the level of sales at which the company’s profit is zero. The break-
even point can be computed using either the equation method or the contribution margin method—the two methods are
equivalent.
The Equation Method:
The equation method centers on the contribution approach to the income statement illustrated earlier in the chapter. The
format of this income statement can be expressed in equation form as follows: At the break-even point, profits are zero.
Therefore, the break-even point can be computed by finding that point where sales equal the total of the variable expenses
plus the fixed expenses. For ABC Company, the break-even point in unit sales, Q, can be computed as follows:
Sales - Variable expenses - Fixed expenses = Profits
(USP × Q) – (UVC × Q) – FC = OP
$250Q - $150Q - $35,000 = $0
$100Q = $35,000
Q = $35,000 / $100 per speaker
Q = 350 speakers
where:
Q = Quantity of speakers sold
$250 = Unit selling price
$150 = Unit variable expenses
$35,000 = Total fixed expenses

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

The break-even point in total sales dollars, X, can also be computed as follows:
Sales = Variable expenses + Fixed expenses + Profits
X = 0.60X + $35,000 + $0
0.40X = $35,000
X = $35,000 / 0.40
X = $87,500
where:
X = Total sales dollars
0.60 = Variable expense ratio (Variable expenses / Sales)
$35,000 = Total fixed expenses

The break-even point in units sold is the following:

$87,500 / $250 per speaker = 350 speakers

The Contribution Margin Method:

The contribution margin method is just a shortcut version of the equation method already described. The approach centers
on the idea discussed earlier that each unit sold provides a certain amount of contribution margin that goes toward covering
fixed costs. This approach, based on the CM ratio, is particularly useful when a company has multiple product lines and
wishes to compute a single break-even point for the company as a whole.
Not surprisingly, the equation and contribution margin methods are related:
Sales -Variable expenses - Fixed expenses - Profits
(USP × Q) – (UVC × Q) – FC = OP
(USP – UVC) × Q = FC + OP
UCM × Q = FC + OP
Q = FC + OP
UCM
Unit sales at break-even (Q) = Fixed Expenses/ unit CM

Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net
operating income resulting from changes in sales volume.

ABC Company’s contribution income statement in which sales revenues, variable expenses, and contribution margin are
expressed as a percentage of sales:

Total Per Unit Percent of Sales

Sales (400 speakers) $100,000 $250 100%
Less variable expenses 60,000 150 60%
Contribution margin 40,000 $100 40%
Less fixed expenses 35,000
Net operating income $ 5,000

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The contribution margin as a percentage of total sales is referred to as the contribution margin ratio (CM ratio). This
ratio is computed as follows:
For ABC Company, the computations are:
Contribution Margin Ratio = Contribution Margin = 40,000 = 40%
Sales 100,000
In a company such as ABC Company that has only one product, the CM ratio can also be computed as follows:

Contribution Margin Ratio = Unit Contribution Margin = 100 = 40%

Unit Selling Price 250

Each speaker generates a contribution margin of $100 ($250 selling price, less $150 variable expenses). Since the total fixed
expenses are $35,000, the break-even point in units is computed as follows:
Break-even point in units sold = Fixed Expenses = $ 35,000 = 350 speakers
Unit Contribution Margin $ 100 per speaker

A variation of this method uses the CM ratio instead of the unit contribution margin. The result is the break-even point in
total sales dollars rather than in total units sold.
Break-even point in total sales dollars = Fixed expenses
CM ratio
= $35,000 = $87,500
0.40

The Graphic method: shows graphic presentation of breakeven point. The point at which total revenue line intersect
total cost line or TR=TC. The break-even point is the level of sales at which profit is zero.

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 Sensitivity analysis (Changes in the CVP Variables)
 Sensitivity analysis is a ―what if‖ technique that managers use to examine how a result will change if the original
predicted data are not achieved or if an underlying assumption changes.
 In the context of CVP analysis, sensitivity analysis answers such questions as, what will operating income be if units
sold decreases by 5% from the original prediction? And will operating income be if variable costs per unit increase
by 10%?
 How is sensitivity analysis used to help managers make decisions?
 Answer: Sensitivity analysis shows how the CVP model will change with changes in any of its variables (e.g.,
changes in fixed costs, variable costs, sales price, or sales mix). The focus is typically on how changes in variables
will alter profit(net income)
Assume that the break-even point is 500 units, and Snowboard must sell 800 units to achieve a target profit of $30,000.
Management believes a goal of 800 units is overly optimistic and settles on a best guess of 700 units in monthly sales. This is
called the ―base case.‖ The base case is summarized as follows in contribution margin income statement format:

Question: Although management believes the base case is reasonably accurate, it is concerned about what will happen if
certain variables change. As a result, you are asked to address the following questions from management (you are now
performing sensitivity analysis!). Each scenario is independent of the others. Unless told otherwise, assume that the variabl es
used in the base case remain the same. How do you answer the following questions for management?

How will profit change if the sales price increases by $25 per unit (10 percent)?
How will profit change if sales volume decreases by 70 units (10 percent)?
How will profit change if fixed costs decrease by $15,000 (30 percent) and variable cost increases $15 per unit (10 percent)?
The CVP model “Sensitivity Analysis for Snowboard Company” answers these questions.

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 Target Profit Analysis
CVP formulas can be used to determine the sales volume needed to achieve a target profit. Suppose that ABC Company
would like to earn a target profit of $40,000 per month. How many speakers would have to be sold?

The CVP Equation Method: One approach is to use the equation method. Instead of solving for the unit sales where
profits are zero, you instead solve for the unit sales where profits are $40,000.
Sales = Variable expenses + Fixed expenses + Profits
$250Q = $150Q + $35,000 + $40,000
$100Q = $75,000
Q = $75,000 / $100 per speaker
Q = 750 speaker
where:
Q = Quantity of speakers sold
$250 = Unit selling price
$150 = Unit variable expenses
$35,000 = Total fixed expenses
$40,000 = Target profit

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

The Contribution Margin Approach A second approach involves expanding the contribution margin formula to
include the target profit:

Unit sales to attain the target profit = Fixed Expenses + Target Profit
Unit CM (P-V)

Unit sales to attain the target profit = $35,000 + $40,000

$100
= 750 speakers
This approach gives the same answer as the equation method since it is simply a shortcut version of the equation method.
Similarly, the dollar sales needed to attain the target profit can be computed as follows:
Dollar sales to attain target profit = Fixed Expenses + Target Profit
CM Ratio
Dollar sales to attain target profit = $35,000 + $40,000
0.40
= $187,500

Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales dollars over the breakeven volume of sales dollars. It states
the amount by which sales can drop before losses are incurred. The higher the margin of safety, the lower the risk of not
breaking even. The margin of safety can be viewed as a crude measure of risk.

The formula for its calculation is:

Margin of safety = Total budgeted (or actual) sales - Break-even sales
The margin of safety can also be expressed in percentage form by dividing the margin of safety in dollars by total sales:
Margin of safety percentage = Margin of safety in dollars
Total budgeted (or actual) sales

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The calculation for the margin of safety for ABC Company is:
Sales (at the current volume of 400 speakers) (a) Br 100,000
Break-even sales (at 350 speakers) 87,500
Margin of safety (in dollars) (b) Br 12,500
Margin of safety as a percentage of sales, (b) - (a) 12.5%

This margin of safety means that at the current level of sales and with the company’s current prices and cost structure, a
reduction in sales of Br 12,500, or 12.5%, would result in just breaking even.

In a single-product company like ABC Company, the margin of safety can also be expressed in terms of the number of units
sold by dividing the margin of safety in dollars by the selling price per unit. In this case, the margin of safety is 50 speakers
(Br 12,500 / Br 250 per speaker = 50 speakers).

CVP Considerations in Choosing a Cost Structure

Cost structure refers to the relative proportion of fixed and variable costs in an organization. An organization often has some
latitude in trading off between these two types of costs. For example, fixed investments in automated equipment can reduce
variable labor costs. In this section, we discuss the choice of a cost structure. We focus on the impact of cost structure on
profit stability, in which operating leverage plays a key role.

Cost Structure and Profit Stability

The relative proportion of each type of costs (i,e,. fixed and variable) in an organization is known as its cost structure.
For example, an organization might have many fixed costs but few variable or mixed costs. There are advantages and
disadvantages to high fixed cost (or low variable cost) and low fixed cost (or high variable cost) structures.
An advantage of a high fixed cost structure is that income will be higher in good years compared to companies with lower
proportion of fixed costs.
A disadvantage of a high fixed cost structure is that income will be lower in bad years compared to companies with lower
proportion of fixed costs.

Operating Leverage
Operating leverage is a measure of how sensitive net 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 net operating income.

Operating leverage can be illustrated by returning to the data given previously for the two blueberry farms. We previously
showed that a 10% increase in sales (from Br 100,000 to Br 110,000 in each farm) results in a 70% increase in the net
operating income of Sterling Farm (from Br 10,000 to Br 17,000) and only a 40% increase in the net operating income of
Farm B (from Br 10,000 to Br 14,000). Thus, for a 10% increase in sales, Farm S experiences a much greater percentage
increase in profits than does Farm B. Therefore, Farm S has greater operating leverage than Farm B.
The degree of operating leverage at a given level of sales is computed by the following formula:

Degree of operating leverage = Contribution margin

Net 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. To
illustrate, the degree of operating leverage for the two farms at a Br 100,000 sales level would be computed as follows:
Farm B = Br 40,000 = 4
Br 10,000
Farm S = Br 70,000 = 7
Br 10,000

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 Concept of Sales Mix (Multi product) CVP analysis
The term sales mix refers to the relative proportions in which a company’s products are sold. The idea is to achieve the
combination, or mix, that will yield the greatest amount of profits. Most companies have many products, and often these
products are not equally profitable. Hence, profits will depend to some extent on the company’s sales mix. Profits will be
greater if high-margin rather than low-margin items make up a relatively large proportion of total sales.

Sales Mix and Break-Even Analysis

If a company sells more than one product, break-even analysis is somewhat more complex than discussed earlier in this
chapter. The reason is that different products will have different selling prices, different cost structures, and different
contribution margins. Consequently, the break-even point will depend on the mix in which the various products are sold
personal computers. Two complications are encountered when multiple products are sold by companies. First, companies
rarely sell exactly the same number of units of each product. Second, most products differ in their selling price and variable
cost per unit. As a consequence, in order to determine sales levels at breakeven or target profit levels, these two issues must
be addressed. - The easiest way to use cost-volume-profit analysis for a multi-product company is to use dollars of sales as
the volume measure. For CVP purposes, a multi-product company must assume a given product mix or sales
mix. Product (or sales) mix refers to the proportion of the company’s total sales for each type of product sold.

Assume at present, the company distributes the following CDs to retail computer stores: the Le Louvre CD, a multimedia
free-form tour of the famous art museum in Paris; and the Le Vin CD, which features the wines and wine-growing regions
of France. Both multimedia products have sound, photos, video clips, and sophisticated software. The company’s September
sales, expenses, and break-even point are shown in below exhibit. As shown in the exhibit, the break-even point is $60,000
in sales. This is computed by dividing the fixed costs by the company’s overall CM ratio of 45%. The sales mix is currently
20% for the Le Louvre CD and 80% for the Le Vin CD.

If this sales mix does not change, then at the break-even total sales of $60,000, the sales of the Le Louvre CD would
be $12,000 (20% of $60,000) and the sales of the Le Vin CD would be $48,000 (80% of $60,000). As shown in Exhibit 6–
3, at these levels of sales, the company would indeed break even. But $60,000 in sales represents the break-even point for
the company only if the sales mix does not change.

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 Weighted average unit contribution margin = CM
Unit Sold
= $45000
350
= $128.54
Break-even point in units sold

Break-even point in units sold = Fixed Expenses = $ 27,000

Weighted average Contribution Margin per unit $ 128.54
= 210 CDs

Simply you can divide break even sales in dollars by the selling price per unit for each product. In this case, the break even
sales in units is 60 for the Le Louvre CD (Br 12,000 / Br 200 per CD), while Le Vin CD is 150 units (Br 48,000 / Br 320
per CD). Thus, a combined sale equals 210 CDs (60+150). If the sales mix changes, then the break-even point will also
changes. Usually the assumption is that it will not change. However, if the sales mix is expected to change, then this must be
explicitly considered in any CVP computations.

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