8/3/2022

Cost Volume Profit (CVP) Analysis

Session 2

In this class

• In the last class we saw the concepts of opportunity costs, relevance,

and controllability; and how costs appear on the income statement
• The async lecture drilled down into the details of cost flows for
manufacturing and service companies
• Now we will put these concepts together to understand how to estimate
costs in the context of short-term volume decisions: cost-volume-profit
(CVP) analysis
• The main point is that while GAAP statements classify costs into product costs
and period costs, and allocates joint costs, the relevant costs for decision-making
are fixed costs and variable costs
• Revenues minus variable costs are called contribution margin
• Our job is to restate the GAAP Gross margin income statement (GM) into a
contribution margin income statement (CM)
• CVP analysis leads us to the concept of break-even analysis and risk

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How to measure change in profit when sales

volume changes?

• For revenue, proportional change is a reasonable assumption at least for

small changes in sales volume

• Cost estimation is more complex

• Some costs will change and others will not with volume

• Usual classification
• Variable costs change proportionately with volume
• Fixed costs do not change as volume changes

• We need to model cost behavior to get a good estimate!

Visualizing cost behavior

Cost TOTAL FIXED &

VARIABLE
variable

Fixed

Cost PER UNIT COSTS

Activity (units)

Fixed cost per unit

Variable cost / unit

Activity (units)
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CVP (Cost-volume-profit) analysis and contribution

margin statement

Core idea

• Construct a profit model to evaluate scenarios

• Classify all revenue and cost as volume- or non-volume related, i.e., variable
and fixed
• Measure of volume depends on the business (numbers or tons of product,
software person-days, etc.)
• Fixed costs stay the same (over the relevant range)

• Some definitions
Contribution margin (CM) = Revenue – All variable costs
Unit contribution margin (UCM) = Contribution margin per unit
= Price per unit (P) – Unit Variable Cost (UVC)
Contribution margin ratio (CMR) = Contribution per sales ₹
= UCM / P
= Contribution / Revenue

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Profit model

• Express the contribution margin statement as an equation

• Pre-tax profit = Revenue – cost

= Revenue – variable cost – fixed cost (FC)
= Contribution margin – FC
= CM/unit * # of units (Q) - FC

Profit = ( P – UVC ) × Q - FC, or

Profit = UCM × Q - FC

Presentation of data – Economic v GAAP

Economic – Contribution Margin statement (CM) GAAP – Gross Margin Stmt (GM)

Item Amt Item Amt

Revenue Revenue
Variable Mfg costs Variable Mfg costs
Variable SG&A costs Fixed Mfg costs
Contribution margin Gross profit
Fixed Mfg costs Variable SG&A costs
Fixed SG&A costs Fixed SG&A costs
Net income Net income
• Contribution margin (CM) = Revenue – variable cost
• CM statement groups costs by fixed and variable, regardless of
manufacturing (mfg) or SG&A (selling, general, and administration)
• CM statement suitable for economic analysis in decision making
• Net income will differ, unless inventory is zero (Async Lecture 2)
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Phelps Industries case

• Produces only gears

• Steady demand, stable markets, owner Rick Phelps not overly ambitious
• New CEO Dan Fowler notices that machine capacity utilization was only
60% (50k hours available, 30K hours used for producing 15k gears)
• Today we will analyze what will happen to profits if the number of gears
sold increases

Phelps income and cost, cost classification

Item Amount Total Detail V or F?

Revenue $1,800,000 15,000 gears @ $120 / gear V

- Materials 300,000 @ $20 / gear V

- Labor 375,000 @ $25 / gear V

- Mfg overhead 448,750 $1,123,750 Plug or 29.92 per gear (Exh 2) ?

= Gross margin $676,250

- Selling costs 36,000 @ 2% of revenue V

- Distribution 30,000 $2.00 per gear V

- Administration 280,000 346,000 F

= Profit $330,250
In practice, some firms include labor cost in overhead
Typical textbook treatment is to consider labor as separate from overhead
We will consider it as variable and direct

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Drilling down on mfg. overhead (Exh 3A)

Amount V / F?
Machine depreciation $115,000 F
Supervisor salary 80,000 F
Total fixed Mfg OH =
Factory salaries 60,000 F 332,500
Factory maintenance 62,500 F
Property taxes and utilities 15,000 F (Note 1)
Power to operate machines 56,250 V Total variable Mfg OH
V = 116,250
Oils and lubricants 60,000
Total overhead cost* $448,750

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Revised income statement

15,000 units
Revenue $1,800,000
- Variable costs Materials ($20/gear) 300,000
Labor ($25 / gear 375,000
Variable mfg overhead 116,250
Commissions (2% of sales) 36,000
Distribution ($2/gear) 30,000 $857,250
= Contribution margin $942,750
- Fixed costs Fixed mfg overhead 332,500
Selling & administration 280,000 612,500
= Profit $330,250

Variable cost ratio (VCR) = (857,250/1,800,000)= 47.625%

Variable cost per gear = 857,250/15,000 = $57.15
Contribution margin ratio (CMR) = (942,750/1,800,000)= 52.375%
Contribution margin per gear (UCM) = 942,750/15,000 = $62.85
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Now, we are in business!

15,000 20,000 25,000

Revenue (= $120 / gear) $1,800,000 $2,400,000 $3,000,000
- Variable costs ( = $57.15 / gear) $857,250 1,143,000 $1,428,750
= Contribution margin (= $62.85 per gear) $942,750 $1,257,000 $1,571,250
- Fixed costs 612,500 612,500 612,500
= Profit $330,250 $644,500 $958,750

• Can express this relation as:

• Profit = Unit CM * # of units – Fixed cost
• = $62.85 * # of units - $612,500
• Or Profit = CMR * Revenue – Fixed cost
• = 52.375% *Revenue ($) - $612,500
• Assumes a linear relation. Can make the estimation more precise
• Allow for step-fixed costs
• Allow for curvature in costs

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Comparison of GM (ie GAAP) and CM format

GM format CM format Notes

Revenue $1,800,000 $1,800,000 @ $120 / gear
COGS (or var. mfg) 1,123,750 791,250 COGS includes FMOH
Fixed mfg. overhead -- 332,500 Calculated earlier
Variable SGA costs 66,000 66,000 2% of revenue + $2/gear
Fixed SGA Costs 280,000 280,000 Given
Profit 330,250 $330,250

Inventory 0 0 Sold all units made

No change in income … we have just rearranged the costs for easier analysis
When there are inventories income is not the same (see solved problem in Async
lecture 2)
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Takeaways from this part of Phelps case

• For short-term volume decisions the relevant costs are the variable costs
• Contribution margin (CM) is important for short-term volume decisions,
gross margin is not
• We determine CM by looking at costs and categorizing them into fixed
and variable
• In doing so we use our background knowledge, and in more realistic scenarios,
the actual behavior as reflected in multiple periods
• Linear cost model is simple and accurate but only within its range
• Although not in this example, reported costs themselves may be too
aggregated, in which case we have to dig deeper into the records and
manually classify
• VF travel costs v other travel costs at ISB

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Cost estimation and prediction

Cost Cost Cost

behavior estimation prediction

Build model of Use historical data to Use estimated

expected relationship test model and to parameters to forecast
between cost and determine parameters costs at a particular
activity (usually linear) activity level.

• Cost structure is jargon for relation between activity and cost

(concept: variability)
• When predicting, we also have to consider confidence in estimate
(concept: traceability)

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Variable and fixed costs

Variable costs Fixed costs

Manufacturing Materials Machine depreciation
Labor Supervisor salary
Other factory salaries
Power Maintenance
Oils and lubricants Utilities

Selling and Sales commissions Sales staff salaries

administration Distribution costs General administration

• Easy to come up with similar table for

• Healthcare settings
• Service settings (banks, insurance, education, consulting, non-profit)

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Extension: cost structure

Economies of scale
Variable cost

Total variable cost

Activity (units) Step costs

Cost

Total cost

Activity

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Fixed or variable
• For each of the following costs of a business school for an MBA programme, say
whether they are fixed, step-wise fixed, variable (linear) or variable (with scale
effects) with respect to the number of students. Assume the relevant range is
100 – 500 students

Coursepack costs Variable (linear)

Instructor’s teaching time Step fixed
Instructor’s time for preparing exams Fixed
Advertising costs for student admissions Variable with scale effects
Regulatory/accreditation costs Fixed

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Extension: cost hierarchy (e.g. for printing press

that prints magazines)

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Summary

• Cost accounting systems track cost flows from inputs to outputs

• Costs are classified as “product” costs and “period” costs
• The classification into product and period costs does not pay attention
to cost structure
• Both product costs and period costs can include fixed and variable costs
• It is consistent with financial accounting principles for calculating COGS and
income
• It is not useful for internal decision making
• Clear delineation of fixed and variable costs is important for economic
analysis
• Always go by contribution margin for short term decision making

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Break-even analysis

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Profit model and breakeven quantity

• Express the contribution margin statement as an equation

• Pre-tax profit = Revenue – cost

= Revenue – variable cost – fixed cost (FC)
= Contribution margin – FC
= UCM * # of units (Q) - FC
Profit = ( P – UVC ) × Q - FC, i.e.

Profit = UCM × Q - FC

For break-even quantity, set profit = 0

𝐅𝐂
𝐐𝐁𝐄 =
𝐔𝐂𝐌

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Numerical example

• Assume that a startup has developed an IoT BP sensor that it wants to

sell at ₹ 1,000 each. The contract manufacturer charges ₹ 300 per
device. Selling commissions, shipping, and handling amount to ₹ 100 for
each unit sold. The fixed costs of salaries, rent expense, advertising, and
R&D amount to ₹ 1,200,000 per month. How many units does it need to
sell in order to break even?
• UVC = 300 + 100 = ₹400 per unit
• UCM = 1,000 – 400 = ₹600 per unit
• QBE = FC / UCM = 1,200,000/600 = 2,000 units per month

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Profit model and breakeven revenue

Profit = UCM * Q - FC

Multiply & divide the first term by price (P) to get

Profit = (UCM/P) * (P Q) - FC

Profit = CMR * Revenue – FC

For break-even revenue, set profit = 0

REVBE (₹) = FC / CMR

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Numerical example, contd

• CMR = 600/1,000 = 0.6

• REVBE = FC/CMR = 1,200,000/0.6 = ₹ 2,000,000 per month
• Check: QBE * P = REVBE
2000 units/month * ₹ 1000 per unit = ₹ 2,000,000/month

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Numerical example, contd

• How many units should be sold to earn a profit of 600,000 per month?
• Profit = UCM * Q – FC
• 600,000 = 600 * Q – 1,200,000
• Solving, Q = 3,000 units per month
• How many units should be sold to earn an after-tax profit of 600,000 per
month if the tax rate is 25%?
• Post tax profit of 600,000 requires pre-tax profit of 600,000/(1-0.25) =
800,000
• So 800,000 = 600*Q -1,200,000
• Q = 3,333 units

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Decision contexts

• In general, we can use CVP model as a ‘short cut’ to visualize the

tradeoff inherent in many decision contexts
Helps project profit under “what if’ scenarios

• Pricing Increase price, reduce quantity

• Advertising Increase FC, increase quantity

• Outsourcing / Tradeoff fixed cost for variable costs

Automation

• Branding / Increase FC and increase price

Service

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Numerical example, contd

• Continuing the previous example, assume the company is selling 3000

units per month at a price of ₹ 1,000 each for total sales of 3,000,000.
• UVC 400, UCM = 600, total contribution = 1,800,000, FC = 1,200,000, and profit =
600,000 per month
• If it increases the price to 1,100 it can sell 2,650 units, decreasing sales
to 2,915,000. Should it increase the price to 1,100?
• Answer:
• UCM = 1,100 – 400 = ₹ 700
• total contribution = 1,855,000, higher than 1,800,000 before
• Profit = 1,855,000 – 1,200,000 = 655,000, higher than before
• Learning: To know the effect on profit, compare contribution margin and
not sales

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Numerical example, contd

• Back to the original numbers, assume the company is selling 3000 units
per month at a price of 1,000 each for total sales of 3,000,000.
• UVC 400, UCM = 600, total contribution = 1,800,000, FC = 1,200,000, and profit =
600,000 per month
• If it incurs 200,000 in advertising costs, it can increase its sales to 3,300
units. Should it spend the money on extra advertising?
• Answer:
• total contribution = 600 * 3,300 = 1,980,000 (180,000 higher than
before)
• Profit = 1,980,000 – (1,200,000 + 200,000) = 580,000, lower than before,
therefore do not spend on advertising
• Another way: compare incremental contribution = 600*(3,300 – 3,000) =
180,000 with incremental spending, 200,000

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• For more details on break-even analysis in the context of pricing,

together with competitive considerations and sensitivity analysis, see
the “Note on break-even analysis in marketing. (HBS -9-578-072)”
included in your coursepack.

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New business opening: a common context for

Break-even analysis

• Estimate annual cost

• Salaries, rent, utilities, licenses, … (cash expenses)
• Depreciation … (accounting expenses)

• Compute Contribution Margin Ratio

• Estimate from other business / historical data

• Derive
• Required sales for expected profit
• Cross-check with market analysis
• Check for sensitivity of assumptions (FC, CMR, mix)
• Consider risk implications

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Takeaways

• CVP requires knowing how to make use of one key equation:

Q (Punit – VCunit) – FC = CMR * Revenue – FC = Profit

• It is a tool that
• improves understanding of the cost structure (as Satya Nadella
emphasized)
• informs decisions that affect the cost structure
• Planning volume levels
• Investments in fixed assets (e.g., lease or purchase)
• Structuring contracts with 3rd parties

• CVP assumptions can be limiting, need to perform sensitivity

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Using the CVP model to measure risk

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Measuring risk

• We use three primary measures to quantify the effect of uncertainty in

demand
Cash breakeven: When do I become cash flow positive?
Margin of safety: How much cushion is there in operations?
Operating leverage: How cost structure affects profit elasticity, i.e., its
variability with volume?

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Margin of safety

• At a given volume, how much “cushion” does firm have before

it starts making a loss?
Current Sales - Breakeven sales
Margin of Safety = .
Current Sales

• Margin of safety (MOS) is

• Often expressed as a percentage
• Can be calculated using sales in ₹ or in units

• % change in profit = % change in sales × (1/ MOS)

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Numerical example

Year 1 Year 2 %change

Sales 300 330 10%
Variable cost (50% of sales) 150 165 10%
Contribution margin 150 165 10%
Fixed cost 100 100 0
Net income 50 65 30%

• CMR = 150/300 = 50%

• BE Sales = FC/CMR = 100/0.5 = 200
• Margin of safety = (Current sales – Break even sales)/Current sales
= (300 – 200)/300 = 33%
• % change in profit (30) = % change in sales (10) × (1/ MOS (0.33))

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Operating leverage & profit elasticity

• One can change cost structure

• Automation substitutes FC for VC
• Outsourcing substitutes VC for FC

• Operating Leverage
• Increasing the amount of fixed cost increases business risk, for given volume
• Operating Leverage (OL) = Fixed Cost / Total Cost

• Caution: There is another definition that some people like

• Operating leverage = Contribution margin/Operating Income
• But, this definition is the SAME as (1/ MOS) !
• Harder to interpret for income close to zero

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Alternate cost structures

Dollars ($)

Total costs

Fixed
costs

Crossover volume

Sales Volume (Q)

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Example
• Cost structure
• Proposal 1: $1.5 MM FC, variable cost ratio 40%
• Proposal 2: $675K FC, variable cost ratio 70%
• Which proposal do you prefer if sales is $2,750,000?

Proposal 1 Proposal 2
Revenues $2,750,000 $2,750,000
Variable Costs 1,100,000 1,925,000
Contribution margin* $1,650,000 $825,000
Fixed Costs 1,500,000 675,000
Profit before Taxes $150,000 $150,000

Operating leverage 0.58 0.26

BE revenue $2,500,000 $2,250,000
MOS 9.09% 18.18%

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Example (Contd.)
Suppose expected sales = $4,500,000. Which proposal do you
prefer now?

Proposal 1 Proposal 2
Revenues $4,500,000 $4,500,000
Variable Costs 1,800,000 3,150,000
Contribution Margin $2,700,000 $1,350,000
Fixed Costs 1,500,000 675,000
Profit before Taxes $1,200,000 $675,000

Operating leverage 0.45 0.18

BE revenue $2,500,000 $2,250,000
MOS 44.44% 50.00%

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Example - summary

Profit levels
Revenue levels Proposal 1 Proposal 2

$4,500,000 $1,200,000 $675,000

$2,750,000 150,000 150,000

$2,000,000 ($300,000) ($75,000)

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Points to note

• OL is a measure of the risk in the cost structure

• As demand increases, OL decreases
• For given demand, decisions that increase FC and lower VC
increase OL
• Profit is more sensitive to volume changes when OL is high
• At lower demand levels, a cost structure with lower OL is
typically preferred to a cost structure with higher OL

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For another example of

“variablizing” costs, see the
Session 3 reading “Variable
vs. fixed costs for the supply
chain: a sound approach to
future growth (Third-party
Logistics)”

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Practice Problems

• 4.34, 4.35, 4.36: Contribution margin statement and income

• 5.33, 5.38, 5.39, 5.41, 5.43: CVP, break-even, target profits, taxes, what-
if
• 5.46, 5.48, 5.62, 5.66: Multiproduct CVP, what-if – after Async lecture 2

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Next time

• Be sure to do the HW problems for Class 1 and 2

• Start Baldwin case analysis (You can solve Q1-5 in the case. Only Q6 and
7 will remain. For Q1-5 you have to:
• determine fixed and variable costs including inventory carrying cost (which
requires you to work out inventories),
• work out the incremental costs including opportunity costs from lost sales,
• do the risk analysis.
• Next week we will look at the same kinds of decisions, with two
additional layers of complexity:
• Decisions in the context of multiple products with allocation of joint costs
• Long-term decisions

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