BAM6008 Financial Reporting to Management – CVP Analysis

1.0 Cost-Volume-Profit (CVP) analysis

1.1 The Elements of Cost

Materials = Direct Materials + Indirect Materials

+ + +
Labour = Direct labour + Indirect Labour
+ + +
Overheads = Direct Overheads + Indirect Overheads
= = =
Total Cost = Total Direct Cost + Total Indirect Cost
Overheads
•Fuel costs
•Administration costs
•Property costs
•Selling costs
•Communication costs
•Maintenance costs

1.2 Behaviour of Costs

1. Variable Costs
2.
Fixed costs
3.
Mixed costs

Examples of different costs

Variable Fixed Mixed

The graphs below represent the behaviour of different costs; identify which graph
represents which cost behaviour?

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BAM6008 Financial Reporting to Management – CVP Analysis

1.3 Example 1. Division of costs into Fixed & Variable

The High Low Method
Month %Occupancy Cost of Gas $
Jan 20 250
Feb 25 275
March 40 370
April 50 385
May 60 450
June 70 515
July 80 550
August 75 510
Calculation of Variable Element
%Occupancy Cost of Gas
High point-July
Low point- Jan
Difference
Thus:
The variable element is:

The Fixed Cost = Total Cost – Variable cost

Jan: Variable cost =
Fixed cost =

July: Variable cost =

Fixed cost =

1.4
Example 2.
The following figures relate to a company that manufacture many items.

Sales Costs
Jan – June 2003 3,900,000 3,480,000
July – Dec 2003 4,300,000 3,760,000
Using the High Low method, calculate the fixed & variable costs.

1.5 Example 3. Motel

A motel has two different sales levels as follows
Monthly Room Sales
2,000 3,000
Payroll: $ $
Salaries 15,000 15,000
Wages 40,000 60,000
Employee benefits 9,200 10,700
Supplies 2,000 3,000
Utilities 8,000 9,000
Other costs 4,000 5,000
Rent 8,000 8,000
Interest 2,000 2,000
Insurance 3,000 3,000

a) Identify each cost as fixed, variable or mixed.

b) What are the total estimated variable costs per room sold?
c) What are the total estimated monthly fixed costs?

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BAM6008 Financial Reporting to Management – CVP Analysis

d) Develop an equation to estimate total costs at various levels of activity

e) Project the total costs if 3,500 rooms were sold

1.6 Example 4. Pizza Bar

A Pizza bar has the following costs at various levels of weekly sales:
Weekly sales in units 2,000 3,500
Materials $ 6,000 $ 10,500
Payroll costs 3,300 4,800
Insurance 1,000 1,000
Lease 600 1,050
Supplies 600 1,200
Depreciation 500 500
Utilities 400 700
Other operating costs 300 500

a) Identify the mixed costs. (3 marks)

b) Identify the variable costs (3 marks)
c) Identify the fixed costs (2 marks)
d) Calculate the variable cost per unit. (4 marks)
e) Calculate the total fixed costs. (4 marks)
f) Develop an equation to estimate costs at various levels of activity. (2 marks)
g) Project total costs with weekly sales of 4,000 units. (2 marks)

2.0
Fixed versus Variable Costs
Many goods and services may be offered on either a fixed or a variable cost
arrangement. A good example is a lease. Management’s decision to select the fixed
or variable lease will be based on cost benefit considerations.

With the fixed lease, the cost will remain the same, no matter the level of activity.
Under a variable lease, the cost is directly dependent upon the level of activity.

The level of activity at which the fixed lease cost = the variable lease cost is known
as the indifference point.

For example: Assume that a food service operation has an option of signing either an
annual fixed lease of $48,000 or a variable lease set at 5% of revenue. The
indifference point is calculated as follows:

The indifference point is where: Variable cost % x Revenue = Fixed Lease Cost

0.05(Revenue) = $48,000; Revenue = $48,000; Revenue = $960,000

0.05

Thus, where the annual revenue is exactly $960,000, the lease expense will be
$48,000, regardless of whether the lease arrangement is fixed or variable.

Therefore, if annual revenue is expected to exceed $960,000, then management

should select a fixed lease to minimise its lease expense.

However, if annual revenue is expected to be less than $960,000, a variable lease

will minimise its lease expense.

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BAM6008 Financial Reporting to Management – CVP Analysis

2.1 Example 5.
Doug Little is interested in renting space for an F & B business, he has the following
3 alternatives:
a) $2,000 fixed rent per month
b) $1,000 fixed rent per month plus 2% of sales
c) 4% Sales

Required:
a) Determine the indifference point
b) Calculate the total lease cost for each alternative if monthly sales are expected to
be $80,000, and state which alternative you recommend.

2.0 Cost Structure & Profitability

Market orientated businesses tend to operate at a high level of fixed costs.

High fixed costs tend to produce a condition of profit instability, particularly when
sales volumes fluctuate.

In the following example, sales have decreased by 10% between period 1 & period 2.
Show the period 2 figures and evaluate the affect on profitability?

2.1 Cost Structure & Profitability

Hifix Lofix
Period 1 2 1 2
Sales (£) 10000 10000
Fixed cost 6000 3000
Variable cost 3000 6000
Total cost 9000 9000
Net profit 1000 1000
% Change in
period 2 Profit

What would have been the affect on profits if sales had increased by 10% from
period 1 to period 2?
Hifix Lofix
Period 1 2 1 2
Sales (£) 10000 10000
Fixed cost 6000 3000
Variable cost 3000 6000
Total cost 9000 9000
Net profit 1000 1000
% Change in
period 2 Profit

The relationship between fixed and variable cost is known as Operational Gearing.

•A higher proportion of fixed to variable costs is known as high operational gearing.

•A higher proportion of variable to fixed costs is known as low operational gearing.

•The higher the fixed costs the greater the impact of sales fluctuations.

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BAM6008 Financial Reporting to Management – CVP Analysis

•The lower the net profit on sales the greater the risk of losses when sales fluctuate.
3.0 Short-term Decisions.
These tend to be operational affecting costs & revenues over weeks and months, up
to a maximum of 1 year. i.e. Increasing sales over the season by reducing prices or
giving special offers, or action to reduce costs in the short-term.

Long-term decisions tend to be investment decisions involving large sums and

greater risk.

3.1 Cost, Contribution & Profit

To aid decision-making costs are classified as either fixed or variable.

Selling price per unit – VC per unit = Contribution Margin per unit (CM)

The sale of each unit contributes towards fixed costs. Once fixed costs have been
covered subsequent contribution margin (CM) is all profit.

Total Contribution – Fixed cost = profit

3.2 Breakeven Analysis

This is concerned with determining the point at which neither profit nor loss is made,
i.e. Sales = Total cost.
The breakeven point in units of output = Fixed costs
Contribution Margin
3.3 Example 6: breakeven analysis
The Clock, a restaurant, has a current output of 10,000 covers per month. The ASP
is $5.00. The fixed costs amount to $18,000 per month and variable costs are 40% of
sales.
Calculate how many meals must be sold each month to breakeven.

This problem may be solved by:

1. Calculation using the formula, this is a quick method.

2. Table showing costs & profit/loss at different levels of output.

3. Graph for presentation to management of the bank.

3.4 The formula method BEP in units = Fixed costs

Contribution Margin
3.5 Table Method:
Units of Fixed Cost Variable Cost Total Cost Sales Profit/(loss)
output $ $ $ $ $
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000

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BAM6008 Financial Reporting to Management – CVP Analysis

3.6 The Graph Method

60,000 Sales

Sales 50,000
& costs Profit Total Cost
40,000

30,000 BEP

20,000
Loss
10,000 Margin of safety

0 X
2000 4000 6000 8000 10000
Number of customers

Breakeven analysis is useful for all businesses:

Sports clubs number of tickets it needs to sell
Barber number of haircuts
Dinner/dance number of tickets it needs to sell
Newspaper number of copies it needs to sell
Coach company number of passengers needed

4.0 The Margin of Safety (MOS)

This is the amount by which the sales exceed the BEP, expressed as units, sales
revenue or a percentage.
MOS in Units = Current output in units – BEP in units

MOS in sales revenue = Current sales in $’s – BEP in £’s

MOS % = Current output – BEP x 100

Current output

What is the MOS% for the Clock Restaurant?

The margin of safety shows the percentage or amount by which the sales have to fall
before the business starts making a loss. The higher the margin of safety, the safer
the business is from making losses when sales volumes fluctuate.

5.0 Breakeven and target profit.

This calculates the level of output that will give a specified profit.

Output to achieve a target profit = Fixed cost + Target Profit

Contribution Margin

Calculate the required level of output if the Clock Restaurant’s target profit was
$3,000?

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6.0 Contribution Margin Ratio (CMR)

CMR = Selling price – Variable cost

Selling price

This may be calculated for a single unit or the whole business. The CMR may also be
used to calculate the sales volume in £’s at which the business will breakeven, or the
sales volume to give a target profit.

Calculate the CMR for the Clock Restaurant?

The breakeven formula using the CMR to give a BEP in sales volume in £’s is:

Fixed costs
CMR
Calculate the breakeven point in sales volume?

The formula to give the sales volume that will achieve a target profit is:

Fixed costs + Profit

CMR
Calculate the sales volume to give a target profit of $3,000?

7.0 When to use breakeven analysis

1. Before starting a new business. It will identify the level of output needed to
cover costs. The feasibility of the scheme may then be considered by the
owner and other parties, such as the bank.
2. When making changes. The cost of major changes, for example, a large
increase in production could alter the balance between fixed and variable
costs. Breakeven would be used as part of the planning process to ensure
that the business remains profitable.
3. To answer “What if?” questions. i.e. “What if sales fell by 10%?” and “What if
fixed costs increased by $1,000?” These questions may be answered subject
to the limitations mentioned earlier.
4. To evaluate alternative viewpoints. There are often different methods of
production, this is particularly true of manufacturing, for example, a product
could be made by:

 using a labour-intensive process, or with large numbers of employees

supported by basic machinery. Thus, a high variable cost, and low fixed cost,
consequently a low BEP.

 or using expensive machinery in an automated process, with very few

employees. Here the opposite of the above would exist.

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BAM6008 Financial Reporting to Management – CVP Analysis

8.0 Target profit and income tax

If profits are subject to Tax, then the target profit must be expressed as a pre-tax
profit. This means inflating the target profit to allow for the subsequent deduction of
tax.

8.1 target profit & income tax

A hotelier requires $50,000 profit net of tax (after tax). The tax rate is 20%.
Calculate the pre-tax profit that will be necessary.

Pre-tax profit = After tax profit (1-t) = 1-the tax rate. Therefore 1-0.2 = 0.8
(1-t)

Pre-tax profit = 50,000 = $62,500

0.8
8.2 Example 7. target profit & income tax
A hotelier requires a profit after tax of $90,000; Annual fixed costs are $200,000
The tax rate is 40%; The CMR is 0.35.
Calculate the revenue (sales) to achieve the target profit.

9.0 C-V-P and the weighted average CMRw

The calculation of the BEP for a single product company is not appropriate in the
modern business environment where businesses make and sell multiple products
over in different divisions or departments. it is therefore necessary to calculate an
overall breakeven point in sales revenue.

9.1 Example 8. weighted average CMR & overall breakeven point

A hotel has $200,000 per year sales and a sales mix as follows:
Rooms 50%; F&B 25%; Shop 25%. Variable costs are: Rooms 23%, F&B 50%,
Shop 24%. The annual fixed costs are $98,000.
Required:
a) Prepare a profit statement to show the contribution for each department and the
total profit.
b) Calculate the CMR for each department.
c) Calculate CMRw for the hotel.
d) Calculate the breakeven point for the hotel.
e) If the sales mix changes to Rooms 70%, F&B 20%, Shop 10% recalculate the
CMRw for the hotel.
f) Recalculate the breakeven point.

10.0 Example 9. Calculation of a selling price to make a specified profit

A motel has a VC per room of $10.00. The average price to sell 250 rooms is
between $45 – 50. The monthly fixed costs are $5,000.

Calculate the average daily rate (ADR) to achieve $4,000 profit per month.

Selling price = VC per room + (FC + Profit)

(No of rooms)

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10.1 Calculation of a selling price to achieve the same breakeven point if fixed
costs increase
Example:
A motel has a VC per room of $30.00. The selling price is $50. The monthly fixed
costs are $10,000. Calculate the breakeven point.

Breakeven point = Fixed costs = $10,000 = 500 units

CM 20
If the fixed costs increase by 10%, calculate a selling price that will still have a BEP
of 500 units

Selling price = VC per room + (Fixed costs x 1.1) = $30 + $11,000 = $52
BEP in units 500

11.0 Limitations & advantages of C-V-P analysis

The usefulness of CVP analysis is restricted by its unrealistic assumptions. Such as:
constant sales price at all levels of activity. However, CVP has the advantage of
being more easily understood by non-financial managers due to its graphical
depiction of cost and revenue data.

Exam Focus: As well as being able to carry out CVP calculations, you will be asked
to criticise the CVP approach to short-term decision-making. This means dealing with
both limitations and advantages.

11.1 Limitations of CVP

1. It is assumed that fixed costs are the same in total and variable costs are the same
per unit at all levels of output. This assumption is a great simplification.

(i) Fixed costs will change if output falls or increases substantially, (most fixed
costs are stepped costs).

(ii) The variable cost per unit will decrease where economies of scale are
made at higher output volumes, but variable cost per unit will also eventually
rise when diseconomies of scale begin to appear at even higher volumes of
output, (for example the cost of labour in overtime working).

The assumption is only correct within a normal range or relevant range of output. It is
generally assumed that both the budgeted output and breakeven point lie within this
relevant range.

2. It is assumed that sales prices will be constant at all levels of activity. This may not
be true, especially at higher volumes of output where prices may have to be reduced
to attract the extra sales.

3. Production and sales are assumed to be the same, so that the consequences of
any increase in inventory levels are ignored.

4. Uncertainty in the estimates of fixed costs and unit variable costs is often ignored.

5. Assumes all output will be sold. It may be that the product will not sell in sufficient
quantities. But it is a good guide for new businesses.

6. Costs & revenues are expressed as straight lines. However, selling prices may
vary with quantities sold. Variable costs may change as advantage is taken of lower
prices due to bulk buying, or more efficient production methods.

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7. It is not possible to extrapolate the graph. At higher levels of output the method of
production may be different.

8. It concentrates too much on the breakeven point. While this is important, efficient
production and monitoring of costs is just as important.

9. The basic model that calculates a breakeven point in units is unrealistic in practice,
as it can only deal with a single products sales and production, unlikely in the modern
business environment.

10. CVP analysis depicts relationships that are essentially short-term. This makes
them inappropriate in the long-term.

11.2 Advantages of CVP

1. Graphical presentation of cost and revenue data can be more easily understood by
non-financial managers.

2. A breakeven model enables profit or loss to be identified at any level of activity

within the range for which the model is valid.

3. The contribution margin ratio (CMR) can indicate the relative profitability of
different products.

4. The breakeven point and margin of safety give some indication of the level of risk
involved.

Question 1
The Eastpointe Café’s average lunch sells for $12, while its variable costs per lunch
average $8.00. It plans to advertise a Monday lunch special for $11. The special
would cost Eastpointe $7.75 per meal (variable cost). An advertisement in the local
paper to promote the special would cost Eastpointe $200.

a) What are the café’s contribution margin (CM) and contribution margin ratio (CMR)
for the average lunch?
b) What is the CM and CMR based strictly on the lunch special?
c) How many lunches must be sold to cover the promotion of the lunch special?

Question 2
The 100 room Pepper Inn has an ADR of $80 and variable costs per room sold of
$15. Assume there is no other sales activity. The monthly fixed costs are $100,000.

a) How many rooms must be sold to breakeven?

b) What day of the month does it breakeven if it averages a paid occupancy
percentage of 60%?
c) If the variable costs are reduced by $3 and fixed costs increase by $72,000
annually. What are the monthly breakeven revenues?

Question 3
Matt Smith spent $750 for a tent, a table, and chairs for his lemonade stand. He
expects to sell a cup of lemonade in the park for $0.75. His cost per drink is $0.20. he
also has other costs to cover such as napkins, cups, and other variable costs of
$0.05 per cup of lemonade sold.
He will open for business on June 1st (Monday) and be open for 5 days per week for
the summer months of June – August. He will pay his parents $2.00 per day to
transport him to the park. He expects to sell 100 cups of lemonade per day.

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BAM6008 Financial Reporting to Management – CVP Analysis

a) What is his CM?

b) What is the breakeven point in units?
c) On which day in the summer will he breakeven?

Question 4
The German Inn cost its owners $3,000,000 of which they borrowed $1,500,000. The
GM estimates the following costs:

Variable costs per room old: 20% of ADR

Annual Fixed costs: $550,000
Tax rate: 25%

a) Calculate the monthly breakeven point in sales revenue.

b) Calculate the annual sales required if the owners are to earn 20% return on their
investment.

Question 5
The Lucas Inn has room & food operations. The rooms operation provides 65% of
the total revenue and has variable costs of 25%. The food operation provides 35% of
the total revenue and has variable costs of 60%. The total annual fixed costs are
$300,000.

a) What is the CMR for the rooms operation?

b) What is the CMR for the food operation?
c) What is the weighted average CMR for the Lucas Inn?
d) What is the breakeven point?
e) If the average tax rate is 20%, what is the annual revenue required to achieve
annual net income of $100,000?

Question 6
The AA Inn is a hotel and coffee shop the average revenue and costs are as follows:
Rooms Coffee Shop
Revenue $600,000 $400,000
Variable costs 120,000 200,000

Fixed costs are $410,000

Tax rate 30%

Assuming, that the sales mix remains constant, calculate the following:
a) The breakeven point in annual sales revenue.
b) The total Net Income after tax when total revenue equals $1,200,000
c) The required revenue to achieve a Net Income after tax of $200,000
d) Answer the same questions again but assume that the sales mix has changed to
Rooms 75%, and Coffee Shop 25%

Question 7
The Rhoades Inn has 50 rooms and provides the following information:
ADR = $30; Monthly fixed costs = $20,000; Variable cost per room sold = $10.

a) Calculate the breakeven point in sales revenue.

b) If revenues equal $450,000, what is the margin of safety in revenues and rooms
sold.
c) If a pre-tax profit of $100,000 is required, how many rooms must be sold?
d) What will be the occupancy percentage in part (c).

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Question 8
The owner of the Iowa Inn has the following information on each department’s sales
and costs: Rooms dept. sales $2,500,000 with a contribution of $1,750,000. The
Coffee shop has sales of $750,000 and variable costs of $300,000. The Restaurant
had sales of $1,200,000 and variable costs of $750,000. Total fixed costs are
$1,000,000. Tax rate is 30%

a) What is the CMRw?

b) What level of sales revenue would be necessary to generate a Net Income of
$500,000.

Question 9
Toni Towers, the CEO of Piccadilly Hotels is considering expanding the company’s
operations. The company requires an 18% on investment after tax. She has identified
an hotel with the following results:

1. The rooms department generates 80% 0f sales with a contribution margin

ratio (CMR) of 0.76
2. The F&B department generates the remaining 20% of sales with a CMR of
0.55.
3. Fixed costs per year are estimated at $240,000.
4. To purchase the hotel an investment of $1,500,000 would be required.
5. Piccadilly Hotels have a tax rate of 30%.

Required:
What level of sales is required before Toni Towers would recommend the investment
in the hotel to the Board of Directors of Piccadilly Hotels?

Question 10
The Income statement of The M & L Inn is as follows:
Rooms Food Total
$ $ $
Revenues 1,500,000 500,000 2,000,000
Variable costs 300,000 400,000 700,000
Contribution 1,200,000 100,000 1,300,000
Fixed costs* 1,000,000
Net income before tax 300,000
Tax 75,000
Net Income 225,000
* Includes lease expense of $480,000
a) Calculate the breakeven point of the M & L Inn.
b) If the fixed cost lease is changed for a variable lease of 5% of total sales, what
is the revised breakeven point?

Question 11
The Myer Motel (MM), a room only 50 room Motel has the following cost structure:
Monthly fixed costs = $20,000; Variable costs per room sold = $20
ADR = $60; Average tax rate = 20%

a) What is MM’s CMR?

b) What is MM’s breakeven point in rooms?
c) What revenue will be necessary to make an after-tax profit of £10,000?
d) If the MM makes a profit of £10,000 during June, what day of the month will it
breakeven? (Assume that the same number of rooms is sold each day)

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Question12
The Blue Moon Inn is planning to open a Food and Beverage operation. The forecast
Sales & annual expenses are as follows:
Sales: $500,000
Variable costs:
Food 30%
Labour 20%
Other 10%
Fixed costs $100,000

The Blue Moon Inn can sign a variable, mixed, or fixed lease for the space and
equipment. The lease expense is in addition to the above listed expenses. The lease
options are as follows:

Variable Lease: 6% of sales

Mixed Lease: 2% of sales plus $1,500 per month
Fixed Lease: $2,500 per month

Required:
a) Calculate the level of sales required to break even for each lease option.
b) If the Inn has annual sales of $700,000, calculate the net income given each lease
option.
c) If the annual sales were $400,000, which lease option would you recommend?
Support your answer with calculations.

Question 13
The Dick Turpin Inn’s summary income statement is as follows:

Rooms Food Total

$ $ $
Revenues 1,000,000 500,000 1,500,000
Variable costs 250,000 200,000 450,000
Contribution 750,000 300,000 1,050,000
Fixed costs* 560,000
Net income before tax 490,000
Tax 98,000
Net Income 392,000

 Includes lease expense of $105,000

 The fixed lease may be exchange for a variable lease of 20% of sales

Required:
a) Using your knowledge of C-V-P analysis, calculate measures and clearly explain
how they may be useful in assessing business plans used in management control.

b) Critically evaluate the use of C-V-P as a model that can be used to manage The
Dick Turpin Inn.

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Question 14
A company leases a theatre that opens 5 nights per week for 50 weeks of the year.
The business plan is as follows:

Admission fee $80 per person (the fee includes dinner & entertainment package).
Theatre performers 12 performers are paid $30,000 each per year
Average number of customers per night 200 persons.
Utility: Costs are expected to be $37,500 per year.
Lease payment: A fixed lease of $200,000 per year to rent the theatre. However, if
preferred, an alternative variable lease is available at 10% of sales revenue.
Food cost: It is estimated that the cost of providing food will be $10 per customer.
Beverage cost: Customers purchase their own drinks. The average contribution
margin ratio is 60%. The bar generates 60% of sales
Labour Costs: Ten staff will be employed at a rate of $20,000 each per year to
perform catering, cleaning and other general duties.
Overheads are estimated at $625 per month.
Target profit after tax of $150,000 per year.
Tax rate: 20%

Required:
a) Using your knowledge of C-V-P analysis, explain how it may be useful in
assessing business plans and its use in management control.

b) Critically evaluate the use of C-V-P as a model that can be used to manage the
business.

Question 15.
A Pizza Parlour has the following costs at various levels of monthly sales:
Monthly sales in units 3,000 6,000 9,000
Cost of food sold $ 4,500 $ 9,000 $ 13,500
Payroll costs 3,500 5,000 6,500
Supplies 600 1,200 1,800
Utilities 360 420 480
Other operating costs 1,500 3,000 4,500
Building rent 1,000 1,000 1,000
Depreciation 200 200 200
Total 11,660 19,820 27,980

Required:
a) Identify each cost as variable, fixed, or mixed.
b) Develop an equation to estimate costs at various levels of activity.
c) Project total costs with monthly sales of 8,000 units

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