CHAPTER ONE

COST-VOLUME PROFIT RELATIONSHIP

Chapter objectives:
After completing the chapter, you are expected to
 Absorption versus Variable Costing
 The concept of profit contribution
 Define a break-even point and grasp the equation and contribution margin
approaches to break even analysis.
 Understand the importance of target-profit analysis and the computation of
margin of safety.
 Explain the effect of changes in CVP variables
 Analyze cost structure
 Understand and limitation of CVP and benefits of CVP
Absorption versus variable (Direct) Costing
Variable cost is the accounting method in which all the variable production costs are
only included in product cost whereas Absorption costing is where all the absorbed costs
are taken into account and under this method, all the fixed and variable production costs
are deducted and then fixed and variable selling expenses are deducted.
Variable costing is defined as an accounting method for production expenses where only
variable costs are included in the product cost, whereas, Absorption costing includes all
costs associated with a production process that is assigned to the units produced.
 Variable costing consists of direct material costs, direct labor costs, and
variable manufacturing overheads, whereas, Absorption costing consists of direct
material costs, direct labor costs, variable manufacturing overheads, and fixed
manufacturing overheads.
 Under variable costing, there is no concept of over and under absorption of
overheads. Under absorption costing, fixed costs are absorbed on an actual basis, or on
the basis of the predetermined rate based on normal capacity

Variable vs Absorption Costing Comparative Table

Basis Variable Costing Absorption Costing

Variable costing includes only

Costs variable costs directly incurred Absorption costing includes both variable costs and fixed
in production. costs related to production.

DTU 1 Cost & Management Acc.

 Basis Variable Costing Absorption Costing

Variable costing is also known

Alternative
as marginal costing or direct Absorption costing is also known as full costing.
Names
costing.

Variable costing is generally

Absorption costing is used for reporting to the external stakeholders
used for internal reporting
Internal / as well as for the purpose of filing taxes. It is in line
purposes. Managerial
External Use with GAAP (Generally Accepted Accounting Principles) and IFRS
decisions are taken on the
(International Financial Reporting Standards).
basis of variable costing.

Variable costing is used for

comparing the profitability
of different product lines. Absorption costing is used for calculating per unit cost based on all
Relevance
The organization can carry out costs including fixed overhead costs.
an analysis based on costs,
volumes, and profits.

Variable costing is based on

Absorption costing is based on external reporting standards given by
Reporting internal specifications of
external agencies.
reporting and presentation.

Variable costing involves only

variable production costs to be
Absorption costing involves considering all production costs and
Inventory assigned to inventory, work-
including them in inventory and work-in-progress.
in-progress, and cost of goods
sold.

Variable costing calculates

contribution which is the
Contribution Absorption costing is used to calculate the net profit.
difference between sales and
variable cost of sales.

Profit is much easier to predict It is much more difficult to predict the effect of change in sales on
Profit
as it is a function of sales. profit.

1.2 The concept of profit contribution

Profit contribution is a tool intended to help make management decisions. You

should use the information that you calculate to make recommendations for the
business, such as increasing production, ending production of a product with a low
contribution margin or reducing variable costs to achieve a higher profit contribution

DTU 2 Cost & Management Acc.

In any retail or manufacturing business, it is important to know how much each unit
sold contributes to the business's profit. This is commonly referred to as the
"contribution margin." This is part of cost volume profit analysis, a management
accounting technique that allows businesses to understand their profit levels at varying
levels of production. By calculating the contribution margin, a manager can determine
which products are most profitable and make production decisions accordingly. It is
easy to calculate the profit contribution of a product by following several basic steps.

STEP1 Write down the unit price. This is the price at which each unit is sold; it is not
the unit cost or the unit profit.

STEP2 Calculate the unit variable cost. This is calculated by first determining the total
variable costs for all the products. Variable costs are all the costs that increase
proportionately to an increase in production. They include material costs, direct labor
costs and any other costs that increase as production increases. Variable costs include
all costs that are not fixed costs, such as equipment, indirect labor and real estate. Add
all of the variable costs and divide the total by the number of units produced. This will
give you the unit variable cost. Write this number down.

STEP3 Subtract the unit variable cost from the unit price. This figure gives you the
contribution margin of each unit, which tells you how much one unit contributes to the
profit. Write down the unit contribution margin. For example, if your unit price is $5
and your unit variable cost is $2, then each unit that you produce will contribute $3
toward profits.

STEP4. Multiply the unit contribution margin by the number of units produced. This
will give you the total contribution margin for all units. This is useful if you want to
know how much your total production is contributing to profits.
Cost Volume profit Analysis
Cost volume/profit analysis can help you to answer these, and many more, questions
about your business operations.
CVP analysis, is a way of examining the relationship between
 your fixed and variable costs,
 Your volume (in terms of units or in terms of dollars), and
 Your profits.
More specifically, it looks at the effects on profits of changes in such factors as
 Variable costs,  Volume, and
 Fixed costs,  Mix of products sold.
 Selling prices,
By studying the relationships of costs, sales, and net income, management is better able
to cope with many planning decisions.

DTU 3 Cost & Management Acc.

Generally cost- volume profit (CVP) analysis summarizes how profits, costs and revenue
change with a change in volume of activity.
The CVP analysis helps to answer questions of the following type;-
 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 (CVP) Analysis can be used to show the effects on profit if
changes in selling price, service fees, income tax rates and organization mix of
products or services. Therefore CVP analysis provides management with a
comprehensive overview of the effect on revenue and costs of all kinds of short-run
financial changes.
Even though the term profit appears in the term Cost- volume profit (CVP) Analysis,
It is not confined (restricted) to profit seeking enterprises.

Managers in non profit seeking organizations also use CVP analysis to examine
 The effect of activity and
 Other short-run changes on revenue and costs.
For example CVP analysis can be used by a social welfare agency to find out how many
people can be assisted given the agency’s’ fixed and variable costs, by a charity hospital
to determine the number of patients to be admitted, by a public school to determine the
number of students to be enrolled, and others.
Cost- volume profit (CVP) Analysis is one of the most powerful and simple business
planning and analysis tools that managers have at their command. It helps managers
understand the interrelation between cost, volume, and profit in an organization by
focusing on interactions between the following elements.
 Price of product  Total fixed costs
 Volume or level of activity  Mix of products sold
 variable cost per unit

DTU 4 Cost & Management Acc.

Cost- volume profit (CVP) Analysis is therefore a vital tool in businesses decisions as what
products to produce and sale, what pricing policy, what marketing strategy to employ, and what
type of productive facilities to acquire and utilize.
Note from the out set that an important first step in any CVP analysis is categorizing an
organization’s costs according to their cost behaviors in to fixed or variable costs.
1.1 Contribution Margin
The contribution margin is the difference between sales revenue and variable costs. It is a
measure of the amount available to cover the fixed costs and there after to provide profits for the
enterprise. The contribution margin to per unit is calculated as the difference between sales price
per unit and the variable cost per unit.
Take the following example;-
Assume that Addis company produce and sales cosmetics. The cosmetics is produced at a cost of
$80 cost per bottle and sold for $100 per bottle. The company’s fixed cost amount is $120,000
per year. The plant capacity is 10,000 bottles of cosmetics annually.
Sales price per bottle------------------$100
Less Variable cost per bottle---------- (80)
Contribution margin--------------------$20
After the fixed cost have been covered the $20 per bottle contribution margin represents the
amount of birr added to profits each time a bottle of cosmetics is sold.
The concept of contribution margin is easily understood by taking the above example. Assume the
company produces 5,998, 5,999, 6,000, 6001 and 6,002 units.
Addis Company
Contribution Income Statement
Number of bottles sold (X)
5998 5999 6000 6001 6002
Sales ($100x) $599,800 $599,900 $600,000 $600,100 $600,200
Variable cost ($80x) 479,840 479,920 480,000 480,080 480,160
Contribution margin ($20x) 119,960 119,980 120,000 120,020 120040
Less fixed cost 120,000 120,000 120,000 120,000 120,000
Net Income (loss) (40) (20) 0 20 40
Thus from the above example the contribution margin is the amount remaining from sales
revenue after variable expense have been deducted. It is the amount available to cover fixed costs
and then to provide profits for the period.
In general it important to mention the following key points:
1. If the contribution margin is just sufficient to cover the fixed expenses there will be neither
profit nor loss, for our example sales of 6,000 bottles or $600,000 is called the break-even
point the level of sales at which profit is zero, and it is computed either in terms of units sold
or the Birr amount.
2. Once the break even point has been reached net income will increase by the unit contribution
margin for our case $20 for each additional unit sold. In other words every bottle of cosmetics
sold in excess of the break even point will add $20 to net income. As sales increase from
6,000 to 6,001 net income increases from 0 to $20 (i.e. $20X 1 bottle). More over as sales
increase from 6,001 to 6,002 bottles net income again rises by $20 from $20 to $40. Net
income continues to increase by $20 per unit contribution margin each time an additional unit
is sold. This all shows that beyond the break even point the effect of an increase in sales on
 net income can be quickly computed by multiplying the amount of increase by the
contribution margin per unit.
To support this let the sales has increase from 6,300 bottles to 6,700 bottles, the effect of
change profit is calculated below
 Current sales in units of bottle 6,700
 Past sales in units of bottle 6,300
 Increase in sales of units of bottle 400
 Contribution margin in units of sales $20
Increase in company’s profit $8,000
Thus as sales increase from 6,300 to 6,700 bottles by 400 bottles the company’s profit will
increase by $8,000. To estimate the effect of a planned increase in sales on profit, the manager
can simply multiply the increase in units sold by the unit contribution margin so as to arrive at
expected increase in profit.
3. If the contribution margin is not sufficient to cover the fixed expense, then a loss occurs for
the period. Each loss sale below the break-even point will reduce the company’s net income
by the $20 unit contribution margin. As sales falls below 6,000 bottle the company’s
profitability declines from zero to a loss of $20.
What will happen to Addis Company’s profit if sales fall from 5,800 bottles to 5,500 bottles
The Company’s loss will increase by $6,000 ( 5,800 – 5,500 ) x $20. It is presented below:
Current sales in units of bottle ------------------------- 5,800
Past sales in units of bottle ------------------------- 5,500
Increase in sales of units of bottle -------------------------- 300
Contribution margin in units of sales----------------------- $20
Increase in company’s loss ----------------------------- ----$6,000
To summarize what has been said so far
 If there is no sales, the company’s loss would equal its fixed expenses
 Each unit sold reduces the loss by the amount of unit contribution margin.
 Once the break-even point has been attained each additional unit sold increase the
company’s profit by the amount of unit contribution margin.

Contribution margin Ratio

Contribution margin ratio is the ratio of contribution margin to sales
Contribution margin ratio = Contribution margin
Sales
The contribution margin and sales figures, in the above formula could be expressed in total or on
per unit basis.
For Addis company if it sales 6,200 bottles then the total sales revenue is 6,200 x $100 =
$620,000, and the contribution margin per unit is $20 while the total contribution margin will be
6,200 x $20 = $124, 000
The Contribution margin ratio is computed as follows
CM ratio = Contribution margin per unit = $20 = 20% or 0.2
Sales price per unit $100
CM ratio = Total Contribution margin = $124,000 = 20% or 0.2
Total sales revenue $620,000
The contribution margin ratio suggests that every birr of sales provides for 20 cents to cover the
fixed costs. After the fixed costs have been covered each birr of sales provides 20 cents of profit.
The CM is useful since it shows how the contribution margin will be affected by a change in total
sales.
To show a contribution margin of 20% means that for each Birr increase in sales, total
contribution margin increase by 20 cents (Birr 1 sales X CM ratio of 20%).Net income will also
increase by 20 cents, assuming that there are no changes in fixed costs. In general, the impact on
net income of any given Birr change in total sales can be simply computed by applying the CM
ratio to the birr change.
To illustrate, if Addis Company plans a $60,000 increase in sales from its current sales of
$620,000 (i.e. at 6200 bottles of sales), contribution margin and net income will increase by
$12,000 if fixed costs do not change which is calculated as below:
Anticipated increase in sales ------------------------------$60,000
CM ratio --------------------------------------------------------20%
Increase in contribution margin and net income---------$12,000
Sales volume
Present Expected Increase
Sales ($100x) $ 620,000 $680,000 $60,000
Variable cost ($80x) 496,000 544,000 48,000
Contribution margin ($20x) 124,000 136,000 12,000
Less fixed cost 120,000 120,000 0
Net Income (loss) 4,000 16,000 12,000
Managers mostly prefer to work with the CM ratio rather than the unit contribution margin
figure. The CM ratio is particularly valuable in those situations where the manager must make
trade-offs between more birr sales of one product versus more Birr sales of another product.
Generally speaking, when trying to increase sales, products that yield the greatest amount of
contribution margin per Birr of sales should be emphasized or promoted.
1.2 Break Even Analysis
Break-even is the point where total revenue equals total costs. At break-even point, a company
neither incurs a loss nor earns a profit on operating activities. At break-even, the company’s
revenue simply covers its costs. The profit at break-even is zero. Break-even analysis is the
important elements of CVP analysis. The break-even point can be computed using the equation
method, the contribution margin method, or graphic methods.
To illustrate the above methods let us take our previous example Addis Company. The company
normal production capacity is 10,000 bottles of conditioner annually. Addis fixed cost is
$120,000, sales price per bottle is $100, and the variable cost per unit is $80 .Based on this data:
Compute the number of bottles of conditioner the company should produce and sale per year at
break-even.
1. Determine the break-even sales in Birr.
2. Graph the cost-volume-profit relationship using the CVP graph.
Answer
1. Method one: Equation method
This method uses an algebraic equation to make CVP analysis, assume the following
designations:
Q—Number of units produced and sold
TC—Total cost of producing and selling Q units
TR—Total sales revenue from selling Q units
P—selling price per unit
V—Variable expense per unit
F—Total fixed cost
Sales Revenue = Selling price per unit X Number of units sold
TR = P X Q
Total Costs = Variable Expenses + Fixed Expenses
Total Costs = (Variable Expense X Number of Units Sold) + Fixed expenses
Symbolically: TC
TC = (V) X (Q) + F
The above formula represents the total cost equation. Cost here mean operating costs including
production or manufacturing costs, selling costs or marketing costs, and administrative costs.
The equation method centers on the contribution approach to the income statement illustrated in
this chapter at the beginning.
Break-even in units can be calculated using the following formula:
Net income = Total revenue (PQ)-Total cost (TC)
But total cost is the sum of total variable cost (QV) plus total fixed cost (FC).
Net income = PQ-(VQ+FC) = PQ-VQ-FC
= Q (P-V) –FC
Q (P-V) = FC, at break-even since total cost equals total revenue
P-V is contribution margin (CM)
Break-even in units Q = FC
P-V
Break-even in units Q = FC
CM
Given
 Selling price per unit =$100
 Variable cost per unit =$80
 Fixed cost = $120,000
Break-even in units equals = $120,000 = 6,000 units (bottles of conditioner)
($100-$80)
Thus, the company should produce and sell 6,000 bottles of conditioner per year so as to break-
even. The break-even point in units, 6,000 bottles represents 60% (i.e. 6,000/10,000bottles) of its
normal capacity.
Break-even in Birr is calculated as follows
Sales ($100 x 6,000 bottles) -----------------------------$600,000
Less variable expenses ($80 x 6,000 bottles) --------$480,000
Contribution margin ($20 x 6,000 bottles) -------------120,000
Less fixed cost ----------------------------------------------120,000
Net income--------------------------------------------------------0
Thus, at break-even point, there is no profit or loss for the contribution margin is just equal to
cover the fixed expenses.
The calculation of the break-even point in sales birr can be computed by multiplying the break-
even level of unit sales by the selling price;
6,000 bottles x $100 = $600,000
We can also, however, derive a formula in the equation form that helps us determine the break-
even point in sales birr.
The break-even point in units is: Q = FC
 P-V
If we multiply both sides by P, we get
P x Q = FC x P
P-V
Last, let us divide both the numerator and denominator of the right-hand side of the above
equation by P, thus we get
PQ = FP/P
P/P-V/P
Simplifying the above equation will yield the following equation, which is used to compute the
break-even point in Birr sales:
PQ = F
1-V/P
PQ = 120,000 120,000 = 120,000 = $600,000
1-80/100 1-0.80 0.20
Firms often have data available only in percentage form, and the approach just illustrated must
then be used to find the break-even point. Notice further that the use of percentage in the equation
yields a break-even point in sales Birr rather than in units sold.
2. The Contribution Margin Method (Approach)
The contribution margin method approach centers on the idea earlier that each unit sold provides
a certain amount of contribution margin that goes toward covering fixed costs. To find how many
units must be sold to break-even, divide the total fixed costs by the unit contribution margin.
Break-even point in units sold = Fixed expense
Unit contribution margin
For Addis Company we have;
Selling price per unit------------------$100
Variable expenses per unit--------------80
Unit contribution margin ---------------20
Fixed expenses---------------------$120,000
Thus, the break-even point in units for Addis Company is 6,000 bottles where there is no profit or
loss for the contribution margin is just equal to cover the fixed expenses.
The break-even point in units = Fixed expenses = $120,000 = 6,000 bottle
Contribution margin 20
The break-even point in Birr sales = Fixed expenses
Contribution margin ratio
Remember that we have already computed the contribution margin ratio for Addis Company
using the formula below:
Contribution margin ratio = contribution margin = $20 = 0.20 or 20%
Sales $100
Thus, the break-even point in Birr sales will be = $120,000 = $600,000
0.2
This approach, based on the CM ratio is particularly useful in those situations where a company
has multiple product lines and wishes to compute a single break-even point for the company as a
whole.
3. Graphic method
Break-even point conveys useful information to management, but it fails to show how profit
changes as activity changes. To understand the relation ship between profit and volume of
activity, a cost-volume-profit graph is commonly used. A cost-volume-profit (CVP) graph is,
therefore, prepared to express graphically the relationship among revenue, cost, profit, and
volume. A cost-volume-profit graph highlights CVP relationship over wide range of activity and
can give managers a perspective that can be obtained in no other way.
The following steps are used to prepare CVP graph, which is also called a break-even chart.
1. Draw the axes of the graph. Label the vertical axis in Birr and the horizontal axis in volume of
units of sales (in our case number of bottles of shampoo).
2. Draw a line parallel to the horizontal axis labeled in volume of units of sales to represent the
total fixed expenses. The line is parallel to the horizontal axis because fixed expenses do not
change in with activity. For our Addis Company the fixed expense is $120,000.
3. Choose some volume of sales and plot the point representing total expenses (fixed and
variable expenses) at the activity level you have selected. For example, if you select a volume
of 5,000 bottles, the total expense at this volume will be computed as follows:
Variable expenses ($80 X 5,000 bottles) ------$400,000
Fixed expenses -------------------------------------120,000
Total expenses--------------------------------------$520,000
4. Draw the variable expense line. This line passes through the origin (0) and goes up ward
parallel to the total revenue line but lies below the revenue line.
5. Choose some volume of sales and plot the point representing total sales in Birr at the activity
level you have selected. For example, if you select a volume of 5,000 bottles, the total sales at
this volume will be computed as follows:
Total sales ($100 X 5,000 bottles) --------------= $500,000
6. Draw the total revenue line. This line passes through the point plotted in step 5 above and
begins from the origin (0). The revenue line crosses the origin simply because total revenue is
zero if no sales are made.
The anticipated profit or loss at any given level of sales is measured by the vertical distance
between the total revenue and total expenses (variable expense plus fixed expense lines). The
break-even point is where the total revenue and total expense lines intersect. The break-even point
of 6,000 bottles, which occurs at a point where total revenues and total expenses are equal to
$600,000, agrees with the break-even point obtained for Addis Company in our example
computation using the equation and contribution margin methods.
It is possible to derive the following conclusions.
Break-even point is determined by the intersection of the total revenue line and the total expense
line. Addis Company’s break-even for the year is at 6,000 bottles, or $600,000 of sales. This
result agrees with the conclusions that are reached at by the equation and contribution methods.
Profit and loss areas;- the CVP graph discloses more information than the break-even calculation.
From the graph, a manager can see the effects on profit of changes in volume. The vertical
distance between the total revenue and total expenses lines on the graph represents the profit or
loss at a particular sales volume. If Addis Company sells fewer than 6,000 bottles in a year, the
organization will suffer a loss and the magnitude of the loss increase as bottle sales decline. The
company, on the other hand, will have a profit if sales exceed 6,000bottles in a year.
Another approach to graphing cost-volume-profit relationship is shown below. This format is a
profit-volume (PV) graph because it highlights the amount of profit or loss. Notice the graph
intercepts the vertical axis at the amount equal to fixed expenses at the zero activity level. This
indicates that the loss will equal the fixed expenses of $120,000 if no product is produced and
sold. The graph, moreover, crosses the horizontal axis at the break-even point of 6,000 bottles
peer year suggesting that profit will be zero at this volume of sales. The vertical distance between
the horizontal axis and the profit line, at particular level of sales volume, is the profit or loss at
that volume.
1.4 Planning With Cost-Volume-Profit Data
Managers of a company will prepare different plans to be attained. It may be planned to attain a
desired level of profit before tax or profit after tax depending on the target managers want to
attain. Using CVP analysis will help managers to compute the number of units they need to
produce in order to achieve the target profit they planned.
The break-even point provides a starting point for planning further operation. Managers want to
earn operating profits rather than simply cover costs. Consequently, CVP analysis can be used to
answer the following questions;
1. How much sales volume in units and in Birr should a company generate if a fixed amount
of profit before or after tax is desired?
2. How much sales volume in units and in Birr should a company generate if a variable
amount of profit before or after tax is desired?
Managers use CVP analysis to determine the sales volume needed to achieve a desired profit
called target or planned profit. In making target profit analysis, we are aimed at finding a
contribution margin figure that is sufficient to cover the fixed cost and to provide the desired
profit. The problem of computing the volume of sales required to earn a particular amount of
target profit is very similar to the problem of finding the break-even point. After all, the
break-even point is the sales volume required to earn a target profit of zero.
To illustrate, assume that the management of Addis Company has planned that the company’s
operation should produce a yearly profit before tax of $40,000. Then determine:
1. The number of bottles of conditioner the company should produce and sale to achieve its
target before tax profit of $40,000.
2. The sales volume in Birr, which the company should generate to attain its target before tax
profit of $40,000.
The answer can be computed using the two methods discussed before.
1. The equation method
Let PBT = target (desired) profit before tax
Q= Quantity in units to achieve the target profit
P= selling price per unit
V= variable cost per unit
FC= Total Fixed Cost
Thus, the sales volume should not only cover total expenses but also provide for the desired profit
anticipated by management.
Sales revenue = Variable expenses + Fixed expenses + Target profit before tax
Mathematically, PQ = VQ + FC + PBT
PQ—VQ = FC + PBT
Q (P--V) = FC + PBT
Q = FC + PBT
P-V

The formula gives in the box indicates the number of units a company should produce and sale to
attain its target profit before tax. Applying this formula the Company should produce and sale
8,000 bottles of conditioner to get its target profit before tax of $40,000.
Q = FC + PBT
P-V
Q= $120,000 +$40,000 = $160,000 = 8,000 bottles
$100-$80 $20
Sales ($100 X 8,000 bottles) -------------------------------$800,000
Less variable expenses ($80 X 8,000 bottles) -------------640,000
Contribution Margin ($20 x 8,000 bottles) ----------------160,000
Less fixed expenses -------------------------------------------120,000
Target before tax profit----------------------------------------$40,000
The sales volume in Birr required to achieve the target profit before tax of $40,000 can be
computed by multiplying the target Quantity by the selling price (P) as follows;
8,000 bottles X $100 = $800,000

2. The contribution margin approach

The contribution margin approach involves expending or modifying the contribution margin
formulas given in this chapter to include the target profit. The following formula is used:
PBT in units = Fixed expenses + Target PBT = $120,000 + $40,000 =
Unit contribution margin $20
= $160,000 = 8,000 bottles
$20
PBT in Birr sales = Fixed expenses + Target PBT = $120,000 + $40,000 =
Unit contribution margin ratio 0.20
= $160,000 = $800,000
0.20
Now suppose that the management of Addis has planned that the company’s operation should
produce a yearly profit after tax rate is 40%
Then, determine the following;
1. Number of units the company should produce and sale to achieve the target profit after tax
of $90,000
2. The sales volume in Birr, which the company should generate to attain its after tax profit
$90,000.
Solution
Let PBT = target (desired) profit before tax
PAT = Target profit after tax
T = the income tax rate (40% in our example)
Q= Quantity in units to achieve the target after tax profit
P= selling price per unit
V= variable cost per unit
FC= Total Fixed Cost
Profit after tax = (Profit before tax) – T (Profit before tax)
PAT = PBT – T (PBT)
Rearranging the above equation
PAT = (PBT) (1– T)
PBT = PAT
(1-T)
Sales = variable expenses + fixed expenses + Target profit before tax
PQ = VQ + FC + PBT
PQ = VQ + FC + PAT
(1-T)
PQ- VQ = FC + PAT
(1-T)
Q (P-V) = FC + PAT
(1-T)
Q = FC + PAT
(1-T)
P-V

The formula in box gives the number of units a company should produce and sale so as to reach
its target after tax profit. Using this formula the number of units to be produced is 13,500 bottles
of conditioner.
Q = $120,000+ $90,000 = = $120,000+ $90,000 =
1-0.40 0.6
$100-$80 $20
120,000 + $150,000 = $270,000 = 13,500 bottles
$20 $20
Sales ($100 X 13,500) ---------------------------------------$1,350,000
Less variable expenses ($80 X 13,500) -------------------- 1,080,000
Contribution margin ($20 X 13,500) ------------------------ $270,000
Less fixed cost --------------------------------------------------120,000
Target profit before tax -----------------------------------------$150,000
Less income tax (40% x $150,000) ----------------------------60,000
Target profit after tax (PAT) -------------------------------------$90,000
Now sales volume in Birr required to achieve a target profit after tax of $90,000 can be
Target sales = $100 X 13,500 = $1,350,000
We have the target after tax profit point in units is given by the following formula;
Q = FC + PAT
(1-T)
P-V
If we multiply both sides by P we will find the following;
P X Q = (FC + PAT) X P
(1-T)
P-V
If we divide both the numerator and the denominator of the above equation by P, we will find;
PQ = FC + PAT
1-T
1- V/P
PQ = $120,000 + $90,000 = $120,000 + $90,000
1-0.40 0.60
1- $80/$100 1-0.80
= $120,000 + $150,000 = $270,000 = $1,350,000
0.20 0.20
Let us compute the same problem using the contribution margin method, as follows;
Target profit points in units = Fixed expense + Target after tax profit
1-T
Unit contribution margin
For Addis Company, we have;
Target profit points in units = $120,000 + $90,000 =
1-0.40
$20
$120,000 + $150,000 = 13,500 bottles
$20

Target profit points in sales Birr = Fixed expense + Target after tax profit
1-T
Unit contribution margin ratio
Target profit points in sales Birr = $120,000 + $90,000
1-0.40
0.20
= $120,000 + $150,000
0.20
= $1,350,000
13,500 bottles of conditioner should be sold to achieve $90,000 after tax profit. The company’s
break-even point, as computed earlier is 6,000 bottles the product.
1.5. The Margin of Safety
The margin of safety is the excess of budgeted or actual sales over the break-even volume of
sales. It states the amount by which sales can drop before losses begin to be incurred. The margin
of safety, therefore, gives management a clue for how close projected or actual operations are to
the organization’s break-even point. If the actual (budgeted) sales are significantly above the
break-even sales, there is high margin of safety and profitability can be expected even if the actual
(budgeted) sales falls for one reason or another. The margin of safety is a measure of risk because
it indicates the amount by which sales can decline before a firm suffers a loss. The formula to
calculate margin of safety;
Absolute margin of safety = Total budgeted (actual) sales – break-even sales
Relative margin of safety = Total budgeted (actual) sales-Break-even sales
Total budgeted (actual) sales
The relative margin of safety is also called the margin of safety percentage or the margin of safety
ratio.
Example: Assume that Addis Company is currently selling 8,000 bottles of conditioner. Required
calculate and interpret
1. The absolute margin of safety
2. The relative margin of safety
Solution;-
1. The absolute margin of safety = Total budgeted (actual) sales – break-even sales
Units in Birr
Actual sales-------------------8,000--------------- (8,000 x $100) = $800,000
Less break-even sales--------6,000--------------- (6,000 x $100) = $600,000
Absolute margin of safety –2,000---------------- (2,000 x $100) = $200,000
2. The relative margin of safety= Total budgeted (actual) sales-Break-even sales
Total budgeted (actual) sales
= 8, 000 -6,000 = 2,000 = 0.25 or 25%
8,000 8,000
Or 2,000 X $100 = 25%
8,000 X $100
Interpretation:- This margin of safety means that at the current level of sales and with the
company’s current prices and cost structure, a decline in sales of 2,000 bottles or $200,000
sales Birr or by 25% would result in just breaking even. Thus, the company will not suffer a
loss. However, if actual sales fall short of the break-even sales by more than this figure, the
company will experience a loss.
The margin of safety focuses on the vulnerability of profits to a decline is sales volume. Other
factors could threaten profitability as well. For example profit decline if costs increases.
Safety margins could be determined for fixed and variable costs as well as sales volume. The
disadvantage of the margin of safety approach is that it constitutes a one-dimensional
(considering only sales volume) analysis when profits are subjected to multi-dimensional
factors. This will be dealt in the following sections.
1.6 Analysis of Changes in CVP Variables
For any given linear CVP analysis we can see how increases and decreases in CVP variables
could affect the resulting profit. Thus, we will look here the effect of changes in variable
costs, fixed costs, sales price and sales volume on the company’s profitability.
By changing the CVP variables, management can get a real feel for the sensitivity of profits to
such changes for the project that is under consideration.
Investigation a variety of what-if questions regarding simultaneous changes in variable costs,
fixed costs, sales prices, and sales volume is called sensitivity analysis.
Next we will see the effect of changes in CVP variables on the company’s profitability.
Let us take our previous Addis Company with the given data in earlier sessions.
Fixed cost--------------------------------$120,000
Selling price per unit-----------------------$100
Variable cost per unit------------------------80
1.6.1 Change in Fixed Cost and Sales Volume
Assume that Addis Company is currently selling 8,000 bottles of conditioner per year. The
sales manager feels that a $20,000 increase in the yearly advertising budget would increase
annual sales to 8,400 bottles. Should the advertising budget be increased? Let us prepare the
following table:
Current Sales with additional Difference
Sales Advertising budget
(8,000 bottles) (8,400 bottles) (400 bottles)
Sales ---------------------------$800,000 $840,000 $40,000
Less variable costs ------------640,000 672,000 32,000
Contribution margin-----------160,000 168,000 8,000
Less fixed cost 120,000 140,000* 20,000
Net income ----------------------40,000 28,000 (12,000)
$140,000* = $120,000(fixed cost) plus $20,000 advertising cost
Assuming that there are no other factors to be considered, the increase in the advertising budget
should not be approved since it leads to a decline in net income ($12,000) from its current level of
$40,000 to $28,000.
1.6.2 Change in Variable Costs and Sales Volume
Referring the previous example, Addis Company is currently selling 8,000 units of its product per
year. The management of the Company is planning to use a high quality material in producing its
product. The use of this material would increase variable costs (and there bye reduce the
contribution margin) by $4 per bottle. However the sales manager predicts that the higher overall
quality would increase sales from 8,000 bottles to 10,500 bottles per year. Should the quality
material be used?
Now let us compute the two situations using a table below.
Current Sales with higher
Sales Quality material
(8,000 bottles) (10,500 bottles)
Per Per Difference
Total unit Total unit (2,500 bottles)
Sales ---------------------$800,000 $100 $1,050,000 $100 $250,000
Less variable cost--------640,000 80 882,000 84* 242,000
Contribution margin ---$160,000 $20 $168,000 $16 $8,000
Less fixed expenses------120,000 120,000 0
Net income (Loss) ------- $40,000 $48,000 $8,000
84* = $80 + $4 additional variable costs
Based on the above analysis made above, the higher the quality material should be used since
it would lead to an increase in net income from its current level of $40,000 to $48,000 by
$8,000. Remember here that fixed cost will not change.
The above analysis can be computed in another way using the incremental approach. As we
see above notice that the $4 increase in variable cost will cause the unit contribution margin to
decrease from $20 to $16.
Expected total contribution margin with
Higher- quality material (10,500 X $16) -----------------------------$168,000
Present total contribution margin (8,000 bottles X $20) --------------160,000
Increase in total contribution margin ---------------------------------------8,000
Since fixed costs will not change, the net income of Addis Company will increase by the
$8,000 as shown in the above computations.
Change in Fixed Costs, Sales Price, and Sales Volume
To see the effect of changes in the above variables let’s take the Addis company, which is
currently selling 8,000 bottles per year. To increase sales, the sales manager would like to cut
the selling price by $5 per bottle and increase the advertising budget by $25,000 per year. The
sales manager argues that, if these two steps are taken, the number of units sold will increase
by 45% rate per year. Should the change be made?
First let’s calculate the expected number of bottles of shampoo that could be sold per year if
the changes set forth in the question above are implemented.
Expected sales if the changes are made = 8,000 + [8,000 X 40%]
= 8,000 + [3,200]
= 11,200 bottles
By using the comparative income statement let’s examine the whether the change should be
made or not.
Current Expected
Sales Sales
(8,000 bottles) (11,200 bottles)
Per Per Difference
Total unit Total unit (3,200 bottles)
Sales ---------------------$800,000 $100 $1,064,000 $95* $264,000
Less variable cost--------640,000 80 896,000 80 256,000
Contribution margin ---$160,000 $20 $168,000 $15 $8,000
Less fixed expenses------120,000 145,000** 25,000
Net income (Loss) ------- $40,000 $23,000 ($17,000)
$95* = $100 - $5 reduction in unit selling price
$145,000** = $120,000 + $25,000 additional yearly advertising budget
Based on the above comparative income statement, it is observed that the net income has
declined from $40,000 to $23,000 which is a reduction of $17,000. Thus the change should
not be accepted.
By using the incremental approach, we can reach at the same result. Notice that a decrease of
$5 in the selling prices per unit causes the unit contribution margin to fall from $20 to $15.
Thus using the incremental analysis, we have the following result, which indicates the same
effect on net income as that obtained by the comparative income statement shown above.
Expected total contribution margin with
Lower selling price (11,200 bottles X $15) ----------------------$168,000
Present total contribution margin (8,000 bottle X $20) ----------160,000
Incremental contribution margin---------------------------------------8,000
Change in fixed costs:
Less incremental advertising expenses------------------------------$25,000
Decline in net income-------------------------------------------------- ($17,000)
1.7. Assumptions of CVP Analysis
The following assumptions must be satisfied for a CVP analysis to be valid with in the
relevant range.
1. The behavior of total revenue is linear (straight line). This implies that the price of a
product or service will not change as sales volume varies within the relevant range. To put it
in another way the selling price is constant throughout the entire relevant rang.
2. The behavior of cost is also linear over the relevant range. This implies the following
more specific assumptions:
a. Costs can be accurately divided in to variable and fixed costs. As activity changes
the variable cost is constant per unit and fixed costs are constant in total over the entire
relevant range.
b. The efficiency and productivity of the production process and workers remain
constant.
3. In multi-product Company, the sales mix remains constant over the relevant range.
4. In manufacturing companies inventories don’t change the inventory levels at the beginning
and end of the period (are the same). This implies the number of units produced during the
period equals the number of units sold.
Some of these assumptions may be technically violated; the violations are usually not serious
enough to call in to question the basic validity of CVP analysis. For example, in most multi-
product companies, the sales mix is constant enough so that the result of CVP analysis is
reasonably valid.
May be the greatest danger lies in relying on simple CVP analysis when a manager is
contemplating a large change in volume that lies out side of the relevant range. For example, a
manager might contemplate increasing the level of sales far beyond what the company has ever
experience before. However, even in these situations a manager can adjust the model to make into
account anticipated changes in selling prices, fixed costs, and the sales mix that would otherwise
violate the assumptions. For example, in a decision that would affect fixed costs, the change in
fixed costs can be explicitly taken into account as illustrated earlier in this chapter for Addis
Company.
1.8. Limitations of CVP Analysis
The accuracy of CVP analysis is limited because it assumes strictly linear relationship among
the variables. True linearity among actual CVP variable is the exception rather than the norm. For
example, suppose that a business receives a volume discount on material that it purchases. The
more material it purchases, the lower its cost per unit. In this case, the cost varies but not in direct
proportion of to the amount of material purchased. The relation is no linear, therefore. Similarly,
fixed cost can change. A supervisor’s salary that is thought to be fixed may change if the
supervisor receives a raise. Likewise, amounts changed for telephone, rent, insurance, taxes, and
so on may increase or decrease subjected to market conditions and government policies. In
practice, fixed costs fluctuate. Accordingly, the relationships are not strictly linear. CVP assumes
that factors such as worker efficiency are not over the range of activity analyzed. Businesses
frequently are able to increase productivity, thereby reducing variable or fixed costs, but CVP
formulas are not constructed to allow for such changes in efficiency.
The other important issue is the analytical technique that says the level of inventory does not
change during the period. In other words, sales and production are assumed to be equal. CVP
formulas are used to provide the estimated number of units that must be produced and sold to
attain breakeven status or to achieve some designated target profit. Producing or acquiring
inventory that is not sold generates costs with out producing corresponding revenue. This
condition undoubtedly affects the CVP relationship
The following are limitations of CVP analysis:
1. CVP analysis requires estimations or projections of expected sales, fixed costs, variable
costs, and any other cost that portrays both fixed and variable components.
2. CVP analysis is useful only over a limited range of activity extending not too far what a
form expects to operate within. Moving much beyond that range will require additional
capital expenditure for more floor space, more plant assets, more personnel, and the like
which will distort the estimates of fixed and variable costs.
3. It is generally accepted in basic financial theory that the appropriate way to make
investment decisions is to consider the “discounted value of the cash flows” of a proposed
project. Such an analysis focuses on the time value money to better describe the true value
of an investment. CVP does not focus on the time value of money.
4. CVP analysis assumes that the cost-revenue relationship is linear. This may or may not
hold good for any particular business. For example, many businesses experience a
reduction in fixed costs and variable costs per unit as the overall scale of the business
 increases. This refers to as the “economies of scale”. Most very small businesses do not
experience significant economies of scale.
1.9. Benefits of CVP Analysis
A manager, who exercises good judgment, will certainly find the data generated by CVP analysis
to be useful tool regardless of its limitations. In general, despite its shortcomings, CVP analysis is
a very useful tool with which to approach a variety of decisions situations. Such questions as the
cost of expansion, evaluation of sales or profit performance, estimation of the impact of changes
in CVP variables on profit, setting selling prices and financial analysis in general are
appropriately addresses using CVP analysis. CVP analysis is best used in conjunction with other
financial analysis technique or as a screening device to determine whether more investigation is
needed.

1. Margin of safety approach considers all CVP variables in the analysis of profit.
2. Breakeven point in revenue is computed by dividing total fixed costs by contribution margin
percentage
3. An increase in the income tax rate decreases the breakeven point
4. Margin of safety is the true measure of risk when loses are incurred
5. From the following one is NOT correct about break even analysis?
A. Contribution margin must equal fixed cost
B. Break even revenue equals to the sum of contribution margin and variable costs
C. Contribution margin must equal to variable costs
D. Companies should not incur loss and should not generate profit
6. Among the following CVP assumptions one is not correctly stated.
A. As activity changes the variable cost is varied per unit over the entire relevant range
B. As activity changes fixed costs are constant in total over the entire relevant range
C. As activity changes fixed costs are varied at per unit basis over the entire relevant range
D. As activity changes variable costs are varied in total over the entire relevant range
7. Investigation a variety of what-if questions regarding simultaneous changes in CVP variables
is referred to as ------------------.
A. Margin of safety C. Contribution margin
B. Sensitivity analysis D. Break even analysis
8. In the fiscal year just completed, ABC business center reported profit after tax of $24,000
from revenues of $300,000. The variable cost as percentage of revenue is 70% with the rate of
income tax 40%. What is the amount of fixed cost?
A. $30,000 B. $50,000 C. $66,000 D. $170,000
9. Based on the information given in question number 7 contribution margin equals to------
A. $90,000 B. $170,000 C. $66,000 D. $50,000

10.