Cornerstones of Managerial

Accounting 2e

Chapter Four
Cost-Volume-Profit Analysis: A
Managerial Planning Tool
Mowen/Hansen

Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. 1

Thomson, the Star logo, and South-Western are trademarks used herein under
license.
 Cost-Volume-Profit Analysis

A powerful tool for planning and decision making. It

can be used to calculate:

The number of units The impact of an

that must be sold to increase in price on
break-even profit.

The impact of a given

reduction in fixed
costs on the break-
even point.

2
 Break-Even Point

Total Revenue = Total Cost

Or to put it another way:

Total Revenue
– Total Cost
Zero Profit

3
 Using Operating Income in
Cost-Volume-Profit Analysis

Contribution Margin
Variable = Contribution
Sales -
Expense Margin

Contribution Margin is then

used to cover Fixed Costs
and Operating Income.

4
 Contribution Margin Income
Statement

• Divides costs based on behavior

• Costs are divided into variable and fixed
components
• Important subtotal is contribution margin
◦ Sales revenue minus variable expenses

5
 Contribution Margin

- Variable = Contribution
Sales
Expense Margin

Contribution Fixed Operating

Margin - Costs = Income

Break-even point is when

Operating Income is zero.

6
 Units to Be Sold to Achieve a
Target Income

Two ways:
1. Using Operating Income equation
2. Using the Basic Break-even equation

Cornerstone 4-5 will walk us

through these computations

7
 Units to Be Sold to Achieve a
Target Income
Number of units
Fixed Cost + Target Income
to earn target =
income Price – Variable Cost per unit

Number of units
$45,000 + $37,500
to earn target =
income $400 - $325

Number of units
to earn target = 1,100
income

8
 Sales Revenue to Achieve a
Target Income
Sales dollars to
Fixed Cost + Target Income
earn target =
income Contribution margin ratio

Sales dollars to
earn target $45,000 + $37,500
=
income 0.1875

Sales dollars to
earn target = $440,000
income

9
 Profit-Volume Graph

• Visually portrays the relationship

between profits and units sold
• Operating Income is the dependent
variable
• Units sold is the independent variable

10
 Cost-Volume-Profit Graph
• Depicts the relationship among cost,
volume, and profits
• To obtain the more detailed relationships,
it is necessary to graph two separate lines:
◦ Total revenue
◦ Total cost
• The vertical axis is measured in dollars
• The horizontal axis is measured in units
sold

11
 Assumptions of Cost-Volume-
Profit Analysis
• Revenue and cost functions are linear
• Price, total fixed costs, and unit variable costs can
be identified and remain constant over relevant
range
• All units produced are sold-there are no change in
inventory levels
• Sales mix is constant
• Selling prices and costs are known with certainty

12
Linear Cost and Revenue Functions

Cost-Volume-Profit assumes that cost

and revenue functions are linear. In
other words they are straight lines.

13
 Production Equal to Sales

• Cost-Volume-Profit assumes that what is

produced is actually sold
• Inventory levels do not change over the
period
• CVP focuses on current costs by
excluding inventory costs of previous
periods

14
 Constant Sales Mix

Multiple product break-even analysis

requires a constant sales mix.
Relative combination of products
being sold by a firm

Sales mix is difficult to predict with

certainty

15
Certainty of Prices and Costs

In actuality, firms seldom know prices,

variable costs, and fixed costs with
certainty. There are formal ways of
explicitly building uncertainty into the
Cost-Volume-Profit model.

16
 Multiple-Product Analysis

Cost-Volume-Profit analysis becomes

more complex with multiple products.

We need to adapt the single-product

formulas.

17
 Direct Fixed Expenses

Those fixed costs that can be traced to

each segment and would be avoided if the
segment did not exist.

18
 Common Fixed Expenses

The fixed costs that are not traceable to

the segments and would remain even if
one of the segments was eliminated.

19
 Multiple-Product Analysis

Break-even point in units

Key is to identify the expected sales mix.

Sales mix is the relative combination of

products being sold by a firm.

20
 Sales Mix

• Measured in units sold

• Reduced to the smallest possible whole
numbers
• Required in order to determine break
even point in units

21
CVP Analysis: Risk and Uncertainty

• The break-even point can be affected

by changes in:
◦ Price
◦ Unit contribution margin
◦ Fixed cost

Changes in any of the above will

affect the sales mix.

22
Risk and Uncertainty Effects on Managers

• Management must realize the uncertain

nature of future prices, costs, and
quantities.
• Managers move from consideration of a
break-even point to what might be called
a “break-even band”.
• Managers may engage in sensitivity or
what-if analysis.

23
 Margin of Safety

• The units sold or the revenue earned

above the break-even volume.
• Can be viewed as a crude measure of
risk.
◦ When there is a downturn in sales, the risk of
suffering losses will be less if the firm’s
margin of safety is large than if the margin of
safety is small.

24
 Margin of Safety

Margin of Safety Sales in Break-even

in units = -
units units

Margin of Safety
= 1,000 - 600
in units

Margin of Safety
in units = 400

25
 Margin of Safety

Margin of Safety Break-even

= Sales -
in sales revenue sales

Margin of Safety
= $400(1,000) - $400(600)
in sales revenue

Margin of Safety
in sales revenue = $160,000

26
 Operating Leverage
• The relative mix of fixed costs to variable costs
in a company
• Higher proportions of fixed costs to the amount
of variable costs create higher operating
leverage
• The greater the degree of operating leverage,
the larger the effect on operating income when
sales change

Degree of Contribution Margin

=
Operating Leverage Operating Income

27
 Operating Leverage
The degree of operating leverage (DOL) can be
measured for a given level of sales.

Degree of
operating Contribution Margin
=
leverage Operating Income

Degree of
($400 – $325)(1,000 units)
operating =
leverage $30,000

Degree of
operating = 2.5
leverage
28
 Percentage Change in Operating
Leverage

% change in operating
leverage = DOL x % change in sales

% change in operating
leverage = 2.5 x 20%

% change in operating
leverage = 50%

29
 Expected Operating Income

Expected Original
Operating = operating + (% change x Orig. operating income)
Income income

Expected
Operating = $30,000 + (0.50 x $30,000)
Income

Expected
Operating = $45,000
Income

30