Cost-Volume-Profit

Analysis
 Cost-Volume-Profit Assumptions
and Terminology
1. Changes in the level of revenues and
costs arise only because of changes in
the number of product (or service) units
produced and sold.

2. Total costs can be divided into a fixed

component and a component that is
variable with respect to the level of
output.
 Cost-Volume-Profit Assumptions
and Terminology

3. When graphed, the behavior of total

revenues and total costs is linear
(straight-line) in relation to output units
within the relevant range (and time
period).

4. The unit selling price, unit variable

costs, and fixed costs are known and
constant.
 Cost-Volume-Profit Assumptions
and Terminology

5. The analysis either covers a single

product or assumes that the sales mix
when multiple products are sold will
remain constant as the level of total
units sold changes.

6. All revenues and costs can be added

and compared without taking into
account the time value of money.
 Cost-Volume-Profit Assumptions
and Terminology
Operating income =
Total revenues from operations
– Cost of goods sold and operating costs
(excluding income taxes)

Net income = Operating income – Income taxes

 Essentials of Cost-Volume-Profit
(CVP) Analysis Example

Assume that the Pants Shop can purchase pants

for $32 from a local factory; other variable costs
amount to $10 per unit.

The local factory allows the Pants Shop to

return all unsold pants and receive a full $32
refund per pair of pants within one year.

The average selling price per pair of pants is $70

and total fixed costs amount to $84,000.
 Essentials of Cost-Volume-Profit
(CVP) Analysis Example
How much revenue will the business
receive if 2,500 units are sold?
2,500 × $70 = $175,000
How much variable costs will the
business incur?

2,500 × $42 = $105,000

$175,000 – 105,000 – 84,000 = ($14,000)

 Essentials of Cost-Volume-Profit
(CVP) Analysis Example

What is the Contribution Margin per unit?

$70 – $42 = $28 Contribution Margin per unit

What is the total Contribution Margin

when 2,500 pairs of pants are sold?

2,500 × $28 = $70,000

Essentials of Cost-Volume-Profit
(CVP) Analysis Example

Contribution margin percentage

(contribution margin ratio) is the
contribution margin per unit divided
by the selling price.
What is the contribution margin percentage?

$28 ÷ $70 = 40%

 Essentials of Cost-Volume-Profit
(CVP) Analysis Example

If the business sells 3,000 pairs of pants,

revenues will be $210,000 and
contribution margin would equal 40% ×
$210,000 = $84,000.

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 Breakeven Point

Variable Fixed
Sales – expenses = expenses

Total revenues = Total costs

 Abbreviations

SP = Selling Price
VCU = Variable Cost per unit
CMU = Contribution Margin per unit
CM% = Contribution Margin percentage
FC = Fixed costs
 Abbreviations

Q = Quantity of output units sold

(and manufactured)
OI = Operating Income
TOI = Target Operating Income
TNI = Target Net Income
 Equation Method
(Selling Price × Quantity sold) – (Variable
unit cost × Quantity sold) – Fixed Costs =
Operating Income

Let Q = number of units to be sold to Break

Even
$70Q – $42Q – $84,000 = 0
$28Q = $84,000
Q = $84,000 ÷ $28 = 3,000 units
Contribution Margin Method

$84,000 ÷ $28 = 3,000 units

$84,000 ÷ 40% = $210,000

 Graph Method
Breakeven
378
336
294
252
$(000)

210
168
126 Fixed costs
84
42
0
0 1000 2000 3000 4000 5000
Units
Target Operating Income

(Fixed costs + Target operating

income) divided either by
Contribution margin percentage or
Contribution margin per unit
 Target Operating Income
Assume that management wants to have an
operating income of $14,000.
How many pairs of pants must be sold?
($84,000 + $14,000) ÷ $28 = 3,500
What dollar sales are needed to achieve
this income?
($84,000 + $14,000) ÷ 40% = $245,000
 Target Net Income
and Income Taxes Example

Management would like to earn

an after tax income of $35,711.
The tax rate is 30%.
What is the Target Operating Income?
Target Operating Income
= Target net income ÷ (1 – tax rate)
TOI = $35,711 ÷ (1 – 0.30) = $51,016
 Target Net Income
and Income Taxes Example

How many units must be sold?

Revenues – Variable Costs – Fixed Costs
= Target Net Income ÷ (1 – Tax Rate)
$70Q – $42Q – $84,000 = $35,711 ÷ 0.70
$28Q = $51,016 + $84,000
Q = $135,016 ÷ $28 = 4,822 pairs of pants
 Target Net Income
and Income Taxes Example

Proof:
Revenues: 4,822 × $70 $337,540
Variable costs: 4,822 × $42 202,524
Contribution margin $135,016
Fixed costs 84,000
Operating income 51,016
Income taxes: $51,016 × 30% 15,305
Net income $ 35,711
 Using CVP Analysis Example

Suppose the management anticipates

selling 3,200 pairs of pants.
Management is considering an advertising
campaign that would cost $10,000.
It is anticipated that the advertising will
increase sales to 4,000 units.
Should the business advertise?
 Using CVP Analysis Example

3,200 pairs of pants sold with no advertising:

Contribution margin $89,600

Fixed costs 84,000
Operating income $ 5,600

4,000 pairs of pants sold with advertising:

Contribution margin $112,000

Fixed costs 94,000
Operating income $ 18,000
 Using CVP Analysis Example

Instead of advertising, management is

considering reducing the selling price
to $61 per pair of pants.
It is anticipated that this will increase
sales to 4,500 units.
Should management decrease the selling
price per pair of pants to $61?
 Using CVP Analysis Example

3,200 pairs of pants sold with no change

in the selling price:

Operating income = $5,600

4,500 pairs of pants sold at a reduced
selling price:
Contribution margin: (4,500 × $19) $85,500
Fixed costs 84,000
Operating income $ 1,500
 Sensitivity Analysis and
Uncertainty Example

Assume that the Pants Shop can sell 4,000

pairs of pants.
Fixed costs are $84,000.
Contribution margin ratio is 40%.
At the present time the business cannot
handle more than 3,500 pairs of pants.
 Sensitivity Analysis and
Uncertainty Example
To satisfy a demand for 4,000 pairs,
management must acquire additional
space for $6,000.
Should the additional space be acquired?
Revenues at breakeven with existing
space are $84,000 ÷ .40 = $210,000.
Revenues at breakeven with additional
space are $90,000 ÷ .40 = $225,000
 Sensitivity Analysis and
Uncertainty Example

Operating income at $245,000 revenues with

existing space = ($245,000 × .40)
– $84,000 = $14,000.

(3,500 pairs of pants × $28) – $84,000 = $14,000

 Sensitivity Analysis and
Uncertainty Example

Operating income at $280,000 revenues with

additional space = ($280,000 × .40) – $90,000 =
$22,000.

(4,000 pairs of pants × $28 contribution

margin) – $90,000 = $22,000
 Alternative Fixed/Variable
Cost Structures Example
Suppose that the factory the Pants Shop is
using to obtain the merchandise offers the
following:

Decrease the price they charge from $32

to $25 and charge an annual
administrative fee of $30,000.
What is the new contribution margin?
 Alternative Fixed/Variable
Cost Structures Example
$70 – ($25 + $10) = $35
Contribution margin increases from $28
to $35.
What is the contribution margin
percentage?
$35 ÷ $70 = 50%
What are the new fixed costs?
$84,000 + $30,000 = $114,000
 Alternative Fixed/Variable
Cost Structures Example

Management questions what sales volume

would yield an identical operating income
regardless of the arrangement.
28x – 84,000 = 35x – 114,000
114,000 – 84,000 = 35x – 28x
7x = 30,000
x = 4,286 pairs of pants
 Alternative Fixed/Variable
Cost Structures Example

Cost with existing arrangement

= Cost with new arrangement
.60x + 84,000 = .50x + 114,000
.10x = $30,000  x = $300,000
($300,000 × .40) – $ 84,000 = $36,000
($300,000 × .50) – $114,000 = $36,000
 Operating Leverage
Operating leverage describes the
effects that fixed costs have on
changes in operating income as
changes occur in units sold.
Organizations with a high proportion
of fixed costs have high operating
leverage.
 Operating Leverage Example

Degree of operating leverage

= Contribution margin ÷ Operating income
What is the degree of operating leverage
of the Pants Shop at the 3,500 sales level
under both arrangements?
Existing arrangement:
3,500 × $28 = $98,000 contribution margin
 Operating Leverage Example

$98,000 contribution margin – $84,000 fixed

costs = $14,000 operating income
$98,000 ÷ $14,000 = 7.0
New arrangement:
3,500 × $35 = $122,500 contribution margin
Operating Leverage Example

$122,500 contribution margin

– $114,000 fixed costs = $8,500
$122,500 ÷ $8,500 = 14.4
The degree of operating leverage at a
given level of sales helps managers
calculate the effect of fluctuations in
sales on operating income.
Effects of Sales Mix on Income

Pants Shop Example

Management expects to sell 2 shirts at
$20 each for every pair of pants it sells.
This will not require any additional fixed
costs.
Effects of Sales Mix on Income

Contribution margin per shirt:

$20 – $9 = $11
What is the contribution margin of the
mix?
$28 + (2 × $11) = $28 + $22 = $50
 Effects of Sales Mix on Income

$84,000 fixed costs ÷ $50 = 1,680 packages

1,680 × 2 = 3,360 shirts
1,680 × 1 = 1,680 pairs of pants
Total units = 5,040
 Effects of Sales Mix on Income

What is the breakeven in dollars?

3,360 shirts × $20 = $ 67,200
1,680 pairs of pants × $70 = 117,600
$184,800
Effects of Sales Mix on Income

What is the weighted-average budgeted

contribution margin?
Pants: 1 × $28 + Shirts: 2 × $11
= $50 ÷ 3 = $16.667
 Effects of Sales Mix on Income

The breakeven point for the two products is:

$84,000 ÷ $16.667 = 5,040 units
5,040 × 1/3 = 1,680 pairs of pants
5,040 × 2/3 = 3,360 shirts
 Effects of Sales Mix on Income

Sales mix can be stated in sales dollars:

Pants Shirts
Sales price $70 $40
Variable costs 42 18
Contribution margin $28 $22
Contribution margin ratio 40% 55%
Effects of Sales Mix on Income

Assume the sales mix in dollars

is 63.6% pants and 36.4% shirts.
Weighted contribution would be:
40% × 63.6% = 25.44% pants
55% × 36.4% = 20.02% shirts
45.46%
 Effects of Sales Mix on Income

Breakeven sales dollars is

$84,000 ÷ 45.46% = $184,778 (rounding).
$184,778 × 63.6% = $117,519 pants sales
$184,778 × 36.4% = $ 67,259 shirt sales
Multiple Cost Drivers Example

Suppose that the business will incur an

additional cost of $10 for preparing
documents associated with the sale of
pants to various customers.

Assume that the business sells 3,500

pants to 100 different customers.
What is the operating income from this
sale?
 Multiple Cost Drivers Example

Revenues: 3,500 × $70 $245,000

Variable costs:
Pants: 3,500 × $42 147,000
Documents: 100 × $10 1,000
Total 148,000
Contribution margin 97,000
Fixed costs 84,000
Operating income $ 13,000
 Multiple Cost Drivers

Would the operating income of the Pants

Shop be lower or higher if the business
sells pants to more customers?
The cost structure depends on two cost
drivers:
1. Number of units
2. Number of customers
Contribution Margin versus
Gross Margin

Contribution income statement

emphasizes contribution margin.
Financial accounting income statement
emphasizes gross margin.