Cost-Volume-Profit Analysis: Mcgraw-Hill/Irwin

Chapter
20
COST-VOLUME-
PROFIT ANALYSIS
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Cost-Volume-Profit
Cost-Volume-Profit Relationships
Relationships
Cost-volume-profit (CVP) analysis is used to

answer questions such as:
How
 How much
much must
must II sell
sell to
to earn
earn my
my desired
desired
income?
income?
How
 How will will income
income bebe affected
affected
ifif II reduce
reduce selling
selling prices
prices to
to
increase
increase sales sales volume?
volume?
What
 What will will happen
happen to to
profitability
profitability ifif II expand
expand
capacity?
capacity?

Learning
Learning Objective
Objective
To explain how fixed,

variable, and semivariable
costs respond to
changes in the volume
of business activity.
LO1
Fixed
Fixed Costs
Costs
Total fixed costs remain unchanged
when activity changes.
Telephone Bill
Monthly Basic
Your monthly basic

telephone bill probably
does not change when
Number of Local Calls you make more local calls.

Fixed
Fixed Costs
Costs
Fixed costs per unit decline as activity increases.
Monthly Basic Telephone

Bill per Local Call
Your average cost per
local call decreases as
more local calls are made.
Number of Local Calls

Variable
Variable Costs
Costs
Total variable costs change when activity
changes.
Total Long Distance
Telephone Bill
Your total long distance

telephone bill is based
on how many minutes
Minutes Talked you talk.

Variable
Variable Costs
Costs
Variable costs per unit do not change

as activity increases.
Telephone Charge
The cost per long distance Per Minute
minute talked is constant.
For example, 10
cents per minute. Minutes Talked
Semivariable
Semivariable Costs
Costs (Mixed
(Mixed Costs)
Costs)
Mixed costs contain a fixed portion that is

incurred even when facility is unused, and a
variable portion that increases with usage.
Example: monthly electric utility charge

 Fixed service fee
 Variable charge per
kilowatt hour used

Semivariable
Semivariable Costs
Costs (Mixed
(Mixed Costs)
Costs)
Slope is
variable cost
per unit
of activity.
Total Utility Cost
ost
d c Variable
i xe
l m
ta Utility Charge
To
Fixed Monthly
Utility Charge
Activity (Kilowatt Hours)
Cost
Cost Behavior
Behavior Summary
Summary
Summary of Variable and Fixed Cost Behavior

Variable Costs Fixed costs
Remains the same even Dereases as activity level

Per Unit
when activity level changes. increases.
Changes as activity level Remains the same over wide
Total
changes. ranges of activity.

Learning
Learning Objective
Objective
To explain how economies of

scale can reduce unit costs.
LO2
Economies
Economies of
of Scale
Scale
Recall
Recall our
our earlier
earlier telephone
telephone example.
example.
Monthly Basic Telephone

Bill per Local Call
Fixed
Fixed costs
costs per
per unit
unit
decline
decline as
as activity
activity
increases.
increases.
Number of Local Calls
Economies
Economies of
of Scale
Scale
Economies
Economies ofof scale
scale are
are most
most apparent
apparent
in
in business
business with
with high
high fixed
fixed costs.
costs.
Utility Steel
Companies Mills
Oil
Refineries Airlines
Economies
Economies of
of Scale
Scale
Economies
Economies ofof scale
scale are
are most
most apparent
apparent
in
in business
business with
with high
high fixed
fixed costs.
costs.
Number
Fixed Costs of Flights Fixed Cost
per Month per Month per Flight
$ 100,000,000 1,000 $ 100,000
$ 100,000,000 2,000 $ 50,000
$ 100,000,000 4,000 $ 25,000
$ 100,000,000 8,000 $ 12,500
Airlines
Airlines
Stair-Step
Stair-Step Costs
Costs
Total cost remains

constant within a
narrow range of
activity.
Cost
Activity

Stair-Step
Stair-Step Costs
Costs
Total cost increases to a
new higher cost for the
next higher range of
activity.
Cost
Activity

Curvilinear
Curvilinear Costs
Costs
Curvilinear
Cost Function
Total Cost
A straight line
closely (constant
unit variable cost)
approximates a
curvilinear variable
Relevant Range
cost line within
the relevant range.
Volume of Output
Learning
Learning Objective
Objective
To prepare a
cost-volume-profit
graph.
LO3
Preparing
Preparing aa CVP
CVP Graph
Graph
 Starting at the origin, draw the total revenue
line with a slope equal to the unit sales price. Revenue
Costs and Revenue
in Dollars
 Total fixed cost

extends horizontally
from the vertical axis.
Total fixed cost

Volume in Units
Preparing
Preparing aa CVP
CVP Graph
Graph
Revenue
 Draw the total cost line with a slope
equal to the unit variable cost.
Costs and Revenue
Break-even
Profit
Point
in Dollars
Total cost
Loss
Total fixed cost
Volume in Units
Learning
Learning Objective
Objective
To compute the contribution

margin and explain
its usefulness.
LO4
Computing
Computing Break-Even
Break-Even Point
Point
The break-even point (expressed in units
of product or dollars of sales) is the
unique sales level at which a company
neither earns a profit nor incurs a loss.

Computing
Break-Even Point
Point
Total Unit
Sales Revenue (2,000 units) $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Operating income $ 10,000
How
How
How
How much
How
many
much
many
How much contribution
many
units
units
Contribution
How much mustmargin
units
must
contribution
Contribution margin
contribution
margin
contribution is
ismust
this
margin must
amount
this
margin
amount
margin bythis
this
company
must
by
company
must
mustthis company
company
whichsell
company
this
which
this to
revenue
sell have
to cover
have
cover
company
revenue
company
exceeds
exceedsto
haveto
have cover
cover
theto
its
theto its
variable
cover
fixed
variable
cover fixed
its its
fixed
costs
costsfixed
costs
its fixedcosts
costs
of (break
(break
producing
costs
(break
of (breakeven)?
even)?
even)?
producing
costs (break the revenue.
even)?
the revenue.
even)?
its fixed costs (break
sell to cover its fixed costs even)?
Answer: $30,000
Answer:even)?
$30,000
Answer: (break
Answer: $30,000 ÷ $20 per unit
$30,000 ÷ $20 per unit == 1,500
1,500 units
units
Formula
Formula for
for Computing
Computing
Break-Even
Finding Sales
Sales (in
(in Units)
the Break-Even
Break-Even Point
Units)
We have just seen one of the basic CVP

relationships – the break-even computation.
Fixed costs
Break-even point in units =
Contribution margin per unit
Unit sales price less unit variable cost

($20 in previous example)

Formula
Formula for
for Computing
Computing
Break-Even
Break-Even Sales
Sales (in
(in Dollars)
Dollars)
The break-even formula may also be

expressed in sales dollars.
Fixed costs
Break-even point in dollars =
Contribution margin ratio
Unit sales price

Unit variable cost
Computing
Break-Even Sales
Sales
ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf
fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs are
are
$3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must be
be sold
sold to
to
break
break even?
even?
a.
a. 100,000
100,000 units
units
b.
b. 40,000
40,000 units
units
c.
c. 200,000
200,000 units
units
d.
d. 66,667
66,667 units
units

Computing
Break-Even Sales
Sales
ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf
fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs are
are
$3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must be
be sold
sold to
to
break
break even?
even?
a.
a. 100,000
100,000 units
units
b.
b. 40,000
40,000 units
units
Unit contribution = $5.00 - $3.00 = $2.00
c.
c. 200,000
200,000 units
units
d. 66,667 unitsFixed costs $200,000
d. 66,667 units = $2.00 per unit
Unit contribution
= 100,000 units
Computing
Break-Even Sales
Sales
Use
Use the
the contribution
contribution margin
margin ratio
ratio formula
formula to
to
determine
determine the
the amount
amount ofof sales
sales revenue
revenue ABC
ABC must
must
have
have to
to break
break even.
even. All
All information
information remains
remains
unchanged:
unchanged: fixed
fixed costs
costs are
are $200,000;
$200,000; unit
unit sales
sales
price
price is
is $5.00;
$5.00; and
and unit
unit variable
variable cost
cost is
is $3.00.
$3.00.
a.
a. $200,000
$200,000
b.
b. $300,000
$300,000
c.
c. $400,000
$400,000
d.
d. $500,000
$500,000
Computing
Break-Even Sales
Sales
Use
Use the
the contribution
contribution margin
margin ratio
ratio formula
formula to
to
determine
determine the
the amount
amount ofof sales
sales revenue
revenue ABC
ABC must
must
have
have to
to break
break even.
even. All
All information
information remains
remains
unchanged:
unchanged: fixed
fixed costs
costs are
are $200,000;
$200,000; unit
unit sales
sales
price
price is
is $5.00;
$5.00; and
and unit
unit variable
variable cost
cost is
is $3.00.
$3.00.
a.
a. $200,000
$200,000
Contribution margin ratio = $2.00 ÷ $5.00 = .40
b.
b. $300,000
$300,000
Break-even revenue = $200,000 ÷ .4 = $500,000
c.
c. $400,000
$400,000
d.
d. $500,000
$500,000
Learning
Learning Objective
Objective
Determine the sales volume

required to earn a desired
level of operating income.
LO5
Computing
Computing Sales
Sales Needed
Needed toto
Achieve
Achieve Target
Target Operating
Operating Income
Income
Break-even formulas may be adjusted to

show the sales volume needed to earn
any amount of operating income.
Fixed costs + Target income

Unit sales =
Contribution margin per unit

Dollar sales =
Contribution margin ratio

Computing
Computing Sales
Sales Needed
Needed toto
Achieve
Achieve Target
Target Operating
Operating Income
Income
ABC
ABC Co. Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit.
IfIf fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs
are
are $3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must be
be
sold
sold to to earn
earn operating
operating income
income ofof $40,000?
$40,000?
a.
a. 100,000
100,000 units
units
b.
b. 120,000
120,000 units
units
c.
c. 80,000
80,000 units
units
d.
d. 200,000
200,000 units
units

Computing
Computing Sales
Sales Needed
Needed toto
Achieve
Achieve Target
Target Operating
Operating Income
Income
ABC
ABC Co. Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit.
IfIf fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs
are
are $3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must be
be
sold
sold to to earn
earn operating
operating income
income ofof $40,000?
$40,000?

a.
a. 100,000 units
100,000 units
b.
b. 120,000 units
120,000 units Unit contribution
c.
c. 80,000
80,000 units
units
$200,000 + $40,000
= 120,000 units
d.
d. 200,000 units
200,000 units $2.00 per unit

What
What is
is our
our Margin
Margin of
of Safety?
Safety?
Margin of safety is the amount by which sales may
decline before reaching break-even sales:
Margin of safety = Actual sales - Break-even sales
Margin of safety provides a quick means of

estimating operating income at any level of sales:
Operating Margin Contribution

Income = of safety × margin ratio

What
What is
is our
our Margin
Margin of
of Safety?
Safety?
ADM contribution margin ratio is 40 percent.

If sales are $100,000 and break-even sales
are $80,000, what is operating income?
Operating Margin Contribution

Income = of safety × margin ratio
Operating
Income = $20,000 × .40 = $8,000

Learning
Learning Objective
Objective
To use the contribution

margin to estimate the
change in operating
income caused by a
change in sales volume.
LO6
What
What Change
Change in
in Operating
Operating Income
Income
Do
Do We
We Anticipate?
Anticipate?
Once break-even is reached, every additional dollar
of contribution margin becomes operating income:
Change in Change in Contribution
operating income = sales volume × margin ratio
ADM expects sales to increase by $15,000 and has a

contribution margin ratio of 40%. How much will
operating income increase?
Change in
operating income = $15,000 × .40 = $6,000

Learning
Learning Objective
Objective
To use CVP relationships

to evaluate a new
marketing strategy.
LO7
Business
Business Applications
Applications of
of CVP
CVP
Consider the following information
developed by the accountant at Speedo, a
bicycle retailer:
Total Per Unit Percent

Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000

Business
Applications of
of CVP
CVP
Should Speedo spend $12,000 on

advertising to increase sales by 10 percent?
Total Per Unit Percent

Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%

Business
Applications of
of CVP
CVP
Should Speedo spend $12,000 on

advertising to increase sales by 10 percent?
500 550
550 × $500
Bikes Bikes
Sales $ 250,000 $ 275,000
Less: variable expenses 150,000 550 × $300 165,000
Contribution margin $ 100,000 $ 110,000
Less: fixed expenses 80,000 92,000
Operating income $ 20,000 $80K + $12K $ 18,000
No, income is decreased.

Business
Applications of
of CVP
CVP
Now, in combination with the advertising,
Speedo is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?
500
Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin $ 100,000

Business
Applications of
of CVP
CVP
Now, in combination with the advertising,
Speedo is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?
500 1.25 × 500 625
Bikes Bikes
Sales $ 250,000 625 × $450 $ 281,250
Less: variable expenses 150,000 187,500
Contribution margin $ 100,000 625 × $300 $ 93,750
Operating income $ 20,000 $80K + $12K $ 1,750
Income is decreased even more.

Business
Applications of
of CVP
CVP
Now, in combination with advertising and a price cut, Speedo
will replace $50,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?
500
Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin $ 100,000

Business
Applications of
of CVP
CVP
Now, in combination with advertising and a price cut, Speedo
will replace $50,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?
500 1.5 × 500 750
Bikes Bikes
Sales $ 250,000 750 × $450 $ 337,500
Less: variable expenses 150,000 243,750
Contribution margin $ 100,000 750 × $325 $ 93,750
Operating income $ 20,000 $92K - $50K $ 51,750
The combination of advertising, a price cut,

and change in compensation increases income.
Additional
Additional Considerations
Considerations in
in CVP
CVP
 Different products with

different contribution margins.
 Determining semivariable
cost elements.
 Complying with the

assumptions of CVP analysis.
Learning
Learning Objective
Objective
To use CVP when

a company sells
multiple products.
LO8
CVP
CVP Analysis
Analysis When
When aa Company
Company
Sells
Sells Many
Many Products
Products
Sales mix is the relative combination in which

a company’s different products are sold.
Different products have different selling
prices, costs, and contribution margins.
If Speedo sells bikes and carts, how
will we deal with break-even analysis?

CVP
CVP Analysis
Analysis When
When aa Company
Company
Sells
Sells Many
Many Products
Products
Speedo provides us with the following

information:
Bikes Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% $ 265,000 48%
Fixed exp. 170,000
Net income $ 95,000

CVP
CVP Analysis
Analysis When
When aa Company
Company
Sells
Sells Many
Many Products
Products
The overall contribution margin ratio is:
Bikes Carts Total

Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% $ 265,000 48%
Fixed exp. 170,000
Net income $ 95,000
$265,000
= 48% (rounded)
$550,000

CVP
CVP Analysis
Analysis When
When aa Company
Company
Sells
Sells Many
Many Products
Products
Break-even in sales dollars is:

Bikes Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% $ 265,000 48%
Fixed exp. 170,000
$170,000
= $354,167 (rounded)
.48

Learning
Learning Objective
Objective
To determine semivariable
cost elements.
LO9
The
The High-Low
High-Low Method
Method
Matrix, Inc. recorded the following production activity and
maintenance costs for two months:
Units Cost
High activity level 9,000 $ 9,700
Low activity level 5,000 6,100
Change 4,000 $ 3,600
Using these two levels of activity, compute:
 the variable cost per unit.
 the total fixed cost.
 total cost formula.

The
The High-Low
High-Low Method
Method
Units Cost
Change 4,000 $ 3,600
in cost $3,600

 Unit variable cost = in units = 4,000 = $0.90 per unit

The
The High-Low
High-Low Method
Method
Units Cost
Change 4,000 $ 3,600
in cost $3,600

 Fixed cost = Total cost – Total variable cost

The
The High-Low
High-Low Method
Method
Units Cost
Change 4,000 $ 3,600
in cost $3,600

Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600

The
The High-Low
High-Low Method
Method
Units Cost
Change 4,000 $ 3,600
in cost $3,600

Fixed cost = $9,700 – ($0.90 per unit × 9,000 units)
Fixed cost = $9,700 – $8,100 = $1,600
 Total cost = $1,600 + $.90 per unit
The
The High-Low
High-Low Method
Method
IfIf sales
sales commissions
commissions are are $10,000 when 80,000
units
units are
are sold and $14,000 when 120,000 units
are
are sold,
sold, what is the
the variable
variable portion
portion of
of sales
sales
commission
commission per per unit
unit sold?
sold?
a.
a. $.08
$.08 per
per unit
unit
b.
b. $.10
$.10 per
per unit
unit
c.
c. $.12
$.12 per
per unit
unit
d.
d. $.125
$.125 per
per unit
unit
The
The High-Low
High-Low Method
Method
IfIf sales
sales commissions
commissions are are $10,000 when 80,000
units
units are
are sold and $14,000 when 120,000 units
are
are sold,
sold, what is the
the variable
variable portion
portion of
of sales
sales
commission
commission per per unit
unit sold?
sold?
Units Cost
a.
a. $.08
$.08 per
per unit
unit High level 120,000 $ 14,000
Low level 80,000 10,000
b.
b. $.10
$.10 per
per unit
unit Change 40,000 $ 4,000
c.
c. $.12
$.12 per
per unit
unit
$4,000 ÷ 40,000 units
d.
d. $.125
$.125 per
per unit
unit = $.10 per unit
The
The High-Low
High-Low Method
Method
If sales commissions are $10,000 when

80,000 units are sold and $14,000 when
120,000 units are sold, what is the fixed
portion of the sales commission?
a. $ 2,000
b. $ 4,000
c. $10,000
d. $12,000
The
The High-Low
High-Low Method
Method
If sales commissions are $10,000 when

80,000 units are sold and $14,000 when
120,000 units are sold, what is the fixed
portion of the sales commission?
Total cost = Total fixed cost +
Total variable cost
a. $ 2,000 $14,000 = Total fixed cost +
b. $ 4,000 ($.10 × 120,000 units)
Total fixed cost = $14,000 - $12,000
c. $10,000 Total fixed cost = $2,000
d. $12,000
Assumptions
Assumptions Underlying
Underlying
CVP
CVP Analysis
Analysis
 A limited range of activity, called the relevant

range, where CVP relationships are linear.
 Unit selling price remains constant.
 Unit variable costs remain constant.
 Total fixed costs remain constant.
 Sales mix remains constant.
 Production = sales (no inventory changes).

Ethics,
Ethics, Fraud,
Fraud, and
and
Corporate
Corporate Governance
Governance
Some industries, such as the airline industry

are characterized by high fixed costs, namely
investments in equipment.
The Sarbanes-Oxley Act requires public companies

to disclose material changes in these fixed costs
within four business days after they occur.

End
End of
of Chapter
Chapter 20
20

Cost-Volume-Profit Analysis: Mcgraw-Hill/Irwin

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Chapter

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Cost-volume-profit (CVP) analysis is used to

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

To explain how fixed,

Your monthly basic

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Fixed costs per unit decline as activity increases.

Monthly Basic Telephone

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Your total long distance

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Variable costs per unit do not change

Mixed costs contain a fixed portion that is

Example: monthly electric utility charge

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Summary of Variable and Fixed Cost Behavior

Remains the same even Dereases as activity level

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

To explain how economies of

Monthly Basic Telephone

Total cost remains

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

 Total fixed cost

Total fixed cost

To compute the contribution

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

We have just seen one of the basic CVP

Unit sales price less unit variable cost

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

The break-even formula may also be

Unit sales price

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Determine the sales volume

Break-even formulas may be adjusted to

Fixed costs + Target income

Fixed costs + Target income

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Unit contribution = $5.00 - $3.00 = $2.00

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Margin of safety = Actual sales - Break-even sales

Margin of safety provides a quick means of

Operating Margin Contribution

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

ADM contribution margin ratio is 40 percent.

Operating Margin Contribution

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

To use the contribution

ADM expects sales to increase by $15,000 and has a

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

To use CVP relationships

Total Per Unit Percent

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Should Speedo spend $12,000 on

Total Per Unit Percent

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Should Speedo spend $12,000 on

No, income is decreased.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2008

Income is decreased even more.