Chapter Two

Multi-Product CVP Analysis

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Outline:

1. Apply CVP analysis form different prospective.

2. Identify the three ways to determine the break-even

point.

3. Define margin of safety, and give the formulas for

computing it.

4. Compute the degree of operating leverage at a

particular level of sales and explain how the degree
of operating leverage can be used to predict changes
in net operating income

5. Compute the break-even point for a multiple product

company.
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 2.1 Cost-Volume-Profit (CVP) Analysis
• CVP analysis is a technique used to analyze the relationships
between volume of output, total revenues, total costs, and
profits.

• The management of a company should answers the following

questions:

1. At what level of sales will the firm cover all costs and
expenses (BEP)?

2. If selling price is changed or if costs and expenses are

changed, what will be the effect on profits?

3. In order to earn a certain profit, how much sales will have to

be sold?
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Basic components of CVP analysis:

1. Volume or level of activity

2. Unit selling prices

3. Variable cost per unit

4. Total fixed cost

5. Sales mix

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 2.1.1 Assumptions of CVP Analysis

1. Behavior of both costs and revenues is linear.

2. All costs can be classified as either variable or fixed.

3. The number of units sold is the only revenue driver and

the only cost driver (selling price, variable cost per unit,
and total fixed costs are known and constant as volume
changes).

4. All units produced are sold.

5. When more than one type of product is sold, the sales

mix will remain constant.
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 2.1.2 Contribution Margin

Contribution margin = Total revenue – Total variable costs

• Contribution margin < Fixed costs = Loss

For example, MM Video produces a high-definition

digital camcorder with 15 optical zoom and a wide-
screen, high-resolution LCD monitor. Relevant data for
the camcorders sold by this company during the
month of May ,2020 are as follows.

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 …Cont

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 …Cont

 After the BEP, operating income can be estimated:

Operating income = Units sold over BEP X Unit contribution margin.

 Contribution margin per unit:

Unit contribution margin = Unit selling price – Unit variable cost

Contribution margin = Unit Contribution margin X units sold

Operating income = Contribution margin - Fixed Costs

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 …Cont

 Contribution margin percentage (Contribution margin ratio):

Contribution margin ratio = Unit Contribution margin/Unit selling price or

Contribution margin ratio =Total revenues/Total variable costs

Contribution margin percentage is the contribution

margin per dollar of revenue. MM Video earns 40% of
each dollar of revenue (equal to 40 cents).

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 2.1.3 CVP Relationships

• To make good decisions using CVP analysis, we must

understand the relationships among the variables.

• There are three related methods (Helps managers

visualize the relationship between units sold and
operating income):

1. The equation method

2. The contribution margin method

3. The graph method

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 1. The equation method

Operating income = Revenues - Variable costs - Fixed costs

To illustrate with MM Video example, the calculation

of operating income when MM Video sells 999
Camcorders is:

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 2. Contribution Margin Method

Rearranging equation 1,

Operating income = Revenues - Variable costs - Fixed

costs

In our MM Video example, contribution margin per

unit is $20 ($50 - $30), so when MM Video sales 999
Camcorders the operating income is:

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 3. The graph method

• Called a break-even chart

 Preparing a CVP graph involves three steps:

a. Total Fixed costs line

Draw a line parallel to the volume axis to represent total
fixed expenses.

b. Total costs line

c. Total revenues line

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 …Cont

For example, Cost of $2,000 is a fixed cost for ESS

because it will not change no matter how many units
ESS sells within the relevant range. The cost of the
unit itself is a variable cost because it increases in
proportion to the number of units sold. ESS will incur
a cost of $120 for each unit that he sells by $200.

Show graphically the relationships among revenue, cost,

profit, and volume.

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 …Cont
Solution:

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 2.1.4 Some Applications of CVP Concepts

To show the effects of changes:

Variable costs contribution margin

Fixed costs operating income
Selling price
Volume

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 …Cont

• For example: Jasmindeep, the accountant at MM

Video, wanted to demonstrate to the company’s
president, Rajeev, how the concepts of CVP can be
used in planning and decision making. Jasmindeep
gathered the following basic data:

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 …Cont

• Recall that fixed expenses are $20,000 per month.

Jasmindeep will use these data to show the effects of
changes in variable costs, fixed costs, sales price,
and sales volume on the company’s profitability. Based
on the following five cases, make the appropriate
decision.

1. Change in Fixed Cost and Sales Volume MM video is

currently selling 1,001 Camcorders per month (monthly
sales of $50,050). The sales manager feels that a
$10,000 increase in the monthly advertising budget
would increase monthly sales by 600 units to a total of
1,601 units. Should the advertising budget be
increased?
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 …Cont

2. Change in Variable Costs and Sales Volume Refer to

the original data. Recall that MM video is currently
selling 1,001 Camcorders per month. Management is
considering the use of higher-quality components,
which would increase variable costs by $10 per unit
However, the sales manager predicts that the higher
overall quality would increase sales by 200 units to a
total of 1,201 Camcorders per month. Should the
higher-quality components be used?

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 …Cont

3. Change in Fixed Cost, Sales Price, and Sales

Volume Refer to the original data and recall again that
the company is currently selling 1,001 units per
month. To increase sales, the sales manager would like
to cut the selling price by $4 per unit and increase the
advertising budget by $8,000 per month. The sales
manager believes that if these two steps are taken, unit
sales will increase by 50% to 2,002 Camcorders per
month. Should the changes be made?

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 …Cont

4. Change in Variable Cost, Fixed Cost, and Sales

Volume Refer to the original data. As before, the
company is currently selling 1,001 camcorders per
month. The sales manager would like to pay a sales
commission of $3 per unit sold, rather than the flat
salaries that now total $3,400 per month. The sales
manager is confident that the change will increase
monthly sales by 20% to 1,201 camcorders per
month. Should the change be made?

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 …Cont

5. Change in Regular Sales Price Refer to the original

data where MM Video is currently selling 1,001
camcorders per month. The company has an
opportunity to make a bulk sale of 200 camcorders
to a wholesaler if an acceptable price can be agreed
on. This sale would not disturb the company’s regular
sales and would not affect the company’s total fixed
expenses. What price per unit should be quoted to
the wholesaler if MM video wants to increase its
monthly profits by $1,000?

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 2.1.5 Break-Even Analysis

• CVP analysis is sometimes referred to simply as

break-even analysis because break-even analysis is
only one element of CVP analysis.

Total Revenue = Total Costs, Contribution margin =

Fixed Costs, Profit = 0

Break-even analysis is designed to answer questions

such as, how far could sales drop before the
company begins to lose money?

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 …Cont

• Expressed either in sales units or in sales dollars.

Methods of BEP computation:

1. Equation method

2. Contribution margin method and

3. Graph method

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 1. Equation method

• For example, Cost of $2,000 is a fixed cost for ESS

because it will not change no matter how many units
ESS sells within the relevant range. The cost of the
unit itself is a variable cost because it increases in
proportion to the number of units sold. ESS will incur
a cost of $120 for each unit that he sells by $200.
What is break-even point of ESS in units and
amounts?

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 2. Contribution margin method

• At the break-even point,

Contribution margin = Total fixed costs.

• The break-even point can be computed using either

contribution margin per unit or contribution
margin ratio. For example: Recall to the original data
of ESS.

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 …Cont
1. Based on contribution margin per unit:

Sales = Variable costs + Fixed Costs + Operating income

Breakeven revenues = Breakeven number of units x Selling price

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 …Cont

2. Based on contribution margin ratio:

Contribution margin = Total fixed costs.

Break-even units = Break-even revenues/Unit selling price

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 3. Graph method

• The point in which the interaction of total revenues

and total costs. For example, refer again the ESS
example, and show graphically the BEP.

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 2.1.6 Target Operating Income
• Level of sales necessary to achieve a specified income.

• Expressed either in sales units or in sales dollars.

Methods:

1. Equation method

2. Contribution margin method and

3. Graph method

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 1. Equation Method

Sales = Variable costs + Fixed Costs + Operating income

For example: recall the ESS company example, to earn

before tax profit of $1,200, how many units must
be sold?

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 2. Contribution margin method

• The target operating income can be computed using

either contribution margin per unit or contribution
margin ratio.
To illustrate, recall the ESS company example, to earn
before tax profit of $1,200, how many units must be
sold?

• Based on contribution margin per unit:

Sales = Variable costs + Fixed Costs + Operating income

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 …Cont

Based on contribution margin ratio:

To illustrate, recall the ESS company example, to earn

before tax profit of $1,200, how many units must
be sold?

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 3. Profit-Volume Graph (PV graph)

• A PV graph shows how changes in the quantity of

units sold affect operating income. Use the following
equation to proof the result and draw the graph:

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 …Cont

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 2.1.7 Target Net Income and Income Taxes

Net income = Operating income + non-operating revenues –

non-operating costs – income taxes

• The target net income units/sales can be computed by using

three methods:

1. Equation method

2. Contribution margin method and

3. Graph (Profit- Volume graph) method

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 1. Equation Method

Target net income = Operating income - Income taxes

For example, ESS may be interested in knowing the

quantity of units that must sell to earn a net income
of $720, assuming an income tax rate of 40%.

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 2. Contribution margin method

Sales = Variable costs + Fixed Costs + Operating income

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 3. Profit-Volume Graph (PV graph)

• A PV graph shows how changes in the quantity of

units sold affect net income. Use the following
equation to proof the result and draw the graph:

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 2.1.8 Sensitivity Analysis and Margin of
Safety
How sensitivity analysis helps managers cope with uncertainty?

Sensitivity analysis is a “what-if” technique that

managers use to examine how an outcome will
change if the original predicted data are not
achieved or if an underlying assumption changes,
The two common approaches of sensitivity analysis
regarding the uncertainty are:

1. Spreadsheets and

2. Margin of safety
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 1. Spreadsheets

• Electronic spreadsheets, such as Excel, enable

managers to conduct CVP-based sensitivity
analyses. Example consider ESS company.

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 2. Margin of Safety

• It states the amount by which sales can drop

before losses are incurred.

• It indicates that at the current level of sales and with

the company’s current prices and cost structure, a
reduction in sales by margin of safety, would
result in just breaking even.

• The margin of safety answers the “what-if” question:

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 …Cont
• Margin of safety can be expressed in amounts or as a
units or ratio.

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 …Cont

• For example: Recall the example of ESS has fixed

costs of $2,000, a selling price of $200, and variable
cost per unit of $120. If ESS sells 40 units, what is
the margin of safety in terms of amounts, units,
percentage, and interpret the result?

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 2.2 Operating leverage

• A measure of how sensitive net income is to

percentage changes in sales.

• Organizations with high operating leverage leads to a

greater risk of operating losses and income.

• The degree of operating leverage at a given level of

sales is computed by the following formula:

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 …Cont

• To illustrate, the degree of operating leverage for the

ESS at a $10,000 sales or 50 units level would be
computed as follows:

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 2.3 The Concept of Sales Mix

• The term sales mix refers to the relative proportions

in which a company’s products are sold.

or

• Sales mix is the quantities (or proportion) of various

products (or services) that constitute total unit sales of
a company.

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 …Cont

• Hence, profits will depend to some extent on the

company’s sales mix.

• Profits will be greater if high-margin rather than low-

margin items.

How do we compute the break-even point for a

multiple product company?

What is the effects of shifts in the sales mix on

contribution margin and the break-even point?

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 …Cont
• Example 1: MM Products markets two computer
games: X and Y. A contribution format income
statement for a recent month for the two games
appears below:

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 …Cont
Required:
1. Compute the overall contribution margin ratio (CMR)
for the company.
2. Compute the overall break-even point for the
company in sales dollars.
3. Verify the overall break-even point for the company
by constructing a contribution format income
statement showing the appropriate levels of sales
for the two products.
4. If the sales mix is reversed, what is the overall
contribution margin ratio, overall break-even point,
and verify the overall break-even for the two
products.

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 …Cont
• Example 2: Suppose MM producer plans to sell two
different products- D product and N product, and
budgets the following:

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 …Cont

Required: Using contribution margin per unit and

contribution margin ratio (CMR), compute the overall
break-even point for the company in sales amount
and units.

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 End of Chapter Two

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