Chapter 5

Cost-Volume-Profit (CVP)
Analysis
 Lecture outline
• Cost-Volume-Profit (CVP) relation
 main version: profit=f(sales volume in units)
 version 2: profit=f(sales revenue in $)
• Using CVP for short-term profit planning
• Predicting profit at different sales levels
• Breakeven analysis
• Target profit planning
• Pricing decisions
• Measures of operating risk
• Margin of safety
• Operating Leverage

2
 Why do we care?
• CVP is the main tool that managers use to evaluate short-
term decisions related to changes in sales.
• Managers need to make a lot of such decisions.

3
 Lead-in example: CVP analysis
You are planning to open a coffee shop in Center City.
You plan to charge $2.00 for a cup of coffee (ignore food and
fancy drinks for simplicity).
Your cost estimates are
• variable costs: $0.25 per cup (coffee beans, paper cups, etc)
• fixed costs: $17,500 per month
(rent $6,000, staff salaries $8,000, utilities $1,500, depreciation $2,000)

1) What is the profit (loss) if you sell 5,000 cups per month?
““ “” ““ 15,000 cups per month?
2) How many cups do you need to sell to break even (i.e., make
zero profit)?
3) How many cups do you need to sell to make a profit of $7,000
per month?

4
 Cost-Volume-Profit Relation (version 1)
We can compute profit as:

Profit = Revenue – total costs =

= Revenue – variable costs – fixed costs =
= Contribution margin – fixed costs =
= Unit contribution margin × sales volume – fixed
costs

Cost-Volume-Profit relation version 1:

Profit = unit CM × Volume – FC
where
unit CM (contribution margin per unit) = price – unit VC
(or = total CM / volume)
Volume = sales volume in units
5
FC = total fixed costs
 Cost-Volume-Profit relation (version 2)
Can also compute profit as a function of sales revenue in $
via contribution margin ratio (CMR) =
= CM / sales revenue

Cost-Volume-Profit relation version 2:

Profit = CMR × Revenue – FC
where
CMR = contribution margin ratio (contribution per $ of sales)
Revenue = sales revenue in $
FC = total fixed costs

6
 How do we use the CVP
analysis?
• Short-term profit planning:
• Predicting profit for different sales scenarios
• Breakeven analysis
• Target profit analysis
• Pricing decisions
• Evaluating short-term operating risk:
• Margin of safety
• Operating Leverage

7
 Predicting profit at different sales levels
Sales volume 100 units
Revenue $2,500
Variable costs $1,000
Contribution $1,500
margin
Fixed costs $1,200
Profit $300
1. Write down version 1 of the CVP relation.
Profit = _______ × Volume − ______
If sales volume increases to 125 units,
Profit =
2. Write down version 2 of the CVP relation.
Profit = _______ × Revenue − ______

If sales revenue increases to $3,000,

Profit =
8
 Breakeven Volume and Revenue
in Version 1 of CVP
• Breakeven volume = sales volume at which profit is
zero
to compute breakeven volume, solve
Profit = unit CM × Volume – FC = 0
=>
breakeven volume = FC / unit CM

• Breakeven revenue = sales revenue at which profit

is zero
breakeven revenue = breakeven volume × price
9
 Breakeven Revenue in Version 2 of CVP

to compute breakeven revenue, solve

Profit = CMR × Revenue – FC = 0
=>
breakeven revenue = FC / CMR

10
 It can take a while to break even…
Amazon: 1995-2008
Profit/loss at Amazon, $million
1000

500

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

-500

-1000

-1500

11
 Target Profit
• How much do we need to sell (in units or dollars) to meet
a given profit target?

Plug target profit into the CVP relation

unit CM × Volume – FC = target profit
or

CMR × Revenue – FC = target profit

and solve for volume or revenue

12
 Exercise: Breakeven volume and revenue,
target profit
The price is $50, unit variable cost is $20, and fixed costs are
$900.
1. Compute the breakeven point in units and dollars
Breakeven volume =

Breakeven revenue =

2. Your boss gave you a profit target of $1,500. How many

units do you need to sell to meet this target?
Profit = ____ ×Volume − _____ = ________ (target)
=>
Volume =

13
Exercise: Breakeven revenue and target profit
Sales revenue is $5,000, total variable costs are $2,000, and
total fixed costs are $900 (no data on units).
1. Compute breakeven revenue
 not enough information?
 enough information?
Breakeven revenue =

2. The profit target is $2,400. How much do you need to sell in

dollars to meet this target?
Profit = ____ ×Revenue − _____ = ________ (target)

=>
Revenue =
14
 Short-Term Pricing Decisions
Unit variable cost is $10. Fixed costs are $1,200. The demand
estimates from the market research department are as follows.
Should we set the selling price to $15, $20, or $25?

Demand Profit = unit CM × Volume – FC =

Price
in units = ( price – unit VC ) × Volume – FC

$25 100 Profit=

$20 160 Profit=

$15 240 Profit=

15
 Evaluating Operating Risk
• Future demand is uncertain (e.g., think of GM
right before the Great Recession).
• If sales fall, how much risk of making a loss do
we face?
• 2 measures of operating risk:
• Margin of safety
• Operating leverage

16
 Evaluating Operating Risk
Margin of Safety: amount by which current sales exceed the
breakeven point

Margin of safety = sales volume – breakeven volume

sales volume

or = revenue – breakeven revenue

revenue

 how much “cushion” does the firm have against sales

decreases?
 higher margin of safety indicates lower operating risk

17
 Exercise: Margin of Safety
Current sales volume is 100,000 units. Breakeven
volume is 80,000 units.

1. Margin of safety =

2. If sales decrease by 15%, will you lose money? Why?

 YES  NO
If sales decrease by 21%, will you lose money? Why?
 YES  NO

18
 Operating Leverage
Cost structure (mix of FC and VC) affects operating risk
firm A: high % FC firm B: low % FC
Profit

Profit
low average high Sales low average high Sales
Loss

Loss

19
 Operating Leverage
• When the proportion of fixed costs is higher, profit is more
sensitive to changes in sales
• more likely to make a loss when sales are low
• (but also larger profit when sales are high)

• Higher proportion of fixed costs means higher operating risk.

To measure this risk, we use
Operating Leverage = Fixed Costs / Total Costs

20
Example: High operating leverage can kill you
Income statement for General Motors during the Great Recession
2006 2008 % change
Revenue $207b $149b -39%
COGS $165b $151b -8%
Gross Margin $42b ($2b) -105%
SG&A costs $30b $25b -17%
Profit $12b ($27b) -325%

When sales decreased by 39%, total costs (COGS+SG&A) decreased by just 10%.
This indicates high operating leverage.
Due to high operating leverage, when sales decreased by 39%, GM had a HUGE
loss and went bankrupt. The federal government had to step in and bail it out.

21
 Dealing with High Operating Leverage
If you have high operating leverage like GM, which of the
following are reasonable ways to mitigate operating risk:
 maintain large cash reserves to be able to survive a few bad
years
 YES  NO
 maintain small cash reserves to improve financial flexibility
 YES  NO
 secure a large line of credit from a bank just in case
 YES  NO
 outsource production to convert fixed costs into variable costs
 YES  NO
 become “too big to fail” to ensure a government bailout if you get
in trouble
 YES  NO

22
 Additional Exercises

23
 Exercise: CVP version 1
The price is $50, unit variable cost is $30, and fixed costs are
$900.
1. Write down the CVP relation
Profit = _____ ×Volume − _______
2. Predict profit at sales volume of 100 units
Profit =
3. Breakeven volume =
Breakeven revenue =
4. How many units do you need to sell to meet a profit target of
$2,100?
Profit = ____ ×Volume − _____ = ________ (target)
=>
Volume =
24
 Exercise: CVP version 2
Current sales revenue is $10,000, total variable costs are
$6,000, and total fixed costs are $1,800 (no data on units)
1. Write down the CVP relation
Profit = _____ ×Revenue − _______
2. Predict profit at sales revenue of $8,000.
Profit =
3. Breakeven revenue =

4. How much do you need to sell in dollars to meet a profit target

of $2,200?
Profit = ____ ×Revenue − _____ = ________ (target)
=>
Revenue =
25
 Exercise: CVP version 1
Sales volume 100 units
Revenues $5,000
Variable costs $2,000
Contribution margin $3,000
Fixed costs $2,400
Profit $600

1. Write down the CVP relation.

Profit = _____ ×Volume − _______

2. Breakeven volume =

3. Margin of safety =

26
 Exercise: Pricing Decisions
Unit variable cost is $40. Total fixed costs are $40,000.
At current price of $100, you sell 1,000 units per month.
If you reduce the price to $90, sales volume will increase by
10% to 1,100 units.

1. How much will the profit change if you reduce the price?
At price = $100, profit =

At price = $90, profit =

Change in profit =

2. Should you reduce the price?  YES  NO

27
 A very simple and VERY DEADLY
exam question
Price is $20 per unit. At current sales volume, unit cost (total
cost per unit) is $15. It consists of $3 per unit of fixed costs
and $12 per unit of variable costs.
How much will the profit change in the short term if we
sell one more unit?
A. increase by $5
B. increase by $8
C. increase by $17
D. not enough info

To get the right answer, do the following

Profit = _____ ×Volume − FC, where FC = const
∆Profit = _____ × ∆Volume =
28