Cost-Volume-Profit Analysis

• Cost-volume-profit analysis is an integral part

of financial planning and decision making.
• Cost-volume-profit analysis is the
examination of the relationships among
selling prices, sales and production volume,
costs, expenses, and profits.
 LO 2

Cost-Volume-Profit Relationships
• Some of the ways cost-volume-profit
analysis may be used include the
following:
1. Analyzing the effects of changes in selling prices on
profits
2. Analyzing the effects of changes in costs on profits
3. Analyzing the effects of changes in volume on profits
4. Setting selling price
5. Selecting the mix of products to sell
6. Choosing among marketing strategies
• CVP analysis is the analysis of three variable
viz. cost, volume and profit.
• Such analysis explores the relationship
existing amongst costs, revenue,
activity level and resulting profit. It
aims at measuring variation of cost
with profit.
 Fixed Cost
• These are the costs which incurred for a
period and which within certain output and
turnover limits, tend to be unaffected by
fluctuations in the levels of activity
(Output or turnover).
For example: Rent, insurance of factory
building etc. remain the same for different
levels of production.

4
 Fixed Costs - in Total
Costs that remain the same in
total regardless of changes in the
activity level.
Property Taxes
Insurance
Rent
Supervisory Salaries
Depreciation on building, equipment
 Fixed cost is fixed within a relevant range.
 The relevant range is the level of activity or volume in which the
total fixed cost is the same or constant.
 The fixed costs remain constant in total.
 The unit fixed cost will vary with volume of activity.
• For instance, if you are paying Birr 600 and you are
living in that house alone, the cost per person is Birr
600. If you share the house with your fried, the cost
per person will be Birr 300 (Birr 600 divided by two
persons). If you share with three persons, the cost per
person will be Birr 200 (Birr 600 divided by three
persons) and so on. The cost per unit will decrease
as the volume of activity increases; the total cost
Birr 600 per month will remain constant within the
relevant range.
 Illustration 5-2

Fixed Cost - in Total

Costs that remain the same in
total regardless of changes in
the activity level.

Total Fixed Costs= $ 10,000

2 units = $ 10,000 per month
4 units = $ 10,000 per month
6 units = $ 10,000 per month
8 units = $ 10,000 per month
10units = $ 10,000 per month
 Illustration 5-2

Fixed Cost - per Unit

Costs that very inversely with
activity. As volume increases,
unit cost declines.

Total Fixed Costs= $ 10,000

2 units = $ 5,000 per unit
4 units = $ 2,500 per unit
6 units = $ 1,667 per unit
8 units = $ 1,250 per unit
10units = $ 1,000 per unit
 Fixed Cost Graph

Total Cost
Amt

Fixed Cost

Units
9
 Variable Cost

These costs tend to vary with the

volume of activity. Any increase in
activity results in an increase in the
variable cost and vice versa.
For example: Cost of direct labour,
direct material, etc.

10
 which change in total
• Variable costs are those costs,
directly with the volume of activity. However, the unit
cost remains constant regardless of the change in volume of
activity.
• For example, how much can you buy a loaf of bread? Suppose that
the price of a loaf of bread is Birr 0.50, how much will it cost you to
buy 10 loaves of bread? 20 loaves of bread? Your answer will be
Birr 5 for 10 loaves of bread and Birr 10 for 20 loaves of bread. In
short, the answer is the number of loaves of bread multiplied by the
unit price.
• As you can see from these simple illustrations, the total cost varies
with number of loaves of bread that you buy, but we assumed that
price of a loaf of bread is Birr 0.50.
 Variable Cost Graph

Variable Cost
`

Units 12
 Illustration 5-1

Variable Costs - in Total

Costs that vary in total directly and
proportionately with changes in
the activity level.

Variable Cost= $10 per unit

 0 units = $ 0= total
 2 units = $ 20= total
 4 units = $ 40= total
 6 units = $ 60=total
 8 units = $ 80=total
10units = $100=total
 Illustration 5-1

Variable Costs - per Unit

Costs that remain the same
per unit at every level
of activity.

Variable Cost= $10 per unit

 0 units = $ 0 per unit
 2 units = $ 10 per unit
 4 units = $ 10 per unit
 6 units = $ 10 per unit
 8 units = $ 10 per unit
10units = $ 10 per unit
 Summary of Variable and Fixed Cost Behavior
Cost In Total Per Unit

Changes as activity level Remains the same over wide

Variable
changes. ranges of activity.
Remains the same even Dereases as activity level
Fixed
when activity level changes. increases.
 Mixed Costs
Costs that contain both a variable
and a fixed cost element and
change in total but not
proportionately with changes
in the activity level.
Rental of U-haul Truck
 $50 a day (Fixed Amount) +
 $.50 a mile (Variable Cost)
 Illustration 5-5

Behavior of a Mixed Costs

 LO 2
Contribution Margin
• Contribution margin is the excess of
sales over variable costs, as shown in the
formula below.
• The contribution margin can be useful for
analyzing the profit potential of projects
Contribution Margin = Sales – Variable Costs
 LO 2
Contribution Margin
Assume the following data for Lambert, Inc.:
 LO 2

Contribution Margin

Contribution
ContributionMargin
Margin
Margin
 LO 2

Contribution Margin Ratio

• The contribution margin ratio, sometimes
called the profit-volume ratio, indicates the
percentage of each sales dollar available to
cover fixed costs and to provide income
from operations. It is computed as follows:
Contribution Margin
Contribution Margin Ratio =
Sales
 LO 2

Contribution Margin Ratio

The contribution margin ratio is 40% for Lambert Inc.,
computed as follows:
Contribution Margin
Contribution Margin Ratio =
Sales
$400,000
Contribution Margin Ratio =
$1,000,000

Contribution Margin Ratio = 40%

 The Break-Even Point
The break-even point is the point in the volume
of activity where the organization’s revenues
and expenses are equal.

Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 100,000
Net income $ -

7-23
 Consider the following information developed
by the accountant at Curl, Inc.:
Total Per Unit Percent
Sales (500 surfboards) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000
 Equation Approach
Sales revenue – Variable expenses – Fixed expenses = Profit

Unit Sales Unit Sales

sales × volume variable × volume
price in units expense in units

($500 × X) – ($300 × X) – $80,000 = $0

($200X) – $80,000 = $0
X = 400 surf boards
7-25
 Contribution-Margin Approach
Consider the following information developed
by the accountant at Curl, Inc.:
For each additional surf board sold, Curl
generates $200 in contribution margin.

Total Per Unit Percent

Sales (500 surf boards) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

7-26
 Contribution-Margin Approach

Fixed expenses Break-even point

=
(in units)
Unit contribution margin
Total Per Unit Percent
Sales (500 surf boards) $250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000

$80,000
= 400 surf boards
$200
7-27
 Contribution-Margin Approach

Here is the proof!

Total Per Unit Percent

Sales (400 surf boards) $200,000 $ 500 100%
Less: variable expenses 120,000 300 60%
Contribution margin $ 80,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ -

400 × $500 = $200,000 400 × $300 = $120,000

7-28
 Contribution Margin Ratio

Calculate the break-even point in sales dollars rather

than units by using the contribution margin ratio.

Contribution margin
= CM Ratio
Sales
Fixed expense Break-even point
=
CM Ratio (in sales dollars)
7-29
 Graphing Cost-Volume-Profit
Relationships
Viewing CVP relationships in a graph gives managers a
perspective that can be obtained in no other way.
Consider the following information for Curl, Inc.:

7-30
 Cost-Volume-Profit Graph
450,000

400,000
a les
350,000 al s ea
Break-even Tot fit a r
300,000 Pro
point
250,000
Dollars

ses
200,000
e n
l exp
150,000 Tota
100,000
Fixed expenses
area
50,000 Lo ss

100 200 300 400 500 600 700 800

Units

7-31
 Profit-Volume Graph
Some managers like the profit-volume
graph because it focuses on profits and volume.

100,000

80,000

60,000
Break-even
point re a
40,000
t a
fi
20,000 Pro
Profit

0 `

(20,000) 100 200 300 400 500 600 700

r e a Units
(40,000) sa
Los
(60,000)

7-32
 Target Net Profit

We can determine the number of surfboards that

Curl must sell to earn a profit of $100,000 using the
contribution margin approach.

Fixed expenses + Target profit Units sold to earn

=
Unit contribution margin the target profit

$80,000 + $100,000
= 900 surf boards
$200

7-33
 Equation Approach

Sales revenue – Variable expenses – Fixed expenses = Profit

($500 × X) – ($300 × X) – $80,000 = $100,000

($200X) = $180,000

X = 900 surf boards

7-34
Assume that as an investor, you are
planning to enter the construction industry
as a panel formwork supplier. The potential
number of forthcoming projects, you
forecasted that within two years, your fixed
cost for producing formworks is Birr
300,000. The variable unit cost for making
one panel is birr 15.  The sale price for
each panel will be birr 25. If you charge
birr 25 for each panel, how many panels
you need to sell in total, in order to start
making money?
Break even Point in unit= 300,000
25-15
Answer 30,000 panels
A manufacturing company supplies
its products to construction job
sites. The average monthly fixed
cost per site is birr 4,500, while
each unit cost birr 35 to produce
and selling price is birr 50 per unit.
Determine the monthly breakeven
volume.
Break even point in volume=4500
50-35
300
• Suppose you intend to open a business to supply a
nationally-known line of women’s shoes.  You’ve
found a good location in Addis Ababa to open your
shop, and have determined that the average prices and
costs of operating the store are:
• Price =Birr50 per pair                                             
• Cost = Birr 30 per pair
• Rent = Birr 2,500 per month                                   
•  Insurance = Birr 500 per month
• Utilities & Telephone = Birr 300 per month
• In addition, you plan to hire two sales ladies on a
commission basis of 10% in order to provide them with
incentive to sell shoes.  You are required determine the
breakeven point in Birr? es?
 Solution:
Answer: Break-Even in Rupees = Birr 11,000
 Exercise 4

• P Company has provided the following data:

Sales Price per unit: $50
Variable Cost per unit: $30
Fixed Cost: $135,000
Expected Sales: 20,000 units
a)What is the breakeven point in sales dollars?
b)What is the current margin of safety?
c)If the company wants to have net income of
$70,000, how many units must they sell?
 Exercise2

• A company has fixed costs of $20,000 in order

to sell a product that costs them $50 per unit.
If a company sells the product for $120 per
unit,
• Determine the break-even units
• Determine the units required to produce
$100,000 in profit?
 Applying CVP Analysis
Safety Margin
• The difference between budgeted sales
revenue and break-even sales revenue.
• The amount by which sales can drop before
losses begin to be incurred.

7-43
The Margin of Safety in Dollars
The margin of safety in dollars is the excess
of budgeted (or actual) sales over the
break-even volume of sales.
Margin of safety in dollars = Total sales - Break-even sales

Let’s look at Racing Bicycle Company and

determine the margin of safety.
 The Margin of Safety in Dollars
If we assume that RBC has actual sales of
$250,000, given that we have already
determined the break-even sales to be
$200,000, the margin of safety is $50,000
as shown.
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
The Margin of Safety Percentage
RBC’s margin of safety can be expressed as
20% of sales.
($50,000 ÷ $250,000)
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
 The Margin of Safety in Unit
The margin of safety can be expressed in
terms of the number of units sold. The
margin of safety at RBC is $50,000, and
each bike sells for $500; hence, RBC’s
margin of safety is 100 bikes.

Margin of $50,000
= = 100 bikes
Safety in units $500
 Changes in Fixed Costs

• Curl is currently selling 500 surfboards per year.

• The owner believes that an increase of $10,000 in
the annual advertising budget, would increase
sales to 540 units.

 Should the company increase the advertising

budget?

7-48
 Total Per Unit Percent
Sales (500 surfboards) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000
 Changes in Fixed Costs

540 units × $500 per unit = $270,000

7-50
$80,000 + $10,000 advertising = $90,000
 Changes in Fixed Costs

Sales will increase by

$20,000, but net income
decreased by $2,000.

7-51
Changes in Fixed Costs and Sales
Volume
A shortcut solution using
incremental analysis
Increase in CM (40 units X $200) $ 8,000
Increase in advertising expenses 10,000
Decrease in net operating income $ (2,000)
 Change in Variable Costs and
Sales Volume
What is the profit impact if Racing Bicycle
can use higher quality raw materials, thus
increasing variable costs per unit by $10, to
generate an increase in unit sales from 500
to 580?
 Change in Variable Costs and
Sales Volume
580 units × $310 variable cost/unit = $179,800

500 units 580 units

Sales $ 250,000 $ 290,000
Less: Variable expenses 150,000 179,800
Contribution margin 100,000 110,200
Less: Fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,200

Sales increase by $40,000 and net operating income

increases by $10,200.
Change in Fixed Cost, Sales Price,
and Volume
What is the profit impact if RBC: (1) cuts its
selling price $20 per unit, (2) increases its
advertising budget by $15,000 per month, and
(3) increases sales from 500 to 650 units per
month?
Change in Fixed Cost, Sales Price,
and Volume
650 units × $480 = $312,000

500 units 650 units

Sales $ 250,000 $ 312,000
Less: Variable expenses 150,000 195,000
Contribution margin 100,000 117,000
Less: Fixed expenses 80,000 95,000
Net operating income $ 20,000 $ 22,000

Sales increase by $62,000, fixed costs increase by

$15,000, and net operating income increases by $2,000.
 Change in Variable Cost, Fixed
Cost,
and Sales Volume
What is the profit impact if RBC: (1) pays a $15
sales commission per bike sold instead of
paying salespersons flat salaries that currently
total $6,000 per month, and (2) increases unit
sales from 500 to 575 bikes?
 Change in Variable Cost, Fixed
Cost,
and Sales Volume
575 units × $315 = $181,125
500 units 575 units
Sales $ 250,000 $ 287,500
Less: Variable expenses 150,000 181,125
Contribution margin 100,000 106,375
Less: Fixed expenses 80,000 74,000
Net operating income $ 20,000 $ 32,375

Sales increase by $37,500, fixed expenses decrease by

$6,000, and net operating income increases by $12,375.
Exercise
 Quick Check 
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. An average of 2,100 cups are sold each
month. What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139
 Quick Check 
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. An average of 2,100 cups are sold each
month. What is the CM Ratio for Coffee Klatch?
a. 1.319 Unit contribution margin
CM Ratio =
b. 0.758 Unit selling price
c. 0.242 ($1.49 - $0.36)
=
d. 4.139 $1.49
$1.13
= = 0.758
$1.49
 Quick Check 
Coffee Klatch is an espresso stand in a
downtown office building. The average selling
price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average
fixed expense per month is $1,300. Use the
formula method to determine how many cups of
coffee would have to be sold to attain target
profits of $2,500 per month.
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
 Quick Check 
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is
Unit sales fixed expense per month is $1,300.
$0.36. The average Target profit + Fixed expenses
to attain
Use the formula method= to determineUnit howCM many cups of
target
coffee would profit
have to be sold to attain target profits of
$2,500 per month. $2,500 + $1,300
= $1.49 - $0.36
a. 3,363 cups
b. 2,212 cups $3,800
=
c. 1,150 cups $1.13
d. 4,200 cups = 3,363 cups
 Quick Check 
Coffee Klatch is an espresso stand in a
downtown office building. The average selling
price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average
fixed expense per month is $1,300. Use the
formula method to determine the sales dollars
that must be generated to attain target profits of
$2,500 per month.
a. $2,550
b. $5,013
c. $8,458
d. $10,555
 Quick Check 
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is $1.49
and the average variable expense per cup is $0.36. The
average fixed expense per month is $1,300. Use the formula
method to determine
Sales $ the sales dollars that must be
generated to attain target Target
profits of profit per
$2,500 + Fixed expenses
month.
to attain = CM ratio
a. $2,550 target profit
b. $5,013 $2,500 + $1,300
= ($1.49 – 0.36) ÷ $1.49
c. $8,458
d. $10,555 $3,800
=
0.758
= $5,013
 Quick Check 
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is $0.36.
The average fixed expense per month is $1,300. An average
of 2,100 cups are sold each month. What is the break-even
sales dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129
 Quick Check 
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is $0.36.
The average fixed expense per month is $1,300. An
average of 2,100 cups are sold each month. What is the
break-even sales dollars?
a. $1,300 Break-even Fixed expenses
b. $1,715 =
sales CM Ratio
c. $1,788 $1,300
=
0.758
d. $3,129
= $1,715
 Quick Check 
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. An average of 2,100 cups are sold each
month. What is the break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
 Quick Check 
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is $1.49
and the average variable expense per cup is $0.36. The
average fixed expense per month is $1,300. An average of
2,100 cups are sold eachBreak-even
month. What isFixed
the expenses
break-even
= CM per Unit
sales in units?
a. 872 cups $1,300
=
$1.49/cup - $0.36/cup
b. 3,611 cups
c. 1,200 cups $1,300
=
$1.13/cup
d. 1,150 cups
= 1,150 cups
Quick Check 
In its budget for next month, McGwire Company
has revenues of $500,000, variable costs of $350,000,
and fixed costs of $135,000.
a. Compute contribution margin percentage.
b. Compute total revenues needed to break even.
c. Compute total revenues needed to achieve a target
operating income of $45,000.
d. Compute total revenues needed to achieve a target net
income of $48,000,
 Quick Check 
Coffee Klatch is an espresso stand in a
downtown office building. The average selling
price of a cup of coffee is $1.49 and the
average variable expense per cup is $0.36.
The average fixed expense per month is
$1,300. An average of 2,100 cups are sold
each month. What is the margin of safety
expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
 Quick Check 
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. An average of 2,100 cups are sold each
month. What is the margin of safety expressed in
cups?
a. 3,250 cups
b. 950 cups
Margin of safety = Total sales – Break-even sales
c. 1,150 cups
= 2,100 cups – 1,150 cups
d. 2,100 cups = 950 cups
 Quick Check 
Coffee Klatch is an espresso stand in a
downtown office building. The average selling
price of a cup of coffee is $1.49 and the
average variable expense per cup is $0.36.
The average fixed expense per month is
$1,300. An average of 2,100 cups are sold
each month. What is the operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
 Quick Check 
Coffee Klatch is an espresso stand in a Actual sales
2,100 cups
downtown office building. The
Sales
average selling
$ 3,129
price of a cup of coffeeLess:
is $1.49 andexpenses
Variable the average756
variable expense per cup is $0.36.
Contribution The average2,373
margin
fixed expense per month isFixed
Less: $1,300. An average1,300
expenses
of 2,100 cups are soldNeteach month.
operating What is$the1,073
income
operating leverage?
a. 2.21
b. 0.45 Operating Contribution margin
c. 0.34 leverage = Net operating income
d. 2.92 $2,373
= $1,073 = 2.21
 Quick Check 
At Coffee Klatch the average selling price of a cup of coffee
is $1.49, the average variable expense per cup is $0.36, the
average fixed expense per month is $1,300, and an
average of 2,100 cups are sold each month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
 Quick Check 
At Coffee Klatch the average selling price of a cup of coffee
is $1.49, the average variable expense per cup is $0.36, the
average fixed expense per month is $1,300, and an
average of 2,100 cups are sold each month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0% Percent increase in sales 20.0%
c. 22.1% × Degree of operating leverage 2.21
d. 44.2% Percent increase in profit 44.20%
End of Chapters

We made
it!