Chapter 6

COST-VOLUME-PROFIT ANALYSIS
BREAK-EVEN POINT ANALYSIS

References:
CMA Excel Learning System – Exam Review Part 1 and Part 2 (2019) Publisher: Wiley.
Weygandt, J., Kimmel, P., and Kieso, D. (2015). Accounting Principles 12 th edition, John Wiley and Sons, Singapore.
Learning outcomes
After studying this chapter, you should be able to:
1. PREPARE A CVP INCOME STATEMENT TO DETERMINE THE CONTRIBUTION MARGIN.

2. COMPUTE THE BREAK-EVEN POINT USING THREE APPROACHES.

3. DETERMINE THE SALES REQUIRED TO EARN THE TARGET NET INCOME AND DETERMINE
THE MARGIN OF SAFETY.

4. USE CVP ANALYSIS TO RESPOND TO CHANGES IN THE BUSINESS ENVIRONMENT.

 Cost-volume-profit (CVP) analysis
- The study of the effects of changes in costs and volume on a company’s profits.
 Important in profit planning.
 Critical factor in management decisions as
► Setting selling prices, determining product mix, and maximizing use of production
facilities.

Basic
Components:
 CVP Income Statement
 A statement for internal use. CVP Income Statement

 Classifies costs and expenses as fixed or variable. Per

Total unit
 Reports contribution margin in the body of the statement. Sales
Less: Variable costs
► Contribution margin – amount of revenue remaining
after deducting variable costs. = Contribution Margin
Less: Fixed costs
 Reports the same net income as a traditional income
statement. Net Income
 Test Your Knowledge (3)
Vargo Video Company produces a high-definition digital camcorder. Relevant data for
the camcorders sold by this company in June 2017 are as follows.

Prepare the CVP income statement for Vargo Video.

Answer
Test Your Knowledge (4)
Ampco Industries produces and sells a cell phone-
operated thermostat. Information regarding the costs and
sales of thermostats during September 2017 are provided
below.

Unit selling price of thermostat $85

Unit variable costs $32
Total monthly fixed costs
$190,000
Units sold 4,000

Prepare a CVP income statement for Ampco Industries for

the month of September. Provide per unit values and total
values.
Answer
 UNIT CONTRIBUTION MARGIN
- Contribution margin is available to cover fixed costs and to contribute to income.

- Could be computed in total and per unit.

- Formula for contribution margin in Total:

Total Sales – Total Variable Costs = Total Contribution Margin “$”

Formula for contribution margin per unit:

Unit Selling Price – Unit Variable Costs = Unit Contribution Margin “$ per unit”
 UNIT CONTRIBUTION MARGIN
Vargo’s CVP income statement assuming a zero net income.
 UNIT CONTRIBUTION MARGIN
Assume that Vargo sold one more camcorder, for a total of 1,001 camcorders sold.
 CONTRIBUTION MARGIN RATIO
- Shows the percentage of each sales dollar available to apply toward fixed costs and profits.

- Could be computed in total and per unit.

- Formula using Total contribution margin:

Total Contribution Margin ÷ Total Sales = Contribution Margin Ratio “%”

Formula using contribution margin per unit:

Unit Contribution Margin ÷ Unit Selling Price = Contribution Margin Ratio “%”
CONTRIBUTION MARGIN RATIO
 CONTRIBUTION MARGIN RATIO
Assume Vargo Video’s current sales are $500,000 and it wants to know the effect of
a $100,000 (200-unit) increase in sales.
 Break-Even Analysis
 Process of finding the break-even point level of activity at which total revenues
equal total costs (both fixed and variable).
Break-even occurs
 Can be computed or derived where total sales =
TVC+ TFC
► from a mathematical equation,
i.e., net income is
► by using contribution margin, or zero

► from a cost-volume profit (CVP) graph.

 Expressed either in sales units or in sales dollars. And computed using either
contribution margin per unit or contribution margin ratio.
 At the break-even point, contribution margin must equal total fixed costs

(CM = total revenues – variable costs)

 Break-Even in Units
- When the break-even-point in units is desired, contribution margin per unit is used.
- Formula for break-even in units:
Fixed Costs ÷ Contribution Margin per Unit = Break-Even Point in Units

The computation for Vargo Video:

 Break-Even in Units
- When the break-even-point in dollars is desired, contribution margin ratio is used.
- Formula for break-even in dollars:
Fixed Costs ÷ Contribution Margin Ratio = Break-Even Point in Dollars

The computation for Vargo Video:

 Target Net Income
 Level of sales necessary to achieve a specified income.
 Can be determined from each of the approaches used to determine break-even
sales/units:
► from a mathematical equation,
► by using contribution margin technique, or
► from a cost-volume profit (CVP) graph.

 Expressed either in sales units or in sales dollars. And computed using either
contribution margin per unit or contribution margin ratio.
 Target Net Income in Units
- When the required sales in units is desired, contribution margin per unit is used.
- Formula for required sales in units:
(Fixed Costs + Target Net income) ÷ Contribution Margin per Unit = Required Sales in
Units

The computation for Vargo Video:

 Target Net Income in Dollars
- When the required sales in dollars is desired, contribution margin ratio is used.
- Formula for required sales in dollars:
(Fixed Costs + Target Net income) ÷ Contribution Margin Ratio = Required Sales in Dollars

The computation for Vargo Video:

 Margin of Safety
 Difference between actual or expected sales and sales at the break-even point.
 Measures the “cushion” that a particular level of sales provides.
 May be expressed in dollars or as a ratio.
 The higher the dollars or percentage, the greater the margin of safety.

- Formula for margin of safety in dollars:

Actual (Expected) Sales – Break-even in Sales Dollars = Margin of Safety in Dollars
- Formula for margin of safety as a ratio:

Margin of Safety in Dollars ÷ Actual (Expected) Sales = Margin of Safety Ratio

 Margin of Safety
The computation for Vargo Video assuming actual/expected sales are $750,000:

Margin of safety in Dollars ÷ Actual (Expected) sales = Margin of safety Ratio

$250,000 ÷ $750,000 = 33%
 Test Your Knowledge (5)
Zootsuit Inc. makes travel bags that sell for $56 each. For the coming year, management
expects fixed costs to total $320,000 and variable costs to be $42 per unit. Compute the
following:

a)break-even point in dollars using the contribution margin (CM) ratio;

b)the margin of safety and margin of safety ratio assuming actual sales are $1,382,400;
and

c)the sales dollars required to earn net income of $410,000.

 Answer
Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute
break-even point in dollars using the contribution margin
(CM) ratio.

Contribution margin ratio = [($56 - $42) ÷ $56] = 25%

Break-even sales in dollars = $320,000 ÷ 25% = $1,280,000

 Answer
Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
margin of safety and margin of safety ratio assuming
actual sales are $1,382,400.

Margin of safety = $1,382,400 - $1,280,000 = $102,400

Margin of safety ratio = $102,400 ÷ $1,382,400 = 7.4%

 Answer
Zootsuit Inc. makes travel bags that sell for $56 each. For the
coming year, management expects fixed costs to total
$320,000 and variable costs to be $42 per unit. Compute the
sales dollars required to earn net income of $410,000.

Required sales in dollars =

($320,000 + $410,000) ÷ 25% = $2,920,000

 Changes in CVP variables
• CVP analysis can also be used to assess the
impact on profit of changes in price, unit
contribution margin and fixed costs.
• Whittier Company conducted a market survey
of the mulching mower that revealed three
alternatives:
– If advertising increases by $8,000, sales will
increase from 1,600 units to 1,725 units.
– A price decrease from $400 to $375 per unit will
increase sales from 1,600 units to 1,900 units.
– Decreasing the price to $375 and increasing
advertising by $8,000 will increase sales from 1,600
units to 2,600 units.
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 Changes in CVP variables
• If advertising increases by $8,000, sales will
increase from 1,600 units to 1,725 units.

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 Changes in CVP variables
• A price decrease from $400 to $375 per unit
will increase sales from 1,600 units to 1,900
units.

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 Changes in CVP variables
• Decreasing the price to $375 and increasing
advertising by $8,000 will increase sales from
1,600 units to 2,600 units.

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 Introducing risk and uncertainty

• Risk and uncertainty are part of business decision

making and must be dealt with.
– Under risk, the probability distribution of the variables are
known.
– Under uncertainty they are not known.

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 Sensitivity Analysis and CVP

Sensitivity analysis is the name for a variety of

methods that examine how an amount (e.g., B/E
point) changes if factors involved in predicting that
amount change (e.g., sales volume or unit variable
cost).

For CVP, three methods of sensitivity analysis are

commonly employed:
(1) What-if analysis (using the contribution
margin and contribution margin ratio)
(2) The margin of safety (or, margin of safety
ratio), and
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(3) The degree of operating leverage
 Sensitivity Analysis and
CVP (continued)

What-if analysis is the calculation of an

amount given different levels of a factor
that influences that amount
– Example: if contribution margin (cm) is $40 per unit
and the cm ratio is 0.53333, each unit change in sales
volume affects profit by $40 and each dollar change in
sales affects profits by $0.53333

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 Sensitivity Analysis (continued)
Margin of safety is the $ amount of sales
above the B/E point (i.e., forecasted sales
level minus the B/E sales level)

– Margin of safety can also be used as a ratio

– The margin of safety ratio is the margin of safety divided

by planned sales

– This ratio is a useful measure for assessing risk

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 Sensitivity Analysis
(continued)
Degree of operating leverage (DOL) is the
ratio of CM to operating profit:

DOL = contribution margin/profit

– A higher DOL value indicates a higher risk in the sense

that a given change in sales will have a relatively greater
% impact on profits
– The DOL can be thought of as the extent to which fixed
costs characterize the cost structure of an organization:
the higher the percentage of fixed costs, the higher
the DOL (and therefore the higher the operating risk)

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 Sensitivity Analysis
(continued)

–The DOL is defined at each sales volume level

– Organizations with high DOL work hard for even small %
increases in sales volume (because these changes are
magnified as % changes in operating profit)

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 Operating leverage
• Example:
– A firm is planning to introduce a new product. The
product can be produced with automation or labour. If the
firm chooses automation, fixed costs will be higher but the
unit variable cost will be lower. Data is presented below
for a sales level of 10,000 units:

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 Operating leverage
• Example:
– The degree of operating leverage for the automated
system is 4.0:
• $500,000/$125,000 = 4.0
– The degree of operating leverage for the manual
system is 2.0:
• $200,000/$100,000 = 2.0
– What happens to profit if sales increase by 40%?

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 Multi-Product CVP Analysis
• If all fixed costs are traceable to individual
products, then the organization can develop a
separate CVP model for each product
• Alternatively, the multi-product firm can make
an assumption regarding a standard sales mix
in which its products are sold
• Sales mix can be determined on the basis of
sales dollars or unit sales

• The assumption of sales mix allows the firm to

calculate and use a weighted-average contribution
margin (cm) per unit and weighted average cm
ratio to do multi-product CVP analysis
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 Example: Multi-Product CVP
Analysis
Windbreakers, Inc. sells light-weight sports/recreational jackets and currently has three

products: Calm, Windy, and Gale. Total (joint) fixed costs for the period are expected to be

$168,000, and we assume the windbreakers’ sales mix, measured by sales dollars, will

remain constant. Additional information is provided below.

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Example: Multi-Product CVP
(continued)

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 Chapter Summary

• CVP analysis is a method for analyzing how operating and marketing decisions affect

profit

• CVP analysis depicts the relationship between variable costs, fixed costs, unit selling

price, and output level (volume)

• CVP analysis can help a firm choose its strategic position and execute its strategy by

providing an understanding of how changes in its volume of sales affect costs and

profits

• CVP analysis is a method for analyzing how operating and marketing decisions affect

profit

• CVP analysis depicts the relationship between variable costs, fixed costs, unit selling 42
 Chapter Summary (continued)

The breakeven (B/E) point is the starting point of many business plans:

– B/E is the point at which total revenues equal total costs, i.e., point of sales at which operating profit is

zero

– The B/E point can also be defined as the sales level at which CM = FC

– There are two methods, equation and contribution margin, that can be used for profit-planning (i.e.,

CVP analysis) purposes

• In each method, sales volume can be expressed either on the basis of units or dollars

• CVP analysis can be used to determine the level of sales needed to achieve a desired level of

profit through revenue planning, cost planning, and accounting for the effect of income taxes

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 Recap/“CAN YOU?”
CHECKLIST
 Can you calculate either break-even units or dollars using the units-
sold or sales-revenue approach?
 Can you use either approach to calculate units or dollars needed to
earn a targeted profit? Can you adjust after-tax profits to before-tax
profits?
 Can you calculate break-even and sales volumes for a targeted profit
in a multiple-product setting?
 Can you prepare either a profit-volume graph or a cost-volume-profit
graph?
 Can you explain the difference between margin of safety and operating
leverage?

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