Cost and Management Accounting

Chapter - One

Cost-Volume-Profit Analysis
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Cost-Volume-Profit Analysis- Introduction
CVP analysis
 is a study of the relationships between the sale volume, Cost
, revenue and profit in an organization .
 It focuses on interactions between the five CVP
Components.
 the five CVP analysis Components are: Price, Volume,
Variable cost, Fixed cost and Mix of products sold.
 is one of the most powerful tool used by managers:
 In estimation of break even and Profit at different levels
of activity.
 as it answers questions like: what would be the effect
change in Selling price, VC, FC and sales Mix on profits?
 CVP- Analysis
1.1 Contribution Margin
o Contribution margin – amount of revenue remaining
after deducting variable costs.
o It is the amount available to cover fixed costs and to
contribute to target profit
o Formula for unit contribution margin is:
Unit Selling  Unit Variable = Unit Contribution
Price Costs Margin
3
 Example: Contribution Margin

Assume Tecno Phone Manufacturing Plc has the following

relevant data for the year 2020

Unit selling price of cell phone $500

Unit variable costs $300

Total annual fixed costs $200,000

4
 Unit Contribution Margin(UCM) ?

Unit Selling  Unit Variable = Unit Contribution

Price Costs Margin

$500  $300  $200

Total Contribution Margin?
= Total Revenue – Total Variable Cost

or

= Unit contribution margin * total units sold

For example if 1,600 phones are sold total CM will be:

= (500- 300)*1,600 = $320,000

5
 CVP Analysis
1.2 Contribution Margin Ratio
• The percentage of the contribution margin to sales
• Shows the percentage of each sales available to cover
fixed costs and profits.
• Contribution margin ratio is computed by:
Unit Contribution  Unit Selling = Contribution Margin
Margin Price Ratio

The contribution margin ratio for Tecno Plc will be :

$200  $500  40%

Means:60% of sales is VC and 40% is there to cover FC and target 6

 1.3 Break-Even Analysis
Computing the break-even point
• The break-even point is always a point of interest in CVP analysis

• Finding break-even point is often the first step in planning decision to

avoid operating losses

• The break-even point is the level of activity at which total revenues

equal total costs or operating profit becomes zero.

• Break-even point can be computed in two approaches :

1. Equation method

2. Contribution Method
 Equation Method – Break even quantity(BEQ)
•Break-even occurs where total sales equal variable costs plus fixed costs
and operating income is zero….i.e
•Profit (Operating Income) =(P XQ)-(VxQ)-F
where P =sales price per unit
Q = quantity sold
V = variable cost per unit
F =total fixed cost per period
OI = Operating income
At break-even point, operating income(OI) = 0
That is, OI=PQ-VQ-F
0= PQ-VQ-F
0= Q(P-V)- F
Cont…..
8
 Equation Method – Break even quantity(BEQ)

0= Q(P-V)- F
F= Q(P-V)
Q = F/(P-V)

Break-even quantity (in units) = Fixed costs

Unit selling Price – Unit variable cost

9
 Contribution Margin Method – Break even quantity(BEQ )

When we rewirite the équation method , Break even

quantity(Q)
Q = F/(P-V)
P-V= Unit contribution margin
There fore, BEQ using Contribution Margin Method is:

= Fixed costs
Break-even quantity (in units) Unit contribution margin

10
 Example

• Assume data for Tecno company and Compute

break even point in units using equation and
Contribution margin Method.

11
 Break Even Revenue(BER)
• Is break even point in sales or a total sales that would be
equal to total cost

Equation Method
BER= BEQ * Unit selling Price
Contribution Margin Method
Fixed  Contribution = Break - Even
Costs Margin Ratio Points in Dollars

Example : Compute BER for Tecno Company

12
 BEP – Graphic Meth
• In the graphical method we plot the total costs and revenue
lines to obtain their point of intersection, which is the
breakeven point.
• Total costs line. is the sum of the fixed costs and the
variable costs.
• To plot the total cost line, choose some volume of sale and
plot the point representing total expenses (fixed and
variable) at the activity level you have selected.
TC= TVC + TFC
• Total Cost function for Tecno is:
TC = $300Q+$200,000
 BEP – Graphic Meth
• Total Revenue Line:
• The break-even point is where the total revenues line and the
total costs line intersect. This is where total revenues just
equal total costs.
• TR = Q *SP
• Total Revenue Function of Tecno is :
TR= $500Q

Tecno’s BEP analysis is summarized in next slide.

CVP- Analysis – Graphic Method

LO 4 Copyright ©2018 John Wiley & Sons, Inc. 15

 Exercise Question
1. A Company is planning to sell 200,000 units for $4 per unit. The
contribution margin ratio is 25%. If the company will break even
at this level of sales, what are the fixed costs?
2. A Company manufactures and sales a single product. During the
year just ended, the company produced and sold 60,000 units at a
price of Br.20 per unit. Variable manufacturing costs were Br 8 per
unit, and variable marketing costs were Br 4 per unit . Fixed costs
amounted to Br. 180,000 for manufacturing and Br.72, 000 for
marketing. What is breakeven point in units and birr for the year.

16
 1.4Target Operating income and Net Income
Determine the sales required to earn target operating/
net income
Target Operating Income

• Target Operating income is projected/planned profit before tax.

• CVP analysis is applied to compute the level of sales in units/

birr necessary to achieve this target profit .

• Sales required to achieve target profit can be expressed either in

sales units or in sales dollars/birr.
LO 3-
1

Target Operating Income

Quantity for target Income Fixed costs + Target profit

=
Unit contribution margin

Sales for target Income = Fixed costs + Target profit

Contribution margin ratio
 Example
• Assume Tecno Pls data and
1. Compute the number of cell phones to be sold to earn
an operating income of $120,000 during the year
2. Compute the required sales in dollar to earn an
operating income of $150,000 during the year
3. If Tecno’s variable manufacturing costs are expected
to increase 10 % in the coming year. Compute the
firm’s new breakeven point in sales and in units
4. If Tecno’s variable manufacturing costs do increase
10 %, compute the selling price that would yield the
same CM-ratio in the coming year.
Target Net Income ( profit after tax)
• So far we have ignored income taxes. However, profit-
seeking enterprises must pay income taxes on their
profits.
• A firm’s profit after tax is operating income less profit
tax
• This fact is expressed in the following formula:

• Target net income = Operating Income (1 – tax rate)

LO 3-
4

Target Income After Taxes

How many units must be sold(Q)?

Fixed costs + Target Profit after tax

(1 – Tax rate)]

Unit contribution margin

How many sales should be made(sales)?

Fixed costs + Target profit after tax

(1 – Tax rate)]

contribution margin ratio

 Example
• Assume Tecno Pls data and
1. Compute the number of cell phones to be sold to earn
a Net income of $120,000 during the year(assume
30% tax)
2. Compute the required sales in dollar to earn a net
income of $150,000 during the year(assume 30% tax)
 1.5 CVP Analysis with Multiple Products
(Sales Mix and CVP Analysis)
• Sales mix is the relative percentage in which a company
sells its products.
• Based on the premise that different products have different
selling prices, cost structures, and contribution margins
• If a company’s unit sales are 80% printers and 20%
computers, its sales mix is 80% to 20%.
• If the proportions of the mix change, the CVP relationships
also change.
• Thus, managers try to achieve the combination, or mix, that
will yield the greatest amount of profit.
.
CVP Analysis with Multiple Products
• A shift in sales-mix from high-margin items to low-margin
items can cause total profits to decrease even though total
sales may increase and vise versa.
• The computation of the break-even point (BEP) in multi
product firm follows:
BEQ = Total fixed Cost
Weighted average CM per unit

Weighted average CM per unit = CMUp1*W1+CMUp2*W2+

…..+CMUpn*Wn
CVP Analysis with Multiple Products
• the computation of the break-even point in birr for multi
product is :
BER = Total fixed Cost
Total CM Ratio
or

= BEQp1*USPp1+ BEQp2*USPp2+….+BEQpn*USPpn
 Example:
Assume that Tecno Company also manufactures TV in addition
to phone and the following data are summarized for 2020.

Cell Phones TVs Total

Annual Sales of 2020 in units 1,500 500 2,000
Sales mix 75% 25%
Unit Data Cell Phones TVs
Selling price $500 $1,000
Variable costs 300 720
Contribution margin $200 $ 280
Sales mix—units 75% 25%
Fixed costs = $275,000
 Example Cont…
What is the BEQ and BER?

BEQ = Total fixed Cost

Weighted average CM per unit
Weighted average CM per unit = $200*.75+ $280*.25 = $220

BEQ= $275,000/ $220 = 1,250 units

of which
Cell phone = 1,250*.75= 937.5 units
TV = 1,250*.25 = 312.5 units
 Break-Even Revenue for the sales mix
BER = Total fixed Cost
Total CM Ratio
or
= BEQ1*P1+ BEQ2*P2….BEQn*Pn
Total CM
Total CM Ratio
Total Revenue
CM Ratio =
200*1,500+280*500
500*1,500+1,000*500
= 0.352
Break-Even Revenue for the sales mix

BER = $275,000 = $ 781,250

0.352
OR

From cell phone = 937.5 units *500 = $468,750

From TV = 312.5 units *1,000 = $312,500
Total $ 781,250

29
LO 3-
1

Target Profit for Multiple Product

Quantity for target Profit Fixed costs + Target profit

=
W.A. Unit contribution margin

Sales for target Profit = Fixed costs + Target profit

Total Contribution margin ratio
 Example
Assume the previous data for Tecno and a Target Profit
of $33,000
1. What total units need to be sold to achieve the target
profit
2. How many units of TV and cell phone need to be sold
to achieve the target profit
3. What should be the sales to achieve the target profit
LO 3-
1

Example Cont…
Quantity for target Profit Fixed costs + Target profit
=
W.A. Unit contribution margin

= 275,000+ 33,000
220
= 1,400 units

Phone = 1,400*.75 = 1,050 units

TV = 1,400*.25 = 350 units
LO 3-
1

Example Cont…
Sales for target Profit = Fixed costs + Target profit
Total Contribution margin ratio

= 275,000+33,000

0.352
= $875,000
Or
From Phone = 1050*500= $525,000
From TV = 350*1000= 350,000
Total $875,000
 Exercise:

Manzeck Bicycles International produces and sells three

different types of mountain bikes. Information regarding the
three models is shown below.
Pro Intermediate Standard Total
Units sold 5,000 10,000 25,000 40,000
Selling price $800 $500 $350
Variable costs $500 $300 $250

The company’s total fixed costs are $7,500,000.

(a) Determine the sales mix as a function of units sold for the three
products.
(b) Determine the weighted-average unit contribution margin
(c) Determine the total number of units that the company must sell to
break even
(d) Determine the number of units of each model that the company
must sell to break even
 1.6 Sensitivity Analysis
-Sensitivity analysis is a “what if” technique that examine how
a result will change if the original predicted data are not
achieved or if an underlying assumption changes
-In the context of CVP, sensitivity analysis answers questions
like:
- what will operating income be if the out put , variable cost, selling
price , fixed cost and sales mix changes by a given percentage
from the original prediction ?

LO 1 35
 Example
Original/Current sales and cost data for Tecno is as shown.

Unit selling price $500

Unit variable cost $300

Total fixed costs $200,000

Break-even sales/ units $500,000 or 1,000 units

Annual sales 1,400 units

Current profit …………… $80,000

36
Case .
1. What will be the impact of a 10% decrease in selling
price on Break even point and annual profit ?
2. Management invests in new equipment that will lower
the amount of direct labor required to make cell
phones. They estimate that total fixed costs will
increase by 30% and variable cost per unit will
decrease by 30%. What effect will the new equipment
have on the sales volume required to be break even
and to maintain current annual profit ?
3. Tecno’s principal supplier of raw materials has just
announced a price increase. This higher cost is
expected to increase the variable cost of cell phones
by $25 per unit.
37
Case cont…
Management plans a cost-cutting program that will save
$17,500 in fixed costs . What increase in units sold will be
needed to maintain the same level of annual Profit ?
4. The management of Tecno thinks that a $10, 000 increase in annual
advertising budget(FC) would increase annual sales by 100 cell
phones beyond current sales . Should the advertising budget be
increased? Why?
5. The sales manager would like to cut selling price by $ 20 per unit
and increase the advertising cost(FC) $ 15, 000 . The sales manager
argues that if these two steps are taken, unit sales will increase by
50%. Should the change be made?
6. The sales manager would like to replace the sales staff on a
commission basis of $15 per Phone sold, rather than on flat
salaries(FC) that now total $ 10, 000 per year. The sales manager is
confident that the change will increase annual sales by 15%. Should
the change be made? 38
CVP analysis assumptions
 Changes in the levels of revenues and costs arise
only because of changes in the number of product
(service) units produced and sold.
 Total cost can be separated into two: FC & VC (both
can be direct and indirect)
 Within a relevant range, total revenue and total cost
have a linear relationship with the level of output.
 Selling price, FC, and VC per unit are known and
constant.
 The analysis either covers a single product or
assumes that the proportion of different products
when multiple products are sold will remain
 Margin of Safety

• Measures how close expected sales are to the break-even point.

• Is the excess of projected sales over the break-even point.
• 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.

• Assuming actual/expected sales of Tecno is $750,000:
Actual (Excepted)  Break - Even = Margin of Safety
Sales Sales in Dollars
$750,000  $500,000 = $250,000
40
Margin of Safety
Formula for margin of safety ratio
• Computed by dividing the margin of safety in dollars by
the actual (or expected) sales.
• Assuming actual/expected sales are $750,000:

Margin of Safety  Actual (Excepted) = Margin of Safety

in Dollars Sales Ratio

$250,000  $750,000 = 33%

• The higher the dollars or percentage, the greater the

margin of safety.

41
 CVP use for NGOs
• CVP can be readily applied to decisions by both not-for-
profit and for-profit organizations
• It is also useful in NGOs:
• To compute budget required to run the program
• The number of needy that could be served given its
budget.
Example
• Suppose a Elderly social welfare Organization has got a
donation of $900 000 from USAID. This NGO’s major
purpose is to assist elderly people by providing food, shelter
and medication. The cost of food, shelter and medication is
$5000 per person per year.
• The NGO’s fixed costs( Office rent , salary and others) is
$270 000 per year.
• Required:
• How many people could be served with this donation?
• If the NGO would like to serve 150 people, what budget
does it need?
Copyright ©2018 John Wiley & Sons, Inc.
 Margin of Safety
Question

Marshall Company had actual sales of $600,000 when break-

even sales were $420,000. What is the margin of safety ratio?
a. 25%.
b. 30%.
c. 33⅓%.
d. 45%.

LO 5 44
 Margin of Safety
Answer

Marshall Company had actual sales of $600,000 when break-

even sales were $420,000. What is the margin of safety ratio?
a. 25%.
b. Answer: 30%.
c. 33 1/3%.
d. 45%.

LO 5 45
Exercise
1.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

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.

46
 Exercise
Kris Company reports the following for June.
Total Per Unit
Sales (5,000 units) $300,000 $60
Variable costs 180,000 36
Contribution margin 120,000 $24
Fixed expenses 100,000
Net income $ 20,000

To increase net income, management is considering reducing

the selling price by 10%, with no changes to unit variable
costs or fixed costs. Management is confident that this change
will increase unit sales by 25%.

LO 1
Required: Compute

a) break-even point in dollars

b) the margin of safety and margin of safety

c) Expected operating profit

LO 1