Cost-Volume-Profit Analysis

Chapter Three
 Cost-Volume-Profit Analysis

What is CVP?
COST VOLUME PROFIT

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CVP studies the relationship between
revenue, cost, and volume and their effect
on profits.
 Cost-Volume-Profit Analysis
 Cost-volume-profit (CVP) analysis is a way to
find out how changes in variable and
fixed costs affect a firm's profit.
Companies can use CVP to see how many
units they need to sell to break even (cover
all costs)
 Cost Volume Profit Analysis includes the
analysis of sales price, fixed costs, variable
costs, the number of goods sold, and how it
affects the profit of the business.
 Cost-Volume-Profit Analysis
 Cost Volume Profit (CVP) Analysis, also known
as break-even analysis, is a financial planning
tool that leaders use when determining short-
term strategies for their business.
 The aim of a company is to earn a profit, and
profit depends upon a large number of
factors, most notable among them is the cost
of manufacturing and the volume of sales.
These factors are largely interdependent.
 Cost-Volume-Profit Analysis
• The volume of sales is dependent upon production
volume, which in turn is related to costs that are
affected by the volume of production, product mix,
internal efficiency of the business, production
method used, etc.
• CVP analysis helps management in finding out the
relationship between cost and revenue to generate
profit.
• CVP Analysis also helpful when a business is trying
to determine the level of sales to reach a targeted
income.
 The Profit Equation
The Income Statement
Total Revenue Operating Profit
equals Total Revenue
- Total Costs less Total Costs!

= Operating Profit

The Income Statement written horizontally:

Operating Profit = Total Revenue - Total Cost
 = TR - TC
 Profit Equation
Total Revenue (TR) = Price (P) x Units of output produced and sold (X)

TR = PX

Total Cost (TC) = [Variable Costs per unit (V) x Units of Output (X)] + Fixed Cost (F)

TC = VX + F
 Profit Equation

 = TR - TC

 = PX - VX + F

 = P - V X - F
Marginal Cost Equation
Solutions
 U-Develop: An Example
U-Develop
Income Statement
For the Month Ending March 200X
Per Unit
Total
Sales $ 7,200 $ 0.60
Less: Variable Cost of Goods Sold 3,600 0.30
Less: Variable Selling Costs 720 .06
Contribution Margin 2,880 0.24
Less: Fixed Costs 1,500 Developed
Operating Profit $ 1,380 12,000 prints
in March
 Contribution Margin
Contribution Margin: The contribution margin is when you deduct
all connected variable costs from your
product’s price, which results in the
incremental profit earned for each unit. This
shows whether your company can cover
variable costs with revenue. The contribution
margin is normally shown in monetary terms.
Contribution Margin Per Unit:
Price Per Unit - Variable Cost Per Unit = CM Per Unit

Punit - Vunit = CMunit

 Contribution Margin
The contribution margin concept gives the
business the actual amount the company needs
to cover its fixed costs after it pays its variable
cost.
contribution margin can help you understand
the effect of a specific product on your
company’s profitability.
It can help to evaluate whether the company
should continue to manufacture or buy the
product at a mid-process stage to save cost.
 Contribution Margin (Total)
Total Contribution Margin:

(Price x Quantity) - (Variable Cost x Quantity = Total CM

P - V X = Total CM
or

PX - VX = Total CM
 Example: U-Develop CM

Using the data Sold 12,000 units Per Unit

from U-Develop Total
Sales $ 7,200 $ 0.60
Less: Variable Cost of Goods Sold 3,600 0.30
Less: Variable Selling Costs 720 .06
Contribution Margin 2,880 0.24
Less: Fixed Costs 1,500
Operating Profit $ 1,380

1. What is CM per unit? $0.60 – $0.36 = $0.24

2. What is total CM? ($0.60 - $0.36)(12,000) = $2,880

 Contribution Margin

Contribution Margin, why do I care?

U-Develop:

Cmunit = $0.24

For every $1.00 in sales, U-Develop has

$0.24 available to cover fixed costs. Once
fixed costs are covered, $0.24 for each
dollar sales will increase profits!
 Test-Quiz
 Calculate the total contribution and contribution per unit
from the following information.
 Sales= $40,000,000
 Sales= 4,000 units
 Variable cost $30,000,000
Solution
 Contribution Margin Ratio
The contribution margin ratio is the difference
between a company's sales and variable costs,
expressed as a percentage It is good to have a high
contribution margin ratio, as the higher the ratio, the
more money per product sold is available to cover all
the other expenses.
 Contribution Margin Ratio
Contribution Margin Ratio:
Contribution margin as a percentage of sales revenue.
Total Contribution Margin Ratio:
Total contribution margin as a percent of
total sales revenue. It describes how much P - V X
the contribution margin is for each dollar in
sales. P X
CM Per Sales Dollar
Unit Contribution Margin Ratio:
Contribution margin per unit as a percentage
of sales price per unit. This calculates the P - V
contribution margin provided for each dollar
of revenue. P
CM Per Sales Dollar
Example: Contribution Margin Ratio (CMR)

U-Develop
P V X $.60 $.36 12,000
CMR
P X .60 12,000

CMR $2,880 .40

$7,200

CMR unit $.24

.40
$.60
 In-Class Example
Suppose ABC Ltd. sells a product for $
200. The variable cost per unit is $ 80.
The variable cost per unit includes direct
material expense, labor expense and
variable overhead cost. The fixed
overhead cost is $ 20. Calculate the
contribution margin.
 Solution
In the question, the fixed overhead cost is
given separately. It shall not be included in
the calculation as it does not form part of the
formula.
Contribution (Margin)= Sales Revenue – Variable
Expenses
= $ 200 – $ 80
= $ 120
Therefore, the contribution per unit is $ 120.
 Break-Even
Break-even: The point at which profits equal zero. At
break-even, all fixed costs are covered, but the
firm is not producing any operating profit.

Equations: TR – TC = π TR = PX
TR = TC + π and
TC = VX + F)
PX = VX + F + π
PX – VX = F + π
Break-even is
where π = 0
X(P-V) = F + π
F + π F
Break-Even = =
X P -V X P -V
 Break-Even
Since, sales – variable cost = contribution margin, then:
Fixed Costs
Break-Even =
Contribution Margin

Unit Contribution Margin: If unit CM is used, then the calculation

provides the number of units necessary
to break-even.
Contribution Margin Ratio: If unit CM Ratio is used, then the
calculation provides the sales dollars
necessary to break-even.
Example: Break-Even in Units

F 
X
CM unit

$1,500 $0
X
$.24

X 6,250 prints
 Example: Break-Even in Sales Dollars
The total sales dollars at which profits equal zero.

Break-even: Total revenues = Total costs

F $0
TR = $0
CMR

$1500
TR
.40
= $3,750

6,250 prints X $.60 = $3,750

 Target Volume in Units
Target Profit = P - V X - F

Target Volume Fixed Cost + Target Profit

(units) =
Unit Contribution Margin

F + 
X =
P - V
 Example: Target Volume in Units

U-Develop Target Profit = $ 1,800

F + 
Formula: =
CMunit

$ 1,500 + $ 1,800
X =
$ 0.24

X = 13,750 units
 Target Volume in Sales Dollars

Target volume Fixed costs + Target profit

sales dollars =
Contribution margin ratio
TR

F + 
T =
R CMR
 Example: Target Volume in Sales Dollars
U-Develop:
F + 
Given: Target $1,800 T =
R CMR

$1,500 $1,800
T
R .40

T $8,250
R
13,750 x $.60 = $8,250
 CVP Summary: Break-Even

Break-even Fixed costs

=
volume (units)
Unit contribution margin

Break-even Fixed costs

volume (sales =
Contribution margin ratio
dollars)
 CVP Summary: Target Volume

Target volume Fixed costs + Target profit

=
(units) Unit contribution margin

Target volume Fixed costs + Target profit

=
sales dollars
Contribution margin ratio
 CVP and the Effects of Different Cost Structures

 Describing an organization’s cost structure helps us to

understand the amount of fixed and variable costs
within the organization. What is meant by the term cost
structure?
 Cost structure is the term used to describe the
proportion of fixed and variable costs to total costs. For
example, if a company has $80,000 in fixed costs and
$20,000 in variable costs, the cost structure is
described as 80 percent fixed costs and 20 percent
variable costs.
 Operating leverage: This is the relationship between a
company's fixed and variable costs. The higher a
company's fixed costs compared with its variable costs,
the higher its operating leverage.
CVP and the Effects of Different Cost Structures

Cost Structure: The proportion of fixed and variable

costs to total costs.

Operating The extent to which the cost

Leverage: structure is comprised of fixed cost.

Contribution Margin
Operating Leverage = Fixed Costs
The higher the organization’s operating leverage, the
higher the break-even point.
The degree of operating leverage
The degree of operating leverage (DOL) is a
measure used to evaluate how a company's operating
income changes after a percentage change in its sales.
A company's operating leverage involves assessing fixed
costs and variable costs against sales. Fixed costs do
not change depending on production levels.
The degree of operating leverage measures how
much a company's operating income changes in
response to a change in sales. ... A company with high
operating leverage has a large proportion of fixed costs,
meaning a big increase in sales can lead to great
changes in profits.
 Comparison of Cost Structures
Lo-Level Company High-Level Company
(1,000,000 units) (1,000,000 units)
Amount Percentage Amount Percentage
Sales $1,000,000 100% $1,000,000 100%
Variable Cost $750,000 75% $250,00 25%
Contribution Margin $250,000 25% $750,000 75%
Fixed Costs $50,000 5% $550,000 55%
Operating Profit $200,000 20% $200,000 20%
Break-Even 200,000 units 733,334 units
CM per Unit $0.25 $0.75
Degree of Operating Leverage 1.25 3.75
 Example: Operating Leverage
Why do I care? Suppose Low Level & High-
Level both increase sales 10%
or $100,000

Low-Level High-Level C
Sales $100,000 $100,000
CMR .25 .75
Increase in Profit $25,000 $75,000
Prior NI $200,000 $200,000
NI with Sales increase of 10% $225,000 $275,000
 Operating Leverage
Low-Level High-Level

Percent Increase in sales 10% 10%

Degree of Operating Leverage 1.25 1.75
Percent increase in NI 12.5% 17.5%
Prior NI $200,000 $200,000
Percent increase in NI 12.5% 17.5%
NI with sales increase of 10% $225,000 $235,000
 Margin of Safety
In break-even analysis, the term margin of safety
indicates the amount of sales that are above the break-
even point.
A company’s margin of safety is the difference
between its current sales and its break-even sales. The
margin of safety tells the company how much they could
lose in sales before the company begins to lose money,
or, in other words, before the company falls below the
break-even point.
Let's assume that a company currently sells 3,000
units of its only product. The company has estimated
that its break-even point is 2,800 units. Therefore, the
company's margin of safety is 200 units.
 Margin of Safety
The excess of projected or actual sales volume over
break-even volume.
or
The excess of projected or actual sales revenue over
break-even revenue.

Suppose U-Develop sells 8,000 prints

8,000 6,250 1,750 prints

$4,800 $3,750 $1,050

1750 x $.60 = $1,050

 Margin of Safety
If a company’s current sales are more
than its break-even point, it has a
margin of safety equal to current sales
minus break-even sales. The margin of
safety is the amount by which sales can
decrease before the company incurs a
loss.
 In-Class Example
For example, assume Video Productions
currently has sales of $120,000 and its break-
even sales are $ 100,000. The margin of safety
is $ 20,000, computed as follows:
Margin of safety = Current sales – Break
even sales
Margin of safety = $ 120,000 – $ 100,000 =
$ 20,000
 The Margin of Safety Rate
Sometimes people express the margin of safety as a
percentage, called the margin of safety rate or just
margin of safety percentage. The margin of safety
rate is equal to:
Margin of Safety Percent=Current Sales – Break
even Sales/Current Sales
Using the data just presented, we compute the margin
of safety rate is $20,000 / 120,000 = 16.67 %
This means that sales volume could drop by 16.67
percent before the company would incur a loss.
 Extending CVP: Taxes

What if U-Develop is in the 25% tax bracket and

wants profit after taxes of $1,800?

F target 1-t
Target Volume
CM unit

$1,500 $1,800
.75
X = 16,250
$.24
 CVP and Taxes
To Prove it Works:
Sales 16,250 $.60 $9,750
VC 16,250 $.36 5,850
CM $3,900
FC 1,500
NIBT $2,400
Taxes 2,400 25% 600
Net Income $1,800
 Extending CV P: Multiple Products
What if:
U-Develop does prints and enlargements?

Prints Enlargements
Selling price $.60 $1.00
Variable cost .36 .56
Contribution margin $. 24 $. 44

Total Fixed Costs $1,820

 Example: Product Mix
U-Develop’s product mix: For every 9 prints sold U-
Develop sells 1 enlargement.

Weighted Average Contribution Margin

9/10 $.24 1/10 $.44 $ .26

9/10
Breakeven
6,300 prints
$1,820 7,000
$.26 1/10
700 enlargements
 Assumptions and Limitations of CVP

Assumptions & Limitations:

1. Although the CVP model is a very strong tool, the
output is dependent upon the assumptions made by
cost analyst. These assumptions include which costs
are fixed vs. variable.
2. With the aid of software programs, many of the
limitations have been eliminated. Complicated cost
structures are easily incorporated in CVP analysis
when software tools are used.
 Problems
1.Tokio Ltd manufactures and sells only one product. The
product is sold at N$10 per unit. Other details are as follows:

Variable cost per unit N$5

Fixed cost per month N$20 000
Normal sales per month 6 000 units

A. Calculate the contribution per unit.

B. Calculate the contribution ratio .
C. Calculate the break-even point in units.
D.Calculate the break-even point in sales value (N$).
E. Calculate the margin of safety .
 Problems
2.Mauro Products distributes a single product, a woven basket
whose selling price is $15 per unit and whose variable expense
is $12 per unit. The company’s monthly fixed expense is
$4,200.
Required:
1.Calculate the company’s break-even point in unit sales.
2.Calculate the company’s break-even point in dollar sales.
3. If the company’s fixed expenses increase by $600, what
would become the new break-even point in unit sales? In
dollar sales?
 Problems
3.Last month when Holiday Creations, Inc., sold 50,000 units,
total sales were $200,000, total variable expenses were
$120,000, and fixed expenses were $65,000.
Required:
1. What is the company’s contribution margin (CM) ratio?
2. What is the estimated change in the company’s net
operating income if it can increase sales volume by 250 units
and total sales by $1,000?
 Problems

4.let’s look at how this might work in practice with a sporting

goods company. Imagine that a basketball costs £20, with
variable costs per unit of £8. So, to find the contribution
margin ratio. CMR= 0.6 OR 60%
5.a company sells 15,000 units of shirts for a total revenue of
$400,000. Cost of goods sold is $150,000, labor expenses of
$100,000. Calculate contribution margin per shirt.
CM= $10.00 per shirt.
 Problems
6.The Doral Company manufactures and sells pens. Currently,
5,000,000 units are sold per year at $0.50 per unit. Fixed costs are
$900,000 per year. Variable costs are $0.30 per unit. Consider each case
separately:
1. What is the current annual operating income?
2.What is the present breakeven point in revenues?
Compute the new operating income for each of the following changes:

A.A $0.04 per unit increase in variable costs 3.

B. A 10% increase in fixed costs and a 10% increase in units sold 4.
C.A 20% decrease in fixed costs, a 20% decrease in selling price, a 10%
decrease in variable cost per unit, and a 40% increase in units sold.
 Problems

7.Brooke Motors is a small car dealership. On average, it sells a car for

$27,000, which it purchases from the manufacturer for $23,000. Each
month, Brooke Motors pays $48,200 in rent and utilities and $68,000 for
salespeople’s salaries. In addition to their salaries, salespeople are paid a
commission of $600 for each car they sell. Brooke Motors also spends
$13,000 each month for local advertisements. Its tax rate is 40%.
1. How many cars must Brooke Motors sell each month to break even?
2.Brooke Motors has a target monthly net income of $51,000. What is its
target monthly operating income? How many cars must be sold each
month to reach the target monthly net income of $51,000?
 Problems
8.A company has the capacity to generate a revenue of $3,000,000 a year. The
break even revenue is $2,000,000 a year. From the breakeven point, every
$100 extra revenue generates $40 extra profit and every $100 decrease in
revenue results in $40 extra loss. The costs consist of fixed costs and variable
costs, which are linear related to the revenue.
1.Calculate the fixed costs.
2. Calculate the variable costs at a revenue of $1,500,000 a year.
The company decides to purchase another machine, which results in an
increase of capacity to $4,000,000 a year. The fixed cost of this expansion is
$200,000 a year, and the variable costs are $40 for $100 revenue. The normal
revenue is $4,000,000 a year, and the actual revenue is also $ 4,000,000.
3. Calculate the breakeven point after the expansion.
4. Calculate the full cost per dollar revenue after the expansion.
 Problems
9.Garrett Manufacturing sold 410,000 units of its product for $68 per
unit in 2014. Variable cost per unit is $60, and total fixed costs are
$1,640,000.
1. Calculate (A) Contribution margin and (B) operating income.
2. Garrett’s current manufacturing process is labor intensive. Kate
Schoenen, Garrett’s production manager, has proposed investing in state-
of-the-art manufacturing equipment, which will increase the annual fixed
costs to $5,330,000. The variable costs are expected to decrease to $54
per unit. Garrett expects to maintain the same sales volume and selling
price next year.
 How would acceptance of Schoenen’s proposal affect your answers to
(A) and (B) in requirement 1?