CHAPTER TWO

COST-VOLUME-PROFIT (CVP) ANAYSIS

 CONCEPT DEFINITION and
•
WHY?????
CVP analysis examines the interaction of a firm’s sales
volume, selling price, cost structure, and profitability.
• It is a powerful tool in making managerial decisions
including marketing, production, investment, and
financing decisions.
• How many units of its products must a firm sell to break
even?
• How many units of its products must a firm sell to earn
a certain amount of profit?
• Should a firm invest in highly automated machinery and
reduce its labor force?
• Should a firm advertise more to improve its sales?
 One Product Cost-Volume-Profit Model
• Net Income (NI) = Total Revenue – Total Cost Total
– Revenue = Selling Price Per Unit (P) * Number of Units
Sold (X)
– Total Cost = Total Variable Cost + Total Fixed Cost (F)
– Total Variable Cost = Variable Cost Per Unit (V) * Number
of Units Sold (X)
NI = P X – V X – F
NI = X (P – V) – F
 Underlying Assumptions of CVP Analysis

• Assumptions on:
revenues change in relation to sales
costs can be divided in variable and fixed
categories
revenues and costs behave in a linear
fashion
costs and prices are known
we can ignore the time value of money
Expression Basis Of CVP Analysis Items

• Contribution margin (CM)……….. is the excess of

sales (S) over the variable costs (VC).

………..the amount ( proportion ) of revenue

remaining after all variable costs have been covered.

………….. the amount of Birr available to cover

fixed costs (FC) and to generate profits.
LO 3-
1

Contribution Margin
This is the difference between price and variable cost.

It is what is leftover to cover fixed costs and then add to

operating profit.

Contribution margin = Price per unit – Variable cost per unit

P–V
 Contribution Margin (CM) Income Statement

• XYZ Company has the following contribution

margin income statement:

Total Per Unit

Sales (20,000 units) $1,200,000 $60

Less: Variable costs -$900,000 -$45

Contribution Margin $300,000 $15

Less: Fixed costs -$240,000

Net income $60,000

 • CM = Sales - TVC.

• CM = SP per unit – VC per unit = $300,000

CM Ratio = Contribution Margin= $300,000
Sales $1,200,000
= 0.25= 25%
A high CM ratio indicate low level of variable costs
incurred.
C. Graphic method:

• …………the breakeven point is intersection

point of plotted total costs and revenue lines
 Cost-Volume-Profit Graph
450,000

400,000
a les
350,000
tals rea
Break-even To fit a
300,000 Pro
point
250,000
Dollars

ses
200,000
e n
l exp
150,000 Tota
100,000
Fixed expenses
re a
s a
50,000 Los

100 200 300 400 500 600 700 800

Units

7-15
 Example …..
computation of BEP
LO 3-
1

CVP Example

Contribution margin = $2,880 ÷ 12,000 = $0.24

LO 3-
1

Break-Even Volume in Units

This is the volume level at which profits equal zero.
Profit 0 = X(P – V) – F
If profit = 0, then X = F ÷ (P – V)

Fixed costs
Break-even volume (in units) =
CM per unit
= $1,500 ÷ $0.24

= 6,250 prints
LO 3-
1

Break-Even Volume in Sales Dollars

Contribution margin percentage (contribution
margin ratio) is the contribution margin as a
percentage of sales revenue.

Contribution Margin Percentage

CM per unit /sales = 2880/7200= 0.4

Break-even in Sales Dollars

Fixed cost / CM Ratio
$1,500 ÷ 0.40 = $3,750
LO 3-
1

CVP Summary: Break-Even

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

Break-even volume Fixed costs

=
(sales dollars) Contribution margin ratio
 II) Target Operating Profit Analysis

• …………to determine the total sales in units and

birr needed to reach a target profit.
• ……… all techniques used for breakeven
computation can be used.
LO 3-
1

CVP Summary: Target Volume

Target volume Fixed costs + Target profit
(units) =
contribution margin per unit

Target volume Fixed costs + Target profit

=
(sales dollars) Contribution margin ratio
 Example
• In this example, if management wants to earn
a profit of at least $1,000, how many units
must the company sell?
• No. of units = (Fixed Costs + Target Profit) / CM per
unit
=(1500 + 1,000)/0.24 = 10,417 units
Sales Volume= (1500 + 1,000)/0.4= $6,250
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 Contribution Margin
Method (cont.)

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 Contribution Margin
Method (cont.)
Solution:
To calculate the break-even point, we first need to determine
the weighted average contribution margin. For this, we need
to ‘weigh’ the contribution margin per unit of these three
products and present it as ‘three-in-one’:

Weighted average contribution margin (units)

= (30% × RM3) + (45% × RM2) + (25% × RM2)
= RM2.30

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 Contribution Margin
Method (cont.)

The 4,348 units are then split in accordance with the

proportion as defined in row A (sales mix) of the table given
in Example 10.5.

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 Contribution Margin
Method (cont.)

Truck valves : 4,348 units × 30% = 1,304 units

Car valves : 4,348 units × 45% = 1,957 units

Motorbike valves: 4,348 units × 25% = 1,087 units

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 Contribution Margin
Method (cont.)
 The break-even point for multiproduct production can be
calculated in value of ringgit as well. The numerator is
the same fixed cost. The denominator will now be the
weighted average contribution margin ratio. The
modified formula is as follows:

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 Example 10.3

ABC C. makes and sells product Zee at a price of RM50 per

unit. The variable cost is RM40 per unit and the budgeted
fixed cost is RM60,000. Budgeted sales are 8,000 units.

Required:
(a) The break-even point.
(b) The margin of safety.
 Contribution Margin Method (cont.)
Solution:
 Accepting special orders

 Bulk orders, additional orders and orders from foreign or new

markets, may be accepted at a price below the normal market
price so as to utilize the idle capacity.
 Such orders are received usually asking a price below the
market and hence a decision is to be taken to accept or reject
the special order.
 The order may be accepted at any price above the variable cost
because the fixed costs have to be incurred even otherwise.
 Any contribution margin resulting from the additional sales
would mean an additional profit.
 But care must be taken to see that accepting an order below
the market price does not affect the normal selling price
adversely.
 Accepting special orders . . .

• Example- The Everest Snow Company manufacturers and sells

direct to consumers 10,000 jars of “Everest Snow” per month at
$1.25 per jar. The Company’s normal production capacity is
20,000 jars of snow per month. An analysis of cost per 10,000
jars is given below:
Direct material $1,000
Direct labor 2,475
Power and other supplies 1,170
Fixed expenses 7,955
Total $12,600

 The company has received an offer for the export under a

different brand name of snow at 10,000 jars per month at $0.75
per jar.
 Required:- should the company accept or reject special order?
 Accepting special orders . . .
Per unit Present Add order 50% Total
capacity capacity @ 75 100%
50% cents per unit capacity
Sales (units) 10,000 10,000 20,000
Sales (value) $1.25 $12,500 $7,500 $20,000
Less: Variable cost:
Direct material 0.1000 1,000 1,000 2,000
Direct labor 0.2475 2,475 2,475 4,950
Power & oth. 0.1170 1,170 1,170 2,340
Total variable cost 0.4645 4,645 4,645 9,290
Contribution M. 0.7855 7,855 2,855 10,710
Fixed cost 7,955 - 7,955
Net income/loss ($100) 2,855 2,755
 Make or buy decisions

 Sometimes a concern has to decide whether a certain product

or a component should be made in the factory itself (having
unused production facilities) or bought from outside from a
firm which specializes in it.
 While deciding to “make or buy” a distinction must be made
between fixed cost and variable cost, and variable cost of
manufacturing it should be compared with the price at which
this component or product can be bought from outside.
 It is advisable to make than to buy if the variable cost of
product or component is lower than the purchase price.
 But if the purchase price is lower than the variable cost, it
would be better to buy than to make itself.
 However, this decision is based upon the assumptions that
fixed expenses do not increase and production facilities cannot
be employed more profitability.
 Make or buy decisions . . .
 Example -A manufacturing company finds that while the cost of
making a component in its own workshop is $8 each, the same is
available in market at $6.50 with an assurance of continuous
supply. The cost data is as follows:
Direct materials ……………………….. $3.00
Direct labor ……………………………… 2.00
Other variable expenses…………… 1.00
Depreciation & other fixed exp….. 2.00
Total cost ………………………………….. 8.00
 Required:-
1. Give your suggestion whether to make or to buy this component.
2. Give also your views in case the supplier reduces the price from
$6.50 to $5.50.
 Make or buy decisions . . .
• Since fixed costs are to be incurred whether the company
manufacture this component or not, the decision depends
upon the variable cost of making the component which is
calculated as flows:
costs Production /unit Make Buy
Direct materials $3.00 $3.00
Direct labor 2.00 2.00
Other variable expenses 1.00 1.00
Depreciation & other fixed exp 2.00 -

Out side purchase price $6.50

Total cost $8.00 $6.00 $6.50
Difference in favor of continuing $0.50
to make
 Make or buy decisions . . .
 It is advisable to make the component itself if the
variable cost of making the component is lower
than the outside purchase price.
 But in case the variable cost is higher than the
purchase price, it is better to buy the component
from outside than to make it.
 From the above case we conclude that it is not
advisable to buy the component from outside since
purchase price ($6.50) is higher than variable cost
($6.00).
 Make or buy decisions . . .
• If suppliers reduces the price from $6.50 to $5.50, it is
advisable to buy the component from outside rather than
making since outside price is less than the variable cost.

costs Production /unit Make Buy

Direct materials $3.00 $3.00
Direct labor 2.00 2.00
Other variable expenses 1.00 1.00
Depreciation & other fixed exp 2.00 -
Out side purchase price $6.50
Total cost $8.00 $6.00 $6.50
Difference in favor of continuing to $0.50
make