Chapter – four

Cost -Volume -Profit (CVP) Analysis

The first step in CVP analysis classifying costs as variable and fixed based on their
behavior.
Variable Cost - is a cost that changes in direct proportion to changes in the cost driver.
Fixed Cost - is a cost that remains constant over a given period called relevant range.
Variable cost per unit is constant -where as fixed cost per unit changes in opposite
direction with an increase in cost driver.
Relevant Range: is the limit of cost driver activity with in which a specific relation ship
b/n the cost & the cost driver is valid.
Cost -Volume -Profit (CVP) Analysis
CVP Analysis: is one of the most powerful tools that managers have at their command. It
helps them understand the interrelationship between cost, volume, and the profit of an
organization and hence, it helps to make important decisions like for example:
 what products to manufacture or sell
 what price policy to follow
 what marketing strategy to apply

Basics of CVP Analysis

Consider the following example:
Mary Alebachew plans to sell a home-office software package at a heavily
attended two-month computer convention (Exhibition) in Addis. Mary can
purchase this software from computer software wholesaler at Br.120 per package.
The packages will be sold at Br 200 each. She has already paid Br. 2000 for the
booth rental for a month convention. Assume there are no other costs and number
of units sold is 100.
Summary of the data:
Number of units sold 100 units
Selling price per unit Br.200
Variable cost per unit 120
Monthly fixed costs 2000

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 Contribution Margin
Contribution margin is the difference of sales revenue and all variable costs. Thus
the contribution margin is the amount, which contributes to cover the fixed cost.
Once the fixed cost is recovered, the amount will contribute for profit of the
period.
Total Per unit
Sales Br.20,000 Br.200
Less: VC 12,000 120
Contribution Margin Br.8000 Br.80
Less: Fixed Costs 2000
Operating Income Br.6000
Notice that sales, variable expenses and contribution margin are expressed on a per unit
basis as well as in total.
B. Contribution Margin Ratio: the contribution margin as a percent of total sales is
referred to as the contribution margin ratio.
CM per Unit
CM percentage (CM ratio) = Selling Pr ice

= 80/200 =40%
CM % -Shows CM achieved per dollar of revenue.

BREAKEVEN POINT (BEP) Analysis

Breakeven point is an important aspect of CVP analysis. Managers usually ask ‘what
volume of sales do we need to breakeven? ’when they starting a new product line.
Breakeven point is the level of out put where total revenues equal total costs i.e.
company’s profit is zero. It tells mgrs what level of sales they must generate to avoid a
loss.
METHODS TO DETERMINE BEP
1. EQUATION METHOD
It is used to determine the BEP and focus on the contribution margin approach. It express
the income statement in equation form as follows:

Net Income = Revenues - Variable costs - Fixed costs

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 = (SP x Q) - (V x Q) - FC
Q = FC/(SP-VC)
For Mary, the BEP is:
0 = (200 x Q) - (120 x Q) - 2000
80Q= 2000  Q = 25 units.
IF Mary sells fewer than 25 units, she will have a loss; if she sells 25 units she will
break even; and if she sells more than 25 units, she will make a profit.
BEP in dollars = SP*BEPQ
25 x 200 = $ 5,000
2. CONTRIBUTION MARGIN METHOD
It uses the equation method to determine the BEP. Taking the above general Equation
we've:
NI = (SP x Q) - (V x Q) - FC
 NI + FC = Q(SP - V)
NI  FC
Q= SP V but SP - V = contribution per unit and by definition, at BEP, NI

equals zero.

FC
 Q i.e. Break even in quantity
CM per unit

Fixed Cost
Contribution M arg in Per Unit

2000
Break even in quantity = = 25 units
80 / unit

Break even Revenue = Break even quantity x Price per unit

FC
BE Rev. = , UCM/SP = CM %
UCM / SP

FC
BE Re v. 
CM %

2000
BEP in revenue for the above example = = $ 5,000
40%

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CVP Relationships in Graphic Form

The relationships among revenue, cost, profit, and volume can be expressed graphically
by preparing a CVP graph. A CVP graph highlights CVP relationships over wide range
of activity and can give managers a perspective that can be obtained in no other way.

BEP Graph

Reading the BEP Graph

BEP- BEP is determined by the intersection of the total revenue line and the total
expense line. The company in our example breaks even at 350 units, or $87,500 of sales.
This agrees with the calculation made earlier.

Profit and loss area - The CVP graph discloses more information than the BEP
calculation. From the graph, a manager can see the effects on profits of changes in
volume. The vertical distance between the lines on the graph represents the profit and
loss area at a particular sales volume. If sales are fewer than 350 units, the organization
will suffer a loss. The magnitude of the loss increases as sales decline. The organization
will have a profit if sales exceed 350 units a month.

Implications of the Breakeven Point - The position of the breakeven point within the
organization's relevant range of activity provides important information to management.

Target Profit Analysis

Managers can also use CVP analysis to determine the total sales, in units & dollars,
needed to reach a target profit.
Target sales - Variable costs - Fixed costs = Target NI.
SPQ - VQ - FC = NI
Q (SP-VC) = NI + FC
NI  FC
Q
UCM
Example: If Mary considers Br. 2,000 the minimum acceptable net income, how many
units she must sell?

NI  FC
Q
UCM
2000  2000
= = 50 Units
80
If Mary wants to get a minimum NI of Br. 2000 she has to sell 50 units.

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 NI  FC 2000  2000
Target Sales volume in dollars = CM % = 40 %
$ 10,000

Consideration of Income Tax

NI after tax = Operating Income - Income tax.
SPQ - VQ -FC = Target NI
NI
Q (SP-V) = + FC
1 R
NI  FC (1  TR )
Q
UCM (1  TR )

Example: Suppose Mary considers Br. 2400 minimum acceptable net income and pays
an income and pays an income tax of 40 %, how many units she must sell?

NI  FC (1  TR )
Target sale = Q
UCM (1  TR )

2400  2000(0.6) 3600

= = = 75 units
80(0  60) 48
Margin of Safety:
It is the excess of expected sales over the breakeven volume of sales. It shows how far
sales can fall below the planned level before losses occur. Shows how far sales can fall
below the planned level before losses occur. It can be computed as follows:
Margin of Safety (MOS) = planned sales - BEP unit sales. It can be expressed in ratio by
dividing the MOS amount to the expected sales.
Sensitivity Analysis

Sensitivity analysis involves studying the effects of changes in variable costs, fixed costs,
sales price, and sales volume, on the company’s profitability.

Per unit Percent of sale

Sales Price $250 100%

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Less: Variable Exp. 150 60%
Contribution margin 100 40%

Total monthly fixed expenses=$35, 000

1. Change in fixed cost and sales volume

The company is currently selling 400 units per month (monthly sales of $100, 000). The
sales manager feels that a $10,000 increase in the monthly advertising budget would
increase monthly sales by $30,000. Should the advertising budget be increased?

Incremental cm ($30,000*40%) $12,000

Less: Incremental advertising Expense 10,000
Incremental Net Income 2,000

Assuming there are no other factors to be considered, the increase in the advertising
budget should be approved since it would lead to an increase in net income of $2,000.

2. Change in variable costs and sales volume

Refer back to the original data. Recall that the co. is currently selling 400 units per
month. Management is contemplating the use of high quality components, which would
increase variable costs (and thereby reduce the contribution margin) by $10 per unit.
However, the sales manager predicts that the higher overall quality would increase sales
to 480 units per month. Should the higher quality components be used?

The $10 increase in variable costs will cause the unit contribution margin to decrease
from $100 to $90.

Expected total contribution margin with higher quality

Components: 480 units x $90 $43,200
Present total contribution margin: 400 units x $100 40,000
Increase in total contribution margin $ 3,200

Yes, based on the information above, the higher quality components should be used.
Since fixed costs will not change, net income should increase by the $3,200 increase in
cm shown above.

3. Change in fixed cost, sales price, and sales volume

Refer to the original data and recall again that the company is currently selling 400 units
per month. To increase sales, the sales manager would like to cut the selling price by $20
per unit and increase the advertising budget by $15,000 per month. The sales manager
argues that if these two steps are taken, unit sales will increase by 50% to 600 units per
month. Should the changes be made?

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A decrease of $20 per unit in the selling price will cause the unit contribution margin to
decrease from $100 to $80.

Expected total contribution margin with lower selling price

600 units x $80 $48,000
Present total contribution margin: 400 units x $100 40,000
Incremental contribution margin 8,000
Less: Incremental fixed costs 15,000
Reduction in Net Income $ (7,000)

No, Based on the information above, the changes should not be made.

4. Change in variable cost, fixed cost, and sales volume

Refer to the original data. As before, the company is currently selling 400 units per
month. The sales manager would like to place the sales staff on commission basis of $15
per unit sold, rather than on flat salaries that now total $6,000 per month. The sales
manager is confident that the change will increase monthly sales by 15% to 460 units per
month. Should the change be made?

Changing the sales staff from a salaried basis to a commission basis will affect both fixed
and variable costs. Fixed costs will decrease by $6,000, from $35,000 to $29,000.
Variable costs will increase by $15, from $150 to $165, and the unit contribution margin
will decrease from $100 to $85.

Expected total contribution margin with sales staff on

Commissions: 460 units x $85 $39, 100
Present total contribution margin: 400 units x $100 40, 000
Decrease in total contribution margin (9, 000)
Add: Salaries avoided if a commission is paid 6, 000
Increase in Net Income $ 5, 100

Yes, based on the information above, the changes should be made.

5. Change in regular sales price

Refer to the original data where the company is currently selling 400 units per month.
The company has an opportunity to make a bulk sale of 150 units to a wholesaler if an
acceptable price can be worked out. This would not disturb the company’s regular sales.
What price per unit should be quoted to the wholesaler if the company wants to increase
its monthly profits by $3,000?

Variable cost per unit $150

Desired profit per unit ($3, 000/150 units) 20
Quoted price per unit $170

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Notice that no element of fixed cost is included in the computation. This is because fixed
costs are not affected y the bulk sale, so all of the additional revenue that is in excess of
variable costs goes to increasing the profits of the company.

CVP Analysis with Multiple Products

For any organization selling multiple products, the relative proportion of each type of
product sold is called the sales mix.
Sales mix - is the relative proportion or combinations of quantities of products that comprise
total sales. It is an important assumption in multi-product CVP analysis and is used to compute the
weighted average unit contribution margin.
Example: Suppose Mary intends to sell two soft ware products X & Y for the next convention &
budgets the following.

X Y Total
Units Sold. 60 40 100
Revenues, $200 & $100 per unit $12,000 $ 4,000 $16,000
Variable Costs, $120 & $70 per unit 7,200 2,800 10,000
Unit Contribution Margin, $80 & $ 30 $ 4,800 $ 1200 $ 6,000
Fixed Costs 4,500
Operating Income $ 1,500

Required: What is the BEP (in units & in Birr)? (Assume that the budgeted sales unit
3:2 is maintained i.e. It will not be changed at different level of total unit
sales).
CMUx. X  CMUy.Y
Weighted - Average Contribution Margin per unit =
X Y
80 x 60  30 x 40 6000
= = = $ 60 OR
60  40 100
the CM of each will be multiplied by its sales mix i.e.
(80*60%) + (30*40%) = $60
FC 4,500
 BEP = WA UCM = = 75, units. I.e. 60 % x 75 = 45 units of X
60
40 % X 75 = 30 units of Y

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 To Compute the BER (total revenues required to break even)
Total WCM 80 x 60  30 x 40
Weighted - Average CM % = Total Re venues = = 0.375 or
200 x60  100 x 40
37.50%
FC 4,500
 BER = WA CM % = = $ 12,000
0.375
Assumptions and limitations of CVP analysis
For any CVP analysis to be valid, the following important assumptions must be satisfied
with in the relevant range:
 The total revenue line and the total expenses line must be straight line, i.e. the
selling price per unit, the variable cost per unit, and the total fixed cost must
remain the same within the relevant range.
 In multi-product companies, the sales mix remains constant over the relevant
range.
 In manufacturing firms, number of units produced must equal with the number of
units sold