CHAPTER ONE

COST- VOLUME- PROFIT ANALYSIS

(CVP-ANALYSIS)

By Niway A.

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 Variable & Fixed Cost Behavior & Patterns
Cost behavior refers to how a cost will react or respond to
changes in the level of business activity.
As the activity level rises and falls, a particular cost may rise
and fall as well or it may remain constant.
For example, to predict profit as sales and production volume
changes, to estimate cost which affect a variety of decisions.
Understanding the behavior of cost depend on cost drivers and
its relevant range.
CVP analysis helps managers to understand the
interrelationship between cost, volume, and profit.
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 Types of cost behavior
• Variable Cost - is a cost that changes in direct proportion to changes
in the cost driver. Ex: direct materials, direct labour, manufacturing
overhead (such as utilities, supplies, and lubricants) and sales
commissions.

• Fixed Cost- is a cost that remains constant over a given period called
relevant range. Ex: Rent or depreciation expenses for factory building.

• 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.
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 WHAT IS CVP ANALYSIS?
Cost-volume-profit (CVP) analysis is a technique that
examines changes in profits in response to changes in
sales volumes, costs, and prices. Accountants often
perform CVP analysis to plan future levels of operating
activity and provide information about:
• Which products or services to emphasize
• The volume of sales needed to achieve a targeted level
of profit
• The amount of revenue required to avoid losses
• Whether to increase fixed costs
• How much to budget for discretionary expenditures
• Whether fixed costs expose the organization to an
unacceptable level of risk 4
 Assumptions in CVP Analysis
 All costs are classified as fixed or variable with unit level activity
cost drivers.
 When graphed, the behavior of total revenues and total costs is
linear (straight-line) in relation to output units within the relevant
range.
 The unit selling price, unit variable costs, and total fixed costs are
known and constant.
 It ignores time value of money. In CVP analysis, all revenues and
costs can be added and compared without taking into account the
time value of money.
 For multiproduct companies, sales mix is constant. Sales mix is
the relative proportion of quantities of products or services that
make up total revenue.
 In manufacturing companies, inventories do not change or
beginning inventory equals ending inventory. This implies that
units produced equal units sold.
 Workers and machine efficiency and productivity will be
unchanged 5
 Limitations of CVP Analysis
I. It is assumed that the production facilities
anticipated for the purpose of CVP analysis do not
undergo any change. Such analysis gives misleading
results if expansion or reduction of capacity takes
place.
II. In case where a variety of products with varying
margins of profit are manufactured, it is difficult to
forecast with reasonable accuracy the volume of
sales mix which would optimize the profit.

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 Con’t
III. The analysis will be correct only if input price and
selling price remain fairly constant which in reality is
difficulty to find. Thus, if a cost reduction program is
undertaken or selling price is changed, the relationship
between cost and profit will not be accurately depicted.
IV. In CVP analysis, it is assumed that variable costs are
perfectly and completely variable at all levels of activity and
fixed cost remains constant throughout the range of volume
being considered. However, such situations may not arise in
practical situations.
V. It is assumed that the changes in opening and closing
inventories are not significant, though sometimes they may be
significant.
VI. Inventories are valued at variable cost and fixed cost is
treated as period cost. Therefore, closing stock carried over to
the next financial year does not contain any component of
fixed cost. Inventory should be valued at full cost in reality.
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 CONTRIBUTION MARGIN VS GROSS MARGIN
Contribution margin can be expressed in three ways: in total,
on a per unit basis, and as percentage of revenues.
1. The total contribution margin is total revenue minus total
variable costs. Total CM= Total revenue – Total VC
2. The contribution margin per unit is the selling price per
unit minus the variable cost per unit.
CM per unit= Unit selling price – VC per unit
3. Contribution margin percentage (also called contribution
margin ratio or P/V ratio**) is the percentage of contribution
margin in sales.
CM ratio or percentage = Total CM/Total sales or
CM ratio or percentage = Unit CM÷ Unit Selling Price
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CVP analysis begins with the basic profit equation.
• Profit = Total revenue - Total costs
• Separating costs into variable and fixed categories, we express
profit as:
• Profit = Total revenue - Total variable costs - Total fixed costs
Profit = P.Q -V.Q-FC
Where;
P=sales price per unit V=Variable cost per unit Q=units sold
FC=Fixed cost per period
Variable cost ratio is the percentage of variable cost in sales.
Variable cost ratio is the percentage of variable cost in sales.
Variable cost ratio=
Total VC /Total sales or
Unit variable cost/Unit sales price
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 Break Even Analysis Uses & Techniques
 The study of cost-volume-profit analysis is usually referred as break-
even analysis.
 This term is misleading, because finding break-even point is often just
the first step in planning decision.
 CVP analysis can be used to examine how various alternatives that a
decision maker is considering affect operating income. The break-
even point is frequently one point of interest in this analysis.
 Break-even point (BEP) can be defined as the point where total
sales revenue equals total costs, i.e., total variable cost plus total
fixed costs.
 It is a point where the total contribution margin equals total fixed
expenses. Stated differently, it is a point where the operating income is
zero.
 There are three ways to compute the BEP
1) Equation technique,
2) Contribution margin technique and
3) Graphical method.
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 Con’t
1) Equation Technique
 It is the most general form of break-even analysis that may be
adapted to any conceivable cost-volume-profit situation.

 This approach is based on the profit equation.

 Income (or profit) is equal to sales revenue minus expenses.

Revenues - Variable costs - Fixed costs = Operating income

Revenues= Selling price (SP) x Quantity of units sold (Q)

Variable costs =Variable cost per unit (VCU)x Quantity of units sold (Q)

So,
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 Con’t
2) Contribution Margin Technique
 The contribution margin technique is merely a short version of the
equation technique. Under this method, the breakeven point (BEP) in
units and in revenues is computed as follows:
 BEP units = Total fixed costs/CM per unit
 BEP revenues = Total fixed costs/CM Ratio or
 BEP revenues = BEP units x Selling price
3) Graphical Method
• 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.
 Total Revenue Line is line representing total sales birrs at the activity
you have selected.
 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.
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Example (1) Zoom Company manufactures and sells a telephone
answering machine. The company’s income statement for the most
recent year is given below:
Per Percent
Total Unit
Sales (20,000 units) Br. 1,200,000 Br. 60 100
Variable expenses Br. 900,000 Br. 45 ?
Contribution Margin Br. 300,000 Br. 15 ?
Fixed Expenses Br. 240,000
Net Income Br. 60,000

Required: Based on the above data, answer the following questions.

A. Compute the company’s CM ratio and variable expense ratio.

B. Compute the company’s break-even point in both units and sales birrs. Use
the above three approaches to compute the break-even point.

C. Assume that sales increase by Br. 400,000 next year. If cost behavior patterns
remain unchanged, by how much will the company’s net income increase?
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 Solution:
A. CM ratio = 60-45 = 0.25 (25%)
60
Variable expense ratio = 1 – CM ratio = P-V
P
= 1-0.25 = 60 – 15 = 0.75 (75%)
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B. Method 1: Equation Method
i) Net Income (NI) = PQ – VQ – FC
0 = Q (60-45) – 240,000
15Q = 240,000
Q = 240,000 =16,000 units, at Br. 60 per unit, Br. 960,000
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ii) Let “X” be sales volume in birrs to break-even point
CM- ratio = 0.25
Variable expense ratio = 0.75
Net Income = Total revenue – Total variable expense – Total fixed cost
0 = X – 0.75X-240,000
0.25X = 240,000
X = 240,000 = Br. 960,000
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0.25
Method 2: Contribution Margin Method
i)BEP (in units) = Fixed expenses/CM per unit
= Br. 240,000/Br. 60 – Br. 45
= 16,000 units
ii)BEP (in birrs) = Fixed expenses/CM ratio
= Br. 240,000/0.25
= Br. 960,000

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• Method 3: Graphical method
• To plot fixed costs, measure Br. 240,000 on the vertical axis and
extend a line horizontally.
• Select a point (say, 20,000 units) and determine the total costs (the
total of fixed and variable) at the selected activity level.
• The total costs at this output level are Br. 1,140,000= Br. 240,000 +
(20,000 X Br. 45).
• Then, starting from the selected point draw a line back to the origin
where the fixed cost line touches the vertical axis.
• The break-even point (BEP) is where the total revenues line and the
total costs line intersect. At this point, total revenues equal total
costs. Refer Exhibit 3.2.

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Method 3: Graphical method (Exhibit 3.2)
Exhibit 3.2 Cost-Volume-Profit Chart TR
TC

Br.1,500,00

Br. 750,000 BEP

Br. 500,000
TR= Total revenues line
Br. 250,000 TC = Total costs line

0 , X
10,000 20,000 30,000 40,000

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C. Since the fixed expenses are not expected to change,
net income will increase by the entire Br. 100,000 increase
in contribution margin.
Increase in sales Br. 400,000
Multiply by the CM ratio X 25%
Expected increase in contribution margin Br. 100,000

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 MARGIN OF SAFETY
The margin of safety is the excess of budgeted (or
actual) sales over the breakeven volume of sales.
It states the amount by which sales can drop before
losses begin to be incurred.
Margin of safety= Total sales - Break even Sales
Margin of safety ratio = Margin of safety/Total
sales

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 Sensitivity Analysis
What is sensitivity analysis?
Sensitivity analysis is a "what if" technique that managers
use to 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 analysis, sensitivity analysis
examines how operating income (or the breakeven point)
changes if the predicted data for selling price, variable
costs per unit, fixed costs, or units sold are not achieved.
The sensitivity to various possible outcomes broadens
managers' perspectives as to what might actually occur
before they make cost commitments.
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Example 1 : Addis Matador Tires, Inc. sells tires to service
stations for an average of Br 450 each. The variable cost of
each tire is Br 300 and monthly fixed manufacturing costs
total Br 150,000. Other monthly fixed costs of the company
total Br 120,000.
Required:
a)What is the break-even sale of Addis?
b)What is the break-even level in tires, assuming variable
costs increase by 20 percent?
c)What is the break-even level in tires, assuming the selling
price goes up by 10 percent, fixed manufacturing costs and
other fixed costs decline by 10% and Br 1,500,
respectively? Assume all other factors remain unchanged.

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 Solution:
a) BEP (in units) = Fixed expenses/CM per unit

= Br 270,000/Br 450– Br 300 = 1,800 tires

BEP (in birrs) = BEP (in units) x P=1,800 x 450 = Br 810,000

b) BEP (in units) = Fixed expenses/CM per unit

= Br 270,000/450– 360 = 3,000 tires

**New VC= 300 X 1.2=Br 360

c) BEP (in units) = Fixed expenses/CM per unit

= Br 253,500/495–300= 1,300 tires

** New fixed cost? =Br 253,500

** New sales price= 450 x 1.1=Br 495 22

 TARGET PROFIT ANALYSIS
 CVP analysis often assists in the development of detailed profit
plans by allowing management to manipulate the cost-volume
profit relationships to determine the required sales volume
needed to achieve the desired profit. The sales volume necessary
to achieve a target profit can be determined using the following
formulae:
 Target sales (in units)=Total Fixed Costs+Target Profit /CMper
unit
 Target sales (in dollars) = Total Fixed Costs+ Target profit /CM Ratio

 Thus, the target profit indicates the level of activity or dollar

sales amount at which total contribution margin equals total
fixed costs plus the desired profit amount.

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 IMPACT OF TAXES ON CVP ANALYSIS

In order to determine the level of sales required to

achieve a profit level on an after-tax basis, it is
necessary to first convert the after-tax profit-to-
profit before-tax as follows:
NIBT=NIAT/1-t
*NIBT=net income before tax
T=tax rate
In this equation “t”& NIAT are the prevailing
company tax rate and net income after taxes,
respectively

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Example 1. Selam Company has revenues of Br
500,000, variable costs of Br 350,000 and fixed
costs of Br 135,000.
Required:
a)Compute contribution margin percentage.
b)Compute total revenues needed to break even.
c)Compute total revenues needed to achieve a
target operating income of Br 45,000.
d)Compute total revenues needed to achieve a
target after tax net income of Br 63,000, assuming
the income tax rate is 40%.
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 CVP ANALYSIS AND MULTIPRODUCT COMPANIES
*What if the company deals with several product?
Sales mix (also called revenue mix) is defined as the
relative proportions or combinations of quantities of
products that comprise total sales. 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.

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In the general case the CVP equation could be
presented as:
P1Q1 + P2Q2+...+PnQn – V1Q1 – V2Q2-...VnQn-FC = NI
where
P1 = Selling price per unit of product 1
Q1 = Number units of 1 produced and sold
V1 = Unit variable cost of product 1
FC = Fixed Cost per Period
NI = Net Income

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In a multi product firm, break-even analysis is
somewhat more complex. The reason is that different
products will have different selling prices, different
costs, and different contribution margins. Using
contribution margin approach, the computation of the
break-even point (BEP) in multi product firm follows:
BEP (in units) = Total fixed expenses/*Weighted
average CM
BEP (in birrs) = Total Fixed Expenses/CM ratio
Note: *Weighted average unit contribution margin is
the average of the several products’ unit contribution
margins, weighted by the relative sales proportion of
each product
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For a company with more than one product, sales
mix is the relative combination in which a
company’s products are sold.
Different products have different selling prices,
cost structures, and contribution margins.

Let’s assume ABC company sells X &Y Product

and see how we deal with break-even analysis.

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How much is the BEP Units?

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Summary

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CVP Analysis

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CVP

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 Exercise 1
1. ABC Printers provides photocopy services to its customers.
The unit variable cost and selling price are Br 0.20 and Br 0.50,
respectively, while monthly fixed costs total Br. 1,500.
Required:
a) How many pages must ABC copy in a month to breakeven?
b) How many pages must ABC copy to earn Br. 900 profit per
month?
c) How much sales revenue should ABC earn in a month to
breakeven?
d) How many pages must ABC copy to earn Br. 700 profit after
30% income tax?
e) If price per page is increased to Br. 75, how many pages must
ABC copy in a month to breakeven?

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Exercise 2

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End of chapter 1
Thank You!!!
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