UNIVERSITY OF SAINT LOUIS

Tuguegarao City

SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY

Short Term
A.Y. 2022-2023

COURSE LEARNING MODULE

MATH 1033 (Mathematical Analysis of Management)

Lesson 7: Cost-Volume-Profit (CVP) Analysis

Topics: The Basics of Cost-Volume-Profit (CVP) Analysis

Learning Outcomes: At the end of this module, you are expected to:

1. Explain how changes in activity affect contribution margin and net operating income;
2. Prepare and interpret a CVP graph and a profit graph;
3. Calculate how costs behave and respond to changes in the level of business activity and how it
influences decision making in manufacturing firms;
4. Use the contribution margin ratio to compute changes in contribution margin and net operating income
resulting from changes in sales volume.

LEARNING CONTENT

Introduction:

After knowing the different terms that are used to classify costs in business, we will use many of these
terms in this topic. This module describes the basics of Cost-Volume-Profit (CVP) analysis, an essential tool for
decision making. CVP analysis helps managers understand the interrelationships among cost, volume, and
profit.

Lesson Proper:

COST-VOLUME-PROFIT RELATIONSHIPS
Cost-volume-profit (CVP) analysis helps managers make many important decisions such as what products and
services to offer, what prices to charge, what marketing strategy to use, and what cost structure to maintain. Its primary
purpose is to estimate how profits are affected by the following five factors:

1. Selling prices.
2. Sales volume.
3. Unit variable costs.
4. Total fixed costs.
5. Mix of products sold.

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 To simplify CVP calculations, managers typically adopt the following assumptions with respect to these
factors:

1. Selling price is constant. The price of a product or service will not change as volume changes.
2. Costs are linear and can be accurately divided into variable and fixed elements. The variable element is
constant per unit. The fixed element is constant in total over the entire relevant range.
3. In multiproduct companies, the mix of products sold remains constant.

While these assumptions may be violated in practice, the results of CVP analysis an often “good enough” to be
quite useful. Perhaps the greatest danger lies in relying on simple CVP analysis when a manager is
contemplating a large change in sales volume that lies outside the relevant range. However, even in these
situations the CVP model can be adjusted to take into account anticipated changes in selling prices, variable
costs per unit, total fixed costs, and the sales mix that arise when the estimated sales volume falls outside the
relevant range.

To help explain the role of CVP analysis in business decisions, we’ll now turn our attention to the case of Acoustic
Concepts, Inc., a company founded by Prem Narayan.

Prem, who was a graduate student in engineering at the time, started Acoustic Concepts to market
a radical new Speaker he had designed for automobile sound systems. The speaker, called the Sonic
Blaster, uses an advanced microprocessor and proprietary software to boost amplification to awesome
levels. Prem contracted with a Taiwanese electronics manufacturer to produce the speaker. With seed
money provided by his family, Prem placed an order with the manufacturer and ran advertisements in
auto magazines. The Sonic Blaster was an immediate success, and sales grew to the point that Prem
moved the company’s headquarters out of his apartment and into rented quarters in a nearby industrial
park. He also hired a receptionist, an accountant, a sales manager, and 3 small sales staff to sell the
speakers to retail stores. The accountant, Bob Luchinni, had worked for several small companies where
he had acted as a business advisor as well as accountant and bookkeeper. The following discussion
occurred soon after Bob was hired:

Prem: Bob, I’ve got a lot of questions about the company’s finances that I hope you can help
answer.

Bob: We’re in great shape. The loan from your family will be paid off within a few months.

Prem: I know, but I am worried about the risks I’ve taken on by expanding
operations. What would happen if a competitor entered the market and our sales slipped? HOW
far could sales drop without putting us into the red? Another question I’ve been trying to resolve
is how much our sales would have to increase to justify the big marketing campaign the sales
staff is pushing for.

Bob: Marketing always wants more money for advertising.

Prem: And they are always pushing me to drop the selling price on the speaker. I agree with
them that a lower price will boost our sales volume, but I’m not sure the increased volume will
offset the loss in revenue from the lower price.

Bob: It sounds like these questions are all related in some way to the relationships
among our selling prices, our costs, and our volume. I shouldn’t have a
problem coming up with some answers.

Prem: Can we meet again in a couple of days to see what you have come up with?

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 Bob: Sounds good. By then I’ll have some preliminary answers for you as well as
a model you can use for answering similar questions in the future.

THE BASICS OF COST-VOLUME-PROFIT (CVP) ANALYSIS

Bob Luchinni’s preparation for his forthcoming meeting with Prem begins with the contribution income
statement. The contribution income statement emphasizes the behavior of costs and therefore is extremely
helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. Bob will base
his analysis on the following contribution income statement he prepared last month:

Acoustic Concepts, Inc.

Contribution Income Statement
For the month of June
Total Per Unit
Sales (400 speakers). . . . . P100,000 P250
Variable expenses . . . . . . . 60,000 150
Contribution Margin . . . . . . 40,000 100
Fixed expenses . . . . . . . . . 35,000
Net Operating Income . . . . P 5,000

Notice that sales, variable expenses, and contribution margin are expressed on a per unit basis as well
as in total on this contribution income statement. The per unit figures will be very helpful to Bob in some of his
calculations. Note that this contribution income statement has been prepared for management’s use inside the
company and would not ordinarily be made available to those outside the company.

Contribution Margin

Contribution margin is the amount remaining from sales revenue after variable expenses have been
deducted. Thus, it is the amount available to cover fixed expenses and then to provide profits for the period.
Notice the sequence here-contribution margin is used first to cover the fixed expenses, and then whatever
remains goes toward profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss
occurs for the period. To illustrate with an extreme example, assume that Acoustic Concepts sells only one
speaker during a particular month. The company’s income statement would appear as follows:

Contribution Income Statement

Sales of 1 Speaker
Total Per Unit
Sales (1 speakers). . . . . P 250 P250
Variable expenses . . . . . . . 150 150
Contribution Margin . . . . . . 100 100
Fixed expenses . . . . . . . . . 35,000
Net Operating Income . . . . P(34,900)

For each additional speaker the company sells during the month, P100 more in contribution margin
becomes available to help cover the fixed expenses. If a second speaker is sold, for example, then the total
contribution margin will increase by P100 (to a total of P200) and the company’s loss will decrease by P100, to
P34,800:

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 Contribution Income Statement
Sales of 2 Speakers
Total Per Unit
Sales (2 speakers). . . . . P 500 P250
Variable expenses . . . . . . . 300 150
Contribution Margin . . . . . . 200 100
Fixed expenses . . . . . . . . . 35,000
Net Operating Income . . . . P(34,800)

If enough speakers can be sold to generate P35,000 in contribution margin, then all of the fixed expenses
will be covered and the company will break even for the month-that is, it will show neither profit nor loss but just
cover all of its costs. To reach the break' even point, the company will have to sell 350 speakers in a month
because each speaker sold yields P100 in contribution margin:

Contribution Income Statement

Sales of 350 Speakers
Total Per Unit
Sales (350 speakers). . . . . P 87,500 P 250
Variable expenses . . . . . . . 52,500 150
Contribution Margin . . . . . . 35,000 100
Fixed expenses . . . . . . . . . 35,000
Net Operating Income . . . . P 0

Computation of the break-even point is discussed in detail later in the chapter; for the moment, note that the
break-even point is the level of sales at which profit is zero.

Once the break-even point has been reached, net operating income will increase by the amount of the unit
contribution margin for each additional unit sold. For example, if 351 speakers are sold in a month, then the net
operating income for the month will be P100 because the company will have sold 1 speaker more than the
number needed to break even:

Contribution Income Statement

Sales of 351 Speakers
Total Per Unit
Sales (351 speakers). . . . . P 87,750 P 250
Variable expenses . . . . . . . 56,650 150
Contribution Margin . . . . . . 35,100 100
Fixed expenses . . . . . . . . . 35,000
Net Operating Income . . . . P 100

If 352 speakers are sold (2 speakers above the break-even point), the net operating income for the month will
be P200. If 353 speakers are sold (3 speakers above the break-even point), the net operating income for the
month will be P300, and so forth. To estimate the profit at any sales volume above the break-even point, multiply
the number of units sold in excess of the break-even point by the unit contribution margin. The result represents
the anticipated profits for the period. Or, to estimate the effect of a planned increase in sales on profits, simply
multiply the increase in units sold by the unit contribution margin. The result will be the expected increase in
profits. To illustrate, if Acoustic Concepts is currently selling 400 speakers per month and plans to increase sales
to 425 speakers per month, the anticipated impact on profits can be computed as follows:

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 Increased number of speakers to be sold . . . . . . . . . . . . . . . 25
Contribution margin per speaker . . . . . . . . . . . . . . . . . . . . . X P 100
Increase in net operating income . . . . . . . . . . . . . . . . . . . . . P2,500

These calculations can be verified as follows:

Sales Volume
400 425 Difference (25 Per Unit
speakers speakers speakers)
Sales (@P250 per speaker) . . . . . . . . . . . P100,000 P106,250 P 6,250 P 250
Variable expenses (P150 per speaker). . . 60,000 63,750 3,750 150
Contribution Margin. . . . . . . . . . . . . . . . . 40,000 42,500 2,500 100
Fixed expenses . . . . . . . . . . . . . . . . . . . 35,000 35,000 0
Net operating income . . . . . . . . . . . . . . . P 5,000 P 7,500 P 2,500

To summarize, if sales are zero, the company’s loss would equal its fixed expenses. Each unit that is sold reduces
the loss by the amount of the unit contribution margin. Once the break-even point has been reached, each
additional unit sold increases the company’s profit by the amount of the unit contribution margin.

*** END of LESSON***

REFERENCES

Textbook

Brewer, P., et.al. (2016). Introduction to managerial accounting. International edition 2016. 7th edition.
McGraw-Hill/Irwin.

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