Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

To understand what CVP analysis is, let’s assume that Mostafa restaurant data were as follows:
• Selling price per unit (SP) $
40
• Variable Cost per unit (VC) $
30
• Total fixed cost (Rent, salaries, & advertising) $
1,000
Prepare a contribution format income statement for two level of activities 150 units & 151 units.

increase sales Volume by one more unit will increase NOI (Profit) by $10 (contribution margin per unit)
As you see, any change in the volume of production will change the total cost & the total profit. This is which call CVP
analysis. Cost-volume-profit (CVP) analysis helps managers understand the interrelationships among cost, volume, and
profit by focusing their attention on the interactions among the prices of products, volume of activity, variable costs per
unit (VC), and total fixed costs (TFC).
This analysis is based on the fact that; for each number (#) of units sold there is a certain amount of cost & in turn a
certain amount of profit, so if we change the # of units, the amount of cost & in turn the amount of profit will change.
Assumptions of the CVP analysis
1- Selling price is constant. 2- We are working within the relevant range.
3- # produced = # sold (there is no inventory). 4- We only produce single product.
3 columns contribution format income statement
From now on, we will prepare a contribution format income statement with 3 columns:
1- Total: the default one you always make.
2- Per unit: for the first 3 lines (sales, TVC, & TCM) to be (SP, VC, & CM).
3- Ratio: for the first 3 lines (sales, TVC, & TCM) by dividing each item over sales either from total or per unit columns.

If we do that @ 150 units for Mostafa restaurant

Total Per Unit Ratio

Sales 6,000 SP 40
Sales (150 x 40) 6,000 40 100%
Sales 6,000 SP 40
TVC 4,500 VC 30
(-) TVC (150 x 30) (4,500) (30) (75%)
Sales 6,000 SP 40
TCM 1,500 CM 10
TCM (150 x 10) 1,500 10 25% Sales 6,000 SP 40
(-) TFC (1,000)
NOI 500

VC% & CM% complement each other.

 Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

Uses of CVP analysis

❶ ❷ ❸ ❹
What if analysis Cost structure (DOL) Breakeven analysis Sales mix

❶ What if analysis

Sometimes a manager wants to test some of the possible proposals to choose the best one that yields the
highest NOI for the company. To test any proposal, we will rearrange data in table contain 7 items (horizontal
income statement) with 3 lines:
SP - VC = CM x Sales# = TCM - TFC = NOI
Now - = x = - = ❶
Δ
New - = x = - = ❷
As you see, we just reorganize the given data in a horizontal income statement with 3 lines:
Now: original data, Δ: change according to proposal (BY) & New: New data after applying proposal (TO).

If the question is given sales in dollar instead of units, the first three columns will convert into percentages.
SP% - VC% = CM% x $Sales = TCM - TFC = NOI
Now 100%
- = x = - = ❶
Δ
New 100% - = x = - = ❷

Finally, to decide if accept or reject this proposal you should calculate:

Δ NOI = ❷ - ❶

If result is + If result is (-)

Accept Reject

If you compare between more than one proposal, you should choose the highest positive Δ NOI
 Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

Example (1): Refer to the original data in Mostafa restaurant which has the following income statement:

Total Per Unit Ratio

Sales (150 x 40) 6,000 40 100%

(-) TVC (150 x 30) (4,500) (30) (75%) Management is considering
% some proposals that may be
TCM (150 x 10) 1,500 10 25
useful to the company and
(-) TFC (1,000) needs your help in
NOI 500 evaluating those proposals:
Proposal ❶: The marketing manager argues that a $200 increase in the monthly advertising budget would increase monthly
sales by 50 units.
Proposal ❷: Management is considering using higher-quality components that would increase the variable cost by $2 per unit.
The marketing manager believes the higher-quality product would increase sales by 25 units.
Proposal ❸: The marketing manager would like to introduce sales commissions as an incentive for the sales staff. The marketing
manager has proposed a commission of 10% of sales. In exchange, the sales staff would accept a decrease in their flat salaries
of $400 per month. The marketing manager predicts that introducing this sales incentive would increase monthly sales by 100
units.
Proposal ❹: a top management member proposes that the company’s net operating income will increase if the company increase
its Selling price by $5 with higher-quality components that would increase the variable cost by $3 per unit, this will result in
cutting sales by 25 units.
Proposal ❺: another management member proposes that the company’s net operating income will increase if the company
increase its advertising by $400 which is likely to increase sales by $2,000.
Proposal ❶: + $200 in monthly advertising & + sales by 50 units
SP - VC = CM x
Sales# = TCM - TFC = NOI
Now 40 - 30 = 10 x
150 = 1,500 - 1,000 = 500
Δ + 50 + 200
New 40 - 30 = 10 x 200 = 2,000 - 1,200 = 800
Δ NOI = New – Now = 800 – 500 = + 300 accept
Proposal ❷: + VC by $2 & + sales by 25 units
SP - VC = CM x
Sales# = TCM - TFC = NOI
Now 40 - 30 = 10 x150 = 1,500 - 1,000 = 500
Δ +2 + 25
New 40 - 30 = 10 x 175 = 1,400 - 1,000 = 400
Δ NOI = New – Now = 400 – 500 = (-) 100 Reject
Proposal ❸: + VC by $4 (40 SP x 10% commission), (-) TFC (flat salaries) $400 & + sales by 100 units
SP - VC = CM x
Sales# = TCM - TFC = NOI
Now 40 - 30 = 10 x150 = 1,500 - 1,000 = 500
Δ +4 + 100 (400)
New 40 - 34 = 6 x 250 = 1,500 - 600 = 900
Δ NOI = New – Now = 900 – 500 = + 400 accept
Proposal ❹: + SP by $5, + VC $3 & (-) sales to 125 units
SP - VC = CM x
Sales# = TCM - TFC = NOI
Now 40 - 30 = 10 x
150 = 1,500 - 1,000 = 500
Δ +5 +3 (25)
New 45 - 33 = 12 x 125 = 1,500 - 1,000 = 500
Δ NOI = New – Now = 500 – 500 = 0 no effect.
Proposal ❺: + TFC $400 & + sales by $2,000
SP% - VC% = CM% x $Sales
= TCM - TFC = NOI
Now 100 %
- 75% = 25% x
6,000 = 1,500 - 1,000 = 500
Δ + 2,000 + 400
New 100% - 75% = 25 % x 8,000 = 2,000 - 1,400 = 600
Δ NOI = New – Now = 600 – 500 = + 100 accept
I advise management to choose the third proposal because it achieves the higher NOI
 Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

❷ Cost structure

Manger must decide the relative proportion of fixed cost & variable cost in a company.

• Manager may invest in equipment that leads to more fixed costs (cost of acquisition this machine) and
will also lead to a reduction in the variable cost of the unit produced (Because this equipment will lead
to a decrease in manual work).
• Vice versa, the manager may decide to do more of work manually, which leads to a reduction in fixed
costs and will also lead to an increase in the variable cost (direct labor cost).

It is all due to the preferences and expectations of managers regarding Industry field.

Here we can use Degree of operating leverage (DOL) as an indicator for the sensitivity of changes in net income
according to changes in sales.
TCM
DOL =
NOI

We can use this indicator to predict the percentage of Δ in NOI according to the percentage of Δ in
sales as follows:
% %
Δ NOI = Δ sales × DOL
Example (2):
Given the following data for 2 different companies Mostafa & Malika that produces the same product: (numbers
are in thousands)
Mostafa Malika
Sales volume 10 units 10 units
SP $
20 per unit $
20 per unit
VC $
5 per unit $
10 per unit
TFC $
100 $
50
Required:
1- Prepare comparative income statement & Calculate DOL for each company.
2- Prepare new income statement assuming that sales increased 10% & compute the percentage of increase in NOI
for each company.
3- Prepare new income statement assuming that sales decreased 20% & compute the percentage of decrease in
NOI for each company.
4- Recalculate the percentage of increase & decrease in NOI for each company in the previous 2 cases without
using new income statement.
 Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

1- Comparative Income statement when sales volume is 10 units

Mostafa Malika
Sales (10 x 20) 200 200
(-) TVC (10 x 5) (10 x 10) (50) (100)
TCM 150 100
(-) TFC (100) (50)
NOI 50 50
TCM
/ NOI 150
/ 50 100
/ 50
DOL 3 times 2 times

2 & 3- Comparative Income statement after changing sales

+ 10% of sales: (-) 20% of sales:

New sales = 10 + (10 × 10%) = 11 New sales = 10 - (10 × 20%) = 8
Mostafa Malika Mostafa Malika
Sales (11 x 20) (8 x 20) 220 220 160 160
(-) TVC {(11, x 5) (11, x 10)} {(8 x 5) (8 x 10)} (55) (110) (40) (80)
TCM 165 110 120 80
(-) TFC (100) (50) (100) (50)
NOI 65 60 20 30
New NOI – Old NOI (65 – 50) / 50 (60 – 50) / 50 (20 – 50) / 50 (30 – 50) / 50
Δ% NOI =
Old NOI = 30% = 20% = (-) 60% = (-) 40%

4- Recalculate Δ% NOI without using new income statement

Here the importance of DOL appears, as it helps to speed up the data analysis process (timeliness)

Δ% NOI = Δ% sales × DOL

+ 10% of sales: (-) 20% of sales:

New sales = 10 + (10 × 10%) = 11 New sales = 10 - (10 × 20%) = 8
Mostafa Malika Mostafa Malika

Δ% NOI = Δ% sales × DOL

+ 10% x 3 times + 10% x 2 times - 20% x 3 times - 20% x 2 times
% % %
= 30 = 20 = 60 = 40%

Conclusion
Based on the above, the higher proportion of fixed costs in the company's cost structure, the higher
sensitivity of NOI to change in sales. As higher sales will increase NOI more, while lower sales will
reduce NOI further.
 Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

Example (3):
Malika Corporation produces and sells a single product. Data concerning that product; selling price $140 per unit,
variable cost $42 per unit, & fixed cost are $490,000 per month. The company is currently selling 6,000 units per
month. Consider each of the following questions independently.
1- The marketing manager believes that a $14,000 increase in the monthly advertising budget would result in a
150 unit increase in monthly sales. What should be the overall effect on the company's monthly net operating
income of this change?
2- Management is considering using a new component that would increase the unit variable cost by $5. Since the
new component would increase the features of the company's product, the marketing manager predicts that
monthly sales would increase by 300 units. What should be the overall effect on the company's monthly net
operating income of this change?
3- The marketing manager would like to cut the selling price by $7 and increase the advertising budget by $28,000
per month. The marketing manager predicts that these two changes would increase monthly sales by 500 units.
What should be the overall effect on the company's monthly net operating income of this change?
4- The marketing manager would like to introduce sales commissions as an incentive for the sales staff. The
marketing manager has proposed a commission of $11 per unit. In exchange, the sales staff would accept a
decrease in their salaries of $58,000 per month. The marketing manager predicts that introducing this sales
incentive would increase monthly sales by 100 units. What should be the overall effect on the company's monthly
net operating income of this change?

Required ❶: + $14,000 in TFC & + sales by 150 units

SP - VC = CM x
Sales# = TCM - TFC = NOI
Now 140 - 42 = 98 x
6,000 = 588,000 - 490,000 = 98,000
Δ + 150 + 14,000
New 140 - 42 = 98 x 6,150 = 602,700 - 504,000 = 98,700
Δ NOI = New – Now = 98,700 – 98,000 = + 700 accept

Required ❷: + $5 in VC & + sales by 300 units

SP - VC = CM x Sales# = TCM - TFC = NOI
Now 140 - 42 = 98 x 6,000 = 588,000 - 490,000 = 98,000
Δ +5 + 300
New 140 - 47 = 93 x 6,300 = 585,900 - 490,000 = 95,900
Δ NOI = New – Now = 95,900 – 98,000 = (-) 2,100 Reject

Required ❸: (-) $7 in SP, + 28,000 in TFC & + sales by 500 units

SP - VC = CM xSales# = TCM - TFC = NOI
Now 140 - 42 = 98 x6,000 = 588,000 - 490,000 = 98,000
Δ (7) + 500 + 28,000
New 133 - 42 = 91 x 6,500 = 591,500 - 518,000 = 73,500
Δ NOI = New – Now = 73,000 – 98,000 = (-) 24,500 Reject

Required ❹: + $11 in VC, (-) 58,000 in TFC & + sales by 100 units
SP - VC = CM x
Sales# = TCM - TFC = NOI
Now 140 - 42 = 98 x
6,000 = 588,000 - 490,000 = 98,000
Δ + 11 + 100 (58,000)
New 140 - 53 = 87 x 6,100 = 530,700 - 432,000 = 98,700
Δ NOI = New – Now = 98,700 – 98,000 = + 700 accept
 Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

Example (4):
Mostafa Company's most recent monthly contribution format income statement is given below:

Sales 60,000
(-) TVC (45,000)
TCM 15,000
(-) TFC (18,000)
NOI (3,000)
The company sells its only product for 10 per unit. There was no beginning or ending inventories.
$

Required: If number of unit sales were increased by 10% and fixed costs were reduced by $2,000,
what would be the company's expected net operating income?

First, you should complete income statement as follows:

÷
6,000 U
60,000
= 6,000 units Sales 60,000 10 100%
10
(-) TVC (45,000) (7.5) (75%)
TCM 15,000 2.5 25%
(-) TFC (18,000)
NOI (3,000)
SP - VC = CM x Sales# = TCM - TFC = NOI
Now 10 - 7.5 = 2.5 x 6,000 = 15,000 - 18,000 = (3,000)
Δ + 600 (2,000)
New 10 - 7.5 = 2.5 x 6,600 = 16,500 - 16,000 = 500
So, New NOI = 500
Example (5): Data for Yasser Corporation are shown below:
Per unit Ratio Fixed costs are $30,000
SP 90 100% per month and the
(-) VC (63) (70%) company is selling 2,000
CM 27 30% units per month.
Required: 1. The marketing manager argues that a $5,000 increase in the monthly advertising budget would
increase monthly sales by $9,000. Should the advertising budget be increased?
2. Refer to the original data. Management is considering using higher-quality components that would increase the
variable cost by $2 per unit. The marketing manager believes the higher-quality product would increase sales
volume by 10% per month. Should the higher-quality components be used?

Now $sales = 2,000 × 90 = $180,000

Required ❶: + TFC 5,000 & + sales by $9,000
$

SP% - VC% = CM% x $Sales = TCM - TFC = NOI

Now 100% - 70% = 30%
180,000 x = 54,000 - 30,000 = 24,000
Δ + 9,000 + 5,000
New 100% - 70 % = 30 % x 189,000 = 56,700 - 35,000 = 21,700
Δ NOI = New – Now = 21,700 – 24,000 = (-) 2,300 Reject
Required ❷: + $2 in VC & + sales by 200 units (2,000 x 10%)
SP - VC = CM x
Sales# = TCM - TFC = NOI
Now 90 - 63 = 27 x
2,000 = 54,000 - 30,000 = 24,000
Δ +2 + 200
New 90 - 65 = 25 x 2,200 = 55,000 - 30,000 = 25,000
Δ NOI = New – Now = 25,000 – 24,000 = + 1,000 accept
 Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

Example (6): Next year, Mostafa shirt company expects to sell 32,000 shirts. Mostafa is budgeting the
following operating results for next year: ÷
32,000 U
Sales 800,000 25 100%
(-) TVC (288,000) (9) (36%)
TCM 512,000 16 64%
(-) TFC (192,000)
NOI 320,000
Required: Mostafa is considering increasing its advertising by $48,000 next year by how much would sales have
to increase in order for Mostafa to still generate a $320,000 net operating income.

SP - VC = CM x
Sales# = TCM - TFC = NOI
Now 25 - 9 = 16 x
32,000 = 512,000 - 192,000 = 320,000
Δ +? + 48,000
New 25 - 9 = 16 x ? = 560,000 - 240,000 = 320,000
16 x New sales = 560,000
New sales = 560,000 / 16 = 35,000 units
So, sales should increase by 3,000 units or $75,000 (3,000 units x $25 per unit)
Example (7): XYZ Company distributes a high-quality wooden birdhouse that sells for $20/unit. Variable
costs are $8/unit, & fixed costs total $180,000 per year.
Required: Assume that the company sold 18,000 units last year. The president doesn't want to change the selling
price. Instead, he wants to increase the sales commission by $1/unit. He thinks that this move, combined with
some increase in advertising, would increase annual sales by 25%. By how much could advertising be increased
with profits remaining unchanged?

Increase in # sold = 18,000 × 25% = 4,500

SP - VC = CM x Sales# = TCM - TFC = NOI
Now 20 - 8 = 12 x 18,000 = 216,000 - 180,000 = 36,000
Δ +1 + 4,500 ?
New 20 - 9 = 11 x 22,500 = 247,500 - ? = 36,000
New TFC = 247,500 – 36,000 = 211,500
So, TFC should increase by 211,500 – 180,000 = 31,500
Example (8): The following is the contribution margin income statement for Alex Company for the year
÷
just ended. The company produces & sells a single product. 80,000 U
Sales (80,000 units) 3,000,000 37.5 100%
(-) TVC (1,800,000) (22.5) (60%)
TCM 1,200,000 15 40%
(-) TFC (960,000)
NOI 240,000
Required: Management is considering the use of new technology which is expected to reduce variable costs
percentage by 40% from its current percentage but it will increase fixed costs by $720,000 annually. If the new
technology is used, what will be sales dollars to maintain the same net operating income for the year just ended?

Reducing in VC = 60% × 40% = 24%

SP% - VC% = CM% x $Sales = TCM - TFC = NOI
Now 100%
- 60% = 40% x 3,000,000 = 1,200,000 - 960,000 = 240,000
Δ (24%) + 720,000
New 100% - 36% = 64% x ? = 1,920,000 - 1,680,000 = 240,000
%
64 New sales = 1,920,000 ⸫ New sales = 1,920,000 / 64% = 3,000,000
 Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

Example (9): A company has provided the following data:

Sales volume 3,000 units, SP $70, VC $50 & TFC $25,000.
If the sales volume decreases by 25%, the variable cost per unit increases by 15%, and all other factors remain the
same, determine the effect on net operating income.

Decrease in sales volume = 3,000 × 25% = 750

Increase in VC = 50 × 15% = 7.5
SP - VC = CM x Sales# = TCM - TFC = NOI
Now 70 - 50 = 20 x 3,000 = 60,000 - 25,000 = 35,000
Δ + 7.5 (750)
New 70 - 57.5 = 12.5 x 2,250 = 28,125 - 25,000 = 3,125
Δ NOI = New – Now = 3,125 – 35,000 = (-) 31,875
Example (10):
The budgeted contribution margin income statement for Cairo Corporation for next year given below:
Sales 4,000,000 100%
(-) TVC (2,400,000) (60%)
TCM 1,600,000 40%
(-) TFC (1,200,000)
NOI 400,000
Required:
1- what is the degree of operating leverage at this level of sales.
2- what is the effect on the company's net operating income if sales increase by 10% from the budgeted level?
3- a top management member proposes that the company’s net operating income will increase if the company
increase its advertising by $100,000 which is likely to increase sales by $400,000 do you agree with this proposal?
4- refer to the original income statement and assume that another management member proposes that if the
company pays more sales commission which will increase variable cost percentage by 5 % from its current level
and decrease advertising by $150,000, the company's net operating income is likely to increase from its current
level. do you agree with the statement made by the management member?

Required ❶: DOL = TCM / NOI = 1,600,000 / 400,000 = 4 times

Required ❷: Δ% NOI = Δ% sales × DOL = 10% × 4 times = 40%
Required ❸:
SP% - VC% = CM% x $Sales
= TCM - TFC = NOI
Now 100%
- 60% = 40% x
4,000,000 = 1,600,000 - 1,200,000 = 400,000
Δ + 400,000 + 100,000
New 100% - 60 % = 40 % x 4,400,000 = 1,760,000 - 1,300,000 = 460,000
Δ NOI = New – Now = 460,000 – 400,000 = + 60,000 accept
Required ❹:
Increasing in VC% = 60% × 5% = 3%
SP% - VC% = CM% x $Sales = TCM -
TFC = NOI
Now 100%
- 60 % = 40 % x 4,000,000 = 1,600,000 - 1,200,000 = 400,000
Δ +3 % (150,000)
New 100% - 63 % = 37 % x 4,000,000 = 1,480,000 - 1,050,000 = 430,000
Δ NOI = New – Now = 430,000 – 400,000 = + 30,000 accept
 Lecture 04 Managerial Accounting ❹ CVP (What if & DOL)

Example (11): ABC company produces and sells a single product. The following is the income statement
for the year ended December 31, 2020, under the contribution margin approach (the unit sale price is $50):
÷
10,000 U
500,000 = 10,000 units Sales 500,000 50 100%
50 (-) TVC (300,000) (30) (60%)
TCM 200,000 20 40%
(-) TFC (140,000)
NOI 60,000
Required:
1- If sales for the year 2021 are expected to decrease by 30%, what will be the % of decrease in net income.
2- management is examining the effect of two options on net income:
option (1): a 30% increase in sales units and 30,000 increase in fixed costs.
option (2): a 10% decrease in variable cost per unit with no change in sales or fixed costs.
which option you recommend? and why?

Required ❶: DOL = TCM / NOI = 200,000 / 60,000 = 3.3 times Δ% NOI = Δ% sales × DOL = - 30% × 3.3 times = - 100%
Required ❷: option (1): Increasing in sales volume = 10,000 × 30% = 3,000
SP - VC = CM x Sales# = TCM - TFC = NOI
Now 50 - 30 = 20 x 10,000 = 200,000 - 140,000 = 60,000
Δ + 3,000 + 30,000
New 50 - 30 = 20 x 13,000 = 260,000 - 170,000 = 90,000
Δ NOI = New – Now = 90,000 – 60,000 = + 30,000
option (1): Decreasing in VC = 30 × 10% = 3
SP - VC = CM x Sales# = TCM - TFC = NOI
Now 50 - 30 = 20 x 10,000 = 200,000 - 140,000 = 60,000
Δ (3)
New 50 - 27 = 23 x 10,000 = 230,000 - 140,000 = 90,000
Δ NOI = New – Now = 90,000 – 60,000 = + 30,000
According to this method (the higher Δ NOI) we can’t decide which one is better.
We must use other method (as you will see next lecture)