AKU, CBE Department of Accounting & Finance

CHAPTER ONE
COST-VOLUME-PROFIT (CVP) ANALYSIS
1. Introduction
Cost-volume-profit (CVP) analysis is a powerful tool that helps managers to understand the
relationships among cost, volume, and profit. CVP analysis focuses on 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.
Because CVP analysis helps managers understand how profits are affected by these key
factors, it is a vital tool in many business decisions. These decisions include what products
and services to offer, what prices to charge, what marketing strategy to use, and what cost
structure to implement.

1.1 CVP – UNDERLYING ASSUMPTIONS

Cost-Volume-Profit Assumptions and Terminology

1) Changes in the level of revenues and costs arise only because of changes in the number
of product (or service) units produced and sold.
2) Total costs can be divided into a fixed component and a component that is variable
with respect to the level of output.
3) When graphed, the behavior of total revenues and total costs is linear (straight-line) in
relation to output units within the relevant range (and time period).
4) The unit selling price, unit variable costs, and fixed costs are known and constant.
5) The analysis either covers a single product or assumes that the sales mix when
multiple products are sold will remain constant as the level of total units sold changes.
6) All revenues and costs can be added and compared without taking into account the
time value of money.

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

1.2.1 Contribution Margin Vs Gross Margin Concept

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.

The form of income statement used in CVP analysis is shown in Exhibit 1.1, i.e., the projected
income statement of Sample Merchandising Company for the month ended January 31, 2006.
This income statement is called contribution approach to income statement.

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AKU, CBE Department of Accounting & Finance

Exhibit 1.1
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31, 2006
Total Per Unit
Sales (10, 000 units) Br. 150, 000 Br.15.00
Variable Expenses 120, 000 12.00
Contribution Margin Br. 30, 000 Br.3.00
Fixed Expenses 24, 000
Net Income Br. 6, 0000

Note that: In the income statement here above, sales, variable expenses, and contribution
margin are expressed on a per unit basis as well as in total. This is commonly done on income
statements prepared for management’s own use since it facilitates profitability analysis.

Contribution Margin
 It represents the amount remaining from sales revenue after variable expenses have
been deducted i.e., CM = Sales Revenue – Variable Costs
 Thus, it is the amount available to cover fixed expenses and then to provide profit for
the period.
 Notice the sequence here- contribution margin is used first to cover the fixed expenses,
and then whatever remains goes toward profit.
 In the Sample Merchandising Company income statement shown above, the company
has a contribution margin of Br. 30, 000. In this case, the first Br.24, 000 covers fixed
expenses; the remaining Br. 6, 000 represents profit.

Per unit contribution margin

 It indicates by how much Birrs the contribution margin is increased for each unit sold.
 Sample Merchandising Company’s contribution margin of Br.3.00 per unit indicates
that each unit sold contributes Br.3.00 to covering fixed expenses and providing for a
profit.

To illustrate with an extreme example, assume that the company sells only 5000 units during
a particular month. The company’s income statement would appear as follows:

Sample Merchandising Company

Projected Income Statement
For the Month Ended January 31, 2006
Total Per Unit
Sales (5, 000 units) Br. 75, 000 Br.15.00
Variable Expenses 60, 000 12.00
Contribution Margin Br. 15, 000 Br.3.00
Fixed Expenses 24, 000
Net Loss Br. (9, 0000)

i.e., If the firm had sold 5, 000 units, this would cover only Br.15, 000 of their fixed expenses
(5, 000 units x Br.3.00 per unit). Therefore, the firm would have a net loss of Br.9, 000.

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AKU, CBE Department of Accounting & Finance

If enough units can be sold to generate Br.24, 000 in contribution margin, then all of the fixed
costs will be covered and the company will have managed to show neither profit nor loss but
just cover all of its cost. To reach this point (called breakeven point), the company will have to
sell 8, 000 units in a month, since each unit sold yield Br. 3.00 in contribution margin.
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31, 2006
Total Per Unit
Sales (8, 000 units) Br. 120, 000 Br.15.00
Variable Expenses 96, 000 12.00
Contribution Margin Br. 24, 000 Br.3.00
Fixed Expenses 24, 000
Net Loss Br. 0

Computations of the break-even point are discussed in detail later in this unit. For the
moment, note that the break-even point can be defined as the point where total sales revenue
equals total expenses (variable plus fixed) or as the point where total contribution equals total fixed
expenses.

 Too often people confuse the terms contribution margin and gross margin. Gross
margin (which is also called gross profit) is the excess of sales over the cost of goods sold
(that is, the cost of the merchandise that is acquired or manufactured and then sold). It
is a widely used concept, particularly in the retailing industry.

Contribution Margin Ratio (Cm-Ratio)

 In addition to being expressed on a per unit basis, revenue, variable expenses, and
contribution margin for Sample Merchandising Company can also be expressed on a
percentage basis:
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31, 2006
Total Per Unit Percentage
Sales (10, 000 units) Br. 150, 000 Br.15.00 100%
Variable Expenses 120, 000 12.00 80%
Contribution Margin Br. 30, 000 Br.3.00 20%
Fixed Expenses 24, 000
Net Income Br. 6, 0000

The percentage of the contribution margin to total sales is referred to as the contribution
margin ratio (CM-ratio). This ratio is computed as follows:

CM-ratio = Contribution Margin

Sales

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AKU, CBE Department of Accounting & Finance

 Contribution margin ratio = 1 – variable cost ratio. The variable-cost ratio or variable-
cost percentage is defined as all variable costs divided by sales. Thus, a contribution
margin of 20% means that the variable-cost ratio is 80%.

In the example here below, the contribution margin percent or contribution margin ratio, also
called profit/volume ratio (p/v ratio) is 20%. This means that for each birr increase in sales,
total contribution margin will increase by 20 cents (Br.1 sales x CM ratio of 20%). Net income
will also increase by 20 cents, assuming that there are no changes in fixed costs.

At this illustration suggests, the impact on net income of any given birr change in total sales &
be computed in seconds by simply applying the contribution margin ratio to birr change.

Once the break-even point has been reached, net income will increase by the unit contribution
margin for each additional unit sales. If 8,001 units are sold in a month, for example, then we
can expect that the Sample Merchandising Company’s net income for the month will be Br. 3,
since the company will have sold 1 unit more than the number needed to break even:

Sample Merchandising Company

Projected Income Statement
For the Month Ended January 31, 2006
Total Per Unit
Sales (8, 001 units) Br. 120, 015 Br.15.00
Variable Expenses 96, 012 12.00
Contribution Margin Br. 24, 003 Br.3.00
Fixed Expenses 24, 000
Net Loss Br. 3.00
 If 8002 units are sold (2 units above the break-even point). Then we can expect that the
net income for the month will be Br.9, and so forth.

1.3 BREAK-EVEN ANALYSIS

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 can be defined as the point where total sales revenue equals total expenses
(i.e., total variable cost plus total fixed costs). It is a point where total contribution margin
equals total fixed expenses. Stated differently, it is a point where the operating income is zero.
 There are three alternative approaches to determine break-even point:
(A) Equation technique,
(B) Contribution margin technique and
(C) Graphical method.
A) Equation Method
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)

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AKU, CBE Department of Accounting & Finance

is equal to sales revenue minus expenses. If expenses are separated into variable and fixed
expenses, the essence of the income statement is captured by the following equation:
Operating profit = Total Revenue – Total Costs
TR – TC, where TR = Average SP/unit (sp) x units of output (Q)
TC = (Variable costs/unit (VC) x units of output (Q))+Fixed costs (FC)

 Profit (net income) is the operating income plus non-operating revenues (such as
interest revenue) minus non-operating costs (such as interest cost) minus income taxes.
For simplicity, throughout this unit non-operating revenues and non-operating cost are
assumed to be zero. Thus, the above formula can be restated as follows
 = (SPxQ) – ((VCxQ) +FC) ………… expanding original equation for profits!
 = (SP - VC) Q - FC
 At break-even point, net income=0 because total revenue equal total expenses.
That is, NI=SPQ-VCQ-FC
0= SPQ-VCQ-FC ……………………………………equation (1)
B) Contribution Margin Technique
The contribution margin technique is merely a short version of the equation technique. The
approach centers on the idea that each unit sold provides a certain amount of fixed costs.
When enough units have been sold to generate a total contribution margin equal to the total
fixed expenses, break-even point (BEP) will be reached. Thus, one must divide the total fixed
costs by the contribution margin being generated by each unit sold to find units sold to break-
even.

BEPQ= Fixed expenses BEP

Vs (in sales Birrs) = Fixed expenses = FC___
Unit contribution margin CM ratio SP-VC
SP
 Given the equation for net income, you can arrive at the above short cut formula for
computing break-even sales in units as follows:
NI= SPQ-VCQ-FC
0=Q (SP-VC)-FC ………………………… because at BEP net income equals zero.
Q (SP-VC) =FC …………………………… divide both sides by (p-v)
Q = FC ………………….……………….. Equation (2)
SP-VC
 This approach to break-even analysis is particularly useful in those situations where a
company has multiple product lines and wishes to compute a single break-even point
for the company as a whole. More is said on this point in later section titled Sales Mix
and CVP Analysis.
 The contribution- margin and equation approaches are two equivalent techniques for
finding the break-even point. Both methods reach the same conclusion, and so personal
preference dictates which approach should be used.
C) 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. This line is the sum of the fixed costs and the variable costs. To plot
fixed costs, draw a line parallel to the volume axis. To plot the total cost line, choose
some volume of sale and plot the point representing total expenses (fixed and variable)
at the activity level you have selected. After the point has been plotted, draw a line
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through it back to the point where the fixed expense line intersects the birrs axis (the
vertical axis).
 Total Revenue Line. Again choose some volume of sales to construct the revenue line
and plot the point representing total sales birrs at the activity you have selected. Then
draw a line through this point back to the origin.
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.
Example (1) Zoom Company manufactures and sells a telephone answering machine. The
company’s income statement for the most recent year is given below:
Total Per Unit Percent
Sales (20,000 units) Br. 1,200,000 Br. 60 100
Variable expenses 900,000 45 ?
Contribution Margin Br. 300,000 Br. 15 ?
Fixed Expenses 240,000
Net Income 60,000
Based on the above data, answer the following questions.
Instructions:
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.
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?
Solution:

a) CM – ratio = 60-45 = 0.25 (25%)

60
Variable expense ratio = 1 – CM-ratio = SP-VC= 1-0.25 = 60 – 15 = 0.75 (75%)
SP 60
b) Method 1: Equation Method
i) Net Income (NI) = SPQ – VCQ – FC
0 = Q (60-45) – 240,000
15Q = 240,000
BEPQ = 240,000 = 16,000 units, at Br. 60 per unit, Br. 960,000 (BEP sales in Birr)
15
ii) Let ―X‖ be sales volume in birrs to breakeven
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
0.25
Method 2: Contribution Margin Method
i) BEP (in units) = Fixed expenses = Br. 240,000 = 16,000 units
CM per unit Br. 60 – Br. 45

ii) BEP (in birrs) = Fixed expenses = Br. 240,000 = Br. 960,000
CM – ratio 0.25

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AKU, CBE Department of Accounting & Finance

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 1.2.

Exhibit 1.2 Cost-Volume-Profit Chart

TR
TC

Sales in birr Profit area

(TR>TC)
Br.1, 500,000

TVCs @ Br. 45 per

units

Br. 750,000 Loss area BEP: 16,000 units or

(TR<TC) Br.960, 000 sales

Br. 500,000

TFC @ Br. 240,

000
Br. 250,000
0
10,000 20,000 30,000 Volume in units sold
c)
Increase in sales Br. 400,000
Multiply by the CM ratio X 25%
Expected increase in contribution margin Br. 100.000

 Since the fixed expenses are not expected to change, net income will increase by the
entire Br. 100,000 increase in contribution margin.

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AKU, CBE Department of Accounting & Finance

1.4 APPLYING CVP ANALYSIS

1.4.1 Sensitivity “What If” Analysis
Sensitivity analysis is a ―what if‖ technique that 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, sensitivity analysis answers such questions as,
 What will operating income be if the output level decreases by a given percentage from
the original reduction? And
 What will be operating income if variable costs per unit increase?

The sensitivity analysis to various possible outcomes broadens managers’ perspectives as to

what might actually occur despite their well-laid plans.

Example (1) Zebib Concepts, Inc., was founded by Zenebe Aderajew, a graduate student in
engineering, to market a radical new speaker he had designed for automobiles sound system.
The company’s income statement for the most recent month is given below:

Sample Projected Income Statement

Total Per Unit
Sales (400 speakers) Br. 100, 000 Br.250.00
Variable Expenses 60, 000 150.00
Contribution Margin Br. 40, 000 Br.100
Fixed Expenses 35, 000
Net Income Br. 5,000

 Yohannes Tilahun, the senior accountant at Zebibib Concepts, wants to demonstrate

the company’s president how the concepts developed on the preceding pages can be
used in planning and decision-making. To this end, Yohannes will use the above data
to show the effects of changes in variable costs, fixed costs, sales, and sales volume on
the company’s profitability.
(i) Changes in Fixed Costs and Sales Volume:
 Zebib Concepts is currently selling 400 speakers per month (monthly sales of Br.100,
000). The sales manager feels that a Br.10, 000 increases in the monthly advertising
budget would increase monthly sales by Br.30, 000.
 Should the advertising budget be increased?
Expected contribution margin (Br.130, 000 x 40% CM ratio)………..… Br.52, 000
Present contribution margin (Br.100, 000 x 40% CM ratio)………….… 40, 000
Incremental contribution margin…………………………….……………. 12, 000
Change in fixed costs (incremental advertising expense)……..………… 10, 000
Increased net income……………………………………..…………….... Br. 2, 000
 Answer is: Yes, based on the information above and assuming that other factors in the
company don’t change, the advertising budget should be increased.
(ii) Changes in Variable Costs and Sales Volume
 Refer to the original data. Management is contemplating the use of high- quality
components, which would increase variable costs by Br.10 per speaker. However, the

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sales manager predicts that the higher overall quality would increase sales to 480
speakers per month.
 Should the higher quality component be used?

The Br10 increase in variable costs will cause the unit contribution margin to decrease from
Br.100 to Br90.
Expected total contribution margin (480 speakers xBr.90)…………… Br.43, 200
Present total contribution margin (400 speakers xBr.100)……………. 40, 000
Increase in total contribution margin………………………………….. Br.3, 200
 Answer is: Yes, based on the information above, the high-quality component should be
used. Since the fixed expenses will not change, net income will increase by the Br3, 200
increase in contribution margin shown above.

(iii) Change in Fixed Cost, Sales Price, and Sales Volume:

 Refer to the original data and recall that the company is currently selling 400 speakers
per month. To increase sales, the sales manager would like to cut selling price by Br 20
per speaker and increase the advertising budget by Br 15, 000 per month. The sales
manager argues that if these two steps are taken, unit sales will increase by 50%.
 Should the change be made?
A decrease of Br 20 per speaker in the selling price will cause the unit contribution margin to
decrease from Br100 to Br 80.
Expected total contribution margin :(400-speakersx150%xBr80)………………… Br.80, 000
Present total contribution margin (400 speakers x Br 100)……….…………………… 40,000
Incremental contribution margin……………………………………..……………………………
8,000 Change in fixed costs:
Incremental advertising expenses………………………………...………………………………….
15, 000
Reduction in net
income………………………………………………………………………………… Br. (7, 000)
 Answer is: NO, based on the information above, the changes should not be made.

(iv) Changes in Variable Cost, Fixed Cost, and Sales Volume:

Refer to the original data. The sales manager would like to replace the sales staff on a
commission basis of Br 15 per speaker sold, rather than on flat salaries that now total
Br 6, 000 per month. The sales manager is confident that the change will increase
monthly sales by 15%.
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 Br 6,000, from Br 35, 000 to Br 29, 000. Variable
costs will increase by Br 15, from Br 150 to Br 165, and the unit contribution margin will
decrease from Br 100 to Br 85.
Expected total contribution margin (400speakers x 115% x Br85)………………. Br.39, 100
Present total contribution margin (400 speakers x Br. 100)………….…………… 40, 000
Decrease in total contribution margin……………………………………………….. (900)
Change in fixed costs:
Salaries avoided if a commission is paid [to be added on Br. (900)]……………… 6, 000
Increase in net income…………………………………………………………………… Br.5, 100

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AKU, CBE Department of Accounting & Finance

 Answer is: Yes, based on the information above, the changes should be made. Again,
the same answer can be obtained by preparing comparative income statements:
Present 400 Expected 460*
Speakers per month speakers per month
Total Per unit Total Per unit
Sales Br100, 000 Br.250 Br 115, 000 Br 250
Variable costs 60, 000 150 75, 900 165
Contribution margin 40, 000 Br.100 39, 100 Br 85
Fixed expenses 35, 000 29, 000
Net income Br 5, 000 Br 10, 100
*400 speakers x 115%= 460 speakers

(v) Changes in Regular Sales Price:

 Refer the original data. The company has an opportunity to make a bulk sales of 150
speakers to wholesalers if an acceptable price can be worked out. This sale would not
disturb the company’s regular sales.
 What price per speaker should be quoted to the wholesaler if Zena Concepts wants to
increase its monthly profits by Br 3, 000?
Variable cost per speaker…………………………..…………………. Br 150
Desired profit per speaker (Br3, 000÷150 speakers)……… 20
Quoted price per speaker…………………………………………..… Br 170
Notice that no element of fixed cost is included in the computation. This is because fixed costs
are not affected by the bulk sale, so all of the additional revenue that is in excess of variable
costs goes to increasing the profits of the company.

1.4.2 Target Net Profit Analysis

 Managers can also use CVP analysis to determine the total sales in units and birrs
needed to reach a target profit.
 The method used for computing desired or targeted sales volume in units to meet the
desired or targeted net income is the same as was used in our earlier breakeven
computation.
Example (1): Tre Company manufactures and sales a single product. During the year just
ended the company produced and sold 60,000 units at an average price of Br.20 per unit.
Variable manufacturing costs were Br 8 per unit, and variable marketing costs were Br 4 per
unit sold. Fixed costs amounted to Br. 180,000 for manufacturing and Br.72, 000 for marketing.
There was no year-end work-in-progress inventory. Ignore income taxes.
Instructions:
a) Compute Tre’s breakeven point (BEP) in sales Birrs for the year.
b) Compute the number of sales units required to earn a net income of Br 180,000 during
the year
c) Tre’s variable manufacturing costs are expected to increase 10 % in the coming year.
Compute the firm’s breakeven point in sales birrs for the coming year.
d) If Tre’s variable manufacturing costs do increase 10%, compute the selling price that
would yield the same CM-ratio in the coming year.

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AKU, CBE Department of Accounting & Finance

Solutions:
a) The BEP using contribution margin technique can be calculated as:
BEP (in birrs) = Fixed Expenses = Br. 180,000 + 72,000 = Br. 630,000
Cost –ratio 0.4
b) Target – net profit analysis can be approached using either of these two methods
i. Equation method ii. Contribution margin method
i) Equation Method.
 Managers use a targeted income as the starting point in decision which
marketing and pricing strategies to use.
 The formula to determine a specific targeted income is an extension of the
break-even formula. Here, instead of solving sales volume where profits are
zero, you instead solve sales where profit equals some targeted amount. The
equation for target income is:

TI = Total sales – Variable expenses – Fixed expenses

TI = SPQ – VCQ – FC
Where SP = sales price
Q = sales unit to achieve the targeted income
VC= unit variable costs
FC = fixed costs

For Tre Company, the targeted sales volume in units would be determined as given below:
TI = SPQ – VCQ – FC 180, 000 = 20Q – 12Q – 252, 000 8Q= 180, 000 + 252, 000
Thus, Q= Br.432, 000 = 54, 000 units
8
 Target sales (in birrs) = Br.20 x 54,000=Br. 1, 080, 000
Alternatively computed,
 Target income=SPQ –VCQ – FC = Total CM* - FC = CM-ratio x S – FC where S= Birr
sales to achieve the target income
Target income= 0.4S – Br.252, 000 Br. 180, 000=0.4S- Br.252, 000 = Br.1, 080, 000
ii) Contribution Margin Approach.
 A second approach would be expanding the contribution margin formula to include
the target income requirements. Thus, we can modify the formula given earlier for BEP
computations as follows:

Target sales (in units) = Fixed expenses + Target Profit

Unit CM
 This approach is simpler and more direct than using the CVP equation. In addition, it
shows clearly that once the fixed costs are covered, the unit contribution is fully
available for meeting profit requirements.
Target sales (in units) = Fixed expenses + Target Profit = Br.252, 000+180, 000 =54, 000 units
Unit CM Br. 8
 Target sales in birrs (for Tantu) = Br.20 x 54, 000 = Br.1, 080, 000
 The total birr sales required to earn a target net profit is found by:
Target sales (in birrs) = Fixed expenses + Target Profit
CM-ratio
 Target sales in birrs (for Tre) = Br.252, 000 + Br. 180, 000 = Br. 1, 080, 000
0.4
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AKU, CBE Department of Accounting & Finance

1.4.3 The 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. In
other words, it is the amount of sales revenue that could be lost before the company’s
profit would be reduced to zero.
 The formula for its calculations follows:

Margin of safety = Total sales - Break even Sales

The margin of safety can also be expressed in percentage form. This percentage is obtained by
dividing the margin of safety in birr terms by total sales:
Margin of safety (in %age) = Margin of safety in birrs
Total sales

Example (1): Consider the cost structure for ABC Company and XYZ in Exhibit 1-3
ABC Co. and XYZ Co.
Comparative Cost Structures
ABC Co. XYZ Co.
Amount Percent Amount Percent
Sales Br. 500,000 100 Br. 500,000 100
Variable costs 100,000 20 300,000 60
Contribution Margin 400,000 80 200,000 40
Fixed costs 300,000 100,000
Net income Br. 100,000 Br. 100,000
The break even sales for each company may be computed as follows:
 BEP (in birrs) = Fixed Costs
CM ratio
 BEP (ABC Co.) = Br.300, 000 = Br.375, 000
0.8
 BEP (XYZ Co.) = Br.100, 000 = Br.250, 000
0.4
The margin of safety for each company may be computed as:
 Total sales - Break even Sales = Margin of safety
 ABC Co.’s: Br.500, 000- Br.375, 000 = Br.125, 000
 XYZ Co.’s: Br.500, 000- 250,000 = Br. 250,000

 Note that the companies’ sales revenues are the same (Br. 500,000) and their net
incomes are the same (Br. 100,000) their individual margins of safety are different.
 This is because they have different cost structures, and consequently different
breakeven.
 A higher breakeven sales amount for ABC Co. produces a lower margin of safety.
For ABC Co., the Br.125, 000 margin of safety means that sales would have to
diminish by more than this amount before the company suffers a loss. In effect the
margin of safety is a buffer before losses are incurred.

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AKU, CBE Department of Accounting & Finance

The same analysis applies to XYZ Co., except its buffer is Br. 250,000. At this
point, neither company is experiencing losses;
 Thus it is difficult to say which company is better off. Because they are in different
businesses the amounts computed as buffers may mean the companies’ operating
results are fine. A comparison within each company on a year-by-year basis may shed
light on the possibility of impending difficulties.
The margin of safety may also be expressed as a percentage. The calculation is done by
dividing the margin of safety (in birrs) by the total sales (in birrs). This, the calculation of the
margins of safety percentage is:
Margin of safety percentage = Margin of safety in birrs
Total sales in birrs
ABC Co.’s: Br. 125,000 = 25 %
Br.500, 000
XYZ Co.’s: Br. 250,000 = 50 %
Br.500, 000

1.5 CVP CONSIDERATIONS IN CHOOSING A COST STRUCTURE

Cost structure refers to the relative proportion of fixed and variable costs in an organization.
Managers often have some latitude in trading off between these two types of costs. For
example, fixed investments in automated equipment can reduce variable labor costs. In this
section, we discuss the choice of a cost structure. We introduce the concept of operating
leverage, which plays a key role in determining the impact of cost structure on profit stability.

1.5.1 Cost Structure and Profit Stability

Which cost structure is better — high variable cost and low fixed costs, or the opposite? No
single answer to this question is possible; each approach has its advantages. To show what we
mean, refer to the income statements given below for two farms.
Example (1) Revenue and cost behavior relationships at two firms, A and B, follow:
Firm A Firm B
Amount Percent Amount Percent
Sales …………………………………….… Br.100, 000 100 Br.100, 000 100
Less variable expenses ……………. 60,000 60 30,000 30
Contribution margin ……………..… 40,000 40 70,000 70
Less fixed expenses ………………… 30,000 60,000
Net income ……………………………. Br. 10,000 Br. 10,000

 Firm A has higher variable costs because it is labor-intensive while Firm B has higher
fixed costs as a result of its investment in machines.
 The question as to which firm has the better cost structure depends on many factors,
including the long run trend in sales, year-to-year fluctuations in the level of sales and
the attitude of the owners toward risk.
 If sales are expected to trend above Br. 100, 000 in the future, then Firm B has the
better-cost structure. The reason is that its CM ratio is higher, and its profits will
therefore increase more rapidly as sales increase.
To illustrate, assume that each firm experiences a 10% increase in sales. The new income
statement will be as follows:

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AKU, CBE Department of Accounting & Finance

Firm A Firm B
Amount Percent Amount Percent

Sales ……………………..…… Br.110, 000 100 Br.110, 000 100

Less variable expenses ……... 66,000 60 33,000 30
Contribution margin ………… 44,000 40 77,000 70
Less fixed expenses ………….. 30,000 60,000
Net income …………….... Br. 14,000 Br. 17,000
 As we would expect, for the same birr increase in sales, Firm B has experienced a
greater increase in net income due to its higher CM ratio.
What if sales can be expected to drop below Br.100, 000 from time to time? What are the
break-even points of the two firms? What are their margins of safety? The computations
needed to answer these questions are carried out below using the contribution margin
method.
Firm A Firm B
Fixed expenses ……………………………….. Br.30, 000 Br.60, 000
Contribution margin ratio ………………  40% 70%
Breakeven in total sales birrs. ……………. Br.75, 000 Br.85, 714
Total current sales (a) ……………………… Br.100, 000 Br.100, 000
Break-even sales ………………………………. 75,000 85,714
Margin of safety in sales birrs (b) ……………. Br. 25,000 Br. 14,286
Margin of safety as a %age of sales (b)  (a) 25.0% 14.3%

 This analysis makes it clear that Firm A is less vulnerable to downturns than Firm B.
 We can identify two reasons why it is less vulnerable.
 First, due to its lower fixed expenses, Firm A has a lower break-even point and a
higher margin of safety, as shown by the computations above. Therefore, it will
not incur losses as quickly as Firm B in periods of sharply declining sales.
 Second, due to its lower CM ratio, Firm A will not lose contribution margin as
rapidly as Firm B when sales fall off. Thus, Firm A’s income will be less volatile.
We saw earlier that this is a drawback when sales increase, but it provides more
protection when sales drop.
 To summarize, without knowing the future, it is not obvious which cost structure is
better. Both have advantages and disadvantages. Firm B, with its higher fixed costs
and lower variable costs, will experience wider swing in net income as changes take
place in sales, with greater profits in good years and greater losses in bad years. Firm
A, with its lower fixed costs and higher variable costs, will enjoy greater stability in net
income and will be more protected from losses during bad years, but at the cost of
lower net income in good years.

1.5.2 Operating Leverage

To the scientist, leverage explains how one is able to move a large object with a small force. To
the manager, leverage explains how one is able to achieve a large increase in profits with only
a small increase in sales and/or assets. One type of leverage that the manager uses to do this
is known as operating leverage.

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AKU, CBE Department of Accounting & Finance

Operating leverage –is a measure of how sensitive net operating income is to a given percentage
change in dollar sales. Operating leverage acts as a multiplier. If operating leverage is high, a
small percentage increase in sales can produce a much larger percentage increase in net
operating income.
Operating leverage
 It is a measure of the extent to which fixed costs are being used in an organization.
 It is greatest in companies that have a high proportion of fixed cost in relation to
variable costs.
 Conversely, operating leverage is lowest in companies that have a low proportion of
fixed costs in relation to variable costs.
 If a company has high operating leverage (that is, a high proportion of fixed costs in
relation to variable costs), then profits will be very sensitive to changes in sales. Just a
small percentage increase (or decrease) in sales can yield a large percentage increase
(or decrease) in profits.
Operating leverage can be illustrated by returning to the data given above for the two firms,
A and B. Firm B has a higher proportion of fixed costs in relation to its variable costs than
does Firm A, although total costs are the same in the two firms at a $100,000 sales level. We
previously showed that with a 10% increase in sales (from $100,000 to $ 110,000 in each firm),
the net income of Firm B increases by 70% (from $10,000 to $17,000), whereas the net income
of Firm A increases by only 40% (from $10,000 to $14,000). Thus, for a 10% increase in sales,
Firm B experiences a much greater percentage increase in profits than does Firm A. The
reason is that Firm B has greater operating leverage as a result of the greater amount of fixed
cost in its cost structure.

The DOL at a given level of sales is computed by the following formula:

Degree of operating leverage (DOL) = Contribution margin
Net income
The degree of operating leverage is a measure, at a given level of sales, of how a percentage
change in sales volume will affect profits. To illustrate, the degree of operating leverage for
the two firms at a Br. 100, 000 sales would be as follows:
Firm A: Br.40, 000 = 4 Firm B: Br.70, 000 =7
Br.10, 000 Br.10, 000

 These figures tell us that for a given percentage change in sales we can expect a change
four times as great in the net income of Firm A and a change seven times as great in the
net income of Firm B.
 Thus, if sales increase by 10% then we can expect the net income of Firm A to increase by four
times this amount, or by 40%, and the net income of Firm B to increase by seven times this
amount, or by 70%.
The degree of operating leverage is greater at sales levels near the break-even point and
decreases as sales and profits rise. This can be seen from the tabulation below, which shows
the degree of operating leverage for Firm A at various sales levels. [Data used earlier for Firm
A are shown under column (3)]

Sales ……… Br.75, 000 Br.80, 000 Br.100, 000 Br.150, 000 Br.225, 000

Less: VCs 45, 000 48, 000 60, 000 90, 000 135, 000
Contribution margin (a) 30, 000 32, 000 40, 000 60, 000 90, 000
Less fixed expenses … 30,000 30, 000 30, 000 30, 000 30, 000
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AKU, CBE Department of Accounting & Finance

Net income (b) … Br. –0- Br.2, 000 Br. 10, 000 Br.30, 000 Br.60, 000
DOL (a)÷(b) ∞ 16 4 2 1.5

Thus, a 10% increase in sales would increase profits by only 15%(10% x 1.5) if the company
were operating at a Br. 225, 000 sales level, as computed to the 40% increase we computed
earlier at the Br.100, 000 sales level. The degree of operating leverage will continue to decrease
the farther the company moves from its break-even point. At the break-even point, the degree
of operating leverage will be infinitely large (Br.30, 000 contribution margin÷Br.0 net
income=∞)

A manager can use the degree of operating leverage to quickly estimate what impact various
percentage changes in sales will have on profits, without the necessity of preparing detailed
income statements. As shown by our examples, the effect of operating leverage can be
dramatic. If a company is fairly near its break-even point, then even small increase in sales
can yield large increase in profits. This explains why management often works very hard for
only a small increase in sales volume. If the degree of operating leverage is 5, then a 6%
increase in sales would translate into a 30% increase in profits.

16 CVP ANALYSIS WITH MULTIPLE PRODUCTS

1.16.1 Definition of Sales Mix
The term 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.
A shift in sales-mix from high-margin items to low-margin items can cause total profits to
decrease even though total sales may increase. Conversely, a shift in the sales mix from low
margin items to high-margin items can cause the reverse effect-total profit may increase even
though total sales decrease.

1.16.2 Sales Mix and CVP Analysis

To this point the discussion on CVP analysis focused on a firm that sells a single product;
such a firm is generally unrealistic, existing only in the minds of textbook writers. This section
of the unit examines the usefulness of the CVP technique for firms that deal in several
products. In the general case the CVP equation could be presented as:

SP1Q1 + SP2Q2+...+PnQn – VC1Q1 – VC2Q2-...VnQn – FC = NI

Using contribution margin approach, the computation of the break-even point (BEP) in multi
product firm follows:

BEP (in units) = Total fixed expenses BEP (in birrs) = Total Fixed Expenses
Weighted average CM CM – ratio

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AKU, CBE Department of Accounting & Finance

Exhibit 1–3: Multiproduct Break-Even Analysis

ABC Co. and XYZ Co.
Comparative Cost Structures
Product ―X‖ Product ―Y‖ Total
Amount % Amount % Amount %
Sales Br. 20,000 100 Br. 80,000 100 100,000 100
Variable costs 15,000 75 40,000 50 55,000 55
C.M Br.5,000 25 Br.40,000 50 45,000 45
Fixed Costs …………………………………………… 27,000
Net Income ………………………………………… Br. 18,000

Computation of BEP: Fixed costs = Br. 27,000 = Br. 60,000

Overall CM ratio 0.45
Verification of the BEP:
Product ―X‖ Product ―Y‖ Total
Current Birr sales ……………… Br. 20,000 Br. 80,000 Br. 100,000
Percentage of total Birr sales 20% 80% 100%

Sales at BEP Br. 12,000 Br. 48,0000 Br. 60,000

Product ―X‖ Product ―Y‖ Total

Amount % Amount % Amount %
Sales Br. 12,000 100 Br. 48,000 100 Br. 60,000 100
Variable costs 9,000 75 24,000 50 33,000 55
C.M Br. 3,000 25 Br. 24,000 50 27,000 45
Fixed Costs ……………………………………………… 27,000
Net Income …………………………………………… Br. 0

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