7 – Cost-Volume-Profit

Exportation Costs
Cost-Volume-Profit 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:
1. Per unit variable costs
Cost
2. Total fixed costs
3. Volume of activity
Volume
4. Mix of products sold
5. Prices of products Profit

• It is a vital tool used to assist with business decision-making

CONTRIBUTION
MARGIN
Contribution Margin
• The foundation of CVP Analysis is the contribution margin (CM)
• Contribution margin represents the amount left over to cover fixed
expenses once we have paid variable costs.
• Example: If CM = 2$, that mean that 2$ from each unit sold can be used to
cover the company’s fixed costs
• Contribution margin % represents the proportion of good’s price that
goes towards covering fixed costs.
• Example: If CM% = 20%, that means that 20% of the price of each unit sold can
be used to cover the company’s fixed costs.
Contribution Margin
Contribution Margin – Tip
ALWAYS be sure to distinguish between:
• The unit selling price (SP) vs. total sales
• The unit variable cost (UVC) and total variable cost (TVC)
• The unit fixed cost (UFC) and total fixed cost (TFC)
• Remember: You can always convert back and forth by either dividing
or multiplying by the units sold.
Contribution Margin – Example #1
Kraft sells its Kraft Dinner Mac and Cheese at an average price of $1.50
to its retailers. It costs Kraft $ 0.80 to produce the product. What is their
contribution margin per unit in dollars AND as a percentage of selling
price?
Contribution Margin – Example #2
If Kraft sells 365,000 units of product, what is the total contribution
margin AND the contribution margin as a percentage of total sales?
What have you noticed?
Contribution Margin – Example #3
Casio sells calculators at an average retail price of $12. Last year, they
sold a total of 875,000 units and incurred variable costs of $4,025,000 to
produce all of these units. What is Casio’s unit contribution margin?
Contribution Margin – Example #4
If Casio lowers its total variable costs to $3,500,000, how does this
impact the company’s contribution margin as a percentage of selling
price? Describe what the new contribution margin means for the
company.
 CVP ANALYSIS
FUNDAMENTALS
The Contribution Margin Income Statement
Up until now, we have been
making standard income
statements for reporting and
budgeting purposes. This
method has used absorption
costing principles. Under this
model, costs are grouped by
function
The Contribution Margin Income Statement
Variable costing is often better for decision making.
The Contribution Margin Income Statement
• Product costs include only the variable cost elements: direct materials,
direct labour, and variable manufacturing overhead.
• Fixed manufacturing cost is expensed as a period cost without being
assigned to the products. The cost of the inventory of products will not
include fixed costs of manufacturing (these costs are seen as irrelevant
when making decisions since they are already covered).
• Units in inventory will carry only the variable cost of manufacturing.
 The Contribution Approach - Setup
Consider Wind Bicycles. Each bicycle sells at $500 per unit. Variable costs
are $300 per unit and the company will incur a fixed cost of $80,000.
Total Per Unit Percent
Sales (500 bikes)
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income
 The Contribution Approach - Walkthrough
Consider Wind Bicycles. Each bicycle sells at $500 per unit. Variable costs
are $300 per unit and the company will incur a fixed cost of $80,000.
Total Per Unit Percent
Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000
 The Contribution Approach
For each additional unit Wind sells, $200 more in contribution margin will
help to cover fixed expenses and profit.
Total Per Unit Percent
Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000
The Contribution Approach
Each month Wind must generate at least $80,000 in total contribution
margin (CM) to break even. In this case… they made $100,00 which is
why the ended up with a net income of $20,000.
Total Per Unit Percent
Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ 20,000
The Contribution Approach – Part 2
If Wind sells 400 units in a month, what will the new contribution margin
be? How much net income will the company make?
 The Contribution Approach – Part 2
If Wind sells 400 units in a month, what will the new contribution margin
be? How much net income will the company make?
Total Per Unit Percent
Sales (400 bikes) $ 200,000 $ 500 100%
Less: variable expenses 120,000 300 60%
Contribution margin $ 80,000 $ 200 40%
Less: fixed expenses 80,000
Net income $ -
The Contribution Approach – Part 3
1. What is the contribution margin as a percentage of selling price?
2. If sales increase by $50,000, what will be the increase in total
contribution margin?
The Contribution Approach – Conclusions
400 Bikes 500 Bikes
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net income $ - $ 20,000

Notice… a $50,000 increase in sales revenue…

The Contribution Approach – Conclusions
400 Bikes 500 Bikes
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net income $ - $ 20,000

A $50,000 increase in sales revenue, in turn,

results in a $20,000 increase in CM.
($50,000 × 40% = $20,000)
Quiz Time!
Coffee Klatch is an espresso stand in a downtown office building.
The average selling price of a cup of coffee is $1.49 and the
average variable expense per cup is $0.36. The average fixed
expense per month is $1,300. 2,100 cups are sold each month on
average. What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139
Quiz Time!
Coffee Klatch is an espresso stand in a downtown office building.
The average selling price of a cup of coffee is $1.49 and the
average variable expense per cup is $0.36. The average fixed
expense per month is $1,300. 2,100 cups are sold each month on
average. What is the CM Ratio for Coffee Klatch?
a. 1.319
b. 0.758
c. 0.242
d. 4.139
Additional CVP Exercise
Additional CVP Exercise
Answer the following questions:
1. What is the contribution margin per unit?
2. What is the contribution margin ratio?
3. What is the variable expense ratio?
4. If sales increased to 1,001 units during the period, what would be
the increase in revenue? What would be the increase in net
operating income?
5. If sales decline to 900 units, what would be the net operating
income?
USING CVP ANALYSIS
TO MAKE DECISIONS
Case
Read Managerial Accounting in Action, Chapter 8, page 341
Discussion Questions
1. Why would a CVP analysis help Auto Blast, Inc. in evaluating the
many possible decisions that they are faced with?
2. Why is understanding variable and fixed costs especially
important for small businesses?
Cost-Related Decisions using CVP Analysis
• The goal is generally to:
• Boost units sold (increase sales), and/or
• Decrease costs
• With the end goal of increasing net income
• Cost analysis alone can’t tell you what strategy will work best… but it
can help to justify certain decisions on the basis of financial gain or loss
• Certain elements of CVP Analysis like estimated increase in sales as a
result of some strategies must be given, that is, estimated by
management – the formula isn’t magic!
Which element(s) will we modify to do so…?

Total Fixed Unit Variable

Selling Price
Costs Costs
Sample Decisions
1. Increasing Total Fixed Costs to boost sales
• For example, increase number of cashiers in a store, an advertising
budget, providing a better in-store experience
2. Increasing Unit Variable Cost to boost sales
• Usually involves adding a new product feature
3. Increasing Total Fixed Costs while ALSO lowering price
• Same as #1 but includes reduction to selling price
4. Increasing Total Variable Costs while ALSO lowering fixed costs
• Adding product features while reducing advertising, salaries, staff
 Auto Blast, Inc.
Contribution Margin Income Statement
for the month of June
#1 – Increase Fixed Costs to boost sales
The sales manager at Auto Blast feels that a $14,000 increase in
the monthly advertising budget will increase monthly sales by
30% to 520 speakers, increasing sales revenues by $30,000 from
$100,000 to $130,000.

Should we authorize the requested increase in the advertising

budget?
#1 – Increase Fixed Costs to boost sales

Current Sales Projected Sales

(400 units) (520 units)
Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income $ - $ -
#1 – Increase Fixed Costs to boost sales
$35,000 + $14,000 advertising = $49,000

Current Sales Projected Sales

(400 units) (520 units)
Sales $ 100,000 $ 130,000
Less: variable expenses 60,000 78,000
Contribution margin 40,000 52,000
Less: fixed expenses 35,000 49,000
Net income $ 5,000 $ 3,000

Sales increased by $30,000!

But… net income decreased by $2,000 
#1 – Increase Fixed Costs to boost sales

Shortcut Version

Increase in CM (120 units X $100) $ 12,000

Increase in advertising expenses 14,000
Decrease in net income $ (2,000)
#2 – Increasing Unit Variable Cost to boost sales
The company’s export manager found an opportunity to sell some of the
speakers to the USA which would require small adaptations to the
speakers’ packaging. These product modifications would increase
variable costs per unit from $150 to $160. These changes would be made
to all products manufactured to standardize the production process. The
export manager predicts that the company’s overall sales (which includes
the exported units) would increase by 20% per month.

Should we authorize the requested increase in unit variable cost to

modify the packaging for exportation?
#2 – Increasing Unit Variable Cost to boost sales

Current Sales Projected Sales

(400 units) (??? units)
Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income $ - $ -
#2 – Increasing Unit Variable Cost to boost sales
$160 per unit instead of $150

Current Sales Projected Sales

(400 units) (480 units)
Sales $ 100,000 $ 120,000
Less: variable expenses 60,000 76,800
Contribution margin 40,000 43,200
Less: fixed expenses 35,000 35,000
Net income $ 5,000 $ 8,200

Sales increased by $20,000,

and… net income increased by $3,200 
#3 – Increase Fixed Costs AND Lower Price
The sales manager would like to cut the selling price by $15 per speaker to
appeal more to the US consumer as there is more competition South of
the border. The price decrease would apply for ALL products sold, both
domestically and internationally. To create awareness in the US market,
they would like to increase the advertising budget by $15,000 per month.
The sales manager argues that if these two steps are taken, total unit
sales will increase by 50% per month.

Should we authorize the requested increase in advertising costs and

lower the selling price?
Pause!

Think strategically – putting the

numbers aside, why might this
work?
#3 – Increase Fixed Costs AND Lower Price

Current Sales Projected Sales

(400 units) (??? units)
Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income $ - $ -
#3 – Increase Fixed Costs AND Lower Price
Reduction of $15 per unit
Current Sales Projected Sales
(400 units) (600 units)
Sales $ 100,000 $ 141,000
Less: variable expenses 60,000 90,000
Contribution margin 40,000 51,000
Less: fixed expenses 35,000 50,000
Net income $ 5,000 $ 1,000

Sales increased by $41,000,

and… net income decreased by $4,000 
#4 – Increase Variable & Decrease Fixed Costs
The sales manager would like to pay sales staff a commission of $15 per
speaker sold and, simultaneously, reduce their annual salaries by a total
of $6,000 per month (across all employees). The sales manager is
confident that the change will increase monthly sales by 15%.

Should we authorize the requested increase to the variable costs while

decreasing fixed costs?
#4 – Increase Variable & Decrease Fixed Costs

Current Sales Projected Sales

(400 units) (??? units)
Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income $ - $ -
#4 – Increase Variable & Decrease Fixed Costs
Increase $15 per unit in variable cost (sales commission)
AND decrease fixed costs by $6,000
Current Sales Projected Sales
(400 units) (460 units)
Sales $ 100,000 $ 115,000
Less: variable expenses 60,000 75,900
Contribution margin 40,000 39,100
Less: fixed expenses 35,000 29,000
Net income $ 5,000 $ 10,100

Sales increased by $15,000,

and… net income increased by $5,100 
Assumptions of CVP Analysis
 Selling price is constant (price will not change as volume changes)
 Costs are linear and can be accurately divided into variable and fixed
elements.
o The variable element is constant per unit, and the fixed element is
constant in total over the entire relevant range.
 In multi-product companies, the sales mix is constant.
 In manufacturing companies, inventories do not change (number of
units produced = number of units sold).
BREAK-EVEN
ANALYSIS
Break-Even Analysis
• Break-even point: The point at which total revenues is equal to total
costs. That is, the company is not losing any money, but is also NOT
making any profit!
• If sales drop below this point, the company starts losing money
• Up until now, we have been using the CVP analysis to find the break-
even point. It can also be calculated using a formula.
 Break-Even Formula

IN UNITS
BEQ = Fixed Costs = Fixed Costs
Selling Price – Variable cost per unit Contribution Margin per unit

B/E$ = Fixed Costs

IN DOLLARS
Contribution Margin %
 Example #1
Dell’s new XPS 13 Pro Touch is about to be launched in the coming year in France. Dell
wants to ensure that its costs are in-check before the product’s launch in this new
market. Dell plans to publish a suggested retail price of $825 for its new product. Their
costs for the first year are as follows:
• Advertising: $ 200,000
• Rent: $ 150,000
• Other Overhead: $ 700,000
• Machine maintenance: $ 250,000
• Cost of parts per unit: $230
• Cost of labour per unit: $75
What is Dell’s break-even point in units and dollars for this new product?
 Example #2
PepsiCo prices its 2L bottles of Pepsi at an average selling price of $11.50
per 12-pack for retailers. In the past year, they managed to sell only
150,000 of these 12-packs of Pepsi in the Canadian market and incurred
$1,012,500 of variable costs doing so. Additionally, they incurred
$1,200,000 of fixed costs in order to ensure production was maintained.

Did PepsiCo manage to break-even? What was their total profit or loss?
 When is Break-Even Analysis Used?
1. Assess the feasibility of proposed fixed marketing expenditures
(changes to fixed costs)

2. Assess the feasibility of a permanent price change. If we increase the

price, will we be able to sell enough to meet our break-even?

3. Assess how many units need to be sold in a foreign market in order to

start earning profit.
MARGIN OF
SAFETY
Margin of Safety
• Excess sales over the break-even volume of sales. The amount by
which sales can drop before losses begin to be incurred. Can be
calculated using actual or budgeted sales

Margin of safety ($) = Total sales - Break-even sales

Margin of safety percentage = Margin of safety

Total sales
Margin of safety (units) = Units Sold – Break-even units
Margin of Safety - Walkthrough
Wind has a break-even point of $200,000. If actual sales are $250,000,
how much is their margin on safety?
Break-even
sales Actual sales
400 units 500 units
Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income $ - $ -
Margin of Safety - Walkthrough
Calculate the margin of safety percentage.

Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net income $ - $ 20,000
Margin of Safety - Example
• Assume that Auto Blast has actual sales of $100,000. The Blastomania
speakers sell at $250 dollars each. We have already determined the
break-even sales to be $87,500.
• What is the company’s margin of safety?
• How many units sold does that represent?
• What is the margin of safety as a percentage?

• Interpret the findings

Quiz Time!
Coffee Klatch is an espresso stand in a downtown office building. The
average selling price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average fixed expense per
month is $1,300. 2,100 cups are sold each month on average. What
is the margin of safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
Quiz Time!
Coffee Klatch is an espresso stand in a downtown office building. The
average selling price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average fixed expense per
month is $1,300. 2,100 cups are sold each month on average. What
is the margin of safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
 COST STRUCTURE
AND PROFITABILITY
Optimizing for Profitability?
Which of the following is better?
• High Fixed Costs with Low Unit Variable Cost
• High Unit Variable Cost with Low Fixed Costs

It depends!
Example
Example
• What if sales increase by $10,000? Does this mean Balloon Farm is
better off having higher fixed costs?
Example
• What if sales dropped by $10,000?
Example
Calculate the break-even point and margin of safety for each company.
So, who is better off?
• When sales increase Balloon Farm stands to gain much more
• When sales decrease, Balloon Farm also stands to incur a loss much
faster. Flat Farm is thus less risky.
• Flat Farm is protected from major losses during bad years but also
will not profit as much during good years
• Bottom-Line: It depends on the company, industry, goals, risk
tolerance.
OPERATING
LEVERAGE
Degree of Operating Leverage
• The degree of operating leverage is a measure, at any given level of
sales, of how a percentage change in sales volume will affect profits.
• With high leverage, a small percentage increase in sales can produce
a much larger percentage increase in net income (how sensitive is the
relationship between sales and net income/profit).

Degree of Contribution margin

operating leverage =
Net income
Example – Calculate the Operating Leverage

Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000
What does it mean?
• With a measure of operating leverage of 5, if Wind increases its sales
by 10%, net income would increase by 50%.

Percent increase in sales 10%

Degree of operating leverage × 5
Percent increase in profits 50%
What does it mean?
Actual sales Increased
(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net income $ 20,000 $ 30,000

10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.
Example 2 – Flat Farm
Calculate the DOL at each level of sales for Flat Farm
DOL Summary
Why use DOL?
• To quickly estimate the impact of a percentage change in sales on
your company’s profits (without needing to prepare full statements)

DOL Dynamics
• The closer a company’s sales are to their break-even, the higher their
DOL… a small increase in sales will cause net income to increase
rapidly.
• As sales grow further from break-even, DOL will shrink.
Quiz time!
Coffee Klatch is an espresso stand in a downtown office building. The
average selling price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average fixed expense per
month is $1,300. 2,100 cups are sold each month on average. What is
the operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92

77
Quiz time!
Coffee Klatch is an espresso stand in a downtown office building. The
average selling price of a cup of coffee is $1.49 and the average
variable expense per cup is $0.36. The average fixed expense per
month is $1,300. 2,100 cups are sold each month on average. What is
the operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92

78
Quiz time!
At Coffee Klatch the average selling price of a cup of coffee is $1.49,
the average variable expense per cup is $0.36, and the average fixed
expense per month is $1,300. 2,100 cups are sold each month on
average.

If sales increase by 20%, by how much should net income increase?

a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
Quiz time!
At Coffee Klatch the average selling price of a cup of coffee is $1.49,
the average variable expense per cup is $0.36, and the average fixed
expense per month is $1,300. 2,100 cups are sold each month on
average.

If sales increase by 20%, by how much should net income increase?

a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
 COST BEHAVIOUR
PATTERNS: VARIABLE &
FIXED COSTS REVISITED
Recall: Variable Costs – Total vs. Per Unit
• The TOTAL cost of meals is based on the number of guests.
• The cost per meal is constant. For example, $30 per meal.
Per meal…? Per order? Per unit produced? Sold?
• The reason why the terminology keeps changing is that variable costs are
based on an activity base. Any of the options below make sense depending
on the type of business you’re looking at.
Legal What’s most important
Unit Case is that increasing your
produced A measure of the event
activity base will cause
causing the incurrence of a
variable cost additional costs to be
Also called a cost driver incurred… this is what
Unit makes it variable!
Sold Patient
Customer Order Treated
Served Placed
Examples of Variable Costs by Company Type
Type of Organization Costs That Are Normally Variable
Merchandising company Cost of goods (merchandise) sold
•Manufacturing costs:
Manufacturing company Direct materials
Direct labour
•Variable portion of manufacturing overhead:
Indirect materials
Lubricants
Supplies

Both merchandising and •Selling, general, and administrative costs:

Commissions
manufacturing companies
Clerical costs, such as invoicing
(Any PRODUCT company)
Shipping costs
Service organizations Supplies, travel, hours spent on a file
True Variable vs. Step-Variable Costs
• True variable costs vary
in direct proportion to
changes in the level of
activity
• Step-Variable costs
increase or decrease
only in response to more
than a unit change in the
activity level
Recall: Fixed Costs – Total vs. Per Unit
• The TOTAL cost of renting the building is not affected by meals served.
• The cost per meal is will decline as that fixed cost gets spread across
more meals served
Types of Fixed Costs
Fixed Costs

Committed Discretionary
Long-term, cannot be reduced for even May be altered in the short-term or for
short periods without severely having short periods of time by management;
a negative impact on the business. less crucial.

Examples: Examples:
Depreciation on Buildings, Equipment, Advertising, Research and
Insurance, Key Personnel Development, Employee Bonuses
Trend Toward Fixed Costs
• Increased automation.
• Increase in salaried knowledge workers who are difficult to train and replace.

Implications
Managers are more “locked in” with fewer
decision alternatives.
Planning becomes more crucial because fixed
costs are difficult to change with current
operating decisions.
Labour Cost – Variable or Fixed?
• Depends on the employment terms and how employees are paid.
• If paid strictly on basis of output — Variable
• Example: The employee is paid based on the number of units that they produce in the factory
• IF paid weekly, or monthly (independent of output) — Fixed
• Example: The employee is paid a salary even if they show up to work and nothing is being produced

• We generally say that if an employee touches, handles, manipulates, or

transforms the product in some way, they should be considered direct labour.
Fixed Costs and Relevant Range
Example: Our company is
expanding abroad. Our
current office costs $30,000
per year in increments of
1,000 square meters. As Total cost doesn’t
the business grows and we change for a wide
hire more people to handle range of activity, and
the international operations then jumps to a new
more space is rented, higher cost for the
increasing the total cost. next higher range of
activity.
 Fixed Costs with their Relevant Range vs.
Step-Variable Costs
How do fixed cost differ from a
step-variable cost?

1. Step-variable costs can be adjusted more quickly and

2. The width of the activity steps is much wider for the
fixed cost.

Example: Transportation, strapping fees, demurrage fees are all variable (step-variable); they
may stay stable for a pallet, but will quickly increase as we add more goods to the shipment
PRACTICE
Complete CVP Exercise
• Oslo Company prepared the following contribution format income
statement based on a sales volume of 1,000 units (the relevant range
of production is 500 units to 1,500 units):
Complete CVP Exercise
• Questions:
1. What is the contribution margin per unit?
2. What is the contribution margin ratio?
3. What is the break-even point in unit sales?
4. What is the break-even point in dollars?
5. What is the margin of safety in dollars?
6. What is the margin of safety percentage?
7. What is the degree of operating leverage?
8. Using the degree of operating leverage, what is the estimated percent
increase in net operating income of a 5% increase in sales?