Cost-Volume-Profit Analysis
Chapter 9
CLO 2: Students will be able to demonstrate the use of C-V-P Analysis in
decision making (PLG2)
BEP problem
Tee Times Ltd. produces and sells fine quality golf clubs. The company
expects the following revenues and costs in January 2018 for its Elite Quality
golf club sets:
Revenues (400 sets sold @ Rs. 6000 per set) Rs. 24,00,000
Variable costs Rs. 16,00,000
Fixed costs Rs. 5,00,000
• How many sets of clubs must be sold for Tee Times, Inc. to reach their breakeven
point?
• How many sets of clubs must be sold to earn a target operating income of
Rs.9,00,000?
• What amount of sales must Tee Times have to earn a target net income of
Rs.7,00,000 if they have a tax rate of 30 percent?
Operating Leverage
Firm 1 Firm 2
Sales 10,000,000 10,000,000
VC 5,000,000 7,000,000
CM 5,000,000 3,000,000
FC 3,000,000 1,000,000
Profit 2,000,000 2,000,000
Which firm is in a better position?
Operating Leverage problem
RedHerring Ltd. has the following income statement:
Revenues Rs.100,000
Variable Costs - 40,000
Contribution Margin 60,000
Fixed Costs - 30,000
Operating Income 30,000
• What is RedHerring’s DOL?
• If RedHerring’s sales increase by Rs. 20,000, what will be the company’s
operating profit?
Operating Leverage
Operating leverage (OL) describes the effect that fixed costs
have on changes in operating income as changes occur in units
sold and contribution margin.
OL = Contribution Margin
Operating Income
Notice that the difference between the numerator and the
denominator in our formula = our fixed costs.
USING OPERATING LEVERAGE TO ESTIMATE CHANGES IN
OPERATING INCOME
The formula to estimate the change in operating income that will result
from a percentage change in sales is:
Operating Leverage X % Change in Sales
If sales increase 50% and operating leverage is 1.67, you should expect
operating income to increase 83.5%.
Sales Mix problem
Valley Company sells two products. Product M sells for Rs.12 and has
variable costs per unit of Rs.7. Product Q’s selling price and variable
costs are Rs.15 and Rs.12, respectively.
• If fixed costs are Rs.6,50,000 and Valley sells twice as many units of
Product M as Product Q, what is the BEP in units for Product M?
• How many units of each should they sell (keeping the same ratio) in
order to earn an operating profit of Rs.3,25,000?
CVP: Contribution Margin
• Manipulation of the basic equations yields an extremely important
and powerful tool extensively used in cost accounting: contribution
margin (CM).
• Contribution margin equals revenue less variable costs.
• Contribution margin per unit equals unit selling price less unit variable
costs or can be obtained by taking contribution margin divided by
number of units sold.
CVP: Contribution Margin
Additional calculations
You can also calculate:
Contribution margin which is equal to the contribution margin per
unit multiplied by the number of units sold.
Contribution margin percentage which is the contribution margin per
unit divided by unit selling price or Contribution margin divided by
revenue.
Breakeven Point
• At the breakeven point, a firm has no profit or loss at the given
sales level. Breakeven is where:
• Sales – Variable Costs – Fixed Costs = 0
• Calculation of breakeven number of units
• Breakeven Units = Fixed Costs _
Contribution Margin per Unit
• Calculation of breakeven revenues
• Breakeven Revenue = Fixed Costs _
Contribution Margin Percentage
Breakeven Point, extended:
Profit Planning
The breakeven point formula can be modified to become a profit
planning tool by adding Target Operating Income to fixed costs in the
numerator.
Quantity of Units = (Fixed Costs+Target Operating Income)
Required to Be Sold Contribution Margin per Unit
Example
Ammonia ltd. has fixed costs of Rs.20,000 and a contribution margin
percentage of 40%.
If Ammonia wants to make a profit of Rs.20,000, what must revenue
equal?
What if it wants to make a profit of Rs.30,000, what must revenue
equal?
Remember the formula:
(Fixed Cost+ Target Operating Income) / Contribution Margin %
ANALYSIS FOR TARGET OPERATING
INCOME
For OPERATING INCOME For OPERATING INCOME
of Rs.20,000 of Rs.30,000
Revenue=(FC+TOI)/CM% Revenue=(FC+TOI)/CM%
Revenue = Revenue =
(20,000+20,000)/.40 = (20,000+30,000)/.40 =
Revenue = Rs.1,00,000 Revenue = Rs.1,25,000
CVP and Income Taxes
• After-tax profit (Net Income) can be calculated by:
Net Income = Operating Income * (1-Tax Rate)
• Net income can be converted to operating
income for use in CVP equation
Operating Income = I I Net Income I
(1-Tax Rate)
Note: The CVP equation will continue to use operating income. We’ll use
this conversion formula to obtain the operating income value when
provided with Net Income.
Margin of Safety-Defined
• The margin of safety calculation answers a very important question:
• If budgeted revenues are above the breakeven point, how far can
they fall before the breakeven point is reached. In other words, how
far can they fall before the company will begin to lose money.
Margin of Safety
• An indicator of risk, the margin of safety (MOS), measures the
distance between budgeted sales and breakeven sales:
• MOS = Budgeted Sales – BE Sales
• The MOS ratio removes the firm’s size from the output, and
expresses itself in the form of a percentage:
• MOS Ratio = MOS ÷ Budgeted Sales
