UNIT- 2

COST-VOLUME-PROFIT RELATIONSHIP-COST
BENEFIT ANALYSIS

CVP analysis-An overview

 CVP analysis is one of the most powerful tool that help
managers as they make decisions by facilitating quick estimation
of net income at different levels of activity.
 In other words, it helps them to understand the
interrelationship between cost, volume, and profit in an
organization
 It focuses on interactions between the following five elements:
 prices of products,
 volume or level of activity,
 per unit variable costs,
 total fixed costs, and
 mix of products sold. 1
 Because CVP analysis helps managers understand
the interrelationship between cost, volume, and
profit, it is a vital tool in many business decisions.
 These decisions include, for example, what
products to manufacture or sell, what pricing
policy to follow, what marketing strategy to
employ, and what type of productive facilities to
acquire.

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Basics (essentials) of CVP analysis
 Contribution Margin:
 The form of income statement used in CVP
analysis is that, the projected income statement.
 This income statement is called contribution
approach to income statement.
 The contribution income statement emphasizes
the behavior of the costs and therefore is
extremely helpful to manager in judging the
impact on profits of changes in selling price, cost,
or volume.
 
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 ABC Company
Projected (Contribution) Income Statement
For the Month Ended January 31,2014
 
Total Unit
Sales (10, 000 units) $ 150, 000 $15.00
Variable Expenses 120, 000 12.00
Contribution Margin $30, 000 $3.00
Fixed Expenses 24, 000
Net Income $6, 0000
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.
The contribution margin represents the amount remaining from sales revenue
after variable expenses have been deducted.
Thus, it is the amount available to cover fixed expenses and then to provide
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. 4
 From the above example, the ABC company has a contribution
margin of $30, 000.
 In this case, the first $24, 000 covers fixed expenses; the
remaining $6, 000 represents profit.
 The per unit contribution margin indicates by how much dollar
the contribution margin is increased for each unit sold.
 ABC Company’s contribution margin of $3.00 per unit indicates
that each unit sold contributes $3.00 to covering fixed
expenses and providing for a profit.
 If the firm had sold 5, 000 units, this would cover only $15,
000 of their fixed expenses (5, 000 units x $3.00 per unit).
 Therefore, the firm would have a net loss of $9, 000.
Contribution margin $15, 000
Fixed expenses 24, 000
Net loss $(9, 000) 5
 If enough units can be sold to generate $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 $3.00 in contribution margin.

Total Per Unit

Sales (8, 000 units) $120, 000 $15.00
Variable expenses 96, 000 12.00
Contribution margin $24, 000 $3.00
Fixed expenses 24,000
Net income $ 0 6
 Therefore, the concept of contribution margin is a
valuable aid to management in making
managerial decision for the following regards:
It helps the management in the fixation of selling
prices.
It assists in determining the Break-even point.
It helps in choosing from among alternative methods
of production; the method which gives highest
contribution margin per limiting factor is adopted.
It helps management in the selection of a suitable
product mix for profit maximization.
It helps in taking a decision as regards to adding a new
product in the market.
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 Contribution margin ratio (P/V ratio or C/S ratio)
 The CM ratio establishes a relationship between the contribution
margin and the sales.
 Therefore, it can be expressed as follows:
CM Ratio = Contribution margin /Sales or Per unit contribution
margin/Per unit sales
Since contribution = Sales – VC = FC + Profit; so CM ratio can also be
expressed as:
CM Ratio = Sales – VC / Sales i.e., S –V / S
or
CM Ratio = FC + Profit / Sales i.e., F + P / S
or
CM Ratio = Change in contribution margin/ Change in sales
 CM Ratio is of vital importance for studying the profitability of
operations of a business.
 It reveals the effect on profit of changes in the volume. 8
 Higher the CM Ratio, more will be the profit and
lower the CM ratio, lesser will be the profit.
 Thus, every management aims at increasing the
CM ratio.
 The ratio can be increased by increasing the
contribution margin.
 This can be done by:
Increasing the selling price per unit.
Reducing the variable cost.
Changing the sales mixture and selling more profitable
products for which the CM ratio is higher.

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 The concept of P/V ratio or CM ratio is also useful
to calculate the break-even point, the profit at a
given volume of sales, the sales volume required
to a given (or desired) profit and the volume of
sales required to maintain the present profits if
the selling price is reduced by a specified
percentage.
 The formula for the sales volumes required to
earn a given profit is:
CM Ratio = Contribution margin /Sales (or)
CM Ratio = FC + Profit / Sales (or)
Sales = FC + Profit / CM ratio i.e., F + P / CM ratio.
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 Case-1: Suppose the following information
obtained from XYZ company: Sales $100,000,
Profit $10,000, and Variable cost 70,000.
Required:- Based on the above facts, calculate (i)
CM Ratio, (ii) Fixed cost, (iii) Sales volume to earn
a profit of $40,000, and (iv) also show how do you
calculate variable expense ratio?

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Solution:
I. CM ratio=CM/sales=(P+FC)/sales
= (100,000-70,000)/100,000=0.3=30%
II. Use CM ratio=(P + FC)/sales, to compute FC
CMR (sales)= P + FC
FC=CMR(sales)-p
= 0.3(100,000)- 10,000
= $30,000 - $ 10,000
= $20,000
III. Sales = (FC+profit)/CMR or (FC + P)/CMR
= $20,000 + 40,000/0.3
= $60,000/0.3
=$200,000
IV. Variable expense ratio= VC/Sales= $70,000/100,000 = 0.7=70%

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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 net income.
 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 contribution margin total equals total fixed
expenses.
 Stated differently, it is a point where the net income is zero.
 There are three alternative approaches to determine break-even
point: equation technique, contribution margin technique and
graphical method. 13
 Equation technique:
 To calculate break-even point, the following
formula can apply:
BEP = S = V + F
 To calculate the amount of sales needed to
achieve a target profit, the following formula
applies:
Sales = VC + FC + Profit

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 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.
 Therefore, the following ones can use to calculate BEP in
both units and value in dollars.
BEP in Units = Total Fixed Costs / Unit Contribution Margin

BEP in Sales Dollars = Total Fixed Costs / CM Ratio

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Case-2: Menlo Company manufactures and sells a single product. The company’s
income statement for the most recent year is given below:
Total Per Unit Percent of Sales
Sales (20,000 Units) $1,200,000 $60 100%
Less: Variable cost 900,000 45 75%
  Contribution Margin 300,000 $15 25%
Less: Fixed costs 240,000
Net Income $ 60,000

Required:- Based on the above data,

1.Compute the company’s CM ratio and variable expense ratio.
2.Compute the company’s break-even point in both units and sales dollars. Use the
equation method.
3.Compute the company’s break-even point in both units and sales dollars. Use the
contribution margin method.
4.Refer to the original data. Assume that next year management wants the company
to earn a minimum profit of $90,000. How many units will have to be sold to meet
this target profit figure. Use both methods to do it. 16
• Solution:
1. CMR and Variable expense ratio
a. CMR =CM/sales or (P+ FC)/sales =$300,000/1,200,000=0.25=25%
b. Variable expense ratio=VC/sales=$900,00/1,200,00=0.75=75%
2. Using equation method
a. At BEP, sales= VC + FC , Sales=Units sold, Q* unit selling price of $60
So, BEP sales in unit = Q($60)=QVC/unit +TFC
60Q=Q45+ $240,000
Q(60)=Q45 + $ 240,000
15Q=240,000
Q= 240,000/15
=16,000units (BEP sales in unit)
b. BEP sales in dollar , is BEP sales in unit multiply by unit selling price
Thus, BEP sales in dollar = 16,000 units X $60/unit
=$960,000

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3. Using contribution Margin
a. BEP sales in units =TFC/unit contribution margin= FC/P-V=$240,000/60-45
= $240,000/15=16,000units.
b. BEP sales in dollar = TFC/ CMR= $240,000/0.25= $960,000

4. Using Equation method.

a. Sales = TVC + TFC + P, to determine units to be sold to achieve target profit
of $90,000
Units sold, Q ($60)=Q (VC) +$240,000 + $90,000.
60Q= Q(45) + $330,000
Q(60)-Q45=$330,000
Q= $330,000/15
=22,000 Units

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b. Under contribution margin method
Profit= Sales – (TVC + TFC)
But, sales =Q (P, selling price) and TVC = Q(VC/unit)
Thus, target Profit = QP- Qvc- TFC
= Q(P-vc)-$240,000, (P-vc is unit contribution margin)
Q(15)-240,000
15Q=90,000 + 240,000
Q= 330,000/15
22,000 Units

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 Multiple-product break-even analysis
 So far we have dealt with break-even analysis of firms producing
single product.
 If a company produces and sells more than one product, break-
even analysis is somewhat more complex.
 The reason is that different products will have different selling
prices, different costs, and different contribution margins.
 Consequently, the break-even point will depend on the mix in
which have various products are sold
 We can also calculate the multiple-products break-even point
with the following ones.

Multiple-product BEP in units = FC / Package contribution margin

or Weighted average CM

Multiple-product BEP in Dollars = FC / Contribution margin ratio

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 Multi-Product CVP Model
If the sales mix is constant, CVP problems with multiple products can be solved using the
following equations:

Overall Contributi on Margin

Overall Contribution Margin Ratio =
Total Sales

(P1 - V1 )X1  (P2 - V2 )X 2

=
P1 X1  P2 X 2

NI = (Overall CM ratio) (Total Sales) – F

(P1 – V1) X1 = total contribution margin of product 1

(P2 – V2) X2 = total contribution margin of product 2

 Amount of sales revenue required to achieve a target profit:

(NI + F) / Overall CMR = Sales
 Breakeven sales volume:
BE Sales = F / Overall CMR
Note that if the sales mix changes, the overall contribution margin changes; a new overall contribution margin ratio has
to be calculated to solve a CVP problem.
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 Multi-Product CVP Model - Example
Problem: Trop Co. produces 3 kinds of fruit juice, whose costs, prices, and expected
sales levels are provided below:
Apple Orange Cranberry
Sales price per unit $1.50 $2.00 $2.50
Variable cost per $0.50 $0.50 $0.50
unit
Expected sales 20,000 units $20,000 units 10,000 units
units
Trop Co. has a total fixed cost of $84,000.
Given the current sales mix, what is the overall contribution margin ratio?

TCM / Sales = [20,000 (1.5 – 0.5) + 20,000 (2 – 0.5) + 10,000 (2.5 – 0.5)] /
[20,000 * 1.5 + 20,000 * 2 + 10,000 * 2.5] = 70,000 / 95,000 = 0.73684
If Trop’s sales mix remains constant, what is the breakeven sales volume?

BE Sales = 84,000 / 0.73684 = $ 114,000

BE Sales = 2/5 X * 1.5 + 2/5 X * 2 + 1/5 X * 2.5 = 114,000

X = 60,000 units in total
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 Margin of safety
 The excess of actual or budgeted sales over the break-
even sales is known as the margin of safety.
 It is the difference between actual sales minus the sales
at break-even point.
 It represents the amount by which sales revenue can fall
before a loss is incurred.
 As at break-even point there is no profit no loss, sales
beyond the break-even point represent margin of safety
because any sales above the break-even point will give
some profit.
 Thus,
Margin of Safety = Total sales – Sales at BEP
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 Margin of safety can also be calculated with the
help of the following formula:

Margin of Safety = Profit / CM ratio

 Margin of safety calculated in percentage is also

known as margin of safety ratio and can be
expresses as:
Margin of safety ratio = Margin of safety / Sales × 100

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Computing the Margin of Safety

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 Operating Leverage

• Operating leverage is use of fixed costs to extract

higher percentage changes in profits as sales activity
changes.
• Operating leverage is the measure of the proportion
of fixed costs in a company’s cost structure.
• It is used as an indicator of how sensitive profit is to
changes in sales volume.

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 Operating Leverage
(continued)

• The degree of operating leverage (DOL)

can be measured for a given level of sales
by taking the ratio of contribution margin
to operating income or:
DOL=Contribution margin ÷ Operating
income

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 Computing the
Degree of Operating Leverage

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 Summary of Operating
Leverage
Operating Leverage
HIGH LOW
% profit increase with sales Large Small
increase

% loss increase with sales Large Small

decrease

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Calculating the Impact of Increased Sales on
Operating Income Using
the Degree of Operating Leverage

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Applications of CVP 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 net income be if the output level
(volume) decreases by a given percentage from the original
reduction?
 What will net income be if fixed costs increase?
 What will net income be if selling price changes?
 And what will net income be 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. 31
 CVP analysis can help to management not only to
see how sensitively changes the net income due to
changes in selling price, fixed costs, and volume but
also it is a useful tool for making policy decisions,
profit planning and cost control.
 The following are some of the important managerial
problems where CVP analysis can be also applied.
 Accepting special orders
 Profit planning and maintaining a desired level of profit.
 Make or buy decisions.
 Selection of a suitable production/sales mix,
 Alternative methods of production.

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 Accepting special orders
 Bulk orders, additional orders and orders from foreign or
new markets, may be accepted at a price below the normal
market price so as to utilize the idle capacity.
 Such orders are received usually asking a price below the
market and hence a decision is to be taken to accept or
reject the special order.
 The order may be accepted at any price above the variable
cost because the fixed costs have to be incurred even
otherwise.
 Any contribution margin resulting from the additional sales
would mean an additional profit.
 But care must be taken to see that accepting an order below
the market price does not affect the normal selling price
adversely. 33
 Profit planning and maintaining a desired level of profit.
 Profit planning involves the planning of future
operations to achieve maximum profits or to
maintain a desired level of profits.
 The change in the sales price, variable cost and
product mix affect the profitability of a concern.
 With the help of CVP analysis, the required values
of sales for maintaining or attaining a desired
level of profit can be ascertained.

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 Make or buy decisions
 Sometimes a concern has to decide whether a certain product or
a component should be made in the factory itself (having unused
production facilities) or bought from outside from a firm which
specializes in it.
 While deciding to “make or buy” a distinction must be made
between fixed cost and variable cost, and variable cost of
manufacturing it should be compared with the price at which this
component or product can be bought from outside.
 It is advisable to make than to buy if the variable cost of product
or component is lower than the purchase price.
 But if the purchase price is lower than the variable cost, it would
be better to buy than to make itself.
 However, this decision is based upon the assumptions that fixed
expenses do not increase and production facilities cannot be
employed more profitability. 35
 It is advisable to make the component itself if the
variable cost of making the component is lower
than the outside purchase price.
 But in case the variable cost is higher than the
purchase price, it is better to buy the component
from outside than to make it.

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 Selection of a suitable production/sales mix
 When a concern manufactures more than one
product, a problem often arises as to the product
mix or the sales mix which will yield the maximum
profits.
 In determining the optimum or profitable sales
mix, the products which give the maximum
contribution are to be retained and their
production should be increased.
 The production of products which give
comparatively lesser contribution should be
reduced or dropped altogether.
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 Alternative methods of production
 Sometimes the management has to choose from
among alternative methods of production, for
example, machine work or hand work.
 The same product may be produced either by
employing machine ‘A’ or machine ‘B’ and the
management may be confronted with the
problem of choosing one among them.
 In such circumstances, the method which gives
the highest contribution can be adopted.

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 Assumptions in CVP Analysis:
 For any CVP analysis to be valid, the following important
assumptions must be reasonably satisfied within the
relevant range.
 Costs are linear (straight-line) through the entire relevant
range, and they can be accurately divided into two
variable and fixed elements. This implies the following
more specific assumptions.
– Total fixed expenses remain constant as activity changes, and
the unit variable expense remains unchanged as activity varies.
– The efficiency and productivity of production process and
workers remain constant.
 The behavior of total revenue is linear (straight-line). This
implies that the price of the product or service will not
change as sales volume varies within the relevant range.39
 In multiproduct companies, the sales mix remains
constant over the relevant range.
 In manufacturing firms, inventories do not
changes, i.e., the inventory level at the beginning
and end of the period are the same. This implies
that the number units produced during the period
equals the number of units sold.
 The value of a birr received today is the same as
the value of a birr received in any future year.

“The end”
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