Cost Accounting 2

Chapter 2
Cost-volume-profit (CVP)
analysis

Lecturer: Abdirahman Awil

07:11 AM (MBA, BA in Finance & Accounting)
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Learning Objectives
• After studying this chapter, you should be able to:
1. Explain the features of cost-volume-profit (CVP)
analysis
2. Determine the breakeven point and output level needed
to achieve a target operating income
3. Understand how income taxes affect CVP analysis
4. Explain how managers use CVP analysis in decision
making
5. Explain how sensitivity analysis helps managers cope
with uncertainty
6. Use CVP analysis to plan variable and fixed costs
7. Apply CVP analysis to a company producing multiple
products
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Cost-volume-profit (CVP)
analysis
• Cost-volume-profit (CVP) analysis studies
the behavior and relationship among total
revenues, total costs, and income. as changes
occur in the units sold, the selling price, the
variable cost per unit, or the fixed costs of a
product.
• Cost behavior analysis is the study of how
specific costs respond to changes in
the level of business activity.

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Variable costs
• Variable costs are costs that vary in total directly
and proportionately with changes in the activity
level. If the level increases 10%, total variable costs
will increase 10%. If the level of activity decreases
by 25%, variable costs will decrease 25%.
• Examples of variable costs include costs of goods
sold (COGS), raw materials and inputs to
production, packaging, wages, and commissions,
and certain utilities (for example, electricity or gas
that increases with production capacity).
• A variable cost may also be defined as a cost that
remains the same per unit at every level of
activity.

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Fixed Costs
• Fixed costs are costs that remain the same in
total regardless of changes in the activity level.
• Examples include property taxes, insurance,
rent, supervisory salaries, and depreciation on
buildings and equipment.
• Because total fixed costs remain constant as
activity changes, it follows that fixed costs per
unit vary inversely with activity: As volume
increases, unit cost declines, and vice versa

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Contribution Margins
• Contribution margin is the revenue remaining after
subtracting the variable costs that go into producing a
product. 
• Contribution margin, or dollar contribution per unit, is the
selling price per unit minus the variable cost per unit.
• Contribution represents the portion of sales revenue that is
not consumed by variable costs and so contributes to the
coverage of fixed costs.
• Contribution margin per unit is a useful tool for
calculating contribution margin and operating income.
• Contribution margin Per unit = Revenue – Variable
cost

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Example 1
• Emma Frost is considering selling GMAT Success,
a test prep book and software package for the
business school admission test, at a college fair
in Chicago.
• Emma knows she can purchase this package from
a wholesaler at $120 per package, with the
privilege of returning all unsold packages and
receiving a full $120 refund per package. She also
knows that she must pay $2,000 to the organizers
for the booth rental at the fair. She will incur no
other costs. She must decide whether she should
rent a booth.

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Example 1

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Example 1(Contd.)
• Contribution margin indicates why operating income
changes as the number of units sold changes. The
contribution margin when Emma sells 5 packages is $400
($1,000 in total revenues minus $600 in total variable costs);
the contribution margin when Emma sells 40 packages is
$3,200 ($8,000 in total revenues minus $4,800 in total
variable costs). When calculating the contribution margin, be
sure to subtract all variable costs.
• For example, if Emma had variable selling costs because
she paid a commission to salespeople for each package
they sold at the fair, variable costs would include the cost of
each package plus the sales commission.

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Contribution margin
percentage
• The contribution margin ratio is the difference
between a company's sales and variable
expenses, expressed as a percentage. 
• Contribution margin percentage is Also called
as contribution margin ratio
• Contribution margin percentage = Contribution
margin per unit / Selling price

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Expressing CVP Relationships
• To make good decisions using CVP
analysis, we must understand these
relationships
• There are three related ways (we will call them
methods) to think more deeply about and model
CVP relationships:
1. The equation method
2. The contribution margin method
3. The graph method

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Expressing CVP Relationships
• The equation method and the contribution
margin method are most useful when
managers want to determine operating income
at few specific levels of sales
• The graph method helps managers visualize
the relationship between units sold and
operating income over a wide range of
quantities of units sold.

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The equation method

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Contribution Margin Method

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Graph Method

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Example

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Cost-Volume-Profit Assumptions
• Now that you have seen how CVP analysis works,
think about the following assumptions we made during
the analysis:
1. Changes in the levels of revenues and costs arise
only because of changes in the number of product (or
service) units sold. The number of units sold is the
only revenue driver and the only cost driver. Just as a
cost driver is any factor that affects
costs, a revenue driver is a variable, such as
volume, that causally affects revenues.
2. Total costs can be separated into two components: a
fixed component that does not vary with units sold
and a variable component that changes with respect
to units sold.

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Cost-Volume-Profit Assumptions
3. When represented graphically, the behaviors of total
revenues and total costs are linear (meaning they
can be represented as a straight line) in relation to
units sold within a relevant range (and time period).
4. Selling price, variable cost per unit, and total fixed
costs (within a relevant range and time period) are
known and constant.

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Breakeven Point and Target
Operating Income
• The breakeven point (BEP) is that quantity of output
sold at which total revenues
equal total costs—that is, the quantity of output sold that
results in $0 of operating
income.
• The breakeven point is the level of production at which
the costs of production equal the revenues for a product.
• Breakeven Sales Volume=CM/FC​
• where:
• FC=Fixed costs
CM=Contribution margin=Sales−Variable Costs​

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Breakeven

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Example

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Target Operating Income

• Target income is the profit that the managers

of a company expect to attain for a designated
accounting period.

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Exercise 1

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Using CVP Analysis for
Decision Making
1. Decision to Advertise
• Suppose Emma anticipates selling 40 units at the fair.
Exhibit 3-3 indicates that Emma’s operating income will
be $1,200. Emma is considering placing an
advertisement describing the product and its features
in the fair brochure. The advertisement will be a fixed
cost of $500. Emma thinks that advertising will
increase sales by 10% to 44 packages. Should Emma
advertise? The following table presents the CVP
analysis.

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Decision to Advertise

• Operating income will decrease from $1,200 to $1,020, so Emma

should not advertise. Note that Emma could focus only on the
difference column and come to the same conclusion: If Emma
advertises, contribution margin will increase by $320 (revenues,
$800 variable costs, $480), and fixed costs will increase by $500,
resulting in a $180 decrease in operating income.

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2. Decision to Reduce Selling
Price
• Having decided not to advertise, Emma is contemplating
whether to reduce the selling price to $175. At this price,
she thinks she will sell 50 units. At this quantity, the test
preparation package wholesaler who supplies GMAT
Success will sell the packages to Emma for $115 per unit
instead of $120. Should Emma reduce the selling price?

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Sensitivity Analysis and Margin
of Safety
• In break-even analysis, the term margin of
safety indicates the amount of sales that are
above the break-even point. In other words, the
margin of safety indicates the amount by which
a company's sales could decrease before the
company will have no profit.

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 Sensitivity Analysis and Margin of
Safety
• Sensitivity analysis is a financial model that determines
how target variables are affected based on changes in
other variables known as input variables. This model is
also referred to as what-if or simulation analysis. It is a way
to predict the outcome of a decision given a certain range
of variables.
• In the context of CVP analysis, sensitivity analysis answers
questions such as, “What will operating income be if the
quantity of units sold decreases by 5% from the
original prediction?” and “What will operating income be
if variable cost per unit increases by 10%?” Sensitivity
analysis broadens managers’ perspectives to possible
outcomes that might occur before costs are committed.
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Margin of safety
• The margin of safety is the amount of sales over a
company's break-even point
• The margin of safety is the amount sales can fall
before the break-even.
• The margin of safety answers the “what-if” question: If
budgeted revenues are above
breakeven and drop, how far can they fall below
budget before the breakeven point is
reached?

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Example ( sensitivity analysis)
• 32 units must be sold to earn an
operating income of $1,200 if fixed costs are
$2,000 and variable cost per unit is $100.
Emma can also use Exhibit 3-4 to determine
that she needs to sell 56 units to break even
if fixed cost of the booth rental at the Chicago
fair is raised to $2,800 and if the variable
cost per unit charged by the test-prep package
supplier increases to $150.

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Example

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Example ( Margin of safety)
• Assume that Emma has fixed costs of $2,000, a
selling price of $200, and variable cost per unit of
$120. From Exhibit 3-1, if Emma sells 40 units,
budgeted revenues are $8,000 and budgeted
operating income is $1,200. The breakeven point
is 25 units or $5,000 in total revenues.

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Solution

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