Chapter Three

Cost Volume Profit (CVP) Analysis

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Chapter objectives
• At the end of this chapter, students will be able to:
• understand CVP analysis
• apply CVP analysis in decision making

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Cost Volume Profit (CVP) analysis

CVP analysis:
• is a powerful management tool in making managerial
decisions such as Marketing, Production, Investment, and
Financing.
• the analysis of three variables— Cost, Volume, and Profit
• explores the relationship between revenue and cost and
their effect on profits.
• it aims at measuring the variation of cost with profit.

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CVP Analysis (cont---)
• Helps explain interaction between
• Selling price of products
• Volume/level of activities
• Per unit variable cost
• Total fixed costs

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 Fixed cost
• are costs which incurred for a period which within certain
output turnover limits, tend to be unaffected by fluctuation in
the level of activity (output or turnover).
• For example, rent, insurance of factory building, etc., remain
the same for different levels of production

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 Variable costs
• These are costs tend to vary with the volume of activity.
• Any increase/decrease in the activity result in an
increase/decrease in the variable costs.
• For example, cost of direct material, direct labor

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 Semi-variable costs
• This costs contain both fixed and variable components and
thus partly affected by fluctuation in the level of activity.
• Example; telephone bills, gas and electricity.

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 CVP analysis:
• Takes into account:
(a) the total costs (fixed and variable costs)
(b) the total sales revenues
(c) desired profit vis-a -vis the sales volume.
• Is used for forecasting how the changes in cost and sales volume
affect profit.
• It is also known as Break-Even Analysis.
• Is helpful:
• in budget planning: For forecasting profit by considering costs
and profit relation, and volume of production. This will help in
determining the sales volume in required to make a profit.
• To make decisions regarding pricing and sales volume.

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Objectives of CVP analysis
• Understanding the interaction among:
o Price of products
o Volume or level of activity
o Per unit variable cost
o Total fixed cost
o Mix of product sold

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 Assumptions of CVP analysis
• Costs can be classified as either variable or fixed.
• CVP relations are linear over wide range of production
and sales.
• Selling prices, unit variable cost, and total fixed cost will
not vary within the relevant range.

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Profit equation and contribution margin
1) Profit =sales – total costs
2) Profit =sales-total variable cost-total fixed cost
3) Contribution margin =total revenue-total variable cost

Example 1
Sales Birr 50,000
Less Variable cost 20,000
Contribution margin 30,000
Less fixed cost 12,000
Operating profit Birr 18,000
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Example 2

• U-Develop is a firm developing prints and sales 12,000

prints. Average selling price is $0.60 & the average
variable cost of each print was $0.36. The Income
statement is as follows:

,0 00
7,200/12

720/12,000

Contribution margin = $2,880 ÷ 12,000 = $0.24

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 Cont---
• Profit =(S-V)*Q-FC

• Q is no. of units required to be sold to obtain

target profit.
• S=selling price per unit
• VC= variable cost per unit
• FC= fixed cost
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 Example 3
• Suppose that Super bike want to produce a new mountain bike
and forecast the following information.
• Price per bike= birr 800
• Variable cost per bike =birr 300
• Fixed cost related to bike production =birr 5,500,000
• Target profit = birr 200, 000
• Estimated sales=12,000 bikes
• We determined the quantity of needed for the target profit as
follows:
• Q=(5,500,000+200,000)/(800-300) =11,400 bikes
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Exercise 1
• Price/unit=5,000
• Variable cost/unit=2,000
• Q=40
• FC=120,000
• P=?

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 Contribution margin ratio
• The contribution margin ration (CMR) i.e., the Profit Volume (PV) ratio:
• is the percentage by which the selling price (or revenue) per unit exceeds the
variable cost per unit. its contribution margin as percentage of revenue.
• Is the measure indicates how a particular product contributes to the overall
profit of the company.
• It provides one way to show the profit potential of a particular product
offered by a company and shows the portion of sales that helps to cover the
company's fixed costs.
• Any remaining revenue left after covering fixed costs is the profit generated.

•C

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 Example 4
• For mountain bike, we can use the forecast information about
volume (12,000 bikes) to determine the contribution margin.
• Total revenue= 12,000*800=9,600,000
• Total variable cost=300*12,000=3,600,000

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Exercise 2

• Q=800 units
• Selling price/unit= birr 400
• FC=birr 96,000
• TC= birr 256,000
• CM=?
• CMR=?

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Breakeven Point (BEP) Analysis
• is used to find the minimum level of production required.
• evaluate both fixed and variable costs.
• used to find:
1) the sales required to reach a desired revenue
2) the profit at a certain price level and sales

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 Breakeven Point (BEP
• A CVP analysis is used to determine the BEP, or level of
operating activity at which revenues cover all fixed and
variable cost resulting in a zero profit.
• In other words, this is the point where no profit or no loss
have been made.

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 Cost-Volume-Profit Graph

Total revenues
$10,000 Breakeven
line
Point
$8,000 25 units Total costs
line
$6,000
Operating
$4,000 income

$2,000
Operating
$0 loss

0 10 20 30 40 50
Units Sold

Copyright © 2003 Pearson Education Canada Inc. Page 72 Slide 3-21

BEP Formula

Example 5
• Sales = 500 units
• Sales price per unit = birr 50
• Variable cost per unit = birr 30
• Fixed cost = birr 35,000
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Solution
• Contribution per unit = birr 50-30= birr 20
• BEP in units = FC/CM = 35,000/20= 1,750 units
• Breakeven Revenue (BER) = 1,750*birr 50= birr
87,500 or
• BER= (FC*Sales)/(Sales-Variable costs)
=(35,000*25,000)/(25,000-15,000)=87,500
• NB: Sales = 25,000 (500*50); Variable cost= 15,000
(500*30)

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 Sensitivity Analysis
• sensitivity analysis is a “what-if” technique that examines how
a result will change if the original predicted data are not
achieved or if an underlying assumption changes
• What will happen to operating income if volume declines by
5%?
• What will happen to operating income if variable costs
increase by 10% per unit?
• sensitivity analysis broadens management’s perspectives about
possible outcomes
Pages 76 - 77
 Alternative Cost Structures
• CVP helps managers assess the risks and potential
benefits of adopting alternative cost structures
Example: Alternative rental arrangements
Option 2
Option 1 $1,400 Fixed Fee Option 3
$2,000 Fixed Fee + 5% Commission 20% Commission
Rev Rev Rev
$ $ $
Cost Cost Cost

Units Units Units

Breakeven = 25 units Breakeven = 20 units Breakeven = 0 units

Copyright © 2003 Pearson Education Canada Inc. Pages 77 - 78 Slide 3-25

 Margin of safety
• Represents the strength of the business.
• The excess of projected or actual sales volume over break-
even volume or
• The excess of projected or actual sales revenue over
break-even revenue.
• Margin of safety= actual sales – BEP sales
• Margin of safety (%) = (actual sales – BEP sales)/actual
sales*100
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Example 6
• The breakeven sales is birr10,000 and the actual sales is
birr15,000
• Margin of safety = 15,000-10,000 = 5,000
• Margin of safety (%) = (15,000-10,000)/15,000*100 =
5,000/15000*100= 33.33%

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Exercise 3
• Consider the following information of XYZ company.
• Sales = 600 units
• Selling price = birr 60
• Variable cost/unit = birr 40
• FC = birr 50,000
• If the company actually generates a sales revenue of birr
200,000, calculate the margin of safety?

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Discussion questions
• What is CVP analysis and how it is important for decision
making?
• What variables are considered in CVP analysis?
• What is contribution margin?
• What is the break-even point?

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