* Cost Volume Profit Analysis

Plans fail for lack of counsel, but with many advisers they succeed.
Proverbs 15:22
Cost-volume-profit analysis (CVP analysis) is
a powerful tool for planning and decision
making. Because CVP analysis emphasizes
the interrelationships of costs, quantity sold,
and price, it brings together all of the
financial information of the firm. CVP
analysis can be a valuable tool in identifying
the extent and magnitude of the economic
trouble a company is facing and helping
pinpoint the necessary solution.
Cost-volume-profit (CVP) analysis is a
technique for analyzing how costs and
profits change with the volume of
production and sales. It is also called the
Break-even analysis. CVP analysis assumes
that selling prices and variable costs are
constant per unit at all volumes of sales and
that fixed costs remain fixed at all levels of
activity.
The starting point of presenting
the CVP analysis is to find the
firm’s break-even point in units
sold. The break-even point is the
point of zero profit. Two frequently
used approaches to finding the
break-even point in units are the
operating income approach and
the contribution margin approach.
CVP analysis focuses on the factors
that effect a change in the
components of profit. Because we are
looking at CVP analysis in terms of
units sold, we need to determine the
fixed and variable components of
cost and revenue with respect to
units. It is important to realize that
we are focusing on the firm as a
whole. Therefore, the costs we are
talking about are all costs of the
company: manufacturing, marketing,
Thus, when we say variable
costs, we mean all costs that
increase as more units are sold,
including direct materials, direct
labour, variable overhead, and
variable selling and
administrative costs. Similarly,
fixed costs include fixed
overhead and fixed selling and
administrative expenses.
Operating Income Approach
The operating income approach
focuses on the income statement as
a useful tool in organizing the firm’s
costs into fixed and variable
categories. The income statement
can be expressed as a narrative
equation:
Operating income = Sales revenues – Variable
expenses – Fixed expenses
Once we have a measure of units
sold, we can expand the operating
income equation by expressing
sales revenue and variable
expenses in terms of unit dollar
amounts and number of units.
Specifically, sales revenue is
expressed as the unit selling price
times the number of units sold, and
total variable costs are the unit
variable cost times the number of
units sold. With these expressions,
Operating income = (Price × Number of units) –
(Variable cost per unit × Number units)
– Total fixed costs

Suppose you were asked how many

units must be sold in order to break
even, or earn a zero profit. You could
answer that question by setting
operating income equal to zero and then
solving the operating income equation
for the number of units.
Use the following example to solve for the
break-even point in units. Assume that More-
Power Company manufactures a single type of
power tool: sanders. For the coming year, the
controller has prepared the following
projected income statement:
For More-Power Company, the price is
$40 per unit, and the variable cost is
$24 ($1,740,000/72,500 units). Fixed
costs are $800,000. At the break-
even point, then, the operating
income equation would take the
following form:
0= ($40 × Units) – ($24 × Units) –
$800,000
0= ($16 × Units) – $800,000
$16× Units = $800,000
Units= 50,000
Contribution Margin Approach
A refinement of the operating income
approach is the contribution margin
approach. In effect, we are simply
recognizing that at breakeven, the total
contribution margin equals the fixed
expenses. The contribution margin is
sales revenue minus total variable
costs. If we substitute the unit
contribution margin for price minus unit
variable cost in the operating income
equation and solve for the number of
units, we obtain the following break-
Break-even number of units = Fixed costs/Unit
contribution margin
Using More-Power Company as an
example, we can see that the
contribution margin per unit can be
computed in one of two ways. One way
is to divide the total contribution
margin by the units sold for a result of
$16 per unit ($1,160,000/72,500). A
second way is to compute price minus
variable cost per unit. Doing so yields
the same result, $16 per unit ($40 –
$24). Now, we can use the contribution
margin approach to calculate the
 Number of units = $800,000/($40 –
$24)
= $800,000/$16 per unit
= 50,000 units
Profit Targets
While the break-even point is useful
information, most firms would like to earn
operating income greater than zero. CVP
analysis gives us a way to determine how
many units must be sold to earn a particular
targeted income. Targeted operating income
can be expressed as a dollar amount (e.g.,
$20,000) or as a percentage of sales revenue
(e.g., 15 percent of revenue). Both the
operating income approach and the
contribution margin approach can be easily
Assume that More-Power Company wants to
earn operating income of $424,000. How
many sanders must be sold to achieve this
result? Using the operating income approach,
we form the following equation:

$424,000= ($40 × Units) – ($24 × Units) –

$800,000
$1,224,000= $16 × Units
Units= 76,500
Using the contribution margin approach, we
simply add targeted profit of $424,000 to
the fixed costs and solve for the number of
units.

Units= ($800,000 + $424,000)/($40 – $24)

= $1,224,000/$16
= 76,500
Graphical representation of CVP
relationships

Visual portrayals may further our

understanding of CVP relationships. A
graphical representation can help
managers see the difference between
variable cost and revenue. It may also
help managers understand quickly what
impact an increase or decrease in sales
will have on the break-even point. Two
basic graphs, the profit-volume graph
and the cost-volume-profit graph, are
The Profit-Volume Graph
A profit-volume graph visually portrays
the relationship between profits and
sales volume. The profit-volume graph is
the graph of the operating income
equation:
[Operating income= (Price × Units) −
(Unit variable cost × Units) − Fixed
costs].
In this graph, operating income (profit)
is the dependent variable, and units is
the independent variable. Usually,
values of the independent variable are
Assume that Tyson Company produces a
single product with the following cost
and price data:
Total fixed costs $100
Variable cost per unit 5
Selling price per unit 10
Using these data, operating income can
be expressed as follows:
Operating income = ($10 × Units) − ($5
× Units) − $100
= ($5 × Units) − $100
We can graph this relationship by plotting units
along the horizontal axis and operating income
(or loss) along the vertical axis. Two points are
needed to graph a linear equation.
While any two points will do, the two points often
chosen are those that correspond to zero sales
volume and zero profits. When units sold are zero,
Tyson experiences an operating loss of $100 (or a
profit of −$100). The point corresponding to zero
sales volume, therefore, is (0, −$100). In other
words, when no sales take place, the company
suffers a loss equal to its total fixed costs. When
operating income is zero, the units sold are equal
to 20. The point corresponding to zero profits
(breakeven) is (20, $0). These two points, plotted
in the following Exhibit 1-1, define the profit
Profit volume graph E1-1
The graph in Exhibit 1-1 can be used to assess
Tyson’s profit (or loss) at any level
of sales activity. For example, the profit
associated with the sale of 40 units can be
read from the graph by (1) drawing a vertical
line from the horizontal axis to the profit line
and (2) drawing a horizontal line from the
profit line to the vertical axis. As illustrated in
Exhibit 1-1, the profit associated with sales of
40 units is $100.
The profit-volume graph, while easy to
interpret, fails to reveal how costs change as
sales volume changes. An alternative approach
to graphing can provide this detail.
The Cost-Volume-Profit Graph
The cost-volume-profit graph depicts the
relationships among cost, volume, and profits.
To obtain the more detailed relationships, it is
necessary to graph two separate lines: the
total revenue line and the total cost line. These
lines are represented, respectively, by the
following two equations:
Revenue= Price × Units
Total cost = (Unit variable cost × Units) +
Fixed costs
Using the Tyson Company example, the
revenue and cost equations are as follows:
Revenue= $10 × Units
Total cost = ($5 × Units) + $100
To portray both equations in the same
graph, the vertical axis is measured in
revenue dollars and the horizontal axis in
units sold.
Two points are needed to graph each
equation. We will use the same x-
coordinates used for the profit-volume
graph. For the revenue equation, setting
number of units equal to zero results in
revenue of $0; setting number of units
equal to 20 results in revenue of $200.
Therefore, the two points for the revenue
equation are (0, $0) and (20,$200). For the
cost equation, 0 units sold and 20 units
Notice that the total revenue line begins at the
origin and rises with a slope equal to the selling
price per unit (a slope of 10). The total cost line
intercepts the vertical axis at a point equal to
total fixed costs and rises with a slope equal to
the variable cost per unit (a slope of 5). When
the total revenue line lies below the total cost
line, a loss region is defined. Similarly, when the
total revenue line lies above the total cost line, a
profit region is defined. The point where the total
revenue line and the total cost line intersect is
the break-even point. To break even, Tyson
Company must sell 20 units and thus receive
$200 in total revenues.
Cost-Volume-Profit Graph E1-
2
Now, let’s compare the information
available from the CVP graph with that
available from the profit-volume graph. To
do so, consider the sale of 40 units. Recall
that the profit-volume graph revealed that
selling 40 units produced profits of $100.
Examine Exhibit 17-5 again. The CVP graph
also shows profits of $100, but it reveals
more than that. The CVP graph discloses
that total revenues of $400 and total costs
of $300 are associated with the sale of 40
units. Furthermore, the total costs can be
broken down into fixed costs of $100 and
The CVP graph provides revenue and
cost information not provided by the
profit-volume graph. Unlike the profit-
volume graph, some computation is
needed to determine the profit
associated with a given sales volume.
Nonetheless, because of the greater
information content, managers are
likely to find the CVP graph a more
useful tool.
Assumptions of Cost-Volume-Profit Analysis
The profit-volume and cost-volume-profit graphs
rely on some important assumptions:
1.The analysis assumes a linear revenue
function and a linear cost function.
2.The analysis assumes that price, total fixed
costs, and unit variable costs can be
accurately identified and remain constant over
the relevant range (recall that the relevant
range is the range over which the cost
relationship is valid).
3.The analysis assumes that what is produced is
sold.
4.For multiple-product analysis, the sales mix is
assumed to be known.
5.The selling prices and costs are assumed to be
MARGIN OF SAFETY
Actual sales volume will not be the same as budgeted
sales volume. Actual sales will probably either fall
short of budget or exceed budget. A useful analysis of
business risk is to look at what might happen to profit if
actual sales volume is less than budgeted.

The difference between budgeted sales volume and

the break-even sales volume is known as the margin
of safety. It is simply a measurement of how far sales
can fall short of budget before the business makes a
loss. In this respect, a large margin of safety indicates
a low risk of making a loss, whereas a small margin of
safety might indicate a fairly high risk of a loss. It
therefore indicates the vulnerability of a business to a
fall in demand.
CVP ANALYSIS FORMULA
CVP analysis can be undertaken by graphical means or
by formulae which are listed below and have already
been illustrated by examples.

The break-even formulae are summarized below:

Break-even point (units) = Fixed costs
Unit Contribution

Contribution per unit = Selling price – variable cost per

unit

Total contribution = Total sales – Total variable

costs

Contribution/Sales ratio = Contribution per unit x 100

Sales price per unit
Break-even point (K sales) = Fixed costs x Selling price per unit
Unit contribution
Break-even point (K sales) = Fixed Costs
C/S Ratio

Level of sales to result in target profit (in units) = Fixed costs + T. Profit
Contribution per unit