CHAPTER ONE

COST-VOLUME-PROFIT (CVP) ANALYSIS

Learning Objectives
• After completing this chapter, you should be able
to:
 Understand the cost volume profit (CVP) assumptions
 Distinguish between contribution margin and gross
margin
 Explain Essential features of CVP analysis
 Determine break even point and out put to achieve
target operating income
 Explain the use of CVP analysis in decision
making and how sensitivity analysis can help
managers cope with certainty
 Apply CVP analysis to a multi product company
Introduction
• Understanding the relationship between a firm’s
costs, profits and its volume levels is very
important for strategic planning.
• Managers need to estimate future revenues, costs,
and profits to help them plan and monitor
operations.
• They use cost-volume-profit (CVP) analysis to
identify the levels of operating activity needed to
avoid losses, achieve targeted profits, plan future
operations, and monitor organizational
performance.
Meaning, Underlying Assumptions and
Importance of CVP Analysis
Meaning
• Examining shifts in costs and volume and their resulting
effects on profit is called cost-volume-profit (CVP) analysis.
• CVP analysis can be used to determine a company’s break-
even point (BEP), which is that level of activity, in units or
Birr value, at which total revenues equal total costs.
• At breakeven, the company’s revenues simply cover its costs;
thus, the company incurs neither a profit nor a loss on
operating activities.
• Companies, however, do not wish merely to “break even” on
operations.
• The break-even point is calculated to establish a point of
reference.
• Knowing BEP, managers are better able to set sales
goals that should generate income from operations
rather than produce losses.
• CVP analysis can also be used to calculate the sales
volume necessary to achieve a desired target profit.
• Target profit objectives can be stated as either a fixed or
variable amount on a before- or after-tax basis.
• Because profit cannot be achieved until the break-even
point is reached, the starting point of CVP analysis is BEP.
• It also helps in conducting a sensitivity analysis to
understand how the change in variables in the CVP model
affects the profitability.
Cost-volume-profit analysis determines how costs and
profit react to a change in the volume or level of activity, so
that management can decide the 'best' activity level.
Underlying Assumptions of CVP Analysis
• CVP analysis is a short-run model that focuses on
relationships among several items: selling price,
variable costs, fixed costs, volume, and profits.
• This model is a useful planning tool that can
provide information on the impact on profits
when changes are made in the cost structure or
in sales levels.
• It reflects reality but does not duplicate it.
• Although limiting the accuracy of the results,
several important but necessary assumptions are
made in the CVP model.
1. Changes in the levels of revenues and costs arise only
because of changes in the number of products (or
service) or units sold. The number of units sold is the only
revenue driver and the only cost driver.
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.
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
Applications of CVP Analysis
Break Even Analysis
• CVP can be used to determine a company’s break-even
point (BEP), which is that level of activity, in units or
dollars/Birr, at which total revenues equal total costs.
• At breakeven, the company’s revenues simply cover its
costs; thus, the company incurs neither a profit nor a loss
on operating activities.
• 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.
• CVP analysis can be done using three alternative
approaches, namely: contribution margin approach,
equation approach and graphical approach.
1. Equation Method
• In using equation approach to CVP analysis, you need to convert
your income statement in the following equation form.
Revenue –Variable Costs- Fixed Costs = Operating
Income
• Your Sales Revenue is equal to the number of units sold times the
price you get for each unit sold:
Sales Revenue = SPQ
• Assume that you have a linear cost function, and your total costs
equal the sum of your Variable Costs and Fixed Costs:
Total Costs = Variable costs + Fixed costs
• The profit equation can, therefore rewritten as:
(SPXQ) - (VCUXQ) - FC= OI
• At breakeven point,
(SPXQ) - (VCUXQ) - FC = 0
• Example
• If the company sold one unit at $ 200, variable cost per unit
$120, and also fixed cost is $ 2,000, what will be the amount
of break-even quantity?
(SP× Q) – (VCU×Q) – fixed cost = operating income
= ($200×Q) - ($120×Q) - $2,000= 0
= $80× Q = 2,000
= Q = 2,000 ÷ 80 per unit
= 25 units
Interpretation: If the company sells fewer than 25 units, it will
incur a loss; if it sells 25 units, it will be at breakeven; and if it
sells more than 25 units, it will make a profit. While this
breakeven point is expressed in units, it can also be expressed in
revenues (Dollar): 25 units × $200 selling price= $5,000.
2. Contribution Margin Approach
• The contribution margin technique is merely a short version of the
equation technique.
• The formulas used in the determination of the breakeven point in unit
as well as in value are derived by the rearrangement of the terms in the
equation method above, which is
(SP x Q) – (VCU x Q) – FC= OI
• Re-written equation takes the following format:
(SP-VCU) x Q = FC + OI
• That is, Q= FC + OI/ (SP-VCU)
• The difference between unit selling price and unit variable cost is
termed as unit contribution margin.
• You can replace the (P-V) by the term "Contribution Margin per Unit
(CMU),
Q= FC + OI/CMU
• At breakeven point the target operating income is Birr 0, so
replacing OI by 0, you will get,
A. Breakeven point in units using contribution Margin
Approach
• Breakeven point in units using this formula is determined
by dividing the total fixed cost by the contribution margin
per unit due to the fact that this 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 equals to the total expense and only after
that point the units sold contributes for profit of the organization.
• Breakeven number of units = Fixed cost ÷ contribution margin
per unit
= $2,000÷ $80= 25 units
• Breakeven revenues = Breakeven number of units × Selling
price
= 25 units × $200 per unit = $5,000
B. Determining breakeven point in terms of sales value
(Dollar/Birr)
• To find the breakeven sales value, you can use contribution
margin percentage in place of contribution margin per unit in
the formula you used in the determination of breakeven units.
• Contribution margin percentage is simply the ratio of
contribution margin to selling price.
CM% = CMU/USP
• Contribution margin percentage = Contribution margin per
unit/ Selling price = $80/$200
= 0.4 or 40%
• That is, 40% of each dollar of revenue, or 40 cents, is
contribution margin. To breakeven, contribution margin must
equal fixed costs of $2,000. To earn $2,000 of
contribution margin, when $1 of revenue earns $0.40 of
contribution margin, revenues must equal $2,000÷ 0.40 =
• It can also determined by dividing the total contribution margin to total
sales when the unit selling price and variable cost is not known.
• For example, Jimma Electronics Co. produces portable radios. It has
released the following Variable Costing Income Statement. This is the
only financial information that we have regarding the company’s
operations:
• Sales Revenue--------- 100,000
• Less Variable Costs------30,000
• Contribution Margin----- 70,000
• Less Fixed Costs--------- 50,000
• Operating Income ------- Br 20,000
CM% = Br 70,000 ÷ Br 100,000
= 0.7 0r 70%
• The breakeven point in sales is also determined by dividing the total fixed
cost by the contribution margin ratio determined above as follows:
= FC/CM%
= 50,000/0.7
=Br 71,428.57
3. Graphical Approach
• Sometimes managers need information in more visual
format, such as graphs.
• In this approach you can construct a CVP graph by plotting
total cost and total revenue graph at different activity level.
• The breakeven point is found at the intersection point of
total revenue and total cost lines.
• The chart or graph is constructed as follows:
1. Plot fixed costs, as a straight line parallel to the horizontal
axis
2. Plot sales revenue and variable costs from the origin
3. Total costs represent fixed plus variable costs.
4. The breakeven point represents the intersection point of
total revenue and total cost lines
 Target Operating Income Analysis
• Using CVP analysis managers can determine the total sales in unit
and Birr/Dollar needed to reach the target profit level.
• The computation of sales volume in unit and/ or in amount to attain
the targeted profit is similar with that of the break even analysis,
except that the targeted profit is more than offsetting the cost.
• For instance, the management of a company desires to get Br 1,600
profit for the coming month, instead of operating at breakeven point,
how many tickets must be sold?
• Managers want to answer this question to provide the necessary
resource support to attain the desired profit at already determined
volume of activity.
• The analysis can be performed using equation method or
contribution margin approach on the basis of personal preference.
($200 * Q) - ($120 * Q) - $2,000 = $1,600
$80 * Q = $3,600
Q = $3,600/ $80 per unit = 45 units
Equation Method to Determine Contribution Margin
(Target sales unit) Approach (Target sales
unit)
(SP x Q) - (VCU x Q) -FC= TOI Q = FC +TOI/ CMU
(200 x Q) – (120 x Q) - 2,000= Q = (2,000 + 1,600)/80
1,600 Q= 45
80Q= 3,600
Q= 45
Equation Method to Determine Contribution Margin
(Target sales in birr) Approach (Target sales in
birr)
TR= SP x Q Target Sales in Birr = (FC +
=200 x 45 TOI)/CM%
= Br 9,000 = (2,000 + 1,600)/ 40%
= Birr 9,000
3. The Impact of Income Tax on CVP Analysis
• Profit seeking enterprises must pay tax on their profit,
meaning that target income figures are set at high enough
to cover the firm’s tax obligation to the government.
• The relationship between an organization‘s before tax
income and after tax income is expressed in the following
formula:
• After Tax income = Before Tax Income – Income Taxes
NIAT = NIBT- (NIBT x t)
= NIBT x (1-t)
NIAT/ (1-t) = NIBT
• Which gives you the desired before tax income that will
generate the desired after tax income, given the
company’s tax rate.
• For instance, if the target profit given for company above is
expressed on after tax basis and the firm is subject to a 40 percent
income tax rate, what will be the required sales of ticket in units
and Birr?
• If you want to know how many units that you need to produce
and sell in order to generate a target Net Income (or after-tax
profit), just convert the after-tax number into a before-tax
number.
NIBT = NIAT/ (1-t)
=Br 1,600/ (1-0.4)
= Br 2,666.67
• You can then substitute the before-tax profit figure in the
formulas used in target operating income analysis.
• The analysis of sales quantity and amount of company to earn the
desired profit after tax can be determined using the equation and
contribution margin approach as shown on the following table:
Equation Method to Determine Contribution Margin
(Target sales unit) Approach (Target sales
unit)
(SP x Q) - (VCU x Q) -FC= Q = FC +TOIBT/ CMU
TOIBT Q = (2,000 + 2,666.67)/80
(200 x Q) – (120 x Q) - 2,000= Q= 58.33
2,666.67
80Q= 4,666.67
Q= 58.33
Equation Method to Determine Contribution Margin
(Target sales in birr) Approach (Target sales in
birr)
TR= SP x Q Target Sales in Birr = (FC +
=200 x 58.33 TOIBT)/CM%
= Br 11,666.675 = (2,000 + 2,666.67)/ 40%
= Br 11,666.675
4. Sensitivity Analysis and Margin of Safety
• Sensitivity analysis is a “what-if” technique that managers
use to examine how an outcome will change if the original
predicted data are not achieved or if an underlying
assumption changes.
• In the context of CVP analysis, sensitivity analysis answers
questions such as, “What will operating income be if the
quantity of units sold decreased by 5% from the
original prediction?” and “What will operating income
be if the variable cost per unit increases by 10%?”
• Sensitivity analysis broadens managers’ perspectives to
possible outcomes that might occur before costs are
committed.
• 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?
• Sales might decrease as a result of a competitor
introducing a better product, or poorly executed
marketing programs, and so on.
• The margin of safety is the excess of the budgeted or
actual sales over the breakeven sales level.
Margin of safety = Budgeted (or actual) revenues -
Breakeven revenues
Margin of safety (in units) = Budgeted (or actual) sales
quantity - Breakeven quantity
• Assume that the company has fixed costs of $2,000, a
selling price of $200, and variable cost per unit of
$120. If the company 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.
Margin of safety = budgeted revenues - breakeven
revenues = $ 8000 - $ 5000= $ 3,000
Margin of safety (in units) = Budgeted sales unit -
Breakeven sales unit = 40 – 25 = 15 units
Margin of Safety (%) = Margin of safety in Birr/Sales
= $3,000/$8,000
= 37.5%
Using CVP Analysis for Decision Making
• Different choices can affect selling prices, variable cost
per unit, fixed costs, units sold, and operating income.
• CVP analysis helps managers make product decisions
by estimating the expected profitability of these
choices.
• CVP analysis can be used to evaluate how operating
income will be affected if the original predicted data are
not achieved
• For example, if the probability of a decline in sales
seems high, a manager may take actions to change the
cost structure to have more variable costs and fewer
fixed costs.
1. Decision to Advertise
• Suppose the company anticipates selling 40
units at the fair. The data indicate that the
company’s operating income will be $1,200.
• It is considering placing an advertisement
describing the product and its features in the fair
brochure.
• The advertisement will be a fixed cost of $500.
• It thinks that advertising will increase sales by
10% to 44 packages.
• Should the company advertise?
Decision: Operating income will decrease from
$1,200 to $1,020, so it should not advertise.
2. Decision to Reduce Selling Price
• Having decided not to advertise, the company is
contemplating whether to reduce the selling price to $175.
At this price, they think that they will sell 50 units. At this
quantity, the package wholesaler who supplies the product will
sell the packages to it for $115 per unit instead of $120.
Should the company reduce the selling price?
Contribution margin from lowering prices to $175: $3,000
($175 - $115) per unit * 50 units
Contribution margin from maintaining price at $200: $3,200
($200 - $120) per unit * 40 units
Change in contribution margin from lowering prices $ (200)

• Decreasing the price will reduce the contribution margin by

$200 and, because the fixed costs of $2,000 will not change, it
will also reduce operating income by $200. The company
should not reduce the selling price.
CVP Analysis in Multiple Product Company
• The determination of the break-even point in CVP analysis
is easy once variable and fixed costs are determined.
• A problem arises when the company sells more than one
type of product.
• Break-even analysis for multiple products is made possible
by calculating weighted average contribution margins.
• The break-even point in units is equal to total fixed costs
divided by the weighted average contribution margin per
unit (WACMU).
• The break-even point can be computed as: total fixed costs
divided by the weighted average contribution margin ratio
(WACMR).
• For companies that produce more than one
product, break-even analysis may be performed
for each type of product if fixed costs can be
determined separately for each product.
• However, fixed costs are normally incurred for all
the products hence a need to compute for the
composite or multi-product break-even point.
BEP = Total fixed costs
in units Weighted average CM per unit

BEP = Total fixed costs

in dollars Weighted average CM ratio

Example

• Belle Company manufactures and sells three products:

Products A, B, and C. The following data has been
provided the company.
A B C
Selling price $100 $120 $50
Variable cost per unit 60 90 40
Contribution margin per
40 30 10
unit
Contribution margin ratio 40% 25% 20%

• The company sells 5 units of C for every unit of A and 2

units of B for every unit of A. Hence, the sales mix is
1:2:5. The company incurred in $120,000 total fixed
costs.
1. Multi-product break-even point in units
BEP in units = Total fixed costs
Weighted average CM per unit
$120,000
$18.75
BEP in units = 6,400 units
a. Computation of weighted average CM per unit:
∑(CM per unit x Unit sales mix ratio)
Product A ($40 x 1/8) $ 5.00
Product B ($30 x 2/8) 7.50
Product C ($10 x 5/8) 6.25
WA CM per unit $18.75
• The weighted average CM may also be computed by dividing
the total CM by the total number of units.
WA CM per unit = (40x1)+(30x2)+(10x5) = 18.75
8
b. Breakdown of the break-even sales in units:
(B-E point x Unit sales mix ratio)
Product A (6,400 units x 1/8) 800 units
Product B (6,400 units x 2/8) 1,600
Product C (6,400 units x 5/8) 4,000
Total 6,400 units

The company must produce and sell 800 units of Product

A, 1,600 units of Product B, and 4,000 units of Product C
in order to break-even.
2. Multi-product break-even point in dollars
BEP in dollars = Total fixed costs
Weighted average CM ratio
$120,000
25.4237%
BEP in dollars = $472,000
a. Computation of weighted average CM ratio:
∑(CMR x Sales revenue ratio)
Product A (40% x 100/590) 6.7797%
Product B (25% x 240/590) 10.1695%
Product C (20% x 250/590) 8.4745%
WA CM per unit 25.4237%
Take note that this time, the ratio used is individual sales to total sales
amount.
Product A (100x1) 100
Product B (120x2) 240
Product C (50x5) 250
Total Sales 590
The weighted average CM may also be computed by dividing the
total CM by the total sales.
WA CM ratio = (40x1)+(30x2)+(10x5)
(100x1)+(120x2)+(50x5)
WA CM ratio = 25.4237%
b. Breakdown of the break-even sales revenue:
(B-E point x Sales revenue ratio)
Product A ($472,000 x 100/590) $ 80,000
Product B ($472,000 x 240/590) 192,000
Product C ($472,000 x 250/590) 200,000
Total $472,000

The company must generate sales of $80,000 for Product A,

$192,000 for product B, and $200,000 for Product C, in
order to break-even.
End of chapter