Cost-Volume-Profit Analysis

TRANSITION NOTES
This chapter contains updated coverage of strategy and strategic uses of cost information.
The five-step decision process is applied to CVP decisions. There is a shift to the
essentials of cost-volume-profit analysis with less focus on the assumptions of CVP
analysis. This is in line with the increased focus on the managerial aspects of the text.
Discussion of alternative fixed/variable cost structures, multiple product breakeven
analysis and contribution margin versus gross income have been revised and shortened.
There are several significant revisions and additions to the problem material at the end of
the chapter.

PROBLEM MATERIAL
CORRELATION CHART

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I. LEARNING OBJECTIVES
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 managers use sensitivity analysis to 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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II. CHAPTER SYNOPSIS
This chapter presents the cost-volume-profit (CVP) analysis model and illustrates how
managers use that model to help answer important what-if business questions. CVP
analysis also helps management accountants alert managers to the risks and rewards of
decisions they are considering by illustrating how the bottom-line is affected by
changes in activity levels or key pricing or cost components. CVP analysis is based on
several assumptions, one of which is that fixed costs can be distinguished from variable
costs. However, whether a cost is variable or fixed depends on the time period for the
decision and also the range of activity (relevant range) being considered. Students are
also presented with a method for applying CVP analysis to companies with multiple
products and to situations where there is more than one cost driver. The applicability of
CVP to manufacturers, service organizations, and nonprofits is discussed. Contribution
margin is also defined and distinguished from gross margin.

III. POINTS OF EMPHASIS

1. The concepts of contribution margin, contribution margin income statement,
breakeven, target operating income, along with other measures are introduced in
this chapter. This is a nuts and bolts chapter that the student should understand
if they are to grasp the material covered in future chapters. Spend time having the
students work problems covering the concepts from this chapter.
2. Sensitivity analysis is a valuable tool that students can use to determine the
expected outcome from various scenarios.
3. Operating leverage is a concept that will help the students understand why
operating income changes as it does. Help the students see the usefulness of
DOL.

IV. CHAPTER OUTLINE

LEARNING
OBJECTIVE
1
Explain the features of cost-volume-profit (CVP)
analysis

how operating income changes with changes in

output level, selling prices, variable costs, or fixed
costs

1.1 Cost-volume-profit (CVP) analysis studies the behavior of total revenues, total
costs, and operating income as changes occur in the units sold, the selling price,
the variable cost per unit, or the fixed costs of a product.

1.2 The five-step decision process outlined in Chapter 1 can be utilized in doing CVP

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 analysis. To review, those steps are:
a. Identify the problems and uncertainties.
b. Obtain information.
c. Make predictions about the future.
d. Make decisions by choosing among alternatives.
e. Implement the decision, evaluate performance, and learn.
(The Emma Frost example in the text details each of these steps as faced by a
GMAT test preparation salesperson.)
1.3 Contribution margin is the difference between total revenues and total variable
costs. This is an indication of why operating income changes as the number of
units sold changes.
1.4 Contribution margin per unit is the difference between selling price and
variable cost per unit; i.e., contribution margin per unit is the change in operating
income for each additional unit sold.
1.5 A contribution income statement is an income statement that groups costs into
their variable and fixed components. Variable costs are subtracted from revenues
to highlight contribution margin. Fixed costs are subtracted from contribution
margin to arrive at operating income.
(Exhibit 3-1 illustrates a contribution margin income statement.)

TEACHING POINT. This is a good time to reinforce the

definitions of fixed and variable costs and their behavior in total
and per unit. Time spent here will help students grasp the
differences in how these costs behave.

1.6 The contribution margin percentage or ratio equals contribution margin per
unit divided by the selling price. This is an indication of the percent of each sales
dollar that is available to pay fixed costs and return a profit.
1.7 CVP relationships and the calculation of operating income can be illustrated
using three methods:
Equation Method. The equation method is based on the following
formula:
(Selling price Quantity of units sold) (Variable cost per unit
Quantity of units sold) Fixed costs = Operating income

Contribution Margin Method. Under this approach fixed costs are

divided by the unit contribution margin to give the breakeven point in
units.
Graph Method. The graph method represents total costs and total
revenues graphically. When costs and revenues are netted and graphed as
one line, this is often referred to as a profit-volume or PV graph.
(Exhibits 3-1 and 3-2 illustrate the graph method with a cost-
volume-profit graph and a profit-volume graph.) Go over these,
and discuss each line on the graph and its significance.

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 1.8 Cost-Volume-Profit Assumptions. There are a number of assumptions that must
be made in conducting CVP analysis. Although these assumptions do not always
precisely hold, they can allow meaningful analysis.
Changes in the levels of revenues and costs arise only because of
changes in the number of units sold. Thus, number of units sold is the
only revenue and cost driver.
Total costs can be separated into fixed and variable components.
TEACHING POINT. Emphasize to the students that this is
usually possible; the question is: Do they have the ability to
make this division, given the data available and their level of
skill?

Total revenues and total costs are linear; that is, when graphed they can
be represented as a straight line.
Selling price, variable cost per unit, and total fixed costs are known and
constant.
TEACHING POINT. Obviously, these assumptions do not hold
over time. Point out that any time one of the factors changes, it
changes the dynamics and the analysis must be repeated.

Refer to Quiz Question 1

LEARNING
OBJECTIVE
2
Determine the breakeven point and output level
needed to achieve a target operating income

compare contribution margin and fixed costs

2.1 Breakeven Point (BEP). The breakeven point is that quantity of output sold at
which total revenues equal total costs. Following is the formula for calculating
BEP in units:

Fixed costs
Unit contribution margin

2.2 However, BEP, and therefore -0- profit is not what companies should strive for,
managers are concerned with how they can achieve their goals for operating
profit. Target Operating Income is the level of sales needed to attain a specified
dollar amount of operating income. In order to determine TOI, add the desired

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 operating income to fixed cost in the breakeven calculation.
Fixed costs + Target operating income
= Quanity of units to be sold
Unit contribution margin

TEACHING POINT. Work with the class in doing various

exercises that illustrate the points covered in this learning
objective. Contribution margin, CM ratio, and breakeven point
are understood much more readily when students see how
these are calculated, rather than simply learning a definition of
them. Exercises 3-19 and 3-20 illustrate these concepts.

(Exhibits 3-2 and 3-3 graphically illustrate the CVP analysis of

breakeven point.)

(Exhibit 3-4 displays the underlying spreadsheet data.) Lines 6

and 11 illustrate the effects of a choice of fixed over variable in
the cost structure.

Refer to Quiz Questions 2 and 3 Exercises 3-19 and 3-20

LEARNING
OBJECTIVE
3
Understand how income taxes affect CVP analysis

focus on net income

3.1 Net income is operating income plus nonoperating revenues (such as interest
revenues) minus nonoperating expenses (such as interest expense) minus income
taxes.
3.2 To this point, we have ignored the effect of income taxes in our CVP analysis. To
make net income evaluations, however, we must state results in terms of target
net income rather than target operating income.
3.3 The TOI calculation can be easily adjusted to accommodate this change:
Target NI = TOI (TOI Tax rate) or stated another way
Target NI = TOI (1 Tax rate)

Refer to Quiz Questions 4-6 Exercise 3-21

LEARNING
OBJECTIVE
4

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 Explain how managers use CVP analysis in
decision making

determine the alternative that maximizes

operating income

4.1 CVP analysis is useful in numerous situations to evaluate anticipated results from
strategic decisions. Decisions such as whether to increase advertising or reduce
the selling price can be facilitated with CVP analysis. These types of problems
are illustrated in the text.

Exercise 3-24

LEARNING
OBJECTIVE
5
Explain how sensitivity analysis helps managers
cope with uncertainty

determine the effect on operating income of

different assumptions

5.1 Sensitivity analysis is a technique that managers use to examine the effect of
changes in the variables that will affect the outcome of the decision. This is also
referred to as what if analysis; i.e., asking: What would happen if ?
TEACHING POINT. Sensitivity analysis is an excellent tool to
illustrate the practical usefulness of Excel. By programming the
decision data into an Excel spreadsheet, the effect of changes
in variables can be instantly seen by changing the value on the
spreadsheet.

5.2 The Margin of safety is another aspect of sensitivity analysis. It may be

expressed in units, dollars, or as a percentage. It is defined as the amount by
which the current level of sales exceeds the breakeven point; i.e., it is a measure
of how much sales can decline and have the company remain profitable.
Margin of safety in dollars = Revenues Breakeven Revenues
Margin of safety units = Sales in units Breakeven units
Margin of safety percentage = Margin of safety in dollars / Revenues
5.3 Sensitivity analysis recognizes uncertainty, the possibility that actual amounts of
revenue and costs will differ from expected amounts.

Refer to Quiz Questions 7 and 8 Problem 3-25

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 LEARNING
OBJECTIVE
6
Use CVP analysis to plan variable and fixed costs

compare risk of losses versus higher returns

6.1 Managers have the ability to choose the levels of fixed and variable costs in their
cost structures. This is a strategic decision and can be as simple as choosing
between automation and a labor-based manufacturing operation.
6.2 Sensitivity analysis can be utilized in making the decision to substitute fixed
costs for variable costs in the cost structure. Exhibit 3-4, lines 6 and 11 illustrate
the effects of a choice of fixed over variable in the cost structure.
6.3 Operating leverage describes the effects of fixed costs on changes in operating
income with changes in contribution margin or volume. It is defined as the
percentage change in operating income from a given change in sales and is
described as degree of operating leverage (DOL). For example, a company that
has a DOL of 4 will experience a change in operating income four times the
change in revenues. If revenues increase 5 percent, operating income would
increase 4 5 or 20 percent.
6.4 DOL is calculated as follows:
Contribution margin
Degree of operating leverage =
Operating income
TEACHING POINT. Note that DOL is a two-edged sword, with
an increase in revenues. A high DOL accelerates the increase
in operating income. However, a decrease in revenues
accelerates the decrease in operating income. DOL also
changes as revenues change; its value is dependent on the
level of sales.

Refer to Quiz Questions 9 and 10 Problem 3-46

LEARNING
OBJECTIVE
7
7.1 Sales Mix is the
Apply CVP analysis to a company producing
multiple products quantities or proportions of
various products or services
assume sales mix of products remains constant that constitute the total sales of
as total units sold changes a company. The CVP analysis
discussed to this point assumes
a single product. This is not
reasonable, as most companies sell a large variety of products.

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 7.2 Recall that one of the assumptions of CVP analysis was that selling price, variable
cost per unit, and total fixed costs are known and constant. With products
having different selling prices and variable costs, how can the sale of multiple
products be adapted to fit the CVP model?
7.3 CVP analysis with multiple products is performed by calculating a weighted
average contribution margin based upon a constant sales mix percentage. This is
illustrated in the text in Problem 3-46.

See Quiz question 11

Refer to Quiz Questions 11 and 12 Exercises 3-28 and 3-29; Problem 3-47

APPENDIX

A.1 Business decisions are made in a world of uncertainty. A decision model helps
managers deal with uncertainty through a five-step process.
A.2 Step one is to identify a choice criterionan objective that can be quantified.
A.3 Step two identifies the set of alternative actions that can be taken.
A.4 In step three, managers identify the set of events that can occur. An event is a
possible relevant occurrence. These events should be mutually exclusive.
TEACHING POINT. Rolling a die is an event with six possible
outcomes, each of which is mutually exclusive.

A.5 Managers assign a probability to each event that can occur in step four. A
probability distribution describes the likelihood that each of the mutually
exclusive events will occur. These probabilities will equal 1.0.
A.6 Step five is to identify the set of possible outcomesthe predicted economic
results of the possible combinations of actions and events. These outcomes are
summarized in a decision table.
A.7 The expected value is the weighted average of the outcomes with the probability
of each outcome serving as the weight. When measured in monetary terms, this
is called the expected monetary value.

V. OTHER RESOURCES
Please visit the textbook companion Website at www.prenhall.com/horngren. To
download these and other resources, visit the Instructors Resource Center
www.pearsonhighered.com or access them on the Instructors Resource DVD (IR-DVD).

The following exhibits were mentioned in this chapter of the Instructors Manual, and
have been included in the PowerPoint Lecture presentation created specifically for this
chapter. You may use the PowerPoint Lecture presentations as is, or modify them to
suit your individual needs.

Exhibit 3-1 illustrates a contribution margin income statement.

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Exhibits 3-1 and 3-2 illustrate the graph method with a cost-volume-profit graph and a
profit-volume graph. Go over these, and discuss each line on the graph and its
significance.
Exhibits 3-2 and 3-3 graphically illustrate the CVP analysis of breakeven point.
Exhibit 3-4 displays the underlying spreadsheet data.
Exhibit 3-4, lines 6 and 11 illustrate the effects of a choice of fixed over variable in the
cost structure.

Download pdf images of textbook illustrations and exhibits from the Image Library or
access them via your IR-DVD.

Solutions to Select End-of-Chapter Problems mentioned in this chapter, which have

been fully worked out in PowerPoint, are available for download and included on the IR-
DVD.

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

CHAPTER 3 QUIZ
1. Which of the following is not a factor in cost-volume-profit analysis?
a. Units sold
b. Selling price
c. Total variable costs
d. Fixed costs of a product

2. Which of the following is not an assumption of cost-volume-profit analysis?

a. The time value of money is incorporated in the analysis.
b. Costs can be classified into variable and fixed components.
c. The behavior of revenues and expenses is accurately portrayed as linear over the
relevant range.
d. The number of output units is the only driver.

3. Contribution margin is calculated as

a. total revenue total fixed costs.
b. total revenue total manufacturing costs (CGS).
c. total revenue total variable costs.
d. operating income + total variable costs.

Questions 4 through 6 are based on the following data.

Tee Times, Inc. produces and sells the finest quality golf clubs in all of Clay County. The
company expects the following revenues and costs in 2004 for its Elite Quality golf club
sets:
Revenues (400 sets sold @ $600 per set) $240,000
Variable costs 160,000
Fixed costs 50,000

4. How many sets of clubs must be sold for Tee Times, Inc. to reach their breakeven point?
a. 400
b. 250
c. 200
d. 150

5. How many sets of clubs must be sold to earn a target operating income of $90,000?
a. 700
b. 500
c. 400
d. 300

6. What amount of sales must Tee Times, Inc. have to earn a target net income of $63,000 if
they have a tax rate of 30 percent?
a. $489,000
b. $429,000
c. $420,000
d. $300,000

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7. One way for managers to cope with uncertainty in profit planning is to
a. use CVP analysis because it assumes certainty.
b. recommend management hire a futurist whose work is to predict business trends.
c. wait to see what does happen and prepare a report based on actual amounts.
d. use sensitivity analysis to explore various what-if scenarios in order to analyze
changes in revenues or costs or quantities.

8. The Beta Mu Omega Chi (BMOC) fraternity is looking to contract with a local band to
perform at its annual mixer. If BMOC expects to sell 250 tickets to the mixer at $10 each,
which of the following arrangements with the band will be in the best interest of the
fraternity?
a. $2500 fixed fee
b. $1000 fixed fee plus $5 per person attending
c. $10 per person attending
d. $25 per couple attending

Use the following information for questions 9 and 10.

LSB Company has the following income statement:

Revenues $100,000
Variable Costs 40,000
Contribution Margin 60,000
Fixed Costs 30,000
Operating Income 30,000

9. What is LSBs DOL?

a. 3.33
b. 2.00
c. 0.50
d. 1.00

10. If LSBs sales increase by $20,000, what will be the companys operating profit?
a. $42,000
b. $12,000
c. $50,000
d. $30,000

11. Valley Company sells two products. Product M sells for $12 and has variable costs per
unit of $7. Product Qs selling price and variable costs are $15 and $10, respectively. If
fixed costs are $60,000 and Valley sells twice as many units of Product M as Product Q,
what is the BEP in units for Product M?
a. 4,000
b. 6,000
c. 12,000
d. 8,000

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CHAPTER 3 QUIZ SOLUTIONS

1. c
2. a
3. c
4. b
5. a
6. c
7. d
8. b
9. b
10. b
11. d

Quiz Question Calculations

4. Variable costs per unit = $160,000/400 units sold = $400

Contribution Margin = $600 400 = $200 per unit
Breakeven point = $50,000/$200 = 250 units

5. TOI = $50,000 + $90,000/$200 = 700 units

6. TNI = $50,000 + $63,000/(1 .30)/$200 = 700 units $600 = $420,000

8. Cost of option a: $2,500 Profit = 0

Cost of option b: $1,000 + 5(250) = $2,250 Profit = $250
Cost of option c: $10 (250) = $2,500 Profit = 0
Cost of option d: $25 (125) = $3,125 Loss ($625)

9. DOL = $60,000/$30,000 = 2.0

10. $20,000/ $100,000 = 20%

20% 2 = 40%
40% $30,000 = $12,000 increase

11. Product M contribution margin (12-7) = 5 x sales mix of 2 = 10

Product Q contribution margin (10-5) = 5 x sales mix of 1 = 5

Total contribution margin of both products = 12

FC/CM = BEP package
$60,000/14 = 4,000 packages
BEP units of Product M = BEP packages x sales mix of 2 = 8,000 units

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