CHAPTER ONE

Cost-Volume-Profit Relationships

Introduction

Cost behavior analysis is the study of how specific costs respond to changes in the level of
business activity.

1.1. Variable and fixed cost behavior and patterns

a. 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
direct materials and direct labor for a manufacturer; cost of goods sold, sales commissions, and
freight-out for a merchandiser; and gasoline in airline and trucking companies.

b. 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.

c. Mixed Costs

Mixed costs are costs that contain both a variable element and a fixed element. Mixed costs,
therefore, change in total but not proportionately with changes in the activity level.

Example
Helena Company reports the following total costs at two levels of production.
10,000 Units 20,000 Units
Direct materials $20,000 $40,000
Maintenance 8,000 10,000
Direct labor 17,000 34,000
Indirect materials 1,000 2,000
Depreciation 4,000 4,000
Utilities 3,000 5,000
Rent 6,000 6,000

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 1

Required: Classify each cost as variable, fixed, or mixed.

Solution

Variable costs: Direct materials, direct labor, and indirect materials are variable costs.
Fixed costs: Depreciation and rent are fixed costs.
Mixed costs: Maintenance and utilities are mixed costs.

1.2. Break-even analysis uses and techniques

Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume
on a company’s profits. CVP analysis is important in profit planning. It also is a critical factor in
such management decisions as setting selling prices, determining product mix, and maximizing
use of production facilities.
The following assumptions underlie each CVP analysis.
1. The behavior of both costs and revenues is linear throughout the relevant range of the activity
index.
2. Costs can be classified accurately as either variable or fixed.
Changes in activity are the only factors that affect costs.
4. All units produced are sold.
5. When more than one type of product is sold, the sales mix will remain constant. That is, the
percentage that each product represents of total sales will stay the same. Sales mix complicates
CVP analysis because different products will have different cost relationships. In this chapter we
assume a single product. When these assumptions are not valid, the CVP analysis may be
inaccurate.

CVP Income Statement

The CVP income statement classifies costs as variable or fixed and computes a contribution
margin. Contribution margin is the amount of revenue remaining after deducting variable costs.
It is often stated both as a total amount and on a per unit basis.

Illustration: Vargo Video produces a high-end, progressive-scan DVD player/recorder with up

to 160- hour recording capacity and MP3 playback capability. Relevant data for the DVD players
sold by this company in June 2010 are as follows.

Unit selling price of DVD player $500

Unit variable costs $300
Total monthly fixed costs $200,000
Units sold 1,600

Required: Prepare the CVP income statement for Vargo Video company as of June 2010.

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 2

Solution
Vargo Video Company
CVP income statement
For the month ended June 30, 2010
O VIDEO COMPANY
CVP Income Statement Total Per Unit
Sales (1,600 DVD players) $800,000 $ 500
Variable costs 480,000 300
Contribution margin 320,000 $200
Fixed costs 200,000
Net income $120,000

A traditional income statement and a CVP income statement both report the same net income of
$120,000. However a traditional income statement does not classify costs as variable or fixed,
and therefore it does not report a contribution margin. In addition, both a total and a per unit
amount are often shown on a CVP income statement to facilitate CVP analysis.

Contribution margin per unit

The formula for contribution margin per unit is indicated as follows.

Unit Selling Price - Unit Variable Costs = Contribution Margin per Unit

Vargo Video’s CVP income statement shows a contribution margin of $320,000, and a
contribution margin per unit of $200 ($500- $300).

Contribution margin per unit indicates that for every DVD player sold, Vargo has $200 to cover
fixed costs and contribute to net income. Because Vargo Video has fixed costs of $200,000, it
must sell 1,000 DVD players ($200,000 ÷$200) before it earns any net income. Vargo’s CVP
income statement, assuming a zero net income, is as follows.

Vargo Video Company

CVP income statement
For the month ended June 30, 2010

CVP Income Statement Total Per Unit

Sales (1,000 DVD players) $500,000 $ 500
Variable costs 300,000 300
Contribution margin 2000,000 $200
Fixed costs 200,000
Net income $ -0-th

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 3

It follows that for every DVD player sold above 1,000 units, net income increases $200. For
example, assume that Vargo sold one more DVD player, for a total of 1,001 DVD players sold.
In this case Vargo reports net income of $200 as shown below.

Vargo Video Company

CVP income statement
For the month ended June 30, 2010
O VIDEO COMPANY
CVP Income Statement Total Per Unit
Sales (1,001 DVD players) $500,500 $ 500
Variable costs 300,300 300
Contribution margin 200,200 $200
Fixed costs 200,000
Net income $200

Contribution margin ratio

The contribution margin ratio is the contribution margin per unit divided by the unit selling
price. For Vargo Video, the ratio is shown in illustration.

Contribution Margin per Unit ÷ Selling Price = Contribution Margin Ratio

$200 $500 40%

The contribution margin ratio of 40% means that $0.40 of each sales dollar ($1*40%) is
available to apply to fixed costs and to contribute to net income. This expression of contribution
margin is very helpful in determining the effect of changes in sales dollars on net income. For
example, if sales increase $100,000, net income will increase $40,000 (40% *$100,000). Thus,
by using the contribution margin ratio, managers can quickly determine increases in net income
from any change in sales dollars.

We can also see this effect through a CVP income statement. Assume that Vargo Video’s current
sales are $500,000 and it wants to know the effect of a $100,000 increase in sales. Vargo
prepares a comparative CVP income statement analysis as follows.
Ended June 30, 2010

Vargo Video Company

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 4

 CVP income statement
For the month ended June 30, 2010

No Change With Change

Total Per Unit Total per Unit
Sales $500,000 $ 500 $600,000 $ 500
Variable costs 300,000 300 360,000 300
Contribution margin 200,000 $200 240,000 $200
Fixed costs 200,000 200,000
Net income $ –0– $ 40,000

Break-even Analysis

The level of activity at which total revenues equal total costs (both fixed and variable) is called
the break-even point. At this volume of sales, the company will realize no income but will
suffer no loss. The process of finding the breakeven point is called break-even analysis.
Knowledge of the break-even point is useful to management when it decides whether to
introduce new product lines, change sales prices on established products, or enter new market
areas.
The break-even point can be computed by using three techniques:

1. A mathematical equation.
2. Contribution margin.
3. Derived from a cost-volume-profit (CVP) graph.

The break-even point can be expressed either in sales units or sales dollars. A common equation
used for CVP analysis is shown bellow.

Sales = Variable Costs + Fixed Costs + Net Income

Identifying the break-even point is a special case of CVP analysis. Because at the break-even
point net income is zero, break-even occurs where total sales equal variable costs plus fixed
costs. We can compute the break-even point in units directly from the equation by using unit
selling prices and unit variable costs. The computation for Vargo Video is:

Sales = Variable Costs + Fixed Costs + Net Income

$500Q $300Q $200,000 $0
$200Q = $200,000
Q = 1,000 units
where
Q sales volume in units
$500 selling price
$300 variable cost per unit
$200,000 total fixed costs

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 5

Thus, Vargo Video must sell 1,000 units to break even. To find sales dollars required to break
even, we multiply the units sold at the break-even point times the selling price per unit, as shown
below.
1,000 × $500 = $500,000 (break-even sales dollars)

Contribution margin technique

We know that contribution margin equals total revenues less variable costs. It follows that at the
break-even point, contribution margin must equal total fixed costs. On the basis of this
relationship, we can compute the break-even point using either the contribution margin per unit
or the contribution margin ratio. When a company uses the contribution margin per unit, the
formula to compute break-even point in units is fixed costs divided by contribution margin per
unit. For Vargo Video the computation is as follows.

Fixed Costs ÷ Contribution Margin per Unit = Break-even Point in Units

$200,000 $200 1,000 units

One way to interpret this formula is that Vargo Video generates $200 of contribution margin
with each unit that it sells. This $200 goes to pay off fixed costs. Therefore, the company must
sell 1,000 units to pay off $200,000 in fixed costs. When a company uses the contribution margin
ratio, the formula to compute break-even point in dollars is fixed costs divided by the
contribution margin ratio. We know that the contribution margin ratio for Vargo Video is 40%
($200 $500), which means that every dollar of sales generates 40 cents to pay off fixed costs.
Thus, the break-even point in dollars is:

Fixed Costs ÷ Contribution Margin Ratio = Break-even Point in Dollars

$200,000 40% $500,000

Graphic presentation

An effective way to find the break-even point is to prepare a break-even graph. Because this
graph also shows costs, volume, and profits, it is referred to as a cost-volume-profit (CVP)
graph. Sales volume is recorded along the horizontal axis. This axis should extend to the
maximum level of expected sales. Both total revenues (sales) and total costs (fixed plus variable)
are recorded on the vertical axis. At breakeven point sales are equal to fixed cost plus variable
cost. This concept is further explained by the following equation:

[Break even sales (BS) = fixed cost (FC) + variable cost (VC)]
Breakeven sales= Selling price (SP)*Quantity (Q); TC= VC+FC
VC= VC per unit*Quantity (Q); SP*Q=FC+ VC/unit*Q; SP*Q-VC/unit*Q=FC
Q(SP/unit-VC/unit)=FC; Q=FC/Sp/unit-Vc/unit- is quantity to be produced or sold at
breakeven point

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 6

 Sales Line Profit (R>C)

Profit area Cost Line

Breakeven Point

BEP ($) Variable Cost (VC)

Fixed Cost Line

Loss area Fixed Cost (FC)

BEP (U)

i. The total revenue line passes through the origin and hence has a y-intercept of zero
while the total cost line has a y – intercept which is equal to the amount of the fixed
cost.
ii. ii. The fixed cost line which is parallel to the quantity axis (x – axis) is constant at all
levels of output.
iii. iii. To the left of the break – even point the revenue line is found below the cost line
and hence any vertical separation indicates a loss while to the right the opposite is
true.
iv. iv. The total variable cost, which is the gap between the total cost and the fixed cost
line increases as more units are produced.

Example: Lombardi Company has a unit selling price of $400, variable costs per unit of break-
even analysis $240, and fixed costs of $180,000. Compute the break-even point in units using
(a) a mathematical equation and
(b) contribution margin per unit.
Solution

(a) Q = FC/SP-VC = $180,000/400- 240. Q= 1,125 units.

(b) The contribution margin per unit = ($400 -$240) =$160.
Break-even point in units= FC/CMPU= $180,000/ $160 = 1,125 units.

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 7

Target Net Income

Rather than simply “breaking even,” management usually sets an income objective often called
target net income. It indicates the sales necessary to achieve a specified level of income.
Companies determine the sales necessary to achieve target net income by using one of the three
approaches discussed earlier. We know that at the break-even point no profit or loss results for
the company. By adding an amount for target net income to the same basic equation, we obtain
the following formula for determining required sales.

Required Sales = Variable Costs + Fixed Costs + Target Net Income

Required sales may be expressed in either sales units or sales dollars. Assuming that target net
income is $120,000 for Vargo Video, the computation of required sales in units is as follows.

Required Sales = Variable Costs + Fixed Costs + Target Net Income

$500Q $300Q $200,000 $120,000
$200Q = $320,000
Q = 1,600

The sales dollars required to achieve the target net income is found by multiplying the units sold
by the unit selling price [(1,600 × $500) = $800,000].

Contribution margin technique

As in the case of break-even sales, we can compute either in units or dollars the sales required to
meet a target net income. The formula to compute required sales in units for Vargo Video using
the contribution margin per unit is as follows.

(Fixed Costs + Target Net Income) ÷ Contribution margin per unit = required sales in units
($200,000 + $120,000) ÷ $200 = 1,600 units

This computation tells Vargo that to achieve its desired target net income of $120,000, it must
sell 1,600 DVD players. The formula to compute the required sales in dollars for Vargo Video
using the contribution margin ratio is as follows.

(Fixed Costs + Target Net Income) ÷ Contribution margin ratio = required sales in dollars
($200,000 + $120,000) ÷ 40% = $800,000

This computation tells Vargo that to achieve its desired target net income of $120,000, it must
generate sales of $800,000.

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 8

For example, suppose Vargo Video sells 1,400 DVD players. The above CVP graph shows that a
vertical line drawn at 1,400 units intersects the sales line at $700,000 and the total cost line at
$620,000. The difference between the two amounts represents the net income (profit) of $80,000.

Margin of Safety

The margin of safety is another relationship used in CVP analysis. Margin of safety is the
difference between actual or expected sales and sales at the break-even point. This relationship
measures the “cushion” that management has, allowing it to still break even if expected sales fail
to materialize. The margin of safety is expressed in dollars or as a ratio. The formula for stating
the margin of safety in dollars is actual (or expected) sales minus break-even sales. Assuming
that actual (expected) sales for Vargo Video are $750,000, the computation is:

Actual (Expected) Sales - Break-even Sales = Margin of Safety in Dollars

$750,000 $500,000 $250,000

Vargo’s margin of safety is $250,000. Its sales must fall $250,000 before it operates at a loss.
The margin of safety ratio is the margin of safety in dollars divided by actual (or expected) sales.
The formula and computation for determining the margin of safety ratio are:

Margin of Safety in Dollars ÷ Actual (Expected) Sales = Margin of Safety ratio

$250,000 $750,000 33%

This means that the company’s sales could fall by 33% before it would be operating at a loss.
The higher the dollars or the percentage, the greater the margin of safety. Management
continuously evaluates the adequacy of the margin of safety in terms of such factors as the
vulnerability of the product to competitive pressures and to downturns in the economy.

1.3. Planning with cost-volume-profit Data

a. Revenue Planning
CVP analysis assists managers in revenue planning to determine the revenue required to achieve
a desired profit level.
For example, on the information from the above table, the sale of TV stand, if the management
wants to know the sales volume necessary to achieve $48,000 in annual profits, we substitute
$60,000 for fixed costs and $48,000 for desired profit; the solution in units is

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 9

 Q = FC + N
P–V

Q = $60,000 + $48,000 = $ 2,700 units per year

$75 – $35

The solution in sales dollars is

P x Q = $75 x 2,700 = $202,500 per year

b. Cost Planning

For cost planning decisions, the manager assumes the sales quantity and the desired profit are
known, but wants to find the value of the required variable cost or fixed cost to achieve the
desired profit at the assumed sales quantity. Three examples follow.

Trade-Offs between Fixed and Variable Costs—Example One (One Machine)

To facilitate target costing, CVP analysis is used to determine the most cost-effective trade-off
between different types of costs. To continue with the TV stand example, assume sales of 2,700
units per year. Management is now considering the purchase of a new machine that will reduce
variable costs but also increase fixed costs by $2,250 per month. How much must unit variable
costs fall to maintain the current level of profit, assuming that sales volume and all other factors
remain the same?

Q = 2,700 units FC = $5,000 + $2,250 = $7,250 per month ($87,000 per year)

P = $75

N = $48,000 per year

V = an unknown (previously $35)

Now, instead of solving for Q (which is given as 2,700 units), we solve for v, as follows:

Q = FC + N
P–V

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 10

 P – V = FC + N
Q

V = P – FC + N
Q

V = $75 – $87,000 + $48,000

2,700 units

V = $ 25

In effect, for sales and profits to remain unchanged with the increase in fixed costs, unit variable
costs must fall from $35 to $25.

Trade-Offs between Fixed and Variable Costs—Example Two (Two Machines)

A common management decision is choosing the right equipment for the work to be done.
Assume as in example one that management is considering the purchase of a new machine and,
in this case, has the choice between two machines. For example, a particular machine might have
a relatively high purchase cost but will provide lower operating costs in comparison to an
alternative machine. So there is an option to tradeoff between high fixed costs and low unit
variable costs (the high fixed-cost option) versus relatively low fixed costs and relatively higher
unit variable costs (the low fixed-cost option). As volume increases, the high fixed cost option
will be more and more attractive, since it brings a reduction in total variable costs.

Breakeven analysis can help to find the level of sales (called the indifference point), such that
having sales greater than this level will favor the high fixed-cost option, and sales less than this
level will favor the low fixed-cost option.

Example two assumes management in the above example can choose between two machines,
either of which will complete the same operation with the same quality, but with different fixed
and variable costs. Machine A has a fixed cost of $5,000 and a unit variable operating cost of
$10, while machine B has a fixed cost of $15,000 and unit variable operating cost of $5. To find
the indifference point, where the low fixed-cost (A) and high fixed-cost (B) options have the
same total costs, we set the cost equations for each option equal and solve for sales quantity.

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 11

 Cost of machine A = Cost of machine B

$5,000 + $10 x Q = $15,000 + $5 x Q

Q = $10,000 = 2,000 units

$5

If the company is operating at 2,000 units or more, then machine B should be chosen, and if it is
operating at below 2,000 units, then machine A should be chosen. For example, at 3,000 units,
the total cost of machine A is $5,000 + ($10 x 3,000) = $35,000, while the cost of machine B is
$15,000 + ($5 x 3,000) = $30,000, and thus the advantage goes to machine B at this sales level.

Sales Commissions and Salaries—Example Three

Another cost planning use of CVP analysis is to determine the most cost-effective means to
manage selling costs. To illustrate, the management is reviewing sales salaries and commissions
and finds that $1,000 of the monthly $5,000 fixed costs is for sales salaries, and that $7.50 of the
$35.00 unit variable cost is a 10 percent sales commission. Suppose the management is
considering a $450 increase in salary with an expected reduction in commission rate. How much
must management reduce the commission rate to keep profits the same, assuming that sales
volume and all other factors remain unchanged?

With the proposed changes in variable and fixed costs to accommodate the new salary and
commission plan, fixed costs increase by $450 per month and variable costs decrease as a result
of the decrease in the commission rate, r:

V = Commission rate x Sales price

+ Other noncommission-based unit variable costs

V = (r x $75) + $27.50

And:

FC = Current monthly fixed costs

+ Increase in monthly salary

FC = $5,000 + $450

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 12

 = $5,450 per month, or $65,400 per year

Now we use the CVP model to solve for V:

Q = FC + N
P–V

P – V = FC + N
Q

V = P – FC + N
Q

(r x $75) + $27.50 = $75 – $65,400 + 48,000

2,700

r = 0.0733

In this situation, the manager must reduce the commission rate from 10 to 7.33 percent to keep
annual profit the same and pay an additional monthly salary of $450 to the salespeople.

1.4. Limitations of Cost-Volume Profit Analysis

The CVP analysis is generally made under certain limitations and with certain assumed
conditions, some of which may not occur in practice. Following are the main limitations and
assumptions in the cost-volume-profit analysis:

1. It is assumed that the production facilities anticipated for the purpose of cost-volume-
profit analysis do not undergo any change. Such analysis gives misleading results if
expansion or reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit are manufactured, it is
difficult to forecast with reasonable accuracy the volume of sales mix which would
optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly constant
which in reality is difficulty to find. Thus, if a cost reduction program is undertaken or

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 13

 selling price is changed, the relationship between cost and profit will not be accurately
depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and
completely variable at all levels of activity and fixed cost remains constant throughout
the range of volume being considered. However, such situations may not arise in
practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant,
though sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore,
closing stock carried over to the next financial year does not contain any component of
fixed cost. Inventory should be valued at full cost in reality.

IUC 2024 CMA II Prepared by:- Firehun S.(MSc) CH-1 14