Cost-Volume-Profit Analysis: A Simple

Model for Evaluating Decision Options

A model is always an abstraction. It is a

representation, sometimes mathematical,
of what are believed to be the relations
among the relevant decision options.
Sample Questions Raised and
Answered by CVP Analysis
1. How many units must be sold (or how much sales
revenue must be generated) in order to break even?
2. How many units must be sold to earn a before-tax
profit equal to $60,000? A before-tax profit equal
to 15 percent of revenues? An after-tax profit of
$48,750?
3. Will total profits increase if the unit price is
increased by $2 and units sold decrease 15 percent?
4. What is the effect on total profit if advertising
expenditures increase by $8,000 and sales increase
from 1,600 to 1,750 units?
Sample Questions Raised and Answered
by CVP Analysis (cont’d)
5.What is the effect on total profit if the
selling price is decreased from $400 to
$375 per unit and sales increase from
1,600 units to 1,900 units?
6.What is the effect on total profit if the
selling price is decreased from $400 to
$375 per unit, advertising expenditures
are increased by $8,000, and sales
increased from 1,600 units to 2,300 units?
7.What is the effect on total profit if the
sales mix is changed?
 Vocabulary
 Gross Margin = Revenue - Cost of goods sold.
All costs are manufacturing costs. Some of
them are fixed costs.
 Contribution margin = Revenue - Variable
costs
Some variable costs are manufacturing costs,
but some may be non-manufacturing costs.
None are fixed costs.
 Gross margin percent = Gross
margin/Revenue

 Contribution margin percent = Contribution

margin/Revenue
 Gross margin:
• Cost of goods sold = Direct materials
Direct labor
Applied overhead

• Applied overhead = units produced

x predetermined O/H
• Gross Margin = Revenue - COGS.
 Contribution margin:
• Variable costs = manufacturing variable costs +
non-manufacturing variable costs.
• Gross margin + fixed mfg. overhead – non-
manufacturing variable costs = Contribution margin.
• Contribution margin + non-manufacturing variable
costs - fixed mfg. costs = Gross margin.
 Safety margin:

• The dollar amount by which sales revenue

exceeds what is required to break even.

• The number of units by which sales exceed

what is required to break even.
 The Model
• The fundamental accounting equation
Profit () = Revenues - Costs
Revenue = SP*units sold
SP = selling price
Costs = FC + VC(units manufactured)
FC = fixed cost
VC = unit variable costs.
• We are assuming that units manufactured
equal units sold
What if we want to know how much product
we must sell to break even?

The breakeven point is the point where profit is

zero,
so = 0 = Revenue - Cost
= SP*units sold - FC - VC*units sold
= (SP - VC)*units sold - FC
units sold = FC/(SP - VC)

We will call units sold at = 0: BEunits

 Breakeven revenue

Breakeven units (BEunits) * SP, or

SP * BEunits = SP*(FC/CM)

Breakeven revenue = FC/(CM/SP)

 Cost-Volume-Profit Graph
Total Revenue
Revenue

Profit Total Cost

Loss

X Unit sold

X = Break-even point in units

Y = Break-even point in revenue
 Profit-Volume Graph
Profit I = (P - V)X - F

Slope = P - V

Units
Loss Break-Even Point
In Units
-F
 Assumptions underlying CVP analysis

• In manufacturing firms, the inventory levels at the

beginning and end of the period are the same. This
implies that the number of units produced during the
period equals the number of units sold.
• The behavior of total revenue is linear (straight line).
This implies that the price of the product or service will
not change as sales volume varies within the relevant
range.
 Assumptions underlying CVP analysis

• The behavior of costs is linear (straight line) over the

relevant range. This implies the following more specific
assumptions.
a. Costs can be categorized as fixed, variable, or semi-
variable. Total fixed costs remain constant as activity
changes, and the unit variable cost remains unchanged
as activity varies.
b. The efficiency and productivity of the production
process and workers remain constant.
 Assumptions underlying CVP analysis

• In multi-product organizations, the sales mix remains

constant over the relevant range.
• In multi-product organizations, when we do a single
CVP analysis, we assume the products all are sold in the
same market. Substitutes.
• This means that the product mix does not change in
response to changes in production/sales volume.
 Example 1: equation approach

• Movie theater: $48,000 monthly fixed costs

• $8 ticket price.
• $2 variable cost per ticket.
• Give breakeven units and revenue
BEunits = $48,000/($8 - $2)
BEunits = 8,000 tickets.
BErevenue = $64,000
 $000
(per month)

40

30

Profit 20
Break-even point: 8,000 tickets
10 Profit
area
0

-10 2,000 4,000 6,000 8,000 10,000

-20 Volume of
Loss area tickets sold
Loss
-30 in one
month
-40

-50
Fixed expenses = $48,000
 Example 1 Cont’d
• Suppose practical capacity per month is 12,000
tickets and that the movie theater has operated
at 60% capacity during December. It is now
December 30.
• Has the theater made money in December?
• If they could capture 1,000 customers by
lowering the ticket price to $7 for New Year’s
Eve, should they do it?
 Example 2
Data: The Doral Company manufactures and
sells pens. Present sales output is
5,000,000 per year at a selling price of
$.50 per unit. Fixed costs are $900,000
per year. Variable costs are $.30 per unit.
 What is the current yearly operating
income?

 What is the current breakeven point in

sales dollars?
 Example 2 Cont’d
Compute the new operating income if . . .
1. A $.04 per-unit increase in variable
costs.

2. A 20% decrease in fixed costs, a 20%

decrease in selling price, a 10% decrease
in variable costs, and a 40% increase in
units sold.
 Example 2 Cont’d
Compute the new breakeven point in units
for
each of the following changes.
 A 10% increase in fixed costs:

 A 10% increase in selling price and a

$20,000 increase in fixed costs.
 Example 3

The Rapid Meal has two restaurants that are open 24

hours per day. Fixed costs for the two restaurants together
total $450,000 per year. Service varies from a cup of
coffee to full meals. The average sales check for each
customer is $8.00. The average cost of food and other
variable costs for each customer is $3.20. The income tax
rate is 30%. Target net income is $105,000.
Example 3 Cont’d
Compute the total dollar sales needed to obtain
the
target net income.

How many sales checks are needed to break

even?

Compute net income if the number of sales

checks
is 150,000
 Multiple-Product Example
Assume the following:
Regular Deluxe Total Percent
Units sold 400 200 600 ----
Sales price per unit $ 500 $750 ---- ----
Sales $200,000 $150,000 $350,000 100.0%
Less: Variable expenses 120,000 60,000 180,000 51.4
Contribution margin $ 80,000 $ 90,000 $170,000 48.6%
Less: Fixed expenses 130,000
Net income $ 40,000
=======

1. What is the break even point?

2. How much sales revenue of each product must be generated to earn

a before tax profit $50,000?