Cost volume profit analysis

Rabia Abdullah
• Managers are concerned about the impact of their decisions on
profit. The decisions they make are about volume, pricing, or
incurring a cost. Therefore, managers require an understanding of the
relations among revenues, costs, volume, and profit.
• The cost accounting department supplies the data and analysis, called
cost-volume-profit (CVP) analysis, that support these managers.
Operating profit
• The key relation for CVP analysis is the profit equation. Every
organization’s financial operations can be stated as a simple
relation among total revenues ( TR ), total costs ( TC ), and
operating profit:
• Operating profit = Total revenues * Total costs
TR * TC
• Total revenue = Price * Units of output produced and sold
TR = PX
• Total costs= (Variable costs per unit * Units of output) + Fixed
costs
TC = VX + F
• unit contribution margin: Difference between revenues per unit (price) and variable cost
per unit.
• total contribution margin : Difference between revenues and total variable costs.
• In other words, the total contribution margin is the unit contribution margin multiplied
by the number of units
(Price- Variable costs) * Units of output, or ( P V ) X.
• It is the amount that units sold contribute toward
• (1) covering fixed costs and
• (2) providing operating profits.
• Sometimes we use total contribution margin, as in the preceding equation. Other times,
we use the contribution margin per unit, which is
Price - Variable cost per unit
P - V
Question
Jamaal first opened U-Develop, he offered one service only, developing
prints. He charged an average price of $.60.

The fixed costs to operate the store for March, a typical month, were
$1,500. In March, U-Develop processed 12,000 prints. The operating
profit can be determined from the company’s income statement for the
month
a) Calculate operating profit
b) Prepare income statement
 BREAK-EVEN POINT = Volume level at which profi ts equal zero.
• Managers might want to know the break-even volume
expressed either in units or in sales dollars. If the company
makes many products, it is often much easier to think of
volume in terms of sales dollars; if we are dealing with only
one product, it’s easier to work with units as the measure of
Finding volume.
• Calculate break even for U- Developer
Break-Even
and Target
Volumes
 • To find the break-even volume in terms of sales dollars, we first define a new
term, contribution margin ratio. The contribution margin ratio is the
contribution margin as a percentage of sales revenue. Calculate contribution
margin ratio for U-Develop,

Break-Even
Volume in
Sales Dollars

a) Calculate break even sales dollars for U developer

Target Volume in Units
• To find the target volume, we use the profit equation with the target
profit specified. The formula to find the target volume in units is

a) Using the data from U-Develop, we find the volume that provides an operating profit of $1,800 as
follows:
Target Volume in Sales Dollars
To find the target volume in sales dollars, we use the contribution
margin ratio instead of the contribution margin per unit. The formula to
find the target volume follows:

a) calculate target volume sales dollar for U develop

Summary
Question
Q1. Assume that as an investor, you are planning to enter the
construction industry as a panel formwork supplier. The potential
number of forthcoming projects, you forecasted that within two years,
your fixed cost for producing formworks is Rs. 300,000. The variable
unit cost for making one panel is Rs. 15. The sale price for each panel
will be Rs. 25. If you charge Rs. 25 for each panel, how many panels you
need to sell in total, in order to start making money?

Answer 30,000 panels

Question
Suppose you intend to open a franchise business to supply a nationally-known line
of women’s shoes. You’ve found a good location in Abbottabad to open your shop,
and have determined that the average prices and costs of operating the store are:
Price = Rs. 50 per pair
Cost = Rs. 30 per pair
Rent = Rs. 2,500 per month
Insurance = Rs. 500 per month
Utilities & Telephone = Rs. 300 per month
In addition, you plan to hire two sales ladies on a commission basis of 10% in order
to provide them with incentive to sell shoes. You are required determine the
breakeven point in Rupees?
Answer= 11,000 rupees
Questions
1. A manufacturing company supplies its products to construction job
sites. The average monthly fixed cost per site is Rs. 4,500, while
each unit cost Rs. 35 to produce and selling price is Rs. 50 per unit.
A)Determine the monthly breakeven volume.
B) Prove the break even monthly volume on a graph

answer 300 units

Question
A store sells t-shirts. The average selling price is Rs. 15 and the average
variable cost (cost price) is Rs. 9.
• (a) Suppose the fixed costs of operating the store (its operating expenses)
are Rs. 100,000 per year. Find Break-even in units?
• (b) If the owner desired a profit of Rs. 25,000, what will be break-even
point in Rupees?
• (c) If fixed costs rose to Rs. 110,000, break-even in units volume would be?

• (d) If the average selling price rose to Rs.16, break even volume would fall?
Answers
a) 16,667 t shirts b)16,667 rupees c)18,333 t shirts
d)14,286 t shirts
Question
Profi t-Volume Model

Instead of considering
revenues and costs separately,
we can analyze the relation
between profit and volume
directly. This approach to CVP
analysis is called profit-volume
analysis. A graphic comparison
of profit-volume and CVP
relationships is shown
Use of CVP to Analyze the Effect of Different
Cost Structures
• cost structure Proportion of an organization’s fixed and variable costs to its
total costs.
Cost structures differ widely among industries and among firms within an
industry. Electric utilities have a large investment in equipment, which results
in a cost structure with high fixed costs. In contrast, grocery retailers have a
cost structure with a higher proportion of variable costs
• operating leverage Extent to which an organization’s cost structure is
made up of fixed costs.
Operating leverage is high in firms with a high proportion of fixed costs and a
low proportion of variable costs and results in a high contribution margin per
unit. The higher the fi rm’s fixed costs, the higher the break-even point. Once
the break-even point has been reached, however, profit increases at a high
rate.
 The margin of safety is the excess of projected (or actual) sales
over the break-even sales level. This tells managers the margin
between current sales and the break-even point. In a sense,
margin of safety indicates the risk of losing money that a
company faces, that is, the amount by which sales can fall
before the company is in the loss area. The margin of safety
formula is

Margin of
Safety
Income Taxes
• the owner of U-Develop wants to find the number of prints required
to generate after-tax operating profits of $1,800.
• Recall that P $0.60, V $0.36, and F $1,500. We assume the tax rate t
0.25; that is, U-Develop has a 25 percent tax rate.
Find the target volume
How does an increase in the income tax rate affect the breakeven
point?

An increase in the income tax rate does not affect the breakeven point.
Operating income at the breakeven point is zero, and no income taxes
are paid at this point.
Multiproduct CVP Analysis
two methods,
1. A fixed product mix
2. Weighted-average contribution margin
• Units
• Sales dollar
1- Fixed Product Mix

the owner of U-Develop is willing to assume that the prints and enlargements will sell in a 9:1
ratio; that is, of every ten “units” of service sold, nine will be prints and one will be an
enlargement

Calculate breakeven point

 The weighted-average contribution margin also requires an assumed
product mix, which we continue to assume is 90 percent prints and 10
percent enlargements. The problem can be solved by using a weighted
average contribution margin per unit. When a company assumes a
constant product mix, the contribution margin is the weighted-average
2a- contribution margin of all of its products. For U-Develop, the weighted-
average contribution margin per unit can be computed by multiplying

Weighted- each product’s proportion by its contribution margin per unit

Average
Contribution
Margin
2b) Weighted average - Sales Dollars
fixed costs *100
weighted-average contribution margin ratio

The weighted-average contribution margin percent is the ratio of the

weighted-average contribution margin divided by the weighted-average
revenue
 Question

b
a) 16875 units
b)
Give an example of how a manager can decrease variable costs while
increasing fixed costs.

Examples include:
• Manufacturing––substituting a robotic machine for hourly wage workers.
• Marketing––changing a sales force compensation plan from a percent of sales
dollars to a fixed salary.
• Customer service––hiring a subcontractor to do customer repair visits on an
annual retainer basis rather than a per-visit basis.