Cost – Volume – Profit Analysis

Lecture # 20
COST-VOLUME-PROFIT (CVP) ANALYSIS
 Technique that uses the degrees of cost variability
for measuring the effect of changes in volume on
resulting profits.
 It is assumed that fixed costs will remain the
same in total within a range of production volume
in which the firm expects to operate.
LIMITATIONS OF CVP ANALYSIS
 CVP analysis assures that all factors except volume will
remain constant for a given period of time.
 In some cases, costs are relatively unpredictable except
over very limited ranges of activity.
 Anticipated results depend on the stability of the CVP
relationships as they have been established.
BREAK-EVEN ANALYSIS
 The break-even point is the point at which sales
revenue covers all costs to manufacture and sell
the product, but there is no profit.
 Costs must be segregated according to their
degree of variability.
COMPUTING BREAK-EVEN POINT

Total Unit
Sales Revenue (2,000 units) $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Operating income $ 10,000

How much contribution margin must this company have to cover its fixed
How
How
How Howmany
much
many
Contribution
many
Contribution
How much units
contribution
margin
units
margin is
contribution units
must
margin
is
costs
amount
must
amount
margin
costs
of
must
this
must
by
this
by
must this
which
which
(break
of producing
costs costs (break
this
company
company
revenue
company
this revenue
company
even)?
the
the revenue.
company
havesell
to
exceeds
sell
exceeds
have to to
cover
the
to
the
cover cover
its
coverfixed
variable
variable
its fixed
costs (break even)?
producing even)? revenue.
its
its fixed
sell fixed
to cover costs
costs
Answer:
Answer: (break
its fixedeven)?
(break
$30,000
$30,000 even)?
costs
Answer: (break
Answer: $30,000
$30,000 $20even)?
÷÷ $20 per
per unit
unit == 1,500
1,500 units
units
BREAK-EVEN POINT CALCULATIONS
 Sales revenue (to break even) = Cost to
manufacture + Selling and Administrative Costs
 Sales revenue (to break even) = Fixed
manufacturing and selling and administrative costs
+ Variable manufacturing and selling and
administrative costs
BREAK-EVEN POINT CALCULATIONS
(CONT.)
 Break-even sales volume (dollars) = Total fixed
costs / Contribution margin ratio
 Break-even volume (dollars) = Total fixed costs / 1
– (Variable costs/Sales revenue)
 Break-even sales volume (units) = Total fixed cost /
Unit contribution margin per unit
COMPUTING BREAK-EVEN SALES

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf fixed
fixed
costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs are
are $3.00
$3.00 per per
unit,
unit, how
how many
many units
units must
must be
be sold
sold to
to break
break even?
even?

a.
a. 100,000
100,000 units
units
b.
b. 40,000
40,000 units
units
c.
c. 200,000
200,000 units
units
d.
d. 66,667
66,667 units
units
COMPUTING BREAK-EVEN SALES

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf fixed
fixed
costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs are
are $3.00
$3.00 per per
unit,
unit, how
how many
many units
units must
must be
be sold
sold to
to break
break even?
even?

a.
a. 100,000
100,000 units
units
b.
b. 40,000
40,000 units
units
c.
c. 200,000
200,000 units
units
Unit contribution = $5.00 - $3.00 = $2.00
d.
d. 66,667
66,667 units
unitsFixed costs
Unit contribution $200,000
= $2.00 per unit

= 100,000 units
COMPUTING BREAK-EVEN SALES
Use
Use the
the contribution
contribution margin
margin ratio
ratio formula
formula toto
determine
determine the
the amount
amount ofof sales
sales revenue
revenue ABC
ABC must
must
have
have to
to break
break even.
even. All
All information
information remains
remains
unchanged:
unchanged: fixed
fixed costs
costs are
are $200,000;
$200,000; unit
unit sales
sales
price
price is
is $5.00;
$5.00; and
and unit
unit variable
variable cost
cost is
is $3.00.
$3.00.

a.
a. $200,000
$200,000
b.
b. $300,000
$300,000
c.
c. $400,000
$400,000
d.
d. $500,000
$500,000
COMPUTING BREAK-EVEN SALES
Use
Use the
the contribution
contribution margin
margin ratio
ratio formula
formula toto
determine
determine the
the amount
amount ofof sales
sales revenue
revenue ABC
ABC must
must
have
have to
to break
break even.
even. All
All information
information remains
remains
unchanged:
unchanged: fixed
fixed costs
costs are
are $200,000;
$200,000; unit
unit sales
sales
price
price is
is $5.00;
$5.00; and
and unit
unit variable
variable cost
cost is
is $3.00.
$3.00.
Unit
Unit contribution
contribution == $5.00
$5.00 -- $3.00
$3.00 == $2.00
$2.00
a.
a. $200,000
$200,000
Contribution
Contribution margin
margin ratio
ratio == $2.00
$2.00 ÷÷ $5.00
$5.00 == .40
.40
Break-even
Break-even revenue
revenue == $200,000
$200,000 ÷÷ .4.4 == $500,000
$500,000
b.
b. $300,000
$300,000
c.
c. $400,000
$400,000
d.
d. $500,000
$500,000
PREPARING A CVP GRAPH
 Starting at the origin, draw the total revenue Revenue
line with a slope equal to the unit sales price.
Costs and Revenue
in Dollars

 Total fixed cost

extends horizontally
from the vertical axis.

Total fixed cost

Volume in Units
PREPARING A CVP GRAPH
Revenue
 Draw the total cost line with a slope
equal to the unit variable cost.

Break-even
Costs and Revenue

Profit
Point
in Dollars

Total cost

Loss
Total fixed cost

Volume in Units
COMPUTING SALES NEEDED TO ACHIEVE TARGET OPERATING
INCOME

Break-even formulas may be adjusted to

show the sales volume needed to earn
any amount of operating income.

Fixed costs + Target income

Unit sales =
Contribution margin per unit

Fixed costs + Target income

Dollar sales =
Contribution margin ratio
COMPUTING SALES NEEDED TO ACHIEVE TARGET OPERATING
INCOME

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf
fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs
are
are $3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must bebe
sold
sold to
to earn
earn operating
operating income
income ofof $40,000?
$40,000?

a.
a. 100,000
100,000 units
units
b.
b. 120,000
120,000 units
units
c.
c. 80,000
80,000 units
units
d.
d. 200,000
200,000 units
units
COMPUTING SALES NEEDED TO ACHIEVE TARGET OPERATING
INCOME

ABC
ABC Co.
Co. sells
sells product
product XYZ
XYZ at
at $5.00
$5.00 per
per unit.
unit. IfIf
fixed
fixed costs
costs are
are $200,000
$200,000 and
and variable
variable costs
costs
are
are $3.00
$3.00 per
per unit,
unit, how
how many
many units
units must
must bebe
sold
sold to
to earn
earn operating
operating income
income ofof $40,000?
$40,000?

Unit contribution = $5.00 - $3.00 = $2.00

a.
a. 100,000 units
100,000 units
Fixed costs + Target income
b.
b. 120,000
120,000 units
units Unit contribution
c.
c. 80,000
80,000 units
units
$200,000 + $40,000
= 120,000 units
d.
d. 200,000 units
200,000 units $2.00 per unit
CVP ANALYSIS WHEN A COMPANY SELLS MANY PRODUCTS

Speedo provides us with the following information:

Bikes Carts Total

Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% $ 265,000 48%
Fixed exp. 170,000
Net income $ 95,000
CVP ANALYSIS WHEN A COMPANY SELLS MANY PRODUCTS

The overall contribution margin ratio is:

Bikes Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% $ 265,000 48%
Fixed exp. 170,000
Net income $ 95,000

$265,000
= 48% (rounded)
$550,000
CVP ANALYSIS WHEN A COMPANY SELLS MANY PRODUCTS

Break-even in sales dollars is:

Bikes Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100%
Var. exp. 150,000 60% 135,000 45% 285,000 52%
Contrib. margin $ 100,000 40% $ 165,000 55% $ 265,000 48%
Fixed exp. 170,000
Operating income $ 95,000

$170,000
= $354,167 (rounded)
.48
WHAT IS OUR MARGIN OF SAFETY?

Margin of safety is the amount by which sales

may decline before reaching break-even sales:

Margin of safety = Actual sales - Break-even sales

Margin of safety provides a quick means of
estimating operating income at any level of
sales:

Operating Margin Contribution

Income = of safety × margin ratio
WHAT IS OUR MARGIN OF SAFETY?

ADM contribution margin ratio is 40 percent. If

sales are $100,000 and break-even sales are
$80,000, what is operating income?

Operating = Margin × Contribution

Income of safety margin ratio

Operating
Income = $20,000 × .40 = $8,000
WHAT CHANGE IN OPERATING INCOME DO WE ANTICIPATE?

Once break-even is reached, every additional dollar of

contribution margin becomes operating income:
Change in Change in Contribution
operating income = sales volume × margin ratio

ADM expects sales to increase by $15,000 and has a

contribution margin ratio of 40%. How much will operating
income increase?

Change in
operating income = $15,000 × .40 = $6,000
BUSINESS APPLICATIONS OF CVP

Consider the following information developed by

the accountant at Speedo, a bicycle retailer:

Total Per Unit Percent

Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Operating income $ 20,000
BUSINESS APPLICATIONS OF CVP

Should Speedo spend $12,000 on advertising to

increase sales by 10 percent?

Total Per Unit Percent

Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Operating income $ 20,000
BUSINESS APPLICATIONS OF CVP

Should Speedo spend $12,000 on advertising

to increase sales by 10 percent?
500 550
Bikes
550 × $500 Bikes
Sales $ 250,000 $ 275,000
Less: variable expenses 150,000 165,000
550 × $300
Contribution margin $ 100,000 $ 110,000
Less: fixed expenses 80,000 92,000
Operating income $ 20,000 $80K + $12K $ 18,000

No, income is decreased.

BUSINESS APPLICATIONS OF CVP
Now, in combination with the advertising,
Speedo is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?

500
Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin $ 100,000
Less: fixed expenses 80,000
Operating income $ 20,000
BUSINESS APPLICATIONS OF CVP
Now, in combination with the advertising,
Speedo is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?

500 1.25 × 500 625

Bikes Bikes
Sales $ 250,000 625 × $450 $ 281,250
Less: variable expenses 150,000 187,500
Contribution margin $ 100,000 625 × $300 $ 93,750
Less: fixed expenses 80,000 92,000
Operating income $ 20,000 $80K + $12K $ 1,750

Income is decreased even more.

BUSINESS APPLICATIONS OF CVP

Now, in combination with advertising and a price cut, Speedo

will replace $50,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?

500
Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin $ 100,000
Less: fixed expenses 80,000
Operating income $ 20,000
BUSINESS APPLICATIONS OF CVP
Now, in combination with advertising and a price cut, Speedo
will replace $50,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?
1.5 × 500
500 750
Bikes 750 × $450 Bikes
Sales $ 250,000 $ 337,500
Less: variable expenses 150,000 750 × $325 243,750
Contribution margin $ 100,000 $ 93,750
Less: fixed expenses 80,000
$92K - $50K 42,000
Operating income $ 20,000 $ 51,750

The combination of advertising, a price cut,

and change in compensation increases income.