Horngren’s Cost Accounting: A Managerial

Emphasis
Seventeenth Edition

Chapter 3
Cost-Volume-Profit
Analysis

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Learning Objectives (1 of 2)
3.1 Explain the features of cost-volume-profit (CVP) analysis
3.2 Determine the breakeven point and output level needed
to achieve a target operating income
3.3 Understand how income taxes affect CVP analysis
3.4 Explain how managers use CVP analysis to make
decisions
3.5 Explain how sensitivity analysis helps managers cope
with uncertainty

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Learning Objectives (2 of 2)
3.6 Use CVP analysis to plan variable and fixed costs
3.7 Apply CVP analysis to a company producing multiple
products
3.8 Apply CVP analysis in service and not-for-profit
organizations
3.9 Distinguish contribution margin from gross margin

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Essentials of Cost Volume Profit (CVP)
Analysis
• Managers want to know how profits will change as the
units sold of a product or service changes.
• Managers like to use “what-if” analysis to examine the
possible outcomes of different decisions so they can
make the best one.
• In Chapter 2, we discussed total revenues, total costs
and income.
• In this chapter, we take a closer look at the relationship
among the elements (selling price, variable costs, fixed
costs).

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A Five-Step Decision-Making Process in
Planning and Control-Revisited
1. Identify the problem/uncertainties.
2. Obtain information.
3. Make predictions about the future.
4. Make decisions by choosing between alternatives using
cost-volume-profit (CVP) analysis.
5. Implement the decision, evaluate performance, and
learn.

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Foundational Assumptions Used in C VP
Analysis (1 of 2)
• Changes in production/sales volume are the sole cause
for cost and revenue changes.
• Total costs consist of fixed costs and variable costs.
• Revenue and costs behave and can be graphed as a
linear function (a straight line).

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Foundational Assumptions Used in C VP
Analysis (2 of 2)
• Selling price, variable cost per unit, and fixed costs are all
known and constant.
• In many cases, only a single product will be analyzed. If
multiple products are studied, their relative sales
proportions are known and constant.
• The time value of money (interest) is ignored.

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Basic CVP Equations
Contribution Margin (1)  Total Revenue  Total Variable Costs

Contribution Margin per unit Selling Price  Variable Cost Per Unit

Contribution Margin (2)  Contribution Margin per Unit # of Units Sold

Operating Income Contribution Margin  Fixed Costs

Contribution Margin Ratio (or Percentage) Contribution Margin/Revenue

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More CVP Relationships
Manipulation of the basic equations (prior slide) yields an
extremely important and powerful tool called Contribution
Margin.
Contribution margin equals revenue less variable costs.
Contribution margin per unit equals unit selling price less
unit variable costs, but it can also be determined by taking
contribution margin divided by number of units sold.

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Cost-Volume-Profit: Equation and
Contribution Margin Methods (1 of 2)
Equation Method:
Revenue  Variable Costs  Fixed Costs Operating Income
CM Method:
Where:  SP Q  – VC Q   FC OI

Revenue = SP Q :
Selling Price (SP)  Quantity of Units Sold Q 

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Cost-Volume-Profit: Equation and
Contribution Margin Methods (2 of 2)
Variable Costs = VC Q :
Unit Variable Costs (VC)  Quantity Of Units Sold (Q)
Contribution Margin (CM)
Revenue  Variable Costs
Operating Income (OI)
Contribution Margin  Fixed Costs (FC)

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Cost-Volume-Profit—You Try It!
Problem

Revenue  Varibale Costs  Fixed Costs Operating Income

Tiny’s Cabinets sells cabinets for $600 each.

Variable cost is $350 each.
Annual fixed costs are $20,000.
If Tiny sells 100 cabinets, what is his operating income (OI)?

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Cost-Volume-Profit—You Try It!
Solution
Tiny’s Cabinets sells cabinets for $600 each.
Variable cost is $350 each.
Annual fixed costs are $20,000.
If Tiny sells 100 cabinets, what it his operating income (O I)?
Solution:  SP Q   VC Q   FC OI

$600  100   $350  100  Contribution Margin

$60,000  $35,000 $25,000 (CM);
CM  $20,000 Operating Income (OI)
$60,000  $35,000  $20,000 $5,000 (OI)

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Breakeven Point
The breakeven point (BEP) is that quantity of output
sold at which total revenue equals total cost; that is,
the quantity of output sold results in $0.00 of operating
income or where OI = $0

Recall our contribution margin method equation:

 SP Q   VC Q   FC OI

If we set OI to 0 and solve, we’ll get the BEP.

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Breakeven Point Example (1 of 2)
Let’s try this for Tiny’s Cabinets. Recall that his
SP = $600, VC = $350, and Fixed Costs are $20,000, annually.
At what Q (quantity) would Tiny break even?
 SP Q   VC Q   FC OI
$600 Q   $350 Q   $20,000 0
$250 Q 20,000
Q 80
Another way to find the answer is to use C M:
Breakeven revenues = FC / CM%
Breakeven units = FC / CM perunit
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Breakeven Point Example (2 of 2)
Let’s try this for Tiny’s Cabinets.
Recall that his SP = $600, VC = $350, and Fixed Costs are
$20,000.
Here’s another way to find the answer:
Breakeven revenues = FC / CM per unit
Tiny’s CM per unit = $600  $350 $250
Tiny’s CM % = $250 / $600  41.67%
$20,000 / $250 80
Or, in revenues $20,000/41.67% $47,996, which is equal to
80 $600, allowing for rounding.
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Breakeven Point Extended: Profit
Planning/Target Income
The breakeven formula can be modified to become a profit
planning tool by adding target operating income to fixed costs
in the numerator.
Let’s say that Tiny wants to make $30,000 Operating Income:
Q (Qty of Units) (FC  Target Operating Income)/CM per unit

Q $20,000  $30,000  /$250

Q 200

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CVP: Graphically
Exhibit 3.2 Profit-Volume Graph for GMA T Success

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CVP and Income Taxes
• After-tax profit (Net Income) can be calculated by:
– Net Income Operating Income  (1  Tax Rate )
• Net income can be converted to operating income for use
in the CVP equation
NetIncome
– Operating Income 
1 TaxRate 
Note: the CVP equation will continue to use operating
income. We’ll use this conversion formula to obtain the
operating income value when provided with Net Income

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CVP and Income Taxes— Tiny’s
Cabinets
Net income can be converted to operating income for use in
NetIncome
the CVP Equation Operating Income 
1 TaxRate 
What if Tiny wanted to earn $30,000 Net Income instead of
Operating Income? His tax rate is 35%.
Q (Qty of Units) = FC  Target Operating Income  / CM per unit
Q ($20,000   $30,000 / 1  35%  / $250

Q $20,000  $46,154  / $250 265

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Using CVP Analysis for Decision
Making (1 of 5)
Remember Tiny? As is, he expects to sell 100 cabinets.
What if Tiny spent $5,000 on advertising and estimated that
it would increase his sales by 10%. Should he do it?
To find out, we can use CVP analysis as follows:
Blank

Sales without
Advertising Sales with Advertising
Units Sold 100 110
Revenues (SP $600) $60,000 $66,000
Variable Cost ($350) $35,000 $38,500
Fixed Costs $20,000 $25,000
Operating Income $ 5,000 $ 2,500

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Using CVP Analysis for Decision
Making (2 of 5)

As we see from the prior slide, although Tiny’s sales

increase with the advertising expenditure, his
Operating Income decreases by $2,500 (from $5,000 to
$2,500).
Tiny will be better off if he doesn’t advertise.

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Using CVP Analysis for Decision
Making (3 of 5)
Let’s assume that a more detailed analysis indicated that
Tiny’s sales would increase by 25% instead of 10%.
Should he do it?
If sales increase 25%, that is an increase by 25 units.
25 units Contribution Margin per unit of $250 ($600  $350) $6,250.

That is $1,250 greater than the $5,000 Tiny would have to

spend.
So, Tiny will be better off spending money on the
advertising.

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Using CVP Analysis for Decision
Making (4 of 5)
What if you want to decrease sale price?
The concept of using CVP analysis for decision making
works just as well if you are thinking about decreasing
prices.
If you decrease your price, you’d expect more unit sales.
CVP can be used to determine if the combination of lower
price with higher unit sales will improve OI.

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Using CVP Analysis for Decision
Making (5 of 5)
Strategic decision such as lowering sale price entails risk.
We use CVP to evaluate how the Operating Income will
change, but we cannot be certain that our estimates of
increased sales will occur.
Managers use electronic spreadsheets to systematically
and efficiently conduct CVP-based sensitivity analysis to
test how sensitive their conclusions are to different
assumptions.

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Sensitivity Analysis
• CVP provides structure to answer a variety of “what-if”
scenarios.
• “What” happens to profit “IF”:
– Selling price changes
– Volume changes
– Cost structure changes
 Variable cost per unit changes
 Fixed costs change

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Margin of Safety—Defined
• The margin of safety (MOS) measures the distance
between budgeted sales and breakeven (BE) sales:
• MOS Budgeted Sales  BE Sales
• The MOS Ratio removes the firm’s size from the output
and expresses itself in the form of a percentage:
• MOS Ratio = MOS / Budgeted Sales

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Margin of Safety—An Indicator of Risk
The margin of safety (MOS) calculation answers a very
important question:
• If budgeted revenues are above the breakeven point,
how far can they fall before the breakeven point is
reached?
• In other words, how far can they fall before the company
will begin to lose money?

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Cost Structure
• The cost structure is simply the relationship of fixed costs
and variable costs to total costs.
• Managers make strategic decisions that affect the cost
structure of the company.
• We can use CVP-based sensitivity analysis to highlight the
risks and returns as fixed costs are substituted for variable
costs in a company’s cost structure.
• The risk-return trade-off across alternative cost structures
can be measured as operating leverage.

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Operating Leverage = CM/Operating
Income
• The risk-return trade-off across alternative cost structures
can be measured as operating leverage.
• Operating leverage describes the effects that fixed costs
have on changes in operating income as changes occur in
units sold and contribution margin.
• Organizations with a high proportion of fixed costs in their
cost structures have high operating leverage.
• In the presence of fixed costs, the degree of operating
leverage is different at different levels of sales.

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Using Operating Leverage to Estimate
Changes to Operating Income
• We can use Operating Leverage to estimate changes to
Operating Income that will result from a percentage change
in sales.
• Operating Leverage  % Change in Sales = Percentage
Change in Operating Income
For example:
If sales increase 50% and operating leverage is 1.67, how
much would OI increase?
1.67 50% 83.5%
OI (operating income) will increase by 83.5%.
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Effects of Sales Mix on CVP
• Sales Mix—the quantity or proportion of various products
or services that constitute a company’s total unit sales
• It is often the case that the various products or services
have different contribution margins.
• Realistically, company’s will have multiple products with
different costs and different margins.
• We can use the same formula in our CVP calculations but
must use an average contribution margin for the products.
• This technique assumes a constant mix at different levels
of total unit sales.

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CVP for Service and Not-For-Profit
Organizations
• CVP can also be used for service and not-for profit
companies.
• Service and not-for-profit businesses need to focus on
measuring their output, which is different from the units
sold.
• For example, a service agency might measure how many
persons they assist or an airline might measure how many
passenger miles they fly.
• What measure might a hotel use? A restaurant?

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Contribution Margin Versus Gross
Margin
• Gross Margin Revenue  Cost of Goods Sold
• Contribution Margin Revenue  All Variable Costs
• Gross Margin measures how much a company charges for
its products over and above the cost of acquiring or
producing them.
• Contribution Margin indicates how much of a company’s
revenue is available to cover fixed costs.

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Tiny’s Cabinets (Produced 100 Cabinets,
Sold 90 SP $600; VC $350; FC $20,000
[15,000 Mfg]) (1 of 2)
Contribution Margin and Gross Margin for Tiny’s Cabinets
Line Item Contribution Line item Gross Margin
Margin
Sales 90  $600  left parenthesis 90 times $600 right parenthesis $54,000 Sales 90  $600 
left parenthesis 90 times $600 right parenthesis $54,000

Variable Costs $31,500 Cost of Goods Sold (V CU $45,000

90  $350 
left parenthesis 90 times $350 right parenthesis

$350; FCU $150)

Contribution Margin $22,500 Gross Margin $ 9,000

Fixed Mfg Costs $15,000 Non-Manufacturing Costs $ 5,000
Blank Blank

Fixed Non-Mfg Costs $ 5,000

Operating Income $ 2,500 Operating Income $ 4,000

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Tiny’s Cabinets (Produced 100 Cabinets,
Sold 90 SP $600; VC $350; FC $20,000
[15,000 Mfg]) (2 of 2)
Contribution Margin and Gross Margin for Tiny’s
Cabinets
• OI Using CM = $2,500
• OI Using GM = $4,000
• Different = $1,500
• WHY is there a difference?
• Because Tiny produced 100 but sold 90. The 10 units
produced but not sold is still in inventory at the F CU of
$150. $150 10 units $1,500.

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Terms To Learn
Breakeven point Expected value
Choice criterion Gross margin percentage
Contribution income statement Margin of safety
Contribution margin Net income
Contribution margin per unit Operating leverage
Contribution margin percentage Outcomes
Contribution margin ratio Probability
Cost-volume-profit (CVP) analysis PV graph
Decision table Revenue driver
Degree of operating leverage Sales mix
Event Sensitivity analysis
Expected monetary value Uncertainty
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