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Cost-Volume-Profit Relationship

Chapter 3
McGraw-Hill/Irwin Copyright ©2012 The McGraw-Hill
Companies, Inc. All rights reserved.

Learning Objectives:
1. Introducing about contribution margin and cost-volume-profit (CVP)
relationship.
2. Determine the level of sales needed to achieve a desired target profit.
3. Determine the break-even point.
4. Compute the margin of safety and explain its significance.
5. Compute the degree of operating leverage at a particular level of sales
and explain how it can be used to predict changes in net operating
income.
6. Compute the break-even point for a multiproduct company and explain
the effects of shifts in the sales mix on contribution margin and the
break-even point.

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Cost-Volume-Profit Analysis
LO1 Use cost-volume-profit (CVP) analysis to analyze
decisions.

What is CVP?
COST VOLUME PROFIT

#
CVP studies the relationship between
revenue, cost, and volume and their effect
on profits.
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The Profit Equation

The Income Statement
Total Revenue Operating Profit
equals Total Revenue
- Total Costs less Total Costs!

= Operating Profit

The Income Statement written horizontally:

Operating Profit = Total Revenue - Total Cost
p = TR - TC

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Profit Equation, Continued…

Total Revenue (TR) = Price (P) x Units of output produced and sold (X)

TR = PX

Total Cost (TC) = [Variable Costs per unit (V) x Units of Output (X)] + Fixed Cost (F)

TC = VX + F

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Profit Equation, Continued…

p = TR - TC

p = PX - VX + F

p = P - V X - F

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U-Develop: An Example
U-Develop
Income Statement
For the Month Ending March 200X
Per Unit
Total
Sales $ 7,200 $ 0.60
Less: Variable Cost of Goods Sold 3,600 0.30
Less: Variable Selling Costs 720 .06
Contribution Margin 2,880 0.24
Less: Fixed Costs 1,500 Developed
Operating Profit $ 1,380 12,000 prints
in March

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Contribution Margin
Contribution Margin:
AKA: “CM”
The difference between price and
variable cost. It is what is leftover
to cover fixed costs and then add to
operating profit.

Contribution Margin Per Unit:

Price Per Unit - Variable Cost Per Unit = CM Per Unit

Punit - Vunit = CMunit

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Contribution Margin (Total)

Total Contribution Margin:

(Price x Quantity) - (Variable Cost x Quantity = Total CM

P - V X = Total CM
or

PX - VX = Total CM

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Example: U-Develop CM

Using the data Sold 12,000 units Per Unit

from U-Develop Total
Sales $ 7,200 $ 0.60
Less: Variable Cost of Goods Sold 3,600 0.30
Less: Variable Selling Costs 720 .06
Contribution Margin 2,880 0.24
Less: Fixed Costs 1,500
Operating Profit $ 1,380

1. What is CM per unit? $0.60 – $0.36 = $0.24

2. What is total CM? ($0.60 - $0.36)(12,000) = $2,880

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Contribution Margin, cont…

Contribution Margin, why do I care?

U-Develop:

Cmunit = $0.24

For every 1 product in sales, U-Develop

has $0.24 available to cover fixed costs.
Once fixed costs are covered, $0.24 for
each product sales will increase profits!

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Contribution Margin Ratio

Contribution Margin Ratio:
Contribution margin as a percentage of sales revenue.

Total Contribution Margin Ratio:

Total contribution margin as a percent of
total sales revenue. It describes how much P - V X
the contribution margin is for each dollar in
sales. P X
CM Per Sales Dollar
Unit Contribution Margin Ratio:
Contribution margin per unit as a percentage
of sales price per unit. This calculates the P - V
contribution margin provided for each dollar
of revenue. P
CM Per Sales Dollar

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Example: Contribution Margin Ratio (CMR)

U-Develop
P V X $.60 $.36 12,000
CMR
P X .60 12,000

CMR $2,880 .40

$7,200

CMR unit $.24

.40
$.60

McGraw-Hill/Irwin

Break-Even
Break-even: The point at which profits equal zero. At
break-even, all fixed costs are covered, but the
firm is not producing any operating profit.

Equations: TR – TC = π TR = PX
TR = TC + π and
TC = VX + F)
PX = VX + F + π
PX – VX = F + π
Break-even is
where π = 0
X(P-V) = F + π
F + π F
Break-Even (X) = =
P -V P -V
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Break-Even, continued…
Since, sales – variable cost = contribution margin, then:
Fixed Costs
Break-Even =
Contribution Margin

Unit Contribution Margin: If unit CM is used, then the

Contribution Margin Ratio:
calculation provides the number of
units necessary to break-even.
If unit CM Ratio is used, then the
calculation provides the sales
dollars necessary to break-even.

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Example: Break-Even in Units

F p
X
CM unit

$1,500 $0
X
$.24

X 6,250 prints

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Example: Break-Even in Sales Dollars

The total sales dollars at which profits equal zero.

Break-even: Total revenues = Total costs

F $0
TR p = $0
CMR

$1500
TR = $3,750
.40

6,250 prints X $.60 = $3,750

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Target Volume in Units

Target Profit = P - V X - F

Target Volume Fixed Cost + Target Profit

(units) =
Unit Contribution Margin

F + p
X =
P - V

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Example: Target Volume in Units

U-Develop Target Profit = $ 1,800

F + p
Formula: =
CMunit

$ 1,500 + $ 1,800
X =
$ 0.24

X = 13,750 units

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Target Volume in Sales Dollars

Target volume Fixed costs + Target profit

sales dollars =
Contribution margin ratio
TR

F + p
TR =
CMR

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Example: Target Volume in Sales Dollars

U-Develop:
F + p
Given: Target p = $1,800 TR =
CMR

$1,500 $1,800
TR
.40

TR $8,250

13,750 x $.60 = $8,250

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CVP Summary: Break-Even

Break-even Fixed costs

=
volume (units)
Unit contribution margin

Break-even Fixed costs

volume (sales =
Contribution margin ratio
dollars)

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CVP Summary: Target Volume

Target volume Fixed costs + Target profit

=
(units) Unit contribution margin

Target volume Fixed costs + Target profit

=
sales dollars
Contribution margin ratio

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Graphic Presentation: U-Develop Break-Even

$3,750

6,250 prints

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CVP and the Effects of Different Cost Structures

LO2 Understand the effect of cost structure on decisions.

Cost Structure: The proportion of fixed and variable

costs to total costs.

Operating Leverage: The extent to which the cost

structure is comprised of fixed cost.

The higher the organization’s operating leverage, the

higher the break-even point.

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Operating leverage

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Comparison of Cost Structures

Lo-Level Company High-Level Company
(1,000,000 units) (1,000,000 units)
Amount Percentage Amount Percentage
Sales $1,000,000 100% $1,000,000 100%
Variable Cost $750,000 75% $250,000 25%
Contribution Margin $250,000 25% $750,000 75%
Fixed Costs $50,000 5% $550,000 55%
Operating Profit $200,000 20% $200,000 20%
Break-Even 200,000 units 733,334 units
CM per Unit $0.25 $0.75
Degree of Operating Leverage 1.25 3.75

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Example: Operating Leverage

Why do I care? Suppose Low Level & High-
Level both increase sales 10%
or $100,000

Low-Level High-Level C
Sales $100,000 $100,000
CMR .25 .75
Increase in Profit $25,000 $75,000
Prior NI $200,000 $200,000
NI with Sales increase of 10% $225,000 $275,000

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Operating Leverage, Continued. . .

Low-Level High-Level

Percent Increase in sales 10% 10%

Degree of Operating Leverage 1.25 1.75
Percent increase in NI 12.5% 17.5%
Prior NI $200,000 $200,000
Percent increase in NI 12.5% 17.5%
NI with sales increase of 10% $225,000 $235,000

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Margin of Safety
The excess of projected or actual sales
volume over break-even volume.
or
The excess of projected or actual sales
revenue over break-even revenue.

Suppose U-Develop sells 8,000 prints

8,000 6,250 1,750 prints

$4,800 $3,750 $1,050

1750 x $.60 = $1,050

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Using Spreadsheets for CVP Analysis

LO3 Using Microsoft Excel to perform CVP analysis.

Using Excel, combined with an analysis tool such as

Goal Seek, CVP analysis is simplified.
U-Develop

Price $0.60
Steps: Variable Cosst $0.36
Fixed Cost $1,500.00
1. In the “Set cell” edit field, enter the cell
Profit ($300.00)
address for the target profit calculation. Volume 5,000
2. In the “To value” edit field, enter the
target profit.
U-Develop
3. In the “By changing cell” edit field, enter the
cell address of the volume variable. Price $0.60
Variable Cosst $0.36
4. Click “OK” and the program will find the Fixed Cost $1,500.00
break-even volume.
Profit $0.00
Volume 6,250
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Extending CVP: Taxes

LO4 Incorporate taxes, multiple products, and alternative
cost structures into the CVP analysis.

What if U-Develop is in the 25% tax bracket

and wants profit after taxes of $1,800?

F ptarget 1-t
Target Volume
CM unit

$1,500 $1,800
X .75 16,250
=
$.24
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CVP and Taxes, Continued. . .

To Prove it Works:
Sales 16,250 $.60 $9,750
VC 16,250 $.36 5,850
CM $3,900
FC 1,500
NIBT $2,400
Taxes 2,400 25% 600
Net Income $1,800
McGraw-Hill/Irwin

Extending CV P: Multiple Products

What if:
U-Develop does prints and enlargements?

Prints Enlargements
Selling price $.60 $1.00
Variable cost .36 .56
Contribution margin $. 24 $. 44

Total Fixed Costs $1,820

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Example: Product Mix

U-Develop’s product mix: For every 9 prints sold U-
Develop sells 1 enlargement.

Weighted Average Contribution Margin

9/10 $.24 1/10 $.44 $ .26

9/10
Breakeven
6,300 prints
$1,820 7,000
$.26 1/10
700 enlargements
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Alternative Cost Structures

Given: Fixed costs of $1,500 are sufficient for monthly volumes
less than or equal to 5,000 prints. For every additional
5,000 prints U-Develop must rent a machine for $480
per month.
Remember, original break-even was 6,250 units.

(CM x X) – FC = π ($0.24 x 6,250) – ($1,500 + $480) = ($480)

Recalculate break-even using new fixed cost

containing the rental of the additional machine.
Fnew $1,500 +$480
Break-even 8,250
Units = = =
CMunits $0.24

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Assumptions and Limitations of CVP

LO5 Understand the assumptions and limitations of CVP
analysis.

Assumptions & Limitations:

1. Although the CVP model is a very strong tool, the
output is dependent upon the assumptions made by
cost analyst. These assumptions include which costs
are fixed vs. variable.
2. With the aid of software programs, many of the
limitations have been eliminated. Complicated cost
structures are easily incorporated in CVP analysis
when software tools are used.

McGraw-Hill/Irwin

Chapter 3: END!!

McGraw-Hill/Irwin Copyright ©2012 The McGraw-Hill

Companies, Inc. All rights reserved.

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