I opened U-Develop because I love photography and read that managers can calculate the price they need

I wanted to own my own business. I now get to spend
most of my day working with employees and customers
making sure that the photos they take are the best they
can be. It also gives me a chance to encourage younger
people who have an interest in photography, because
I work with many of the school groups and after-school
clubs here in town. That’s the fun part of the job.
But I also have to think about the financial side of
the business. I need a systematic way to understand
the relation between my decisions and my profits. I’ve
to charge to break even (see the In Action item on
CVP analysis and airlines). I should be able to apply
the same analysis to my business.
Jamaal Kidd was discussing the photo-finishing store that
he owns and operates. Starting out five years ago with a
small storefront in the mall offering only photo developing,
he has expanded the business and moved to a larger store
downtown, where he now offers a wide range of products
and services, some made in his own workshop.

Our theme in this book is that the cost accounting system serves managers by provid-
ing them with information that supports good decision making. In this chapter and the
next, we develop two common tools that managers can use to analyze situations and
make decisions that will increase the value of the firm. We begin in this chapter by
developing the relations among the costs, volumes, and profits of the firm. In the next
chapter, we use these relations to make pricing and production decisions that increase cost-volume-profit
profit. (CVP) analysis
Study of the relations among
revenue, cost, and volume
and their effect on profit.

Cost-Volume-Profit Analysis
Managers are concerned about the impact of their decisions on profit. The decisions they L.O. 1
make are about volume, pricing, or incurring a cost. Therefore, managers require an un-
Use cost-volume-
derstanding of the relations among revenues, costs, volume, and profit. The cost account-
profit (CVP) analysis
ing department supplies the data and analysis, called cost-volume-profit (CVP) analysis,
that support these managers. to analyze decisions.

Cost-Volume-Profit Analysis and Airline Pricing In Action

Cost-volume-profit analysis helps managers evaluate the im-
pact of alternative product pricing strategies on profits. It can
also be useful for evaluating competitors’ pricing strategies
and efforts to grow market share, as in the following exam-
ples:
Aloha Airlines CEO David Banmiller and C. Thomas
Nulty, senior vice president for marketing and sales,
explain that their airline must charge $50 per seat to
break even when planes are 62 percent full.
Hawaiian Airlines, Aloha Airlines and go! are each
losing money when they sell interisland tickets below
$50, according to a study commissioned by Aloha
Airlines.
“Why would somebody come in and charge $19, and
$29, and $39 when their costs were substantially higher?
Why would somebody do it?” said Banmiller.
The Sabre study showed that when planes are
62 percent full, Aloha’s costs are $50 per seat,
Hawaiian’s are $55, and go!’s are $67.
However, managers at the parent company of go! (Mesa
Airlines) disputed the estimates with a CVP analysis of their
own:
Jonathan Ornstein, Mesa’s chief executive officer, said
yesterday that Aloha’s cost estimates are way off when
it comes to his airline. He said go!’s expenses per pas-
senger are about $40 when the planes are 80 percent
full.
Note: Aloha Airlines is no longer in business.
Source: Rick Daysog, “Below-Cost Fares Puzzle Aloha Airlines
CEO,” Honolulu Advertiser, December 21, 2006.

81
82
profit equation
Operating profit equals total
revenue less total costs.
unit contribution margin
Difference between revenues
per unit (price) and variable
cost per unit.
total contribution
margin
Difference between revenues
and total variable costs.
Part II Cost Analysis and Estimation
Profit Equation
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
Profit  TR  TC
(For not-for-profit and government organizations, the “profit” may go by different names
such as “surplus” or “contribution to fund,” but the analysis is the same.) Both total
revenues and total costs are likely to be affected by changes in the amount of output.1 We
rewrite the profit equation to explicitly include volume, allowing us to analyze the rela-
tions among volume, costs, and profit. Total revenue (TR) equals average selling price per
unit (P) times the units of output (X):
Total revenue  Price  Units of output produced and sold
TR  PX
In our profit equation, total costs (TC) may be divided into a fixed component that
does not vary with changes in output levels and a variable component that does vary. The
fixed component is made up of total fixed costs (F) per period; the variable component is
the product of the average variable cost per unit (V) multiplied by the quantity of output
(X). Therefore, the cost function is
Total costs  (Variable costs per unit  Units of output)  Fixed costs
TC  VX  F
Substituting the expanded expressions in the profit equation yields a form more use-
ful for analyzing decisions:
Profit  Total revenue  Total costs
 TR  TC
TC  VX  F
Therefore,
Profit  PX  (VX  F)
Collecting terms gives
Profit  (Price  Variable costs)  Units of output  Fixed costs
 (P  V)X  F
We defined contribution margin in Chapter 2 as the difference between the sales
price and the variable cost per unit. We will refer to this as the unit contribution margin
to distinguish it from the difference between the total revenues and total variable cost, the
total contribution margin. In other words, the total contribution margin is the unit con-
tribution 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 the contribution margin, in
total, as in the preceding equation. Other times, we use the contribution margin per unit,
which is
Price  Variable cost per unit
PV
1
We adopt the simplifying assumption that production volume equals sales volume so that changes in
inventory can be ignored in this chapter.
 Chapter 3 Fundamentals of Cost-Volume-Profit Analysis 83

Recall from Chapter 2 that an important distinction for decision making is whether
costs are fixed or variable. That is, for decision making, we are concerned about cost
behavior, not the financial accounting treatment, which classifies costs as either manufac-
turing or administrative. Thus, V is the sum of variable manufacturing costs per unit and
variable marketing and administrative costs per unit; F is the sum of total fixed manufac-
turing costs and fixed marketing and administrative costs for the period; and X refers to
the number of units produced and sold during the period.

CVP Example
When Jamaal first opened U-Develop, he offered one service only, developing prints. He
charged an average price of $.60. The average variable cost of each print was $.36, com-
puted as follows:

Cost of processing (materials and labor) . . . . . . . . . . . . . . . . . . . . . $.30

Other costs (sales and support). . . . . . . . . . . . . . . . . . . . . . . . . . . . .06
Average variable cost per print. . . . . . . . . . . . . . . . . . . . . . . . . . . $.36

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 deter-
mined from the company’s income statement for the month, as shown in Exhibit 3.1.
As a manager, Jamaal might want to know how many units (prints) he needs to sell
in order to achieve a specified profit. Assume, for example, that Jamaal is hoping for
sales to improve in July, when the weather will improve and people take vacations. Given
the data, price  $.60, variable cost per unit  $.36 (therefore, contribution margin per
unit  $.24), and fixed costs  $1,500, the manager asks two questions: What volume is
required to break even (earn zero profits)? What volume is required to make an $1,800
operating profit? Although we could use the income statement and guess at the answer to
these questions, it is easier to set up an equation that summarizes the cost-volume-profit
relation.
Recall that in March, U-Develop processed 12,000 prints. Using the profit equation,
the results for March, therefore, were:
Profit  Contribution margin  Fixed costs
 (P  V ) X  F
 ($.60  $.36)  12,000 prints  $1,500
 $1,380
which is equal to the operating profit shown on the income statement in Exhibit 3.1. To
simplify the equation, we use the term “Profit” in the equation to mean the same thing as
“Operating Profit” on income statements.

Exhibit 3.1
U-DEVELOP
Income Statement
Income Statement
March
Sales (12,000 prints at $.60) . . . . . . . . . . . . . . . . . . . . . . . $7,200
Less
Variable costs of goods sold (12,000  $.30) . . . . . . . . . $3,600
Variable selling costs (12,000  $.06) . . . . . . . . . . . . . . . 720 4,320
Contribution margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,880
Less fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Operating profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,380
84
break-even point
Volume level at which profits
equal zero.
contribution margin
ratio
Contribution margin as a
percentage of sales revenue.
Part II Cost Analysis and Estimation
Finding Break-Even and Target Volumes We can use the profit equation to
answer Jamaal’s questions about volumes needed to break even or achieve a target profit
by developing the formulas discussed here. We start with the answer to the first question,
which we call finding a break-even volume. 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 volume.
Break-Even Volume in Units We can use the profit equation to find the break-even
point expressed in units:
Profit  0  (P  V ) X  F
F
If Profit  0, then X  _______
(P  V )
Fixed costs
Break-even volume (in units)  _____________________
Unit contribution margin
$1,500

$ .24
 6,250 prints
To show this is correct, if U-Develop processes 6,250 prints, its operating profit is
Profit  TR  TC
 PX  VX  F
 ($.60  6,250 prints)  ($.36  6,250 prints)  $1,500
 $0
Break-Even Volume in Sales Dollars To find the break-even volume in terms of sales
dollars, we first define a new term, contribution margin ratio. The contribution mar-
gin ratio is the contribution margin as a percentage of sales revenue. For example, for
U-Develop, the contribution margin ratio can be computed as follows:
Unit contribution margin
Contribution margin ratio  _____________________
Sales price per unit
$.24
 ____
$.60
 .40 (or 40%)
Using the contribution margin ratio, the formula to find the break-even volume
follows:2
Fixed costs
Break-even volume sales dollars  _____________________
Contribution margin ratio
2
We can derive the break-even point for sales dollars from the original formula for units:
F
X  ______
PV
The modified formula for dollars multiplies both sides of the equation by P:
FP
PX  ______
PV
Since multiplying the numerator by P is the same as dividing the denominator by P, we obtain:
F
PX  _________
(P  V )P
The term (P  V)/P is the contribution margin ratio.
 Chapter 3 Fundamentals of Cost-Volume-Profit Analysis 85

For U-Develop, the break-even volume expressed in sales dollars is

$1,500
Break-even sales dollars  ______
.40
 $3,750
Note that $3,750 of sales dollars translates into 6,250 prints at a price of $.60 each.
We get the same result whether expressed in units (6,250 prints) or dollars (sales of 6,250
prints generates revenue of $3,750).

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
Fixed costs  Target profit
Target volume (units)  ________________________
Contribution margin per unit
Using the data from U-Develop, we find the volume that provides an operating profit of
$1,800 as follows:
Fixed costs  Target profit
Target volume  ________________________
Contribution margin per unit
$1,500  $1,800
 ______________
$.24
 13,750 prints
U-Develop must sell 13,750 prints per month to achieve the target profit of $1,800. Each
additional print sold increases operating profits by $.24.

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:
Fixed costs  Target profit
Target volume (sales dollars)  ______________________
Contribution margin ratio
For U-Develop the target volume expressed in sales dollars is
$1,500  $1,800
Target volume (sales dollars)  ______________
.40
Note that sales dollars of $8,250 translates into 13,750 prints at $.60 each. We get the
same target volume whether expressed in units (13,750 prints) or dollars (sales of 13,750
prints generates revenue of $8,250).
Exhibit 3.2 summarizes the four formulas for finding break-even and target
volumes.

Exhibit 3.2
Break-Even Volume
Summary of Break-
Fixed costs
Break-even volume (units)  ____________________ Even and Target Volume
Unit contribution margin Formulas
Fixed costs
Break-even volume (sales dollars)  ____________________
Contribution margin ratio
Target Volume
Fixed costs  Target profit
Target volume (units)  ______________________
Unit contribution margin
Fixed costs  Target profit
Target volume (sales dollars)  ______________________
Contribution margin ratio
86 Part II Cost Analysis and Estimation

Exhibit 3.3
CVP Graph—U-Develop $8,000

$7,000 $7,200
 
$6,000

Revenues, Costs
$5,820

$5,000
Total cost
$4,000 TC  $1,500  $.36 X
Break even
TR  TC
$3,000

$2,000

$1,000 Total revenue

TR  $.60 X
$0
0 2,000 4,000 6,000 8,000 10,000 12,000
Volume per period (X )

Graphic Presentation
Exhibit 3.3 presents the cost-volume-profit (CVP) relations for U-Develop in a graph.
Such a graph is a helpful aid in presenting cost-volume-profit relationships. We plot dol-
lars on the vertical axis (revenue dollars or cost dollars, for example). We plot volume on
the horizontal axis (number of prints sold per month or sales dollars, for example). The
total revenue (TR) line relates total revenue to volume (for example, if U-Develop sells
12,000 prints in a month, its total revenue would be $7,200, according to the graph). The
slope of TR is the price per unit, P (for example, $.60 per print for U-Develop).
The total cost (TC) line shows the total cost for each volume. For example, the total cost
for a volume of 12,000 prints is $5,820 ( [12,000  $.36]  $1,500). The intercept of the
total cost line is the fixed cost for the period, F, and the slope is the variable cost per unit, V.
The break-even point is the volume at which TR  TC (that is, where the TR and TC
lines intersect). Volumes lower than break even result in an operating loss because TR 
TC; volumes higher than break even result in an operating profit because TR  TC. For
U-Develop, 6,250 prints is the break-even volume.

Self-Study Question

1. The following information for Jennifer’s Framing Supply Compute the following:
is given for March: a. Monthly operating profit when sales total $360,000
(as here).
b. Break-even number in units.
c. Number of units sold that would produce an
Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $360,000 operating profit of $120,000.
Fixed manufacturing costs . . . . . . . . . . . . . . . . 35,000
d. Sales dollars required to earn an operating profit of
Fixed marketing and administrative costs . . . . . 25,000
Total fixed costs . . . . . . . . . . . . . . . . . . . . . . . . 60,000 $20,000.
Total variable costs . . . . . . . . . . . . . . . . . . . . . . 240,000 e. Number of units sold in March.
Unit price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 f. Number of units sold that would produce an
Unit variable manufacturing cost . . . . . . . . . . . 55 operating profit of 20 percent of sales dollars.
Unit variable marketing cost . . . . . . . . . . . . . . . 5
The solution to this question is at the end of the chapter on
page 109.
 Chapter 3 Fundamentals of Cost-Volume-Profit Analysis 87

The amount of operating profit or loss can be read from the graph by measuring the
vertical distance between TR and TC. For example, the vertical distance between TR and
TC when X  12,000 indicates Profit  $1,380 ( $7,200  $5,820).

Profit-Volume Model profit-volume analysis

Version of CVP analysis using
Instead of considering revenues and costs separately, we can analyze the relation be- a single profit line.
tween 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 in L.O. 2
Exhibit 3.4. The cost and revenue lines are collapsed into a single profit line. Note that the Understand the effect
slope of the profit-volume line equals the unit contribution margin. The intercept equals of cost structure on
the loss at zero volume, which equals fixed costs. The vertical axis shows the amount of decisions.
operating profit or loss.

Exhibit 3.4
Cost-Volume-Profit Relation Comparison of CVP
$8,000 Graph and Profit-Volume
Graph—U-Develop
Total revenue
TR  $.60 X
$6,000
Dollars

$4,000
Total cost
TC  $1,500  $.36 X

$2,000

$0
0 1,500 3,000 4,500 6,000 7,500 9,000 10,500 12,000
Volume

Profit-Volume Relation

$1,400

$400 Operating profit

Dollars

0
1,500 3,000 4,500 6,000 7,500 9,000 10,500 12,000
Operating loss
$600
Profit  Total contribution margin  Total costs
 $.24X  $1,500

$1,600
Volume
88 Part II Cost Analysis and Estimation

Use of CVP to Analyze the Effect

cost structure
Proportion of an organization’s
fixed and variable costs to its
total costs.
operating leverage
Extent to which an
organization’s cost structure is
made up of fixed costs.
of Different Cost Structures
An organization’s cost structure is the proportion of fixed and variable costs to total
costs. Cost structures differ widely among industries and among firms within an industry.
Electric utilities such as Southern California Edison or Public Service of New Mexico
have a large investment in equipment, which results in a cost structure with high fixed
costs. In contrast, grocery retailers such as Albertsons or Safeway have a cost structure
with a higher proportion of variable costs. The utility is capital intensive; the grocery
store is labor intensive.
An organization’s cost structure has a significant effect on the sensitivity of its profits
to changes in volume. Operating leverage describes the extent to which an organization’s
cost structure is made up of fixed costs. Operating leverage can vary within an industry as
well as between industries. The airline industry in the United States, for example, consists
of so-called legacy carriers, such as American Airlines and Continental Airlines, which
have high fixed labor, pension, and other costs and which operate using a hub and spoke
system. Newer carriers, such as Southwest Airlines and Jet Blue Airlines, have lower la-
bor costs and operate out of lower cost and less-congested airports. Therefore, the operat-
ing leverage of American Airlines is higher than that of Jet Blue.
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 firm’s fixed costs, the higher the break-even point. Once the break-even point has been
reached, however, profit increases at a high rate. Exhibit 3.5 demonstrates the primary dif-
ferences between two companies, Lo-Lev Company (with relatively high variable costs)
and Hi-Lev Company (with relatively high fixed costs).

Different industries have different cost structures. Electric utilities (left) have high fixed costs and
high operating leverage. Grocery stores (right) have lower fixed costs and low operating leverage.

Exhibit 3.5
Lo-Lev Company Hi-Lev Company
Comparison of Cost
(1,000,000 units) (1,000,000 units)
Structures
Amount Percentage Amount Percentage
Sales . . . . . . . . . . . . $1,000,000 100 $1,000,000 100
Variable costs . . . . . . 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 point . . . 200,000 units 733,334 units
Contribution margin per unit $0.25 $0.75
 Chapter 3 Fundamentals of Cost-Volume-Profit Analysis 89

Effect of Cost Structure on Operating

and Investing Decisions
In Action

Different cost structures lead to different decisions that
firms make concerning operations and investments.
Consider the following two statements:
1. “Ahold now has about $23 billion in sales among
its six U.S. supermarket chains—large but uncom-
fortably behind giants such as Wal-Mart, Kroger,
and Albertson’s. The logic of consolidation is that,
in a business with such slim profit margins, bigger
companies gain important competitive advantage
by being able to negotiate better terms and prices
from suppliers, better rents from landlords and bet-
ter advertising deals from media outlets” (Washing-
ton Post, February 8, 2004).
2. “Many experts say the airlines throw planes on a
route to grab market share from rivals. Robert L.
Crandall, the former chief executive of American Air-
lines, said that airlines added planes because growth
spreads fixed costs over more passenger miles. ‘If
everybody is growing to keep their costs down, then
there’s constantly a great deal of capacity in the mar-
ket,’ Mr. Crandall said. ‘So long as there’s lots of ca-
pacity, people have an incentive to cut prices’” (The
New York Times, December 9, 2003).
In the case of firms with low operating leverage, such as
grocery chains, the profit margins are small, so firms do
what they can to improve those margins—even small sav-
ings translate to large improvements in profits. In the case
of firms with high operating leverage, such as airlines, each
S
additional unit (seat-mile) sold provides a large contribu-
tion to profit, so the emphasis is on increasing volume.

Note that although these firms have the same sales revenue and operating profit, they
have different cost structures. Lo-Lev Company’s cost structure is dominated by variable
costs with a lower contribution margin ratio of .25. Every dollar of sales contributes $.25
toward fixed costs and profit. Hi-Lev Company’s cost structure is dominated by fixed
costs with a higher contribution margin of .75. Every dollar of sales contributes $.75
toward fixed costs and profit.
Suppose that both companies experience a 10 percent increase in sales. Lo-Lev Com-
pany’s profit increases by $25,000 ($.25  $100,000), and Hi-Lev Company’s profit in-
creases by $75,000 ($.75  $100,000). Of course, if sales decline, the fall in Hi-Lev’s
profits is much greater than the fall in Lo-Lev’s profits. In general, companies with lower
fixed costs have the ability to be more flexible to changes in market demands than do
companies with higher fixed costs and are better able to survive tough times.

Margin of Safety
The margin of safety is the excess of projected (or actual) sales over the break-even sales margin of safety
level. This tells managers the margin between current sales and the break-even point. In The excess of projected or
a sense, margin of safety indicates the risk of losing money that a company faces, that is, actual sales over the break-
the amount by which sales can fall before the company is in the loss area. The margin of even volume.
safety formula is
Sales volume  Break-even sales volume  Margin of safety
If U-Develop sells 8,000 prints and its break-even volume is 6,250, then its margin of
safety is
Sales  Breakeven  8,000  6,250
 1,750 prints
Sales volume could drop by 1,750 prints per month before it incurs a loss, all other
things held constant. In practice, the margin of safety also may be expressed in sales dol-
margin of safety
lars or as a percent of current sales.
percentage
The excess of the projected or actual sales volume over the break-even volume The excess of projected or
expressed as a percentage of actual sales volume is the margin of safety percentage. actual sales over the break-
If U-Develop sells 8,000 prints and the break-even volume is 6,250 prints, the margin of even volume expressed as
safety percentage is 22 percent ( 1,750 8,000). This means that volume can fall by a percentage of actual sales
22 percent, a relatively large amount, before U-Develop finds itself operating at a loss. volume.
90 Part II Cost Analysis and Estimation

CVP Analysis with Spreadsheets

L.O. 3 It is important to be able to do CVP analysis and understand the relations, so it is impor-
Use Microsoft Excel to tant to work examples and do problems by hand at first. However, a spreadsheet program
perform CVP analysis.
such as Microsoft Excel® is ideally suited to doing CVP routinely. Exhibit 3.6 shows a
Microsoft Excel worksheet for U-Develop. The basic data (price per unit, variable cost
per unit, and total fixed costs) for U-Develop are entered. The profit equation (or formula)
is shown in the formula bar of the spreadsheet.
Once the data are entered, an analysis tool such as Goal Seek can be used to find
the volume associated with a given desired profit level. In the left side screenshot of Ex-
hibit 3.7, the problem is set up as follows:
1. With the spreadsheet open, choose the “Data” tab and select “What-If Analysis” from
the ribbon. Then select “Goal Seek” from the drop-down box.
2. In the “Set cell:” edit field, enter the cell address for the target profit calculation (B7).
The formula in cell B7 is:  ((B3-B4)*B8)-B5.
3. In the “To value:” edit field, enter the target profit (in this example, the target profit is
zero because we are looking for the break-even point).
4. In the “By changing cell:” edit field, enter the cell address of the volume variable
($B$8). (The 5,000 volume in cell B8 in Exhibit 3.6 is only a placeholder; any num-
ber will suffice.)
5. Click “OK” and the program will find the break-even volume as shown in the right
side screenshot of Exhibit 3.7.
Although this spreadsheet is extremely simple, it can easily be edited to analyze al-
ternative scenarios, so-called what-if analyses. For example, we could ask, “Given that I
expect to sell 5,000 prints, what price do I need to charge to break even?” In this case, we
would change Step 4 above to enter the cell for Price (B3) and find the answer ($0.66).

Exhibit 3.6 A B C
1 U-Develop
Screenshot of
2
Spreadsheet Program 3 Price $ 0.60
for CVP Analysis— 4 Variable cost $ 0.36
U-Develop 5 Fixed cost $ 1,500
6
7 Profit $ (300)
8 Volume 5,000
9

Exhibit 3.7 A B C A B C D
1 U-Develop 1 U-Develop
Screenshot of
2 2
Spreadsheet 3 Price $ 0.60 3 Price $ 0.60
Analysis 4 Variable cost $ 0.36 4 Variable cost $ 0.36
Tool—Goal 5 Fixed cost $ 1,500 5 Fixed cost $ 1,500
Seek 6 6
7 Profit $ (300) 7 Profit $ –
8 Volume 5,000 8 Volume 6,250
9 9
10 Goal Seek ? X 10
11 11 Goal Seek Status ? X
12 Set cell: B7 12 Goal Seeking with Cell B7 OK
13 To value: 0 13 found a solution.
14 14 Cancel
By changing cell: $B$8円 Target value: 0
15 15 Current value: $- Step
16 OK Cancel 16
17 17 Pause

18 18
19 19
 Chapter 3 Fundamentals of Cost-Volume-Profit Analysis 91

Extensions of the CVP Model

The basic CVP model that we have developed can be easily extended to answer other L.O. 4
questions or modified to incorporate complications. For example, we can use the model to Incorporate taxes,
determine the fixed costs required to achieve a certain profit for a given volume. We can multiple products,
incorporate the effects of income taxes by modifying the profit equation to include taxes. and alternative cost
Making some simplifying assumptions, we can extend the analysis to firms that make
structures into the
multiple products. Finally, we can incorporate more complicated cost structures (for ex-
CVP analysis.
ample, step fixed costs) by incorporating these complications in the profit equation. We
illustrate these extensions here.

Income Taxes
Assuming that operating profits before taxes and taxable income are the same, income
taxes may be incorporated into the basic model as follows:
After-tax profit  [(P  V)X  F]  (1  t)
where t is the tax rate.
Rearranging, we can find the target volume as follows;
Fixed costs  [Target profit兾(1  t)]
Target volume (units)  ______________________________
Unit contribution margin
Notice that taxes affect the analysis by changing the target profit. That is, to deter-
mine the volume required to earn a target after-tax income, you first determine the re-
quired before-tax operating income ( target after-tax income [1  tax rate]) and then
solve for the target volume using the required before-tax income as before.
For example, suppose that 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  $.60, V  $.36,
the contribution margin per unit  $.24, and F  $1,500. We assume the tax rate t  .25;
that is, U-Develop has a 25 percent tax rate. To find the target volume, first determine the
required before-tax income, which is $2,400 ( $1,800 [1  .25]). Now, we can use
the formula to determine the volume required to earn a target profit of $2,400:
Fixed costs  [Target profit兾(1  t)]
Target volume (units)  ______________________________
Unit contribution margin
$1,500  $2,400
 ______________
$.24
 16,250 prints

Multiproduct CVP Analysis

When U-Develop started, it provided only one service, print processing. After a short
time, a second service, enlargements of photos, was offered. The prices and costs of the
two follow:

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

When these two services were offered, monthly fixed costs totaled $1,820.
Without some assumptions, there is an infinite number of combinations of the two
services that would achieve a given level of profit. To simplify matters, managers often
92 Part II Cost Analysis and Estimation

assume a particular product mix and compute break-even

or target volumes using either of two methods, a fixed prod-
uct mix or weighted-average contribution margin, both of
which give the same result.

Fixed Product Mix Using the fixed product mix

method, managers define a package or bundle of products
in the typical product mix and then compute the break-
even or target volume for the package. For example, sup-
pose that 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. Defining X as a package of
nine prints and one enlargement, the contribution margin
Managers compute the break-even or target volume of a
from this package is
bundle or package of products.

Prints . . . . . . . . . . . . . . . . . 9  $.24 $2.16

Enlargements . . . . . . . . . . . 1  $.44 .44
_____
Contribution margin . . . . . . $2.60
_____
_____

Now the break-even point is computed as follows

X  Fixed costs Contribution margin
 $1,820 $2.60
 700 packages
where X refers to the break-even number of packages. This means that the sale of 700
packages of nine prints and one enlargement per package, totaling 6,300 prints and 700
enlargements, is required to break even.

Weighted-Average Contribution Margin 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 contribution margin of all of its products.
For U-Develop, the weighted-average contribution margin per unit can be computed by
multiplying each product’s proportion by its contribution margin per unit
(.90  $.24)  (.10  $.44)  $.26
The multiple product breakeven for U-Develop can be determined from the break-even
formula:
X  $1,820 $.26
 7,000 units of service
where X refers to the break-even number. The product mix assumption means that U-
Develop must sell 6,300 ( .90  7,000) prints and 700 ( .10  7,000) enlargements
to break even.

Find Breakeven in Sales Dollars To find the breakeven in sales dollars, divide the
fixed costs by the weighted-average contribution margin percent. The weighted-average
contribution margin percent is the ratio of the weighted-average contribution margin
(which is $.26 in our example) divided by the weighted-average revenue.
 Chapter 3 Fundamentals of Cost-Volume-Profit Analysis 93

To find the weighted-average revenue, multiply the proportion of sales (90 percent
prints and 10 percent enlargements) by the sales prices per unit. Prints sell for $.60 per
unit and enlargements sell for $1.00 per unit. Therefore, the weighted-average revenue
can be found as follows:
(.90  $.60) for prints  (.10  $1.00) for enlargements
 $.64
Now, the weighted-average contribution margin percent is found as follows:
$.26 weighted-average contribution margin $.64 weighted-average revenue
 40.625%
The break-even sales amount in dollars is:
$1,820 fixed costs .40625 weighted-average contribution margin percent
 $4,480
(You can verify that $4,480  $.64  7,000 units.)

Alternative Cost Structures

The cost structures we have considered so far have been relatively simple. We have sepa-
rated costs into fixed and variable and we have assumed that the variable cost per unit is
the same for all levels of volume. In Chapter 2, we defined other cost behavior patterns,
including semivariable costs and step costs.
We illustrate how more complicated cost structures can be analyzed by assuming
that the fixed costs of U-Develop include the rental of equipment for photo developing
and that the capacity of these machines is limited. Suppose, for example, that the fixed
costs of $1,500 (from Exhibit 3.1) are sufficient for monthly volumes less than or equal
to 5,000 prints. For every additional 5,000 prints, another machine, renting monthly for
$480, is required. Now what is the break-even volume for U-Develop?
We know from our analysis earlier in the chapter that for a fixed cost of $1,500, the
break-even point is 6,250 prints. But 6,250 prints cannot be developed without the ad-
ditional machine. At a volume of 6,250 prints, U-Develop’s profit will be
Profit  ($0.60  $0.36)  6,250  ($1,500  $480)  ($480)
which is less than breakeven.
If we are going to have to sell more than 5,000 prints to break even, we are going to
have to rent the additional machine. Therefore, to break even, our monthly fixed costs will
be (at least) $1,980 ( $1,500  $480). At this level of fixed costs, the break-even point is
Fixed costs
Break-even volume  _____________________
Unit contribution margin
$1,980
 ______
$ 0.24
 8,250
which is less than 10,000 prints. Therefore, U-Develop can break even at a volume of
8,250 prints. If we had found that the new break-even point was greater than 10,000
prints, we would have repeated the analysis, adding another $480 for an additional
machine.

Assumptions and Limitations of CVP Analysis L.O. 5

Understand the
As with all methods of analysis, CVP analysis relies on certain assumptions and these as- assumptions and
sumptions might limit the applicability of the results for decision making. It is important limitations of CVP
to understand, however, that the limitations are due to the assumptions that the cost analyst
analysis.
makes; that is, they are not inherent limitations to the method of CVP analysis itself.
94 Part II Cost Analysis and Estimation

For example, many people point to the assumptions of constant unit variable cost and
constant unit prices for all levels of volume as important limitations of CVP analysis. As
we saw in the previous section, however, these assumptions are simplifying assumptions
that are made by the analyst. If we know that unit prices are lower for higher volumes, we
can incorporate that relation into the CVP analysis. The result will be a more complicated
relation among costs, volumes, and profits than we have worked with here and the break-
even and target volume formulas will not be as simple as those we have derived. But with
analysis tools such as Microsoft Excel we can model the more complicated relations and
find the break-even point (or points) if they exist.
The lesson from this is that CVP analysis is a tool that the manager can use to help
with decisions. The more important the decision, the more the manager will want to
ensure that the assumptions made are applicable. In addition, if the decisions are sensitive
to the assumptions made (for example, that prices do not depend on volume), the man-
ager should be cautious about depending on CVP analysis without considering alternative
assumptions.

Self-Study Questions

2. High Desert Campgrounds (HDC) rents spaces for

recreational vehicles (RVs) by the day. HDC charges Price per Variable Cost Units Rented
$15 per day for a space. The variable costs (including Unit per Unit per Year
cleaning, maintenance, and supplies) are $7 per day. Tent space . . . . $ 6 $3 6,000
The fixed costs of HDC are $60,000 per year. HDC is RV space . . . . . 15 7 9,000
subject to a tax rate of 35 percent on its income. If a
“unit” is one space rented for one day, how many units
does HDC have to rent annually to earn $48,750 after The fixed costs of HDC are $60,000 annually. Assuming
taxes? the mix of tent and RV spaces is the same as the current
3. Suppose HDC rents spaces for both RVs and tent mix, how many tent spaces and how many RV spaces
camping. The price and cost characteristics for each must be rented annually for HDC to break even?
are as follows (one unit is a tent or RV space rented for The solutions to these questions are at the end of the chapter on
one day): page 109.

The Debrief
Jamaal Kidd considered the spreadsheet he developed
for his business and reflected on how it will help him as a
manager:
The cost-volume-profit analysis I learned in this
chapter gives me a simple and intuitive approach to
understanding how my decisions affect my profits.
I know that there are limitations to the use of CVP analy-
sis and that for many decisions, I will want to develop
more detailed analyses. But for quick answers for rou-
tine decisions, CVP analysis is just what I need.

Summary
The cost analysis approach to decision making is used when the decisions affect costs and revenues
and, hence, profit. In this chapter we considered the cost-volume-profit (CVP) analysis framework
for cost analysis.