CHAPTER 2

COST-VOLUME-PROFIT ANALYSIS
 LEARNING OBJECTIVE
Explain the features of cost-volume-
Determine the breakeven point and profit (CVP) analysis.
output level needed to achieve a
target operating income
Explain how managers use CVP analysis to
Understand how income taxes affect make decisions.
CVP analysis

Explain how sensitivity analysis helps

Use CVP analysis to plan variable and managers cope with uncertainty
fixed costs

Apply CVP analysis in service and not-

Apply CVP analysis to a company
for-profit organizations
producing multiple products

Distinguish contribution margin from gross margin

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 What is CVP?

COST VOLUME PROFIT

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CVP studies the relationship between revenue, cost,
and volume and their effect on profits.

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Contribution Margin (CM)

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 Contribution Margin (CM)

Contribution Margin is the difference between total revenues and total variable
costs. That is,

Contribution margin = Total revenues - Total variable costs

Another way:
Contribution margin = Contribution margin per unit * Number of units sold

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 Contribution Margin (CM)

Compute the Contribution Margin when the company changes the quantity sold

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 Contribution Margin (CM)

Contribution margin per unit is a useful tool for calculating contribution margin
and operating income. It is defined as,

Contribution margin per unit = Selling price - Variable cost per unit
Instead of expressing contribution margin as a dollar amount per unit, we can
express it as a percentage called contribution margin percentage (or
contribution margin ratio):

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 Expressing CVP Relationships

There are three related ways (we will call them methods) to think more deeply
about and model CVP relationships:
1. The Equation Method
2. The Contribution Margin Method
3. The Graph Method.

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 Expressing CVP Relationships

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 Expressing CVP Relationships

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 Expressing CVP Relationships

The Graph Method

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 Breakeven Point

The breakeven point (BEP) is that quantity of output sold at which total revenues equal
total cost, which means the quantity of output sold that results in $0 operating income.

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 Breakeven Point

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 Target Operating Income

How can managers determine how much they need to sell to achieve a targeted amount
of operating income?

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 Target Operating Income

How can managers determine how much they need to sell to achieve a targeted amount
of operating income?

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 Target Operating Income

How can managers determine how much they need to sell to achieve a targeted amount
of operating income?

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 Target Net Income and Income Taxes

How can managers determine how much they need to sell to achieve a targeted amount
of operating income?

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 Target Net Income and Income Taxes

How can managers determine how much they need to sell to achieve a targeted amount
of operating income?

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 Target Net Income and Income Taxes

How can managers determine how much they need to sell to achieve a targeted amount
of operating income?

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 Using CVP Analysis for Decision Making

Emma Firm:
Decision to Advertise
- Quantity sold: 40 Packages
- Unit Price: $200 Forecasting:
- Variable Unit Cost: $120 Increasing advertising fee of
- CM Unit: $80
$500, quantity increases by
- CM: $3,200
- CM %: 40% 10%. Should Emma do?
- Fixed Cost: $2,000

Emma should not

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 Using CVP Analysis for Decision Making

Emma Firm:
Decision to Advertise
- Quantity sold: 40 Packages
- Unit Price: $200 Forecasting:
- Variable Unit Cost: $120 Increasing advertising fee of
- CM Unit: $80
$500, quantity increases by
- CM: $3,200
- CM %: 40% 10%. Should Emma do?
- Fixed Cost: $2,000

Emma should not

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 Using CVP Analysis for Decision Making

Emma Firm: The decision to reduce the selling price

- Quantity sold: 40 Packages
- Unit Price: $200
Forecasting:
- Variable Unit Cost: $120 Reduce the selling price to $175,
- CM Unit: $80 Reduce the variable unit cost to $115
- CM: $3,200
- CM %: 40%
Quantity increases by 50 units.
- Fixed Cost: $2,000 Should Emma do?
New CM:
= 50 * ($175-$115) = $3,000
Old CM:
= 40*($200-$120) = $3,200
Change in contribution Margin from lowering price: 3,000 – 3,200 = $ (200)
Fixed Cost will not change: 0
Profitable changed:
= $ (200) – 0 = $ (200) <0
=> Should not.
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 Using CVP Analysis for Decision Making

Decision to adjust Target Price:

Emma Firm:
- Quantity sold: 40 Packages
- Unit Price: $200
- Variable Unit Cost: $120
- CM Unit: $80
- CM: $3,200
- CM %: 40%
- Fixed Cost: $2,000

Emma could also ask “At what price

can I sell 50 units (purchased at
$115 per unit) and continue to earn
an operating income of $1,200?

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201048-COST-VOLUME-PROFIT ANALYSIS
 Sensitivity analysis and margin of safety

Before choosing strategies and plans about how to implement strategies,

managers frequently analyze the sensitivity of their decisions to changes in
underlying assumptions.
Sensitivity analysis is a “what-if” technique that managers use to examine how
an outcome will change if the original predicted data are not achieved or if an
underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answers questions such as,
“What will operating income be if the quantity sold decreases by
5% from the original prediction?” and “What will operating income be if the
variable cost per unit increases by 10%?”

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201048-COST-VOLUME-PROFIT ANALYSIS
 Sensitivity analysis and margin of safety

Using spreadsheets, managers can conduct sensitivity analysis to examine the effect
and interaction of changes in selling price, variable cost per unit, fixed costs, and target
operating income.

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 Sensitivity analysis and margin of safety

Another aspect of sensitivity analysis is margin of safety:

Margin of safety = Budgeted (or actual) revenues - Breakeven revenues
Margin of safety (in units) = Budgeted (or actual) sales quantity - Breakeven quantity
From Exhibit 3-1, if Emma sells 40 units, budgeted revenues are $8,000 and budgeted
operating income is $1,200. The breakeven point is 25 units or $5,000 in total
revenues.

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201048-COST-VOLUME-PROFIT ANALYSIS
 Sensitivity analysis and margin of safety

Sensitivity analysis is a simple approach to recognizing uncertainty,

which is the possibility that an actual amount will deviate from an
expected amount. Sensitivity analysis gives managers a good feel for the
risks involved.

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201048-COST-VOLUME-PROFIT ANALYSIS
 Cost Planning and CVP

Alternative Fixed-Cost/Variable-Cost Structures

Compared to line 6, line 11, with higher fixed costs, has more risk of loss (has a higher
breakeven point) but requires fewer units to be sold (48 versus 50) to earn operating income
of $2,000. CVP analysis can help managers evaluate various fixed-cost/variable-cost
structures.

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201048-COST-VOLUME-PROFIT ANALYSIS
 Cost Planning and CVP

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.

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201048-COST-VOLUME-PROFIT ANALYSIS
 2.6. Cost Planning and CVP

Operating Leverage

DOL: Degree Operating Leverage

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 Cost Planning and CVP

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.

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201048-COST-VOLUME-PROFIT ANALYSIS
 Effects on Sales Mix on Income

Sales mix is the quantities of various products that constitute total unit sales
of a company.

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201048-COST-VOLUME-PROFIT ANALYSIS
 Effects on Sales Mix on Income

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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 Effects on Sales Mix on Income

U-Develops 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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201048-COST-VOLUME-PROFIT ANALYSIS
 CVP analysis in Service and Nonprofit Organizations

To apply CVP analysis in service and nonprofit organizations, we

need to focus on measuring their output.

Examples of output measures in various service and nonprofit

industries are as follows:

Industry Measure of Output

Airlines Passenger Miles
Hotels/motels Room-nights occupied
Hospitals Patient Days
Universities Student credit-hours

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 Contribution Margin Versus Gross Margin

In the following equations, we clearly distinguish

contribution margin, which provides information for CVP
analysis, from gross margin, a measure of competitiveness.
Gross margin = Revenues - Cost of goods sold;
Contribution margin = Revenues - All variable costs.

 Gross margin measures how much a company can charge for

its products over and above the cost of acquiring or
producing them.

 Contribution margin indicates how much of a company’s

revenues are available to cover fixed costs.

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 Contribution Margin Versus Gross Margin

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201048-COST-VOLUME-PROFIT ANALYSIS
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