Chapter 3

Fundamentals of Cost-Volume-Profit Analysis

Learning Objectives
1. Use cost-volume-profit (CVP) analysis to analyze decisions.

2. Understand the effect of cost structure on decisions.

3. Use Microsoft Excel to perform CVP analysis.

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

5. Understand the assumptions and limitations of CVP analysis.

Chapter Overview
I. COST-VOLUME-PROFIT ANALYSIS
• Profit Equation
• CVP Example
o Finding Break-Even and Target Volumes
§ Break-Even Volume in Units
§ Break-Even Volume in Sales Dollars
§ Target Volume in Units
§ Target Volume in Sales Dollars
• Graphic Presentation
• Profit-Volume Model
• Use of CVP to Analyze the Effect of Different Cost Structures
• Margin of Safety

II. CVP ANALYSIS WITH SPREADSHEETS

III. EXTENSIONS OF THE CVP MODEL

• Income Taxes
• Multiproduct CVP Analysis
o Fixed Product Mix
o Weighted-Average Contribution Margin
§ Find Breakeven in Sales Dollars
• Alternative Cost Structures
• Assumptions and Limitations of CVP Analysis
Chapter Outline
LO 3-1 Use cost-volume-profit (CVP) analysis to analyze decisions.

COST-VOLUME-PROFIT ANALYSIS

• Cost-Volume-Profit (CVP) Analysis

o Cost-volume-profit (CVP) analysis is a study of the relations among revenues, costs, and
volume and their effect on profit.

o Managers make decisions on volume, pricing, or incurring a cost that will impact profit.
(See Business Application box “Cost-Volume-Profit Analysis and On-Demand
Services.”)

• Profit equation

o Profit equation: operating profit equals total revenue less total costs.

§ Operating profit (also referred to as profit) = Total revenues – Total costs

Profit = TR – TC

§ Total revenue (TR) = Price × Units of output produced and sold

TR = PX

§ Total costs = (Variable costs per unit × Units of output) + Fixed costs
TC = VX + F

§ Profit = (Price – Variable costs) × Units of output) – Fixed costs

o Contribution margin is the amount that units sold contribute toward (1) covering fixed
costs and (2) providing operating profits

§ Unit contribution margin

• The difference between sales price and variable cost per unit

• Unit contribution margin = Price – Variable cost per unit = P – V

§ Total contribution margin

• The difference between total revenues and total variable cost

• Total contribution margin

= (Price – Variable cost per unit) x Units of output = (P – V)X
 § Alternatively, in CVP income statement format,

Total Unit Percentage

Sales revenue PX P 100%
- Variable costs VX V V÷P
= Contribution margin (P – V)X P–V (P – V) ÷ P
- Fixed costs F
= Profit (P – V)X – F

o Financial accounting classifies costs as either manufacturing or administrative; for

decision making, costs are classified as fixed or variable.

§ V represents the sum of variable manufacturing cost per unit and variable marketing
and administrative cost per unit.

§ F represents the sum of total fixed manufacturing costs and fixed marketing and
administrative costs.

§ X refers to the number of units produced and sold during the period.

• CVP Example

o Exhibit 3.1 illustrates a contribution margin income statement; profit equals contribution
less fixed costs.

o Finding Break-Even and Target Volumes

§ Break-even point is the volume level at which profits equal zero If the company
makes many products, the volume is usually expressed in terms of sales dollars, and if
the company makes only one product, the volume is usually expressed in terms of
volume.

Fixed costs
• Break-even volume (in units) =
Unit contribution margin

• Break-even volume (in sales dollars)

Unit contribution margin

ú Contribution margin ratio =
Sales price per unit

Fixed cost
ú Break-even volume in sales dollars =
Contribution margin ratio
 § Target volume is the level at which profits equal a target profit.

Fixed costs + Target profit

• Target volume (in units) =
Unit contribution margin

Fixed costs + Target profit

• Target volume (in sales dollars) =
Contribution margin ratio

§ Exhibit 3.2 summarizes the break-even and target volume formulas.

See Demonstration Problem 1

• Graphic Presentation

o Exhibit 3.3 plots total revenues against total costs at various activity levels (volumes).

§ The total revenue line (TR) starts at the origin (0, 0) with slope P, the price per unit.

§ The total cost line (TC) starts at intercept F with slope V, the variable cost per unit.

§ The two lines intersect at the break-even volume where TR = TC.

o Volumes lower than breakeven result in an operating loss (TR < TC); volumes higher
than breakeven result in an operating profit (TR > TC).

o The vertical distance between TR and TC determines the amount of operating profit or
loss.

• Profit-Volume Model

o Profit-volume analysis is a version of cost-volume-profit analysis using a single profit

line.

o A Profit-Volume graph collapses the cost and revenue lines into a single profit line in the
profit-volume graph.

§ The profit line starts at the loss at zero sales volume; the loss equals the fixed costs.

§ The slope of the profit line equals the unit contribution margin.

§ The vertical axis shows the amount of operating profit or loss.

o Exhibit 3.4 (shown in a more generic form below) is a comparison of a CVP graph and a
Profit-Volume graph using the same background information.

Comparison of CVP Graph and PV Graph

TR = PX CVP Graph
$
Operating profit

TC = F + VX

F
Operating loss

Volume

Break-even volume
$
TR = TC PV Graph

TR – TC
0

Volume
–F
LO 3-2 Understand the effect of cost structure on decisions.

• Use of CVP to Analyze the Effect of Different Cost Structures

o An organization’s cost structure is the proportion of fixed and variable costs to total
costs; it has a significant effect on the sensitivity of its profits to changes in volume.

§ A firm with a high proportion of fixed costs, such as electric utilities, is considered
capital intensive.

§ A firm with a high proportion of variable costs, such as a grocery retailer, may be
considered labor intensive.

o Operating leverage describes the extent to which an organization’s cost structure is

made up of fixed costs.

§ 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 its break-even point.

• Once its break-even point has been reached, however, profit increases at a high
rate.

§ Operating leverage is low in firms with a low proportion of fixed costs and a high
proportion of variable costs and results in a low contribution margin per unit.

• Firms with lower operating leverages are more flexible and better at withstanding
economic downtimes.

§ Profit increase (decrease) as a result of improved (declining) sales can be calculated

as the product of operating leverage and sales increase (decrease) in percentage. (See
Business Application box “Break-Even Analysis Used by “Big Oil.”)

§ Exhibit 3.5 compares the cost structure of two companies.

• Lo-Lev Company has a low operating leverage, while Hi-Lev Company has a
high operating leverage.

• The graphs below use the data from this exhibit to illustrate the impact of an
increase in sales on these two companies.
 LO-LEV

1400000

1200000
TR
1000000

800000
TC
$

600000

400000

200000

0
0 200000 400000 600000 800000 1000000 1200000 1400000

Units of output

HI-LEV

1400000

1200000
TR
1000000

800000
TC
$

600000

400000

200000

0
0 200000 400000 600000 800000 1000000 1200000 1400000

Units of output
• Margin of Safety

o Margin of safety is the excess of projected (or actual) sales over the break-even sales
level.

§ The margin of safety indicates the risk of losing money that a company faces; that is,
the amount by which sales can fall before the company is in the loss area.

§ The margin of safety formula is:

Sales volume – Break-even sales volume = Margin of safety

o The margin of safety percentage is the excess of projected (or actual) sales over the
break-even volume expressed as a percentage of the actual volume.

§ The margin of safety percentage indicates the percentage decline in sales volume
before the company finds itself operating at a loss.

§ The margin of safety percentage formula is:

Projected (or actual) sales – Break-even sales

Margin of safety percentage = volume
Break-even volume

Margin of safety is presented below.

TR = PX
$
TC = F + VX

Margin of
safety

Volume
Break-even volume Projected or
actual sales
LO 3-3 Use Microsoft Excel to perform CVP analysis.

CVP ANALYSIS WITH SPREADSHEETS

• Spreadsheet programs such as Microsoft Excel® are ideally suited to doing CVP routinely.

o Exhibit 3.6 illustrates a screenshot of a spreadsheet program for CVP Analysis.

• 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.

o Exhibit 3.7 illustrates a screenshot of a spreadsheet analysis tool.

• The spreadsheet can easily be edited to analyze alternative scenarios, so-called what-if
analyses.

LO 3-4 Incorporate taxes, multiple products, and alternative cost structures

into the CVP analysis.

EXTENSIONS OF THE CVP MODEL

• Income Taxes

o Assuming that operating profits before taxes and taxable income are the same, income
taxes may be incorporated into the basic model as follows (where t is the tax rate):

After-tax profit = [(P – V) X – F] × (1 – t)

Fixed costs + [Target profit/(1 – t)]

o Target volume (in units) =
Unit contribution margin

See Demonstration Problem 2

• Multiproduct CVP Analysis

o Without some assumptions, there is an infinite number of combinations of services or

products that would achieve a given level of profit.

o To simplify matters, managers often assume a particular product mix and compute break-
even or target volumes using either of two methods, a fixed product mix or weighted-
average contribution margin, both of which give the same result.
 o 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.

§ Once the break-even point is calculated for the number of packages required, the
product mix in the package will be multiplied to determine the required units for each
product.

o Weighted-Average Contribution Margin

§ Assuming a constant product mix, the second method calculates a weighted-average

contribution margin per unit for all of the products considered.

§ The break-even formula determines the required total number of units for all products
involved.

§ Multiplying the total by the respective “weights” in the product mix determines the
required units for each product.

See Demonstration Problem 3

• Alternative Cost Structures

o When more complicated cost structures are considered, the basic setup developed so far
must be adapted to deliver relevant information for decision making.

§ Consider the fixed cost that follows a step-cost pattern over the relevant range as
machine capacity is limited. If the break-even calculation results in a required volume
that is within the existing capacity, no further consideration is needed.

§ If, on the other hand, the required volume exceeds the existing capacity, then
additional fixed cost must be incurred to bring up the capacity, and a new break-even
volume will be calculated. The new volume must be within the now higher capacity
to be viable, or another iteration of calculations ensues.
LO 3-5 Understand the assumptions and limitations of CVP analysis.

• Assumptions and Limitations of CVP Analysis

o CVP analysis relies on certain assumptions that may limit the applicability of the results
for decision making.

§ The limitations are due to the assumptions made; they are not inherent to the method
of CVP analysis itself.

§ It is usually assumed that unit variable cost and unit price are constant for all levels of
volume.

§ Simplifying assumptions are easier to deal with, but can be relaxed to incorporate
more realistic situations.

§ The more important the decision, the more the manager will want to ensure that the
assumptions made are suitable.

§ The degree of sensitivity of the decisions to the assumptions made dictates caution
about the results and the need for considering alternative assumptions.
Matching

A. Break-even point G. Operating leverage

B. Contribution margin ratio H. Profit equation
C. Cost structure I. Profit-volume analysis
D. Cost-volume-profit analysis J. Total contribution margin
E. Margin of safety K. Unit contribution margin
F. Margin of safety percentage

_____ 1. Operating profit equals total revenues less total costs.

_____ 2. Volume level at which profits equal zero.

_____ 3. Extent to which an organization’s cost structure is made up of fixed costs.

_____ 4. Version of the cost-volume-profit analysis using a single profit line.

_____ 5. The proportion of fixed and variable costs to total costs of an organization.

_____ 6. Contribution margin expressed as a percentage of sales revenue.

_____ 7. Difference between total revenues and total variable costs.

_____ 8. Difference between revenues per unit (price) and variable costs per unit.

_____ 9. Study of the relations among revenues, costs, and volume and their effect on profit.

_____ 10. The excess of projected (or actual) sales over the break-even sales volume.

_____ 11. The excess of the projected or actual sales volume over the break-even volume
expressed as a percentage of actual sales volume.
Matching Answers

1. H

2. A

3. G

4. I

5. C

6. B

7. J

8. K

9. D

10. E

11. F
Multiple Choice

Use the following information to answer questions 1 through 4:

Company A currently sells a product for $2 each. Fixed cost and unit variable cost are $12,000
and $0.80, respectively.

1. What is the break-even point in units and in sales dollars, respectively?

a. 10,000 units and $20,000
b. 12,000 units and $24,000
c. 10,000 units and $15,000
d. 20,000 units and $20,000

2. What is the contribution margin ratio?

a. 20%
b. 30%
c. 40%
d. 60%

3. To reach a target profit of $33,000, how many units of output should be sold?
a. 22,500 units
b. 31,750 units
c. 37,500 units
d. 42,000 units

4. If variable cost per unit is increased by 15%, fixed cost is increased to $15,120, and the unit
price remains the same, what is the new break-even point in sales dollars?
a. $22,000
b. $24,000
c. $26,000
d. $28,000

5. Relative to companies with low operating leverage, a company with high operating leverage:
a. is more sensitive to economic fluctuations.
b. has a high proportion of variable costs.
c. experiences a smaller break-even volume.
d. has a low contribution margin per unit.

6. The excess of actual or projected sales over the break-even sales is known as:
a. contribution margin.
b. margin of safety.
c. gross margin.
d. target profit.
7. A company produces key chains. The data include price $1, unit variable cost $0.40, monthly
fixed cost $3,000, and tax rate 30%. The owner wants to earn an after-tax profit of $10,500
per month. How many key chains must be produced and sold to meet that goal?
a. 24,000
b. 30,000
c. 32,000
d. 36,000

8. When more than one product is involved:

a. the CVP method reaches its limit.
b. no particular assumption is needed to calculate the break-even volume.
c. a fixed product mix will produce a unique break-even solution.
d. weighted-average product mix method can be used.

9. A start-up company manufactures two products: X is sold for $5 with variable cost of $3
each; Y is sold for $8 with variable cost of $4 each. An annual fixed cost of $10,000 is
projected. The marketing department estimates a 3:1 ratio between X and Y. How many units
of X must be sold to break even for the first year of operation?
a. 3,000
b. 3,600
c. 1,000
d. 1,500

10. CVP analysis:

a. requires certain assumptions to be made.
b. is inherently limited by its applicability.
c. usually assumes unit variable cost to be constantly changing.
d. does not allow for alternative assumptions.

11. In October, Fashionable Clothing manufactured 2,000 items with the following financial
statement amounts: direct materials $12,000, sales $48,000, direct labor $16,000,
depreciation $3,600, rent $1,500, and variable overhead $9,000. What is contribution margin
per unit?
a. $5.50
b. $2.95
c. $3.40
d. $4.10

12. Which of the following statements regarding margin of safety is correct?

a. The margin of safety indicates the risk of losing money.
b. The break-even sales volume is not considered.
c. Margin of safety is expressed in sales dollars only.
d. The higher the fixed costs, the lower the margin of safety.
Multiple Choice Answers

1. a (LO1)

$12, 000
= 10,000 units
$2 - $0.80

$2 × 10,000 = $20,000

2. d (LO1)

$2 - $0.80
× 100% = 60%
$2

3. c (LO1)

$12, 000 + $33, 000

= 37,500 units
$2 - $0.80

4. d (LO2)

Variable cost = $0.80 × (1 + 15%) = $0.92

$2 - $0.92
Contribution margin ratio = × 100% = 54%
$2
$15,120
New break-even point in sales dollars = = $28,000
54%

5. a (LO2)

6. b (LO2)

7. b (LO4)

$10,500
Before-tax profit = = $15,000
1 - 30%
$3, 000 + $15, 000
Target volume in units = = 30,000 key chains
$1 - $0.40

8. c (LO4, LO5)
9. a (LO4)

Weighted-average contribution margin per unit = ($5 − $3) × 0.75 + ($8 − $4) × $0.25 =
$2.50

$10, 000
The multiproduct break-even volume = = 4,000 units
$2.50

X’s share of the total output = 4,000 × 0.75 = 3,000 units

10. a (LO5)

11. a (LO1)

Contribution margin = $48,000 − $12,000 − $16,000 − $9,000 = $11,000

Contribution margin per unit = $11,000/2,000 = $5.50

12. a (LO2)
 Demonstration Problem 1

The Power Tool Division of ABC Hardware sells one product, Jig Saw, and has the following
data for the second quarter:

Units of output 1,200 units

Price per unit $ 150
Variable cost per unit 90
Total fixed costs 48,000

Required:

Determine the following:

1. Quarterly operating profit when 1,200 units are sold.
2. Break-even volume in units.
3. Contribution margin ratio.
4. Break-even volume in sales dollars.
5. Sales dollars and units needed to generate an operating profit of $57,000.
6. Number of units sold that would produce an operating profit of 15% of sales dollars.
 Demonstration Problem 1 – Solution

CM = Contribution margin
F = Fixed costs
P = Price
V – Variable costs per unit
X = Units of output

Part 1

Operating profit = (P – V)X + F = ($150 – $90) × 1,200 – $48,000 = $24,000

Part 2

F $48,000
Break-even volume (in units) = = = 800 units
P–V $150 – $90

Part 3

P–V $150 – $90

Contribution margin ratio = = = 40%
P $150

Part 4

F $48,000
Break-even volume (in sales dollars) = = = $120,000
CM ratio 40%

Part 5

F + Target profit $48,000 + $57,000

Target volume (in sales dollars) = = = $262,500
CM ratio 40%

F + Target profit $48,000 + $57,000

Target volume (in units) = = = 1,750 units
Unit CM $150 – $90

Part 6

Let X = Number of units sold that would produce an operating profit of 15% of sales dollars
PX × 15% = (P – V) X – F
$150X × 15% = ($150 – $90)X – $48,000
$22.50X = $60X – $48,000
$48,000 = $60X – $22.50X
$48,000 = $37.50X
X = 1,280 units
 Demonstration Problem 2

(Same background information as in Demonstration Problem 1.)

The Power Tool Division of ABC Hardware sells one product, Jig Saw, and has the following
data for the second quarter:

Units of output 1,200 units

Price per unit $ 150
Variable cost per unit 90
Total fixed costs 48,000

Required:

Assume that the Power Tool Division of ABC Hardware now faces a tax rate of 30 percent.
Determine the number of Jig Saws required to generate the after-tax operating profit of $16,800.
 Demonstration Problem 2 – Solution

CM = Contribution margin
F = Fixed costs
t = Tax rate

Target volume (in units) =

F + [Target profit/(1 – t)] $48,000 + [$16,800/(1 – 0.30)]

= = 1,200 units
Unit CM $150 – $90
 Demonstration Problem 3

(Same background information as in Demonstration Problem 1.)

The Power Tool Division of ABC Hardware sells one product, Jig Saw, and has the following
data for the second quarter:

Units of output 1,200 units

Price per unit $150
Variable cost per unit 90
Total fixed costs 48,000

Required:

Assume that the Power Tool Division introduces a second product, Circular Saw, with a unit
price of $200 and a unit variable cost of $120. The total fixed cost is increased to $68,000. The
manager of ABC Hardware estimates that Jig Saws and Circular Saws will sell in a 3:2 ratio.
Calculate the break-even volume in units using:

1. The fixed product mix method.

2. The weighted-average contribution margin method.
 Demonstration Problem 3 – Solution

CM = Contribution margin
F = Fixed costs
P = Price
V – Variable costs per unit

Part 1

According to the product mix, out of every 5 units sold, three will be Jig Saws and two will be
Circular Saws. Let X represent the number of such 5-unit packages to break even.

Unit contribution margin = P – V:

Jig Saws = $150 – $90 = $60
Circular Saws = $100 – $120 = $20

Contribution margin for each 5-unit package = ($60 × 3) + ($80 × 2) = $340

F $68,000
Break-even volume (in units) = = = 200 5-unit packages
P–V $340

This means that a total of 600 Jig Saws (or 200 units × 3) and 400 Circular Saws (or 200 units ×
2) must be sold to break even.

Part 2

The produce mix consists of 60 % (or 3 ÷ 5) Jig Saws and 40% (or 2 ÷ 5) Circular Saws.

Weighted-average contribution margin per unit = (0.60 × $60) + (0.40 × $80) = $68

F $68,000
Break-even volume (in units) for both packages = = = 1,000 units
Unit CM $68

To break even, 600 Jig Saws (or 1,000 units × 60%) and 400 Circular Saws (or 1,000 units ×
40%) must be sold.