CHAPTER 1: COST-VOLUME-PROFIT ANALYSIS, ABSORPTION COSTING, AND

VARIABLE COSTING
AN OVERVIEW OF ABSORPTION AND VARIABLE COSTING
Absorption costing is the traditional approach to product costing. Absorption costing treats the costs of
all manufacturing components (direct material direct labor, variable overhead and fixed overhead) as
inventoriable or product costs in accordance with generally accepted accounting principles (GAAP).
Absorption costing is also known as full costing.
Under absorption costing, costs incurred in the non-manufacturing areas of the organization are
considered period costs and expensed in a manner that properly matches with revenue.
Absorption costing presents expenses on an income statement according to their functional
classifications. A functional classification is a group of costs that were all incurred for the same principal
purpose. Functional classifications include categories such as cost of goods sold, selling expense, and
administrative expense.
Under FASB Statement 34, certain interest costs may be capitalized during a period of asset
construction. If a company is capitalizing or has capitalized interest costs, these costs will not be shown
on the income statement but will become a part of the fixed asset cost. The fixed asset cost is then
depreciated as part of fixed overhead. Thus, although interest is typically considered period cost, it may
be included as fixed overhead and affect the overhead application rate.
Exhibit 1.1: Absorption Costing Model

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Variable costing- facilitates the use of models for analyzing break-even point, cost-volume-profit
relationships, the margin of safety. Variable costing is a cost accumulation method that includes only
variable production costs (direct material, direct labor, and variable overhead) as product or
inventoriable costs. Under this method, fixed manufacturing overhead is treated as a period cost.

Like absorption costing, variable costing treats costs incurred in the organization’s selling and
administrative areas as period costs. Variable costing income statements typically present expenses
according to cost behavior (variable and fixed), although they may also present expenses by functional
classifications within the behavioral categories. Variable costing has also been known as direct costing.
Exhibit 1.2 presents the variable costing model.
Exhibit 1.2: Variable costing Model

Two basic differences can be seen between absorption and variable costing. The first difference is the
way fixed overhead (FOH) is treated for product costing purposes.
Under absorption costing, FOH is considered as product cost; under variable costing, it is considered as
period cost. Absorption costing advocates contend that products cannot be made without the capacity
provided by fixed manufacturing costs and so these costs are product costs.
Variable costing advocates contend that the fixed manufacturing costs would be incurred whether or not
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production occurs and, therefore, cannot be product costs because they are not caused by the
production.
The second difference is in the presentation of costs on the income statement. Absorption costing
classifies expenses by function; whereas variable costing categorizes expenses first by behavior and then
may further classify them by function.
Variable costing allows costs to be separated by cost behavior on the income statement or internal
management reports. The cost of goods sold, under variable costing, is more appropriately called
variable cost of goods sold (VCGS) because it is composed only of variable production costs.
Sales (S) minus the variable cost of goods sold is called product contribution margin (PCM) and
indicates how much revenue is available to cover all period expenses and potentially provide net
income.
Variable non-manufacturing period expenses (VNME), are deducted from the product contribution
margin to determine the amount of total contribution margin (TCM).
The total contribution margin is the difference between total revenues and total variable expenses. This
amount indicates the dollar figure available to “contribute” to the coverage of all fixed expenses, both
manufacturing and nonmanufacturing. After fixed expenses are covered, any remaining contribution
margin provides income to the company. A variable costing income statement is also referred to as a
contribution income statement.
A formula representation of a variable costing income statement

Major authoritative bodies of the accounting profession, such as the Financial Accounting Standards
Board and Securities and Exchange Commission, believe that absorption costing provides external
parties with a more informative picture of earnings than variable costing. By specifying that absorption
costing must be used to prepare external financial statements, the accounting profession has, in effect,
disallowed the use of variable costing as a generally accepted inventory method for external reporting
purposes. Additionally, the IRS requires absorption costing for tax purposes.

The Tax Reform Act of 1986 requires all manufacturers and many wholesalers and retailers to include
many previously expensed indirect costs in inventory. This method is referred to as “super-full
absorption” or uniform capitalization. The uniform capitalization rules require manufacturers to assign
to inventory all costs that directly benefit or are incurred because of production including some
administrative and other costs. Wholesalers and retailers, who previously did not need to include any
indirect costs in inventory, now must inventory costs for items such as off-site warehousing, purchasing
agents’ salaries, and repackaging.
Cost behavior (relative to changes in activity) cannot be observed from the absorption costing income

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statement or management report. However, cost behavior is extremely important for a variety of
managerial activities including cost-volume-profit analysis, relevant costing, and budgeting.

Absorption and Variable Costing Illustrations

Comfort Valve Company makes a single product, the climate control valve. Comfort Valve Company is
a 3-year-old firm operating out of the owner’s home. Data for this product are used to compare
absorption and variable costing procedures and presentations. The company employs standard costs for
material, labor, and overhead. Exhibit 1.3 gives the standard production costs per unit, the annual
budgeted nonmanufacturing costs, and other basic operating data for Comfort Valve Company. All
standard and budgeted costs are assumed to remain constant over the three years 2000 through 2002
and, for simplicity, the company is assumed to have no Work in Process Inventory at the end of a
period.4 Also, all actual costs are assumed to equal the budgeted and standard costs for the years
presented. The bottom section of Exhibit 11–3 compares actual unit production with actual unit sales to
determine the change in inventory for each of the three years.
The company determines its standard fixed manufacturing overhead application rate by dividing
estimated annual FOH by expected annual capacity. The total estimated annual fixed manufacturing
overhead for Comfort Valve is $16,020 and the expected annual production is 30,000 units. These
figures provide a standard FOH rate of $0.534 per unit. Fixed manufacturing overhead is typically
under or over applied at year-end when a standard, the predetermined fixed overhead rate is used
rather than actual FOH cost.
Under- or over application is caused by two factors that can work independently or simultaneously.
These two factors are cost differences and utilization differences. If the actual FOH cost differs from the
expected FOH cost, a fixed manufacturing overhead spending variance is created. If actual capacity
utilization differs from expected utilization, a volume variance arises.
Actual costs can also be used under either absorption or variable costing. Standard costing was chosen
for these illustrations because it makes the differences between the two methods more obvious. If actual
costs had been used, production costs would vary each year and such variations would obscure the
distinct differences caused by the use of one method, rather than the other, over a period of time.
Standard costs are also treated as constant over time to more clearly demonstrate the difference
between absorption and variable costing. The independent effects of these differences are as follows:
Actual FOH Cost > Expected FOH Cost = Under applied FOH
Actual FOH Cost < Expected FOH Cost = Over applied FOH
Actual Utilization > Expected Utilization = Over applied FOH
Actual Utilization < Expected Utilization = Under applied FOH

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 Basic Data for 2000, 2001, and 2002 Exhibit 1.3
Sales price per unit------------------------------------------------------------------------------$ 6.00
Standard variable cost per unit
Direct material -----------------------------------------------------------------------------------$ 2.040
Direct labor-----------------------------------------------------------------------------------------1.500
Variable manufacturing overhead-------------------------------------------------------0.180
Total variable manufacturing cost per unit-----------------------------------------$ 3.720
Standard fixed factory overhead rate = Budgeted annual fixed factory overhead
Budgeted annual capacity in units

FOH rate = $16, 020/30,000 = $ 0.534

Total absorption cost per unit:
Standard variable manufacturing cost--------------------------------------------$3.720
Standard fixed manufacturing overhead (SFOH)----------------------------0.534
Total absorption cost per unit--------------------------------------------------------$4.254
Budgeted non-manufacturing expense:
Variable selling expense per unit-----------------------------------------------------$0.24
Fixed selling and administrative expenses --------------------------------------2, 340
Total budgeted non-manufacturing expense= (0.24 per unit + 2,340)

2000 2001 2002 Total

Actual units made 30, 000 29,000 31,000 90,0000
Actual unit sales 30,000 27,000 33,000 90,000
Change in FG inventory 0 +2,000 -2,000 0

In most cases, however, both costs and utilization differ from estimates. When this occurs, no
generalizations can be made as to whether FOH will be under or over-applied. Assume that
Comfort Valve Company began operations in 2000. Production and sales information for the years
2000 through 2002 are shown in Exhibit 1.3.
Because the company began operations in 2000, that year has a zero balance for beginning the
Finished Goods Inventory. The next year, 2001, also has a zero-beginning inventory because all
units produced in 2000 were also sold in 2000. In 2001 and 2002, production and sales quantities
differ, which is a common situation because production frequently “leads” sales so that inventory
can be stock-piled for a later period.
The illustration purposefully has no beginning inventory and equal cumulative units of production
and sales for the 3 years to demonstrate that, regardless of whether absorption or variable costing is
used, the cumulative income before taxes will be the same ($128,520 in Exhibit 1.4) under these

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 conditions. Also, for any particular year in which there is no change in inventory levels from the
beginning of the year to the end of the year, both methods will result in the same net income. An
example of this occurs in 2000 as is demonstrated in Exhibit 1.4.
Because all actual production and operating costs are assumed to be equal to the standard and
budgeted costs for the years 2000 through 2002, the only variances presented are the volume
variances for 2001 and 2002. These volume variances are immaterial and are reflected as
adjustments to the gross margins for 2001 and 2002 in Exhibit 1.4.

Volume variances under absorption costing are calculated as standard fixed overhead (SFOH) of
$0.534 multiplied by the difference between expected capacity (30,000 valves) and actual
production. For 2000, there is no volume variance because expected and actual production is
equal. For 2001, the volume variance is $534 unfavorable, calculated as [$0.534 *(29,000 -
30,000)]. For 2002, it is $534 favorable, calculated as [$0.534 * (31,000 - 30,000)].

Variable costing does not have a volume variance because fixed manufacturing overhead is not
applied to units produced but is written off in its entirety as a period expense.

Absorption and Variable Costing Income Statements for 2000, 2001, and 2002
Exhibit 1.4

Absorption Costing Presentation

2000 2001 2002 Total
Sales ($6 per unit) $180,000 $162,000 $198,000 $540,000
CGS ($4.254 per unit) (127,620) (114,858) (140,382) (382,860)
Standard Gross Margin $ 52,380 $ 47,142 $ 57,618 $157,140
Volume Variance (U) 0 (534) 534 0
Adjusted Gross Margin $ 52,380 $ 46,608 $ 58,152 $157,140
Operating Expenses
Selling and administrative (9,540) (8,820) (10,260) (28,620)
Income before Tax $ 42,840 $ 37,788 $ 47,892 $128,520

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Variable Costing Presentation
2000 2001 2002 Total
Sales ($6 per unit) $180,000 $162,000 $198,000 $540,000
Variable CGS ($3.72 per unit) (111,600) (100,440) (122,760) (334,800)
Product Contribution Margin $68,400 $ 61,560 $ 75,240 $205,200
Variable Selling Expenses
($0.24 3 *units sold) (7,200) (6,480) (7,920) (21,600)
Total Contribution Margin $ 61,200 $ 55,080 $ 67,320 $183,600
Fixed Expenses
Manufacturing $ 16,020 $ 16,020 $ 16,020 $ 48,060
Selling and administrative 2,340 2,340 2,340 7,020
Total fixed expenses $ (18,360) $ (18,360) $ (18,360) $ (55,080)
Income before Tax $ 42,840 $ 36,720 $ 48,960 $128,520
Differences in Income before Tax $0 $1,068 $ (1,068) $0

In Exhibit 1.4, income before tax for 2001 for absorption costing exceeds that of variable costing by
$1,068. This difference is caused by the positive change in inventory (2,000 shown in Exhibit 1.3) to
which the absorption SFOH of $0.534 per unit has been assigned (2,000 *$0.534 = $1,068). This
$1,068 is the fixed manufacturing overhead added to absorption costing inventory and therefore not
expensed in 2001. Critics of absorption costing refer to this phenomenon as one that creates illusionary
or phantom profits. Phantom profits are temporary absorption-costing profits caused by producing
more inventory than is sold. When sales increase to eliminate the previously produced inventory, the
phantom profits disappear. In contrast, all fixed manufacturing overhead, including the $1,068, is
expensed in its entirety in variable costing.
Exhibit 1.3 shows that in 2002 inventory decreased by 2,000 valves. This decrease multiplied by the
SFOH ($0.534), explains the $1,068 by which 2002 absorption costing income falls short of variable
costing income in Exhibit 1.4. This is because the fixed manufacturing overhead is written off in
absorption costing through the cost of goods sold at $0.534 per valve for all units sold in excess of
production (33,000 - 31,000 = 2,000) results in the $1,068 by which absorption costing income is lower
than variable costing income in 2002.
Variable costing income statements are more useful internally for short-term planning, controlling,
and decision-making than absorption costing statements. To carry out their functions, managers need

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to understand and be able to project how different costs will change in reaction to changes in activity
levels. Variable costing through its emphasis on cost behavior provides that necessary information.
The income statements in Exhibit 1.4 show that absorption and variable costing tend to provide
different income figures in some years. Comparing the two sets of statements illustrates that the
difference in income arises solely from which production component costs are included in or
excluded from product cost for each method.
If no beginning or ending inventories exist, cumulative total income under both methods will be
identical. For the Comfort Valve Company over the three-year period, 90,000 valves are produced
and 90,000 valves are sold. Thus, all the costs incurred (whether variable or fixed) are expensed in
one year or another under either method. The income difference in each year is caused solely by the
timing of the expensing of fixed manufacturing overhead.

Comparison of the two approaches

Whether absorption costing income is greater or less than variable costing income depends on the
relationship of production to sales. In all cases, to determine the effects on income, it must be
assumed that variances from the standard are immaterial and that unit product costs are constant
over time. Exhibit 1.5 shows the possible relationships between production and sales levels and the
effects of these relationships on income. These relationships are as follows
If production is equal to sales, absorption costing income will equal variable costing income.
If production is greater than sales, absorption costing income is greater than variable costing
income. This result occurs because some fixed manufacturing overhead cost is deferred as part
of inventory cost on the balance sheet under absorption costing, whereas the total amount of
fixed manufacturing overhead cost is expensed as a period cost under variable costing.
If production is less than sales, income under absorption costing is less than income under
variable costing. In this case, absorption costing expenses all of the current period fixed
manufacturing overhead cost and releases some fixed manufacturing overhead cost from the
beginning inventory where it had been deferred from a prior period.
This process of deferring and releasing fixed overhead costs in and from inventory makes
income manipulation possible under absorption costing, by adjusting the production of
inventory relative to sales. For this reason, some people believe that variable costing might be
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 more useful for external purposes than absorption costing. For internal reporting, variable
costing information provides managers with information about the behavior of the various
product and period costs. This information can be used when computing the break-even point
and analyzing a variety of cost-volume-profit relationships.
Production/Sales Relationships and Effects on Income Measurement and Inventory Assignments
Exhibit 1.5

Absorption Vs. Variable Absorption Vs. Variable

Income statements Balance sheet
Income before tax Ending inventory
P=S AC = VC No additional difference
No difference from the beginning inventory FOHEI = FOHBI
FOHEI = FOHBI = 0
P<S AC>VC Ending inventory increased
(Stockpiling By the amount of fixed OH in ending (by fixed OH in additional
inventory) inventory minus FOH in the beginning units because P > S)
inventory FOHEI > FOHBI
FOHEI – FOHBI = + amount
P<S AC<VC Ending inventory difference
(Selling of By the amount of FOH released from the reduced (by FOH from
beginning balance sheet beginning inventory BI charged to cost of goods
inventory) FOHEI – FOHBI = – amount sold)
FOHEI < FOHBI
The effects of the relationships presented here are based on two qualifying assumptions:
1. That unit costs are constant over time; and
2. That any fixed cost variances from standard are written off when incurred rather than being
rotated to inventory balances.
where P= Production FOHEI = fixed overhead ending inventory
S = Sales FOHBI = fixed overhead beginning inventory
AC = Absorption Costing
VC = Variable Costing

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 COST-VOLUME-PROFIT (CVP) ANALYSIS: UNDERSTANDING THE
CONCEPTS OF BREAK-EVEN-ANALYSIS AND MARGIN OF SAFETY
Cost-volume-profit (CVP) analysis is one of the most powerful tools that helps managers as they make
decisions by facilitating quick estimation of net income at different levels of activity. In other words, it
helps them to understand the interrelationship between cost, volume, and profit in an organization by
focusing on interactions between the following five elements: prices of products, volume or level of
activity, per unit variable costs, total fixed costs, and mix of products sold.
CVP analysis helps managers to understand the interrelationship between cost, volume, and profit. So
it is a vital tool in many business decisions. These decisions include, for example, what products to
manufacture or sell, what pricing policy to follow, what marketing strategy to employ, and what type of
productive facilities to acquire.

VARIABLE AND FIXED COST BEHAVIOR AND PATTERNS

Cost behavior is the manner in which a cost changes as a related activity changes. The behavior of cost
is useful to managers for a variety of reasons. For example, to predict profit as sales and production
volume change, to estimate cost which affects a variety of decisions. Understanding the behavior of a
cost depends on cost drivers and their relevant range.
Variable costs are costs that vary in proportion to changes in activity base. When the activity base is
unit-produced direct materials and direct labor is classified as a variable cost.
Fixed costs are costs that remain the same in total dollar amount as the activity base changes. When
the activity base is units produced many factory overhead costs such as straight-line depreciation is
classified as a fixed cost.
A. Contribution Margin versus Gross Margin
The form of income statement used in CVP analysis is shown in Exhibit 1.6 i.e., the projected income
statement of Sample Merchandising Company for the month ended January 31, 2006. This income
statement is called the contribution approach to the income statement. The contribution income
statement emphasizes the behavior of the costs and therefore is extremely helpful to managers in
judging the impact of changes in selling price, cost, or volume on profits.
Exhibit 1.6
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31, 2006
Total Unit
Sales (10, 000 units) Br. 150, 000 Br.15.00
Variable Expenses 120, 000 12.00
Contribution Margin Br. 30, 000 Br.3.00
Fixed Expenses 24, 000
Net Income Br. 6, 0000
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In the income statement here above, sales, variable expenses, and contribution margin are expressed
on a per-unit basis as well as in total. This is commonly done on income statements prepared for
management’s own use since it facilitates profitability analysis.
The contribution margin represents the amount remaining from sales revenue after variable expenses
have been deducted. Thus, it is the amount available to cover fixed expenses and then to provide
profit for the period.
The per unit contribution margin indicates by how much Birr the contribution margin is increased for
each unit sold. Sample Merchandising Company’s contribution margin of Br.3.00 per unit indicates
that each unit sold contributes Br.3.00 to covering fixed expenses and providing for a profit. If the
firm had sold 5, 000 units, this would cover only Br.15, 000 of their fixed expenses (5, 000 units x
Br.3.00 per unit). Therefore, the firm would have a net loss of Br.9, 000(15,000- 24,000). If enough
units can be sold to generate Br.24, 000 in contribution margin, then all of the fixed costs will be
covered and the company will have managed to show neither profit nor loss but just cover all of its
costs. To reach this point (called the break-even point), the company will have to sell 8, 000 units in a
month, since each unit sold yields Br. 3.00 in contribution margin.
Total Per Unit
Sales (8, 000 units) Br.120, 000 Br.15.00
Variable expenses 96, 000 12.00
Contribution margin Br. 24, 000 Br.3.00
Fixed expenses 24,000
Net income Br. 0

Too often people confuse the terms contribution margin and gross margin. Gross margin (which is
also called gross profit) is the excess of sales over the cost of goods sold (that is, the cost of the
merchandise that is acquired or manufactured and then sold). It is a widely used concept, particularly
in the retailing industry.
Contribution Margin Ratio (Cm-Ratio)
In addition to being expressed on a per unit basis, revenue, variable expenses, and contribution
margin for Sample Merchandising Company can also be expressed on a percentage basis:
Total Per Unit Percentage
Sales (10, 000 units) Br.150, 000 Br.15.00 100%
Variable expenses 120, 000 12.00 80%
Contribution margin Br.30, 000 Br.3.00 20%
Fixed expenses 24,000
Net income Br. 6, 000

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The percentage of the contribution margin to total sales is referred to as the contribution margin ratio
(CM-ratio). This ratio is computed as follows:

CM-ratio= Contribution Margin or

Sales
Contribution margin ratio = 1 – variable cost ratio.
The variable-cost ratio or variable-cost percentage is defined as all variable costs divided by sales.
Thus, a contribution margin of 20% means that the variable-cost ratio is 80%.
The contribution margin percent or contribution margin ratio, also called profit/volume ratio (p/v
ratio) is 20%. This means that for each birr increase in sales, the total contribution margin will
increase by 20 cents (Br.1 sales x CM ratio of 40%). Net income will also increase by 20 cents,
assuming that there are no changes in fixed costs.

BREAK-EVEN ANALYSIS USES AND TECHNIQUES

The study of cost-volume-profit analysis is usually referred to as a break-even analysis. This term is
misleading because finding the break-even point is often just the first step in planning a decision. CVP
analysis can be used to examine how various alternatives that a decision maker is considering affect
operating income. The break-even point is frequently one point of interest in this analysis.
The Break-even point can be defined as the point where total sales revenue equals total expenses, i.e.,
total variable cost plus total fixed costs. It is a point where the total contribution margin equals to total
fixed expenses. Stated differently, it is a point where the operating income is zero. There are three
alternative approaches to determining the break-even point:
 Equation technique,
 Contribution margin technique and
 Graphical method.

EQUATION TECHNIQUE:
It is the most general form of break-even analysis that may be adapted to any conceivable cost-
volume-profit situation. This approach is based on the profit equation. Income (or profit) is equal to
sales revenue minus expenses. If expenses are separated into variable and fixed expenses, the essence
of the income statement is captured by the following equation.
Profit= Sales revenue-Variable expenses-Fixed expenses
Profit (net income) is the operating income plus non-operating revenues (such as interest revenue)
minus non-operating costs (such as interest cost) minus income taxes. For simplicity, throughout this
unit non-operating revenues and non-operating cost are assumed to be zero. Thus, the above formula
can be restated as follows:
(P XQ)-(VxQ)-F=Profit (Net income)
Where P=sales price Q=break-even unit sales V= variable expenses per unit F=fixed expenses
per period, NI= net income
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At the break-even point, net income=0 because total revenue equals total expenses.
That is, NI=PQ-VQ-F
0= PQ-VQ-F……………………………………equation (1)

CONTRIBUTION-MARGIN TECHNIQUE
The contribution margin technique is merely a short version of the equation technique. The approach
centers on the idea that each unit sold provides a certain amount of fixed costs. When enough units
have been sold to generate a total contribution margin equal to the total fixed expenses, the break-
even point (BEP) will be reached. Thus, one must divide the total fixed costs by the contribution
margin being generated by each unit sold to find units sold to break even.
BEP= Fixed expenses
Unit contribution margin
Given the equation for net income, you can arrive at the above shortcut formula for computing break-
even sales in units as follows:
NI=PQ-VQ-F
0=Q (P-V)-F because at BEP net income equals zero.
Q (P-V)=F…divide both sides by (p-v)
Q = F ………………….…. equation (2)
P-V
There is a variation of this method that uses the CM ratio of the unit contribution
margin. The result is the break-even point in total sales birrs rather than in total units sold.
BEP (in sales birrs) =Fixed expenses= F
CM ratio P-V
P
This approach to break-even analysis is particularly useful in those situations where a company has
multiple product lines and wishes to compute a single break-even point for the company as a whole.
More is said on this point in a later section titled Sales Mix and CVP Analysis.
The contribution- margin and equation approaches are two equivalent techniques for finding the
break-even point. Both methods reach the same conclusion, and so personal preference dictates
which approach should be used.

GRAPHICAL METHOD
In the graphical method we plot the total costs and revenue lines to obtain their point of intersection,
which is the breakeven point.
Total costs line is the sum of the fixed costs and the variable costs. Total Revenue Line is line
representing total sales birrs at the activity you have selected. The break-even point is where the total
revenues line and the total costs line intersect. This is where total revenues just equal total costs.

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Example (1) Zoom Company manufactures and sells a telephone answering machine. The company’s
income statement for the most recent year is given below:
Total Per Unit Percent
Sales (20,000 units) Br. 1,200,000 Br. 60 100
Variable expenses Br. 900,000 Br. 45 ?
Contribution Margin Br. 300,000 Br. 15 ?
Fixed Expenses Br. 240,000
Net Income Br. 60,000
Based on the above data, answer the following questions.
A. Compute the company’s CM ratio and variable expense ratio.
B. Compute the company’s break-even point in both units and sales birrs. Use the above three
approaches to compute the break-even point.
C. Assume that sales increase by Br. 400,000 next year. If cost behavior patterns remain
unchanged, by how much will the company’s net income increase?

APPLYING CVP ANALYSIS

Sensitivity “What If” Analysis
Sensitivity analysis is a “what if” technique that examines how a result will change if the original
predicted data are not achieved or if an underlying assumption changes. In the context of CVP,
sensitivity analysis answers such questions as, what will operating income be if the output level
decreases by a given percentage from the original reduction? And what will be the operating income if
variable costs per unit increase? The sensitivity analysis to various possible outcomes broadens
managers’ perspectives as to what might actually occur despite their well-laid plans.
Example (2) Zena Concepts, Inc., was founded by Zemenu Adugna, a graduate student in
engineering, to market a radical new speaker he had designed for an automobile’s sound system. The
company’s income statement for the most recent month is given below:
Total Per Unit
Sales (400 speakers) Br.100, 000 Br.250
Variable expenses 60, 000 150
Contribution margin 40, 000 Br.100
Fixed expenses 35, 000
Net income Br.5, 000
Yohannes Tilahun, the senior accountant at Zena Concepts, wants to demonstrate to the company’s
president how the concepts developed on the preceding pages can be used in planning and decision-
making. To this end, Yohannes will use the above data to show the effects of changes in variable costs,
fixed costs, sales, and sales volume on the company’s profitability.
Changes in Fixed Costs and Sales Volume: Zena Concepts is currently selling 400 speakers per
month (monthly sales of Br.100, 000). The sales manager feels that a Br.10, 000 increase in the

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monthly advertising budget would increase monthly sales by Br.30, 000. Should the advertising budget
will be increased or not increased?
Changes in Variable Costs and Sales Volume: Refer to the original data. Management is
contemplating the use of high- quality components, which would increase variable costs by Br.10 per
speaker. However, the sales manager predicts that the higher overall quality would increase sales to
480 speakers per month. Should the higher quality component be used?
Change in Fixed Cost, Sales Price, and Sales Volume: Refer to the original data and recall that the
company is currently selling 400 speakers per month. To increase sales, the sales manager would like
to cut the selling price by Br 20 per speaker and increase the advertising budget by Br 15, 000 per
month. The sales manager argues that if these two steps are taken, unit sales will increase by 50%.
Should the change be made?
Changes in Variable Cost, Fixed Cost, and Sales Volume: Refer to the original data. The sales
manager would like to replace the sales staff on a commission basis of Br 15 per speaker sold, rather
than on flat salaries that now total Br 6, 000 per month. The sales manager is confident that the
change will increase monthly sales by 15%. Should the change be made?
Changes in Regular Sales Price: Refer the original data. The company has an opportunity to make a
bulk sale of 150 speakers to wholesalers if an acceptable price can be worked out. This sale would not
disturb the company’s regular sales. What price per speaker should be quoted to the wholesaler if
Zena Concepts wants to increase its monthly profits by Br 3, 000?

TARGET NET PROFIT ANALYSIS

Managers can also use CVP analysis to determine the total sales in units and birrs needed to reach a
target profit. The method used for computing desired or targeted sales volume in units to meet the
desired or targeted net income is the same as was used in our earlier breakeven computation.

Example (3) Tantu Company manufactures and sales a single product. During the year just ended
the company produced and sold 60,000 units at an average price of Br.20 per unit. Variable
manufacturing costs were Br 8 per unit, and variable marketing costs were Br 4 per unit sold. Fixed
costs amounted to Br. 180,000 for manufacturing and Br.72, 000 for marketing. There was no year-
end work-in-progress inventory. Ignore income taxes.
Required:
A. Compute Tantu’s breakeven point (BEP) in sales birrs for the year.
B. Compute the number of sales units required to earn a net income of Br 180,000 during the year

THE MARGIN OF SAFETY

The margin of safety is the excess of budgeted (or actual) sales over the breakeven volume of sales. It
states the amount by which sales can drop before losses begin to be incurred. In other words, it is the

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amount of sales revenue that could be lost before the company’s profit would be reduced to zero.
The formula for its calculations follows: Total sales - Break even Sales = Margin of safety
The margin of safety can also be expressed in percentage form. This percentage is obtained by
dividing the margin of safety in birr terms by total sales:
Margin of safety in birrs = Margin of safety Ratio
Total sales
Example (4): Consider the cost structure for ABC Company and XYZ in Exhibit 1-7
ABC Co. and XYZ Co.
Comparative Cost Structures
ABC Co. XYZ Co.
Amount Percent Amount Percent
Sales Br. 500,000 100 Br. 500,000 100
Variable costs 100,000 20 300,000 60
Contribution Margin 400,000 80 200,000 40
Fixed costs 300,000 100,000
Net income Br. 100,000 Br. 100,000
Required: compute BEP, the margin of safety, and the margin of safety ratio for each company.

IMPACT OF INCOME TAXES ON CVP ANALYSIS

Thus far we have ignored income taxes. However, profit-seeking enterprises must pay income taxes
on their profits. A firm’s net income after tax, the amount of income remaining after subtracting the
firm’s income-tax expense, is less than its before-tax income. This fact is expressed in the following
formula:
NIAT = NIBT (1 – tax rate) Where NIAT = net income after taxes NIBT=net income before taxes
The requirement that companies pay income taxes affects their CVP relationships.
To earn a particular after-tax net income will require greater before-tax income than if there were no
tax.
Example (5) Hydro System Engineering Associates, Inc. provides consulting services to city water
authorities. The consulting firm’s contribution margin ratio is 20%, and its annual fixed expenses are
Br. 120, 000. The firm’s income-tax rate is 40%.
Required:
A. Calculate the firm’s break-even volume of service revenue.
B. How much before-tax income must the firm earn to make an after-tax net income of Br. 48, 000?
C. What level of revenue for consulting services must the firm generate to earn an after-tax income of
Br.48, 000?
D. Suppose the firm’s income-tax rate rises to 45 percent. What will happen to the break-even level
of consulting service revenue?

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CVP ANALYSIS WITH MULTIPLE PRODUCTS
Definition of Sales Mix
The term sales mix (also called revenue mix) is defined as the relative proportions or combinations of
quantities of products that comprise total sales. If the proportions of the mix change, the CVP
relationships also change. Thus, managers try to achieve the combination, or mix, that will yield the
greatest amount of profit.
A shift in sales mix from high-margin items to low-margin items can cause total profits to decrease
even though total sales may increase. Conversely, a shift in the sales mix from low-margin items to
high-margin items can cause the reverse effect-total profit may increase even though total sales
decrease.

SALES MIX AND CVP ANALYSIS

To this point the discussion on CVP analysis focused on a firm that sells a single product; such a firm
is generally unrealistic, existing only in the minds of textbook writers. This section of the unit
examines the usefulness of the CVP technique for firms that deal in several products. In the general
case the CVP equation could be presented as:
P1Q1 + P2Q2+...+PnQn – V1Q1 – V2Q2-...VnQn-FC = NI
where Pi = Selling price per unit of product i
Qi = Number units of i produced and sold
Vi = Unit variable cost of product i
FC = Fixed Cost Per Period
NC = Net Income
In a multi-product firm, break-even analysis is somewhat more complex. The reason is that different
products will have different selling prices, different costs, and different contribution margins.
Using the contribution margin approach, the computation of the break-even point (BEP) in a multi-
product firm follows:
BEP (in units) =Total fixed expenses
Weighted average CM
BEP (in birrs) = Total Fixed Expenses
CM – ratio
Weighted average unit contribution margin is the average of the several products’ unit contribution
margins, weighted by the relative sales proportion of each product.
For a company manufacturing and selling three products (X, Y and Z), with sales of mix of n1,n2 and
n3, respectively, the break-even point may be given by the following short cut formula:
BEP (in units) = Total fixed costs
cm1n1 + cm2n2 + cm3n3
n1 + n2 + n3

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 Where cmi = Unit contribution margin for product i.
n= sales proportion of each product
To prove the above formula, let us begin with general CVP equation for a company producing three
products.
NI = P1Q1 + P2Q2 + P3Q3- V1Q1 – V2Q2 – V3Q3 – FC
Where, NI = net income
Pi = Unit sales price for product i
Qi = Sales volume for product
Vi = Unit variable cost for product i
FC = Fixed cost per period
The difference between total sales and total variable costs for each product, i.e. PiQi – ViQi, equals
their total contribution margin (TCM). The above general formula can be restated as follows:
NI = TCM1 + TCM2 + TCM3 – FC
0 = TCM1 + TCM2+ TCM3 – FC (NI equals zero at BEP)
0 = CM1Q1 + CM2Q2 + CM3Q3 – FC
Where CMi=contribution margin per unit for product i
Qi = sales volume for product i to break even
Given the sales mix X: Y: Z = n1: n2 : n3, and assuming that the company break-even at “Q” units, then
0 = CM1 n1Q + CM2n2Q + CM3n3 Q – FC
n1 + n2 + n3
0= Q (Cm1n1 + Cm2n2 + Cm3n3) – FC
n1 + n2 + n3
FC= Q (Cm1n1 + Cm2n2 + Cm3n3)
n1 + n2 + n3
Q (Cm1n1 + Cm2n2 + Cm3n3) = FC (n1 + n2 + n3)
Q= FC (n1 + n2 + n3)
Cm1n1 + Cm2n2 + Cm3n3
Q= FC …………….. equation (1)
Cm1n1 + Cm2n2 + Cm3n3
n1 + n2 + n3
Here in equation (1), the denominator, Cm1n1 + Cm2n2 + Cm3n3 , is weighted average contribution margin.
n1 + n2 + n3
Similarly, the company’s break-even sales in birrs would be calculated as
BEP (in birrs) = Fixed expenses
CM – ratio
= Fixed expenses
Average CM
Average Sales Price

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 = Fixed expenses
Cm1n1 + Cm2n2 + Cm3n3
n1 + n2 + n3
P1n1 + P2n2 + P3n3
n1 + n2 + n3

BEP (in birrs) = Fixed expenses …………….. equation (2)

Cm1n1 + Cm2n2 + Cm3n3
p1n1 + p2 n2 + p3n3
Here in equation (2), the denominator represents the contribution margin ratio.
Example (8) Addis Marine Products Inc. plans to manufacture and sell accessories for recreational fishing
craft and pleasure boats. Three of the principal product lines are manufactured at the Awassa plant.
Operating data for the coming year is estimated as follows:
Product Lines
Ethio-01 Ethio-02 Ethio-03
Sales price Br.150 Br.80 Br.40
Variable costs 100 60 10
Units sales 3, 200 units 1, 600 units 4, 800 units
The total annual fixed cost on the three-product lines amount to Br. 840,000
Required:
A. Assuming the above sales mix, determine the BEP (break-even point) for Addis Company during the
coming year. Also determine the number of units of each product that should be sold to break even in
units and in birrs.
B. What volume of sales in birrs for each product must Addis Marine Products Inc. achieve to earn a net
income of Br. 73,500 after taxes in the coming year? Assume the company is subject to a 30% income
tax rate.
C. Calculate the total sales volume in units and in birrs for each product so that Addis Company achieves
8.4% return on sales.
D. Suggest any other alternative sales mix that can lower the Company’s BEP in units holding the unit
selling price, the unit variable cost and the total annual fixed costs constant.
Exercise1. Topper Sports, Inc., produces high-quality sports equipment. The company’s Racket
Division Manufactures three tennis rackets: - the Standard, the Deluxe, and the Pro- that are widely
used in amateur play. Selected information on the rackets are given below:
Standard Deluxe Pro
Selling price per racket Br. 40.00 Br. 60.00 Br. 75.00
Variable expenses per racket:
Production 22.00 27.00 40
Selling (5% of selling price) 2.00 3.00 4

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All sales are made through the company’s own retail outlets. The Racket Division has the following
fixed costs: Per Month
Fixed production costs………………………….Br. 120, 000
Advertising expenses…………………………… 100, 000
Administrative salaries…………………………. 50, 000
Total Br.270, 000
Sales, in units, for the month of May have been as follows:
Standard Deluxe Pro Total
Sales in units………… 2, 000 1, 000 5, 000 8, 000
Required:
A. Compute weighted- average unit contribution margin, assuming above sales mix is maintained.
B. Compute the Racket Division’s break-even point in birrs for May.
C. How many units of each product should the company sale in order to earn a Br.162, 000
income? Ignore income taxes.

UNDERLYING ASSUMPTIONS IN CVP ANALYSIS

For any CVP analysis to be valid, the following important assumptions must be reasonably satisfied
within the relevant range.
1. Costs are linear (straight-line) through the entire relevant range, and they can be accurately divided
into two variable and fixed elements. This implies the following more specific assumptions.
B. Total fixed expenses remain constant as activity changes, and the unit variable expense
remains unchanged as activity varies.
C. The efficiency and productivity of the production process and workers remain constant.
2. The behavior of total revenue is linear (straight-line). This implies that the price of the product or
service will not change as sales volume varies within the relevant range.
3. In multiproduct companies, the sales mix remains constant over the relevant range.
4. In manufacturing firms, inventories do not change, i.e., the inventory levels at the beginning and
end of the period are the same. This implies that the number units produced during the period
equals the number of units sold.
5. The value of a birr received today is the same as the value of a birr received in any future year.

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